UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 

 

FORM 10-K

 

 

 

Commission File No. 0-22187

RENAISSANCE LEARNING, INC.

(Exact name of Registrant as specified in its charter)

 

 

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

 

Securities registered pursuant to Section 12(b) of the Act:

 

 

Securities registered pursuant to Section 12(g) of the Act: None

 

Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o     No þ

 

Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes o     No þ

 

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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  þ

 

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

Large accelerated filer o     Accelerated filer þ     Non-accelerated filer o

 

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

 

The aggregate market value of the voting stock held by non-affiliates of the Registrant was approximately $110,106,000 as of June 30, 2006. As of February 20, 2007, there were 29,020,902 of the Registrant’s shares of common stock outstanding.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Part III is incorporated by reference from the Proxy Statement for the Registrant’s Annual Meeting of Shareholders to be held on April 18, 2007.

 

 

INDEX

 

 

Renaissance Learning, Inc. is a leading provider of technology for personalizing reading, math and writing practice for pre-kindergarten through senior high (“pre-K-12”) schools and districts. Our products accelerate learning and improve test scores by facilitating increased student practice of essential skills, increasing the quality, quantity, and timeliness of performance data available to educators, helping educators motivate students and providing student access to low cost computing solutions.

 

Our products are primarily focused on three key pre-K-12 curriculum areas: reading, mathematics and writing. Accelerated Reader*, STAR Reading, STAR Early Literacy and Read Now Power Up! comprise our reading products. Our math products include Accelerated Math, STAR Math and Math Facts in a Flash. The AlphaSmart laptops and related software are our primary writing and keyboarding products. We also address language acquisition for English language learners with our English in a Flash software. In addition, we sell our 2Know! response system, which encourages classroom participation and provides instantaneous feedback to instructors in any educational setting. We sell a patented optical-mark card scanner, which is primarily used with Accelerated Math to automate scoring and recordkeeping tasks. Lastly, our other product offerings include supplemental resources for educators and classroom use such as handbooks, workbooks, learning cards and motivational items.

 

Our flagship product, Accelerated Reader, is software that provides information for motivating and monitoring increased literature-based reading practice and support for instruction. We believe that Accelerated Reader and our other products have achieved their significant market positions as a result of demonstrated effectiveness in assisting educators accelerate learning and improve test scores by — facilitating increased student practice of essential skills, increasing the quality, quantity, and timeliness of performance data available to educators, helping educators motivate students and providing student access to low cost computing solutions. Our products help educators manage student practice of curriculum, provide targeted instruction, keep students engaged and measure student progress in order to accelerate student learning.

 

Our educational software products are available on two separate platforms, the traditional desktop versions that run on local area networks of individual schools and our web-based Renaissance Place software platform. The Renaissance Place platform meets the needs of district-wide installations such as scalability, remote access, centralized database and server for multiple campus use, sophisticated statistical analysis, ease of administration and district support, and integration with student data from other district systems. Renaissance Place products are sold primarily on a subscription basis for terms of one year. Our popular Accelerated Reader Enterprise and Accelerated Math Enterprise packages are turn-key solutions consisting of the Renaissance Place platform with enhanced features, unlimited access to reading quizzes and math content, remote software hosting, professional development and technical consulting services.

 

Our desktop products are relatively simple to set up and maintain for an individual school, are designed to require only modest technology resources and are competitively priced, often at or below the discretionary spending level of most school principals. Our traditional desktop products are typically sold as school-wide perpetual software licenses with optional annual support plans.

 

 

*  AR, AccelScan, Accelerated Math, Accelerated Reader, Accelerated Vocabulary, AlphaSmart, Dana, English in a Flash, MathFacts in a Flash, Neo, Read Now, Renaissance, Renaissance Learning, Renaissance Place, STAR Early Literacy, STAR Reading, STAR Math and 2Know! are trademarks of Renaissance Learning, Inc. registered^®, common law or pending registration in the United States and other countries. Other trademarks are the property of their respective owners.

     Power Up! and Steck-Vaughn are trademarks of Harcourt Achieve, Inc., registered in the United States of America and/or other jurisdictions.

 

We offer a full line of professional service and support solutions that integrate with, complement, and enhance the effectiveness of, our products. Sold separately or bundled with our products to provide a complete solution, our service offerings include training workshops and seminars, report and data analysis, program evaluation, guided implementation, distance training, software support, software installation, database conversion and integration services, and application hosting.

 

Renaissance Learning, Inc. was founded in 1986 and is incorporated under the laws of the State of Wisconsin. Our common stock trades on The NASDAQ Global Select Market^® under the symbol “RLRN.” Our principal executive offices are located at 2911 Peach Street, P.O. Box 8036, Wisconsin Rapids, Wisconsin 54495-8036 (telephone: (715) 424-3636). You may obtain, free of charge, copies of this Annual Report on Form 10-K as well as our Quarterly Reports on Form 10-Q and our Current Reports on Form 8-K (and amendments to those reports) filed with, or furnished to, the Securities Exchange Commission (the “SEC”) as soon as reasonably practicable after we have filed, or furnished, such reports by accessing our website at http://www.renlearn.com, clicking on “About Us” and scrolling down to the “SEC Filings” link. You may read and copy any materials filed by us with the SEC at the SEC’s Public Reference Room located at 100 F Street, NE, Washington, DC 20549. You may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. Information contained on our website is not part of this Annual Report on Form 10-K.

 

Accelerated Reader is software for motivating and monitoring increased literature-based reading practice and for providing educators with student progress information to support and target instruction. A student selects a book at an appropriate reading level from a list of books for which the school has an Accelerated Reader quiz, reads the book, and then takes a multiple-choice quiz on a computer. For each book read, Accelerated Reader tracks the amount of reading practice achieved by calculating points based on the length and difficulty of the book and the student’s performance on the quiz. The information generated from this process — titles read, percent of comprehension and amount of reading completed — creates a database of student reading achievement from which reports are generated that help educators monitor the amount and quality of reading practice for each individual student and thereby effectively target their instruction of comprehension, vocabulary and fluency. We currently have computerized book quizzes for Accelerated Reader on over 110,000 titles. Accelerated Reader supports recorded-voice versions of quizzes on literature books for emergent readers, quizzes for assessing reading instruction assignments from reading textbooks, Literacy Skills quizzes which allow educators to assess students’ proficiency on specific skills found in state and district language arts standards, and includes built-in Spanish-English capabilities.

 

STAR Reading is an easy to use, computer-adaptive formative reading assessment system that determines a student’s reading level, statistically correlated to national norms, in ten minutes or less. STAR Reading adapts itself during testing by utilizing proprietary branching logic that evaluates the pattern of the student’s answers to determine the level of difficulty required for subsequent questions. Tests can be administered several times a year and the results provide educators with a database of statistically accurate reading level information on their students, grades 1-12, from which they can generate useful diagnostic reports and adjust instructional strategies accordingly.

 

STAR Early Literacy software provides educators with a fast, accurate and easy solution to assess the phonemic awareness, phonic and other readiness and literacy skills of students in grades pre-K-3. The software helps educators identify each student’s specific strengths and to diagnose specific weaknesses in skills covered by all early literacy curricula and standards. STAR Early Literacy allows for the assessment process to be quickly and easily repeated several times throughout a school year at a lower cost and on a timelier basis than conventional assessments.

 

Read Now Power Up! is a comprehensive reading intervention curriculum solution that combines the instructional materials of Steck-Vaughn with the technology of Renaissance Learning to help educators assist students identified as struggling readers. Read Now Power Up! employs a comprehensive instruction model, multimedia instructional materials, a software e-learning package hosted on a dedicated interactive website, and professional development services to support educators with implementation. These components work together to help educators direct students to material appropriate to their reading ability, provide the extensive practice crucial

to improving reading skills, and develop the range of skills necessary to read successfully, from phonemic awareness through fluency and comprehension. Read Now Power Up! is sold as a subscription package consisting of a one-time purchase price and an annual subscription fee.

 

Accelerated Math software helps educators personalize math instruction and manage the extensive curriculum practice students need to develop math skills, master state standards and to ensure math success for students of all abilities -average, gifted and remedial — from grade one through calculus. Accelerated Math software generates personalized assignments targeted to each individual student’s level and scores them automatically using our AccelScan optical mark reader. Accelerated Math offers state standards-aligned libraries, textbook-aligned libraries for popular math textbooks and extended response libraries that integrate the application of multiple math objectives.

 

AccelScan, primarily used with Accelerated Math, is our innovative, patented optical mark card reader. The reader has intelligent mark recognition capability, which results in more accurate recognition of student marks by distinguishing many degrees of darkness from a variety of marking instruments and ignoring lighter erasures. AccelScan automates scoring of assignments and updating of student records, providing educators with immediate information on student progress without manual scoring.

 

STAR Math is a computer-adaptive formative math assessment test and database that provides the same benefits as STAR Reading. STAR Math reports provide objective information to help educators instantly place their students, monitor progress, and match instruction to individual student levels. Quick, accurate, and easy to administer, STAR Math provides math scores for first grade through high school in approximately 15 minutes, provides comparisons to national norms, forecasts results on major high-stakes tests, and can be administered several times throughout the school year to track math development.

 

MathFacts in a Flash software helps educators motivate students to master computational fluency. It gives students at all skill levels valuable practice on their addition, subtraction, multiplication, and division facts as well as on mental math skills such as squares and fraction/decimal conversion. Timed tests administered by the system accurately measure students’ practice and mastery, while detailed reports give educators timely, reliable feedback on the progress of individual students or entire classrooms.

 

English in a Flash software utilizes a research-based approach to helping educators accelerate the language acquisition of English Language Learners (ELLs) and English as a Second Language (ESL) students. This approach is based on a systematic method of learning language without reliance upon translation, grammatical instruction, or multimedia distractions, which is significantly faster than traditional methods of language acquisition.

 

AlphaSmart Laptops are rugged, portable, easy-to-use, low total-cost-of-ownership computing devices that can operate independently or complement existing computers. Models offered include the Neo and Dana.  AlphaSmart laptops are particularly well suited to facilitating writing practice in a classroom setting. In addition, AlphaSmart laptops run a variety of curriculum-specific software focused on skills improvement and real-time formative assessment in writing, language arts, mathematics, science, keyboarding, social studies, technology literacy and special needs. Lastly, the devices also perform word-processing, function as a calculator, are expandable and feature advanced wireless capabilities, increasing student access to affordable portable computing.

 

2Know! response system is an interactive system that allows educators to easily encourage student classroom participation and obtain instantaneous feedback that can be used to quickly assess student comprehension and performance. The system employs state-of-the-art radio frequency technology allowing wireless communication between students’ handheld devices and Renaissance Learning software. Educators can use the system for quizzes, tests, surveys and exercises while encouraging increased classroom participation and saving time though automatic real-time scoring.

 

Educator Resource Products. We also produce videotapes, handbooks, lesson books, math learning cards, workbooks and motivational items for use by educators in conjunction with our software and training programs. Further, we conduct research on best practices, perform field validation of techniques, publish internally generated as well as third-party research and gather information to guide the development of new and improved products.

 

We offer a full line of professional services to our customers. Our services include support plans for our software solutions, technical services and multiple professional development options.

 

Support Plans. We offer extended service and support plans that provide users of our products access to telephone support. Support plans are packaged with software kits and also sold separately and typically cover a period of 12 months.

 

Technical Services. We provide our customers with a variety of services to help with the implementation and support of their Renaissance programs. These include system setup, software installation, troubleshooting, technical training, data conversion, interface programming and custom report writing. In addition, we offer web hosting for Renaissance Place applications as well as educational technology assessment service to assist schools and districts with assessing their specific system needs.

 

Training and Professional Development Services. Our professional development sessions instruct educators in proven best practices to enhance their curriculum and instruction, and to most effectively use our products and the information they generate. Our content has been organized into beginning, advanced and special topics that can be delivered over time allowing educators to integrate best practices into the classroom and assimilate information as they need it. We offer several delivery options to meet specific customer needs and constraints including: (i) online self-study, (ii) online webinars conducted by a Renaissance implementation specialist using the web and a telephone, (iii) full-day professional development seminars, (iv) consulting provided on an onsite or remote basis, (v) guided implementation in which the educator is paired with one of our specialists for implementation support over an entire school year and (vi) large venues like our regional symposiums and national conference.

 

Our training and professional development services can be accessed through Renaissance Online University which is the gateway to all of our professional development services. Customers can access online self-study content or webinars as well as register for regional symposiums. The site also tracks each person’s courses, online certificates, continuing education (CEU) credits and maintains a transcript of completed professional development.

 

We believe that continued substantial investment in product development is required to remain competitive and grow in the educational marketplace. We invest continuously in the development of new products and services, enhancement of existing products and services, development of new content for existing products, development of tools to increase the efficiency of product development, and scientific research which generates concepts for new products and services, validates the efficacy of our existing products and services and provides useful feedback for improvement of new and existing products and services. For the years ended December 31, 2006, 2005, and 2004, our development expenditures were $17.3 million, $17.0 million and $14.5 million, respectively (excluding capitalized amounts of $689,000, $279,000 and $563,000, respectively).

 

We conduct research on our products and services in order to accumulate information against which to develop new, and refine existing, products and services. We conduct rigorous scientific research on the effectiveness of our products and services in accelerating learning as well as patterns of usage of our products in actual classroom settings. Data acquired and understanding gained from this process is used as an integral part of our product development process.

 

We market our educational products and services to teachers, school librarians, principals, entire schools, and school district personnel, as well as internationally through our UK sales office and distributors. We experience seasonal variations in our sales due to the budget and school-year cycles of our customers. Additionally, our service revenues tend to be more seasonal than product revenues due to customer preferences as to when services are delivered and due to the timing of our larger conferences.

 

Our sales and marketing strategy consists of direct marketing to potential and existing customers and relationship selling through our telesales representatives and our geographically dispersed field sales representatives. We use a variety of lead-generating techniques, including trade shows, advertisements in educational publications, direct mail, websites and referrals.

 

We have resale arrangements with various book dealers and book publishers that sell our software products to their customers. These firms are particularly receptive to such alliances because the use of our products in schools encourages increased purchases of the books and other products that they sell. Some of our hardware products are also distributed by various third-party resellers. We do not offer price protection or stock balancing rights to our resellers.

 

Part of our distribution strategy is to develop cross-marketing arrangements with third-party firms, which sell non-competing products into the education market. We have formed strategic alliances with book distributors, publishers, and other organizations in the pre-K-12 market to develop additional new product opportunities and to enhance the channels available to sell and distribute our products. These alliances take several forms. For example, we offer Accelerated Reader quizzes and Accelerated Math software libraries aligned to popular textbook series and other curriculum materials. Our Read Now Power Up! product is the result of a combined development effort and cross-marketing arrangement with a major textbook publisher. We also have other arrangements in which we have aligned our products to work with and/or complement other educational materials.

 

A growing number of customers purchase our software on a hosted basis and therefore access our products directly from our server through the internet. Our software products are also distributed on CD-ROM. Bulk CD-ROMs are produced by third-party contractors. We produce order-specific and smaller batches of CD-ROMs at our distribution facility. Accelerated Reader quizzes and Accelerated Math libraries can be purchased and downloaded from our website. Additionally, our users can download selected patches and software updates from our website.

 

Our AlphaSmart laptop computing devices, the 2Know! response system and our AccelScan scanners are produced to our specifications by third-party contract manufacturers. Other related products, including videotapes, books, graphics, and motivational items, are produced by third-party vendors.

 

The educational technology and professional development markets in which we operate are very competitive and fragmented. We compete with many other companies offering educational software products, computing devices, interactive response systems, and professional development and technology consulting services to schools. Education continues to emerge as a major global industry and potential competitors, including large hardware manufacturers, software developers, educational publishers, and consulting firms, may enter or increase their focus on the schools market, resulting in greater competition for us. In addition, we compete against other more traditional methods of education, training and testing, including pencil and paper testing.

 

As we enter into new markets, existing competitors could increase the barriers to entering these markets by driving prices lower or making modifications to enhance their products. Success in selling our established products and services may cause competitors to focus on us in their marketing efforts thereby increasing direct competition. There can be no assurance that we will continue to be able to market our products and services successfully or compete effectively in the educational marketplace.

 

We regard certain of our technologies as proprietary and rely primarily on a combination of patent, copyright, trademark, and trade secret laws as well as employee non-disclosure agreements to establish and protect our intellectual property rights. We also employ serialization techniques to prevent unauthorized installation of our software products and related content. There can be no assurance that the steps taken by us to protect our rights will adequately prevent and deter misappropriation. In addition, while we do not believe that our products, trademarks or

other proprietary rights infringe upon the proprietary rights of third parties, there can be no assurance that a third party will not make a contrary assertion. The cost of responding to such assertions can be material, regardless of whether an assertion is validated. The software publishing industry has traditionally experienced widespread unauthorized reproduction of products in violation of intellectual property rights. Such activity is difficult to detect and legal proceedings to enforce intellectual property rights are often burdensome and involve a high degree of uncertainty and costs. There can be no assurance that our software products will not experience unauthorized reproduction, which would have a material adverse effect on our business, financial condition and results of operations.

 

As of February 1, 2007, we had 1,059 full-time and part-time employees. We believe our relations with employees are good. None of our employees is represented by a union or subject to collective bargaining agreements.

 

As of December 31, 2006 and 2005, we had backlogs that aggregated approximately $26.2 million and $20.4 million, respectively. These backlogs are primarily composed of the deferred revenue related to software subscriptions, software support agreements, technology consulting and professional development. Substantially all of the 2006 backlog is expected to be realized during 2007.

 

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 following information contains or may contain forward-looking statements: (1) information included or incorporated by reference in this Annual Report on Form 10-K, including, without limitation, statements made under “Item 1-Business” and “Item 7-Management’s Discussion and Analysis of Financial Condition and Results of Operations,” including, without limitation, statements with respect to growth plans, projected sales, revenues, earnings and costs, and product development schedules and plans, (2) information included or incorporated by reference in our future filings with the SEC including, without limitation, statements with respect to growth plans, projected sales, revenues, earnings and costs, and product development schedules and plans and (3) information contained in written material, releases and oral statements issued by us, or on our behalf, including, without limitation, statements with respect to growth plans, projected sales, revenues, earnings and costs, and product development schedules and plans. Our actual results may differ materially from those contained in the forward-looking statements identified above. Factors which may cause such a difference to occur include, but are not limited to, the factors listed in “Item 1A-Risk Factors.”

 

Reliance on Single Product Line. Our Accelerated Reader software and supplemental Accelerated Reader quizzes accounted for approximately 37%, 37%, and 40% of our net sales in 2006, 2005, and 2004, respectively. An overall decline in sales of Accelerated Reader and supplemental quizzes would have a material adverse effect on our business, financial condition, and results of operations.

 

Geographic Concentration of Sales. A substantial portion of our sales is concentrated in several states, including California, Texas, Florida, Georgia and Illinois, which accounted for approximately 13%, 13%, 5%, 4% and 4%, respectively, of our net sales in 2006. If large numbers of schools or a district or districts controlling a large number of schools in such states were to discontinue purchasing our products and services, our business, financial condition, and results of operations would be materially adversely affected.

 

Dependence on Educational Institutions and Government Funding. Substantially all of our revenue is derived from sales to educational institutions, individual educators, and their other suppliers. There can be no assurance that

educational institutions and/or individual educators will continue to invest in technology-based products and professional development for reading and other curricula or continue to respond favorably to our marketing. Our inability to increase the number of products sold or number of schools served would adversely affect our business, financial condition, and results of operations. Because of our dependence on educational institutions, the funding of which is largely dependent on government support, a substantial decrease in government budgets or funding for educational software or technology would have a material adverse effect on our business, financial condition, and results of operations. Any economic slow downs, which negatively affect school funding, adversely impact the sale of our products and services to schools. In addition, certain aspects of government sponsored education initiatives may not endorse, or be complementary to, the principles and methodologies underlying and associated with our products and services, which could adversely affect our business, financial condition, and results of operations.

 

Dependence on Continued Product Development. The educational technology and services markets in which we compete are characterized by evolving industry standards, frequent product introductions and sudden technological change. Our future success depends, to a significant extent, on a number of factors, including our ability to enhance our existing products, develop and successfully introduce new products in a timely fashion, and respond quickly and cost effectively to technological change, including: shifts in operating systems, hardware platforms, programming languages, alternative delivery systems, the internet and other uncertainties. There can be no assurance that new products will be as well received as our established products, particularly since they may require technology and/or resources not generally available in all schools. We attempt to maintain high standards for the demonstrated academic effectiveness of our products. Our adherence to these standards could delay or inhibit the introduction of new products. Moreover, there can be no assurance that our products will not be rendered obsolete or that we will have sufficient resources to make the necessary investments or be able to develop and market the products required to maintain our competitive position.

 

Acquisitions. In order to strengthen our business, we continually evaluate strategic opportunities, including acquisitions. Acquisitions involve a number of difficulties and risks, including, among others: the failure to integrate personnel, technology, research and development, marketing and sales operations of the acquired company; the diversion of management time and resources and the resulting disruption to our ongoing business; the potential loss of the acquired company’s customers, as well as our own; and unanticipated costs and liabilities. If we fail to integrate an acquired company or business successfully, our business, financial condition, and results of operations could be adversely affected, including the potential need to record a non-cash charge for the impairment of goodwill and other intangibles. Any integration process will require significant time and resources, and we may not be able to manage the process successfully. If customers of the acquired company, or our customers, are uncertain about our ability to operate on a combined basis with the acquired company, they could delay or cancel orders for products and services. Moreover, we may not successfully evaluate or utilize the acquired technology or accurately forecast the financial impact of an acquisition transaction.

 

Reliance on statistical studies to demonstrate effectiveness of our products and services. We rely on statistical studies to demonstrate that our products and related services improve student achievement. We believe that these studies accurately reflect the performance of our products. These studies, however, involve the following risks: (i) the sample sizes used in our studies may yield results that are not representative of the general population of students who use our products; (ii) the methods used to gather the information upon which these studies are based depend on cooperation from students and other participants, and inaccurate or incomplete responses could distort results; (iii) schools studying the effectiveness of our products may apply different methodologies and data collection techniques, making results difficult to aggregate and compare; (iv) we facilitate the collection and analysis of data for some of these studies; and (v) we hire researchers to aggregate and present the results of some of these studies and, in some cases, to conduct the studies.

 

There is growing demand from the No Child Left Behind Act and other sources for research and studies to demonstrate the effectiveness of educational programs and products. Our selling and marketing efforts, as well as our reputation, could be adversely impacted if the public, including our existing and potential customers, is not convinced that the product effectiveness is proven by the studies.

 

Limited Protection of Intellectual Property and Proprietary Rights. We regard certain of our technologies as proprietary and rely primarily on a combination of patent, copyright, trademark and trade secret laws and employee

non-disclosure agreements to establish and protect our intellectual property rights. We also employ serialization techniques to prevent unauthorized installation of our software products and related content. There can be no assurance that the steps taken by us to protect our rights will be adequate to prevent or deter misappropriation. In addition, while we do not believe that our products, trademarks or other proprietary rights infringe upon the proprietary rights of third parties, there can be no assurance that a third party will not make a contrary assertion. The cost of responding to such assertions can be material, regardless of whether an assertion is validated. The software publishing industry has traditionally experienced widespread unauthorized reproduction of products in violation of intellectual property rights. Such activity is difficult to detect and legal proceedings to enforce intellectual property rights are often burdensome and involve a high degree of uncertainty and costs. There can be no assurance that our software products will not experience unauthorized reproduction, which would have a material adverse effect on our business, financial condition, and results of operations.

 

Selling and Marketing Strategy and Product Acceptance. Our business strategy includes the introduction of new products and services directed at new markets as well as the development of new sales and distribution channels. There can be no assurance that we will be successful in offering new products and services, entering new markets and developing new sales and distribution channels or that any such products or services, if introduced, will achieve acceptance in the marketplace.

 

Risks of International Expansion. A component of our growth strategy is the expansion of our operations in international markets. Doing business in international markets is subject to a number of risks, including, among others: acceptance by foreign educational systems of our approach to educational products; lack of existing customer base; unexpected changes in regulatory requirements; potentially adverse tax consequences; tariffs and other trade barriers; difficulties in staffing and managing foreign operations; changing economic conditions; exposure to different legal standards (particularly with respect to intellectual property); burdens of complying with a variety of foreign laws; and fluctuations in currency exchange rates. If any of these risks were to materialize, our business, financial condition, and results of operations could be adversely affected.

 

Educational Philosophies. Our products support all teaching methods and curricula by focusing on continuous feedback, increased student practice of essential skills, and demonstrated product effectiveness through measurable results. Certain educators, academics, politicians, and theorists, however, declaim strong philosophies of instruction that can lead them to oppose educational products or services that fall outside a very narrow definition. These philosophies can include, but are not limited to, opposition to standardized testing or over-reliance on the same; opposition to computers or motivational techniques; exclusive focus on particular types of direct instruction; and highly technical definitions of acceptable research. Some of these philosophical stances have the capacity to negatively influence the market for our products and services, and such influence could have a material adverse impact on demand for our products and services and thus on our business, financial condition, and results of operations.

 

Highly Competitive Industry. The educational technology and professional development markets in which we operate are very competitive and fragmented. We compete with other companies offering educational software products, computing devices, interactive response systems, professional development, and technology consulting services to schools. Education continues to emerge as a major global industry and potential competitors, including large hardware manufacturers, software developers, educational publishers, and consulting firms, may enter or increase their focus on the schools market, resulting in greater competition for us. In addition, we compete against more traditional methods of education, training and testing, including pencil and paper testing.

 

As we enter into new markets, existing competitors could increase the barriers to entering this market by driving prices lower or making modifications to enhance their products. Success in selling our established products and services may cause competitors to focus on us in their marketing efforts thereby increasing direct competition. There can be no assurance that we will continue to be able to market our products successfully or compete effectively in the educational marketplace.

 

Dependence on Key Personnel. Our success depends to a significant extent upon the continued active participation of certain key members of management. We do not have employment agreements with these individuals and have no current intention of entering into any such employment agreements. The loss of the services of key personnel could have a material adverse effect on our business, financial condition, and results of operations.

 

Ability to Attract and Retain Qualified Personnel. Our future success will depend, in part, upon our continuing ability to retain the employees, including senior management personnel, who have assisted in the development and marketing of our products and to attract and retain qualified additional employees trained in computer technology, sales, marketing, finance, and other disciplines to enhance our product offerings and broaden our operations. There can be no assurance that we will continue to be able to attract and retain such personnel. The failure to attract or retain the necessary personnel would have a material adverse effect on our business, financial condition, and results of operations.

 

Fluctuations in Quarterly Performance. We generally ship products as orders are received, and therefore, we have historically operated without a significant backlog of products. The quantity of product orders in any quarter can be affected by a variety of factors, including:

 

 

In addition, our quarterly results can also be affected by:

 

 

Our overall gross margins also fluctuate based upon the mix of software, hardware and service sales. We realize higher margins on our software product sales than our hardware and service sales. Some of our revenues tend to be seasonal due to customer preferences as to when products and services are delivered and due to the timing of our larger conferences, resulting in seasonal variations in margins.

 

Management of Growth. We have experienced periods of rapid growth in the past and anticipate continued growth in the future. Our ability to manage our growth effectively will require us to attract, train, motivate, manage, and retain key employees and to improve our operational, financial, and management information systems. If we are unable to maintain and manage growth effectively, our business, financial condition and results of operations could be adversely affected.

 

Share Price Volatility. Numerous factors, many of which are beyond our control, may cause the market price of our common stock to fluctuate significantly. These factors include announcements of technological innovations and/or new products by us and our competitors, earnings releases and earnings warnings by us and our competitors, expectations regarding government funding levels for education, market conditions in the industry, announcements by us of significant acquisitions and/or divestitures, and the general state of the securities markets. The market price of our common stock may decline significantly if we fail to meet the published earnings estimates of analysts and others. In addition, quarterly fluctuations of our results of operations as described above may cause a significant variation in the market price of our common stock.

 

War, Acts of War and Terrorism. Delays and reductions in purchases of our products and services may occur as a result of war, acts of war and terrorism, and the related impacts, including: a reduction of funds available to our customers to purchase our products and services and disruptions in our ability to develop, produce and distribute products and services to our customers. These events would have a material adverse effect on our business, financial condition and results of operations.

 

Concentration of Share Ownership; Control by Principal Shareholders/Management. As of February 20, 2007, our principal shareholders, Judith Paul and Terrance Paul, our chairman and chief executive officer,

respectively, and co-founders of the company, beneficially owned approximately 70% of our outstanding common stock. As a result, these principal shareholders have the ability to control and direct our business and affairs.

 

Shares Eligible for Future Sale. Sales of a substantial number of shares of our common stock in the public market could adversely affect the market price of the common stock. As of February 20, 2007, approximately 20.3 million shares of our common stock were held by “affiliates” and may be publicly sold only if registered under the Securities Act of 1933 or sold in accordance with an applicable exemption from registration, such as Rule 144. In addition, we have filed registration statements under the Securities Act of 1933 to register an aggregate of 6,000,000 shares of common stock reserved for issuance under our 1997 Stock Incentive Plan and an aggregate of 500,000 shares of common stock reserved for issuance under our Employee Stock Purchase Plan (“ESPP”), which will, when issued in accordance with such plans, be eligible for immediate sale in the public market, subject to the Rule 144 resale limitations for affiliates. We did not offer the ESPP to our employees in 2004, 2005 or 2006 and have no intention of offering it in 2007.

 

Cash Dividends. We declared quarterly cash dividends of $.05 per share for each of the four quarters of 2006. Our dividend policy may be affected by, among other things, our views on potential future capital requirements, including those related to research and development, creation and expansion of sales distribution channels, acquisitions, legal risks, and stock repurchases. Our dividend policy may change from time to time, and we cannot provide assurance that we will continue to declare dividends at all or in any particular amounts. A change in our dividend policy could have a negative effect on the market price of our common stock.

 

Possible Antitakeover Effects of Certain Articles and By-Laws Provisions and Provisions of Wisconsin Law. Our Amended and Restated Articles of Incorporation and Amended and Restated By-Laws, along with Wisconsin statutory law, contain provisions that could discourage potential acquisition proposals and might delay or prevent a change in control of the company. Such provisions could result in our being less attractive to a potential acquirer and could result in the shareholders receiving less for their common stock than otherwise might be available in the event of a takeover attempt.

 

Divestitures. From time to time, we may, for any number of reasons, determine it is in our best interests and in the interests of our shareholders to dispose of a business or product line. Divestitures involve a number of difficulties and risks, including, among others, the diversion of management time and resources and the resulting disruption to our ongoing business, and unanticipated costs and liabilities. If we are unable to manage the divestiture process successfully or if we are incorrect in our assumptions regarding the costs associated with a disposition, our business, financial condition and results of operations could be adversely affected.

 

 

During 2006, we did not receive any written comments from the SEC regarding our periodic or current reports under the Exchange Act.

 

 

Our corporate headquarters is located in Wisconsin Rapids, Wisconsin, in a 125,000 square foot facility owned by us which was constructed in 1996. We also own a 34,000 square foot storage facility in Wisconsin Rapids, Wisconsin. Additionally, we lease various other office and warehouse space. We believe our facilities are adequate to support our operations for the foreseeable future.

 

 

We are subject to various claims and proceedings covering a wide range of matters that arise in the ordinary course of our business activities. We believe that any liability that may ultimately arise from the resolution of these matters will not have a material adverse effect on our financial position, results of operations or shareholders’ equity.

 

 

We did not submit any matters to a vote of our security holders during the fourth quarter of the fiscal year ended December 31, 2006.

 

EXECUTIVE OFFICERS OF THE REGISTRANT

 

 

The term of office of each executive officer is from one annual meeting of the board of directors until the next annual meeting of the board of directors or until a successor has been duly elected and qualified or until his or her death or until he or she resigns or has been removed from office.

 

There are no arrangements or understandings between any of our executive officers and any other person (not an officer or director of the company acting as such) pursuant to which any of the executive officers were selected as an officer of the company.

 

Market Information

 

Our common stock is traded under the symbol “RLRN” on The NASDAQ Global Select Market. Information regarding the market prices of our common stock may be found in Note 16 of Notes to Consolidated Financial Statements included in “Item 8 — Financial Statements and Supplementary Data.”

 

Holders

 

As of February 20, 2007, there were 625 record holders of our common stock.

 

Historical Dividends

 

For the year ended December 31, 2003, no dividends or other distributions were paid to shareholders. We declared a special cash dividend of $2.15 per share on January 28, 2004 and also declared quarterly cash dividends of $0.04 per share for each of the four quarters of 2004 and $0.05 for each of the four quarters of 2005 and 2006. We intend to continue to pay quarterly cash dividends, subject to capital availability and a determination that cash dividends continue to be in the best interests of the company and our shareholders.

 

Performance Graph

 

The following graph compares the total shareholder return on our common stock for the five year period from December 31, 2001 through December 31, 2006 with that of the Nasdaq Composite index and a peer group index constructed by us. The companies included in our peer group index are Laureate Education, Inc. (LAUR), Blackboard Inc. (BBBB), Learning Tree International, Inc. (LTRE), The Princeton Review, Inc. (REVU), School Specialty, Inc. (SCHS), Skillsoft Public Company Limited (SKIL) and Plato Learning, Inc. (TUTR).

 

The total return calculations set forth below assume $100 invested on December 31, 2001 with reinvestment of dividends into additional shares of the same class of securities at the frequency with which dividends were paid on such securities through December 31, 2006. The stock performance graph shown in the graph below should not be considered indicative of potential future stock price performance.

 

COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN*
Among Renaissance Learning, Inc., The NASDAQ Composite Index
And A Peer Group

 

 

Recent Sales of Unregistered Securities

 

There were no sales of unregistered securities during the year ended December 31, 2006.

 

Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities

 

On April 17, 2002, our Board of Directors authorized a repurchase program which provides for the repurchase of up to 5,000,000 shares of our common stock. On February 9, 2005, our Board of Directors authorized the repurchase of an additional 3,000,000 shares under the stock repurchase program.

 

No time limit was placed on the duration of the repurchase program, nor is there any dollar limit on the program. Repurchased shares will become treasury shares and may be used for stock-based employee benefit plans 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 December 31, 2006:

 

 

SELECTED HISTORICAL CONSOLIDATED FINANCIAL DATA
(In thousands, except per share amounts)

 

 

 

 

Generation21 was divested during 2005 and, therefore, its results for all periods presented in the consolidated financial statements are reflected as discontinued operations.

 

Overview

 

Renaissance Learning, Inc. is a leading provider of technology for personalizing reading, math, and writing practice for pre-kindergarten through senior high (“pre-K-12”) schools and districts. Our computerized assessment and progress monitoring tools accelerate learning and improve test scores by facilitating increased student practice of essential skills, helping educators motivate students, increasing the quality, quantity, and timeliness of performance data available to educators and providing student access to low cost computing solutions.

 

Our sales are derived primarily from the sale of software products, computerized hardware products and related services. Revenues are recorded net of an allowance for estimated returns. Allowances for bad debts are also recorded at the time of the sale.

 

Product revenue is derived primarily from the sale of educational software and hardware. Revenue from sales of hardware are generally recognized when the product is shipped to the customer. Revenue recognition from sales of our software depends on whether the software is: (i) off-the-shelf or customized and (ii) how it is licensed, i.e., perpetual licence or subscription. We recognize revenue from off-the-shelf perpetually licensed software sales upon shipment to customers. Subscription-based software sales are recognized as revenue on a straight-line basis over the subscription period. Sales of software that require substantial modification or customization are recognized as revenue using the percentage-of-completion method of accounting. Revenues and deferred revenues from software that require substantial modification or customization are not significant in any of the years presented.

 

Service revenue is primarily derived from: (i) training seminars and conferences, (ii) software telephone support agreements, (iii) consulting services, (iv) technical services, (v) hosting and (vi) other remote services. Revenue from training seminars is recognized when the seminar or workshop is performed. Revenue from consulting and technical services is recognized as the services are performed or on a straight-line basis over the contractual period. Telephone support included with sales of perpetual software licenses has a duration of twelve months or less and is recognized at the time the software is shipped with the related costs of providing the telephone support accrued for at the same time. Revenue from other product support agreements is initially recorded as deferred revenue and then recognized as revenue on a straight-line basis over the term of the agreement, typically 12 months. Deferred revenue includes: (i) amounts invoiced for products not yet delivered and services not yet performed, (ii) advance invoicing on contracts and (iii) that portion of product support agreements and subscription-based product sales that has not yet been recognized as revenue.

 

It is our practice to announce new products prior to when the products are ready for shipment to allow customers sufficient lead time for budgeting and curriculum purposes. This practice can result in fluctuations in backlog for orders of new products. These orders are generally filled within a relatively short period of time after the product is ready for shipment. Registrations for training seminars are generally received from customers in advance of training events, resulting in a backlog for these services. Additionally, under district-wide implementations, customers commit to a comprehensive solution consisting of products and services in advance of delivery of the products and services. The delivery of backlogged products and services in certain periods can cause those periods to have higher revenue and higher revenue growth rates than other periods.

 

Cost of sales consists of expenses associated with sales of our software and hardware products and the delivery of services. These costs include: (i) personnel-related costs, (ii) costs of purchased materials such as our AlphaSmart laptops, optical-mark card scanners, interactive response systems, educational products, training materials, manuals and motivational items, (iii) shipping and freight costs, (iv) amortization of capitalized development costs and (v) other overhead costs. We realize higher gross margins on our software product sales than on our hardware and service sales.

 

We expense all development costs associated with a software product until technological feasibility is established, after which time such costs are capitalized until the product is available for general release to customers. Capitalized product development costs are amortized into cost of sales, beginning when the product is available for general release, using the straight-line method over the estimated economic life of the product, which is generally estimated to be 24 months.

 

Acquisition and Divestiture

 

On June 27, 2005, we acquired AlphaSmart, Inc., a provider of affordable, laptop computing solutions for K-12 schools. The results of AlphaSmart’s operations are included in our consolidated financial statements since that date. AlphaSmart products are rugged, portable, easy-to-use, low total-cost-of-ownership computing devices that can operate independently or complement existing computers. Models offered include the Neo and Dana.  AlphaSmart computing devices run curriculum-specific software focused on skills improvement and real-time formative assessment in writing, language arts, mathematics, science, keyboarding, social studies, technology literacy and special needs. In addition, the devices perform word-processing, function as a calculator, are expandable and feature advanced wireless capabilities, increasing student access to affordable portable computing. The acquisition provides opportunities to achieve future long-term synergies related to the complementary nature of AlphaSmart’s hardware products and Renaissance’s software products. AlphaSmart’s products have the potential to run Renaissance’s software, thus enabling students greater access to our software where ready availability of computer access is currently a product-use limitation.

 

In February 2005, we consummated the sale of our Generation21 subsidiary, a non-core part of our business. The results of Generation21, for all periods presented in our consolidated financial statements, are reflected as discontinued operations. Except as indicated, amounts referred to in this Item 7 relate to continuing 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. Revenue can be significantly impacted by the proportion of sales attributable to our subscription-based product and service offerings relative to sales from non-subscription-based offerings, which can result in a portion of a period’s sales being initially deferred and recognized as revenue in future periods over the subscription term. We also believe our results of operations for 2006 were negatively impacted by transition activities and training needs related to a reorganization and expansion of our sales groups.

 

Our Renaissance Place products are designed to meet the needs of entire school districts from a central server. Sales of products and services at a district level are more complex, have a longer sales cycle, and are typically for a larger dollar amount than sales made to individual schools. Thus, revenues from district sales can be more uneven and are more difficult to accurately predict. Consequently, our revenues and results of operations can be significantly impacted by the timing of large district orders.

 

Since our Renaissance Place product and service offerings are typically sold on a subscription basis with a term of twelve months, a greater portion of our revenue is initially deferred and recognized into income over the subscription period. This can cause our revenue to show a greater decline than it would have if these products had been sold as perpetual licenses, for which the revenue is recognized immediately upon shipment. Deferred revenue increased $5.7 million and $1.8 million, over the years ended December 31, 2006 and 2005, respectively. The increase in deferred revenue during 2006 was driven primarily by sales of subscription-based enterprise software packages.

 

Our net income and results of operations was impacted in 2006 by a $1.9 million charge that was comprised of separation expenses, primarily for former executives. Other items that impacted 2005 were: (i) the acquisition of AlphaSmart, (ii) the divestiture of Generation21, (iii) the sale of our Madison, Wisconsin office building and (iv) the tax benefit related to the settlement of certain state and federal tax positions in 2005.

 

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

 

 

Years Ended December 31, 2006 and 2005

 

Net Sales. Our net sales decreased by $4.8 million or 4.1%, to $111.5 million in 2006 from $116.3 million in 2005. Revenues, excluding AlphaSmart laptops in both periods, declined by $12.2 million or 12.0% for the full year. A significant portion of this decline was related to our customers transitioning their purchases to more subscription-based products and services, particularly Accelerated Reader, as compared to last year. Revenues from subscription-based products are initially deferred and then recognized ratably over the subscription period, generally one year, while the majority of revenues from non-subscription-based sales are recognized immediately upon delivery. During 2006, deferred revenue increased by $5.7 million as compared to an increase of $1.8 million in 2005. We believe that revenue excluding the impact of laptops is a useful metric for investors because it provides a basis upon which to compare the performance of our business, as it existed prior to the June 27, 2005 AlphaSmart acquisition, to earlier periods.

 

Product revenue, including AlphaSmart in both periods, decreased by $3.5 million, or 3.8%, to $90.8 million in 2006 from $94.3 million in 2005. The decrease was driven by the transition to more subscription-based sales

discussed above and generally lower order rates which impacted most product lines, which were partially offset by the inclusion of AlphaSmart’s results for the full year in 2006 as compared to a partial year in 2005.

 

Service revenue decreased by $1.2 million, or 5.5%, to $20.8 million in 2006 compared to $22.0 million in 2005. Service revenues were down due to decreased revenue from professional development services, primarily onsite events, which was partially offset by increases in remote services such as consulting and hosting. Revenue from onsite events was impacted in 2006 by reduced pricing as well as our increased emphasis on remote services. For the past several years, including 2006, we have held a national conference in the first quarter. We will not be holding a national conference in 2007, but instead will be hosting two new but smaller regional events in its place during the first quarter of 2007.

 

Cost of Sales. The cost of sales of products increased by $3.5 million, or 27.4%, to $16.4 million in 2006 from $12.9 million in 2005. As a percentage of product sales, the cost of sales of products increased to 18.1% in 2006 from 13.7% in 2005. The product cost of sales percentage increased primarily due to a higher proportion of sales attributable to hardware in 2006 as compared to 2005 as we realize lower gross profit margins on hardware sales than on software sales.

 

The cost of sales of services increased by $1.3 million, or 15.5%, to $10.0 million in 2006 from $8.7 million in 2005. As a percentage of sales of services, the cost of sales of services increased to 48.2% in 2006 from 39.4% in 2005. The higher cost of sales percentage is the result of personnel and infrastructure investments made in 2006, and to reduced pricing of our onsite events.

 

Our overall gross profit margin percentage decreased to 76.3% in 2006 from 81.4% in 2005. This resulted from the higher cost of sales percentages in 2006, from both products and services, as discussed above.

 

Product Development. Product development expense, which excludes amounts capitalized, increased to $17.3 million in 2006 from $17.0 million in 2005. As a percentage of net sales, product development expenses increased to 15.5% in 2006 from 14.7% in 2005. We capitalized product development expenses of $689,000 in 2006 compared to $279,000 in 2005. Product development spending was higher in 2006 due to the inclusion of AlphaSmart for the full year as compared to only a partial year in 2005.

 

Selling and Marketing. Selling and marketing expenses increased by $2.9 million, or 9.3%, to $33.6 million in 2006 compared to $30.8 million in 2005. Selling and marketing expenses increased primarily due to our sales force expansion, partially offset by reduced marketing expenses as we focus on a more targeted direct marketing approach. As a percentage of net sales, selling and marketing expenses were 30.2% in 2006 compared to 26.5% in 2005.

 

General and Administrative. General and administrative expenses increased by $3.3 million, or 25.7%, to $16.3 million in 2006 from $13.0 million in 2005. General and administrative expenses were higher in 2006 primarily due to: (i) a $1.9 million charge related to separation expenses, primarily for former executives, (ii) a $0.6 million increase in share-based compensation and (iii) the inclusion of AlphaSmart for a full year in 2006 as compared to a partial year in 2005. As a percentage of net sales, general and administrative costs increased to 14.6% in 2006 from 11.1% in 2005.

 

Operating Income. Operating income decreased by $16.1 million, or 47.5%, to $17.8 million in 2006 from $33.9 million in 2005. As a percentage of net sales, operating income decreased to 16.0% in 2006 from 29.1% in 2005 due to the combined effect of the factors discussed above.

 

Other income. Other income decreased $2.3 million to $1.2 million in 2006 from $3.5 million in 2005, primarily due to the sale of an office building which generated a $1.8 million pre-tax gain in 2005.

 

Income Tax Expense — Continuing Operations. Income tax expense of $7.0 million, from continuing operations, was recorded in 2006 at an effective income tax rate of 37.0% of pre-tax income, compared to $13.2 million, or 35.3% of pre-tax income for 2005. In 2005, we recognized a tax benefit of approximately $0.8 million related to the favorable resolution of certain state and federal tax positions, which was the primary reason for the 1.7 point lower effective tax rate in 2005.

 

Discontinued Operations. In 2005 we realized a gain of approximately $0.7 million on the sale of Generation21, which includes a one-time tax benefit of $1.3 million. When combined with the operating losses incurred in January and February 2005 for that subsidiary, the net income from discontinued operations totaled approximately $0.6 million in 2005.

 

Years Ended December 31, 2005 and 2004

 

Net Sales. Our net sales increased by $4.6 million or 4.1%, to $116.3 million in 2005 from $111.7 million in 2004. The increase in sales is due to the inclusion of AlphaSmart revenues in the results of operations for 2005 partially offset by declines in other product and service offerings. Product sales increased by $2.8 million, or 3.1%, to $94.3 million in 2005 from $91.5 million in 2004.

 

Service revenue increased by $1.8 million, or 8.6%, to $22.0 million in 2005 compared to $20.2 million in 2004. Our service revenues grew over the prior year primarily driven by improvement in our newer service offerings such as guided implementation and installation services.

 

Cost of Sales. The cost of sales of products increased by $6.7 million, or 109.5%, to $12.9 million in 2005 from $6.2 million in 2004. As a percentage of product sales, the cost of sales of products increased to 13.7% in 2005 from 6.7% in 2004. The increase in the cost of sales percentage was primarily due to the impact in 2005 of the AlphaSmart hardware product sales which generate lower gross margins than our software sales.

 

The cost of sales of services decreased by $0.8 million, or 9.1%, to $8.7 million in 2005 from $9.5 million in 2004. As a percentage of sales of services, the cost of sales of services decreased to 39.4% in 2005 from 47.1% in 2004. The improved service margins are the result of: (i) operating leverage in our newer service offerings for which we were ramping up costs ahead of revenue in 2004 and (ii) a more profitable 2005 National School Renaissance Conference.

 

Our overall gross profit margin percentage decreased to 81.4% in 2005 from 85.9% in 2004 primarily driven by the increased cost of sales percentage on product sales as discussed above.

 

Product Development. Product development expense, which excludes amounts capitalized, increased to $17.0 million in 2005 from $14.5 million in 2004. As a percentage of net sales, product development expenses increased to 14.7% in 2005 from 13.0% in 2004. Product development expenses increased primarily due to the inclusion of AlphaSmart expenses in 2005 and in part to increases in product development expenditures related to new product offerings. We capitalized product development expenses of $279,000 in 2005 compared to $563,000 in 2004.

 

Selling and Marketing. Selling and marketing expenses were relatively unchanged at $30.8 million in 2005 compared to $30.6 million in 2004. We experienced lower selling and marketing expenses in the first half of 2005 than in 2004 due to comparatively lower levels of field sales personnel. This was offset by higher expenses in the second half of 2005 due to the incremental inclusion of AlphaSmart’s selling and marketing expenses in our results. As a percentage of net sales, selling and marketing expenses were 26.5% in 2005 compared to 27.4% in 2004.

 

General and Administrative. General and administrative expenses increased by $1.0 million, or 8.2%, to $13.0 million in 2005 from $12.0 million in 2004. General and administrative expenses increased primarily due to the inclusion of AlphaSmart expenses in 2005. As a percentage of net sales, general and administrative costs increased to 11.1% in 2005 from 10.7% in 2004.

 

Operating Income. Operating income decreased by $5.0 million, or 13.0%, to $33.9 million in 2005 from $38.9 million in 2004. As a percentage of net sales, operating income decreased to 29.1% in 2005 from 34.8% in 2004 primarily due to the combined impact of the increased product development expenses and the lower gross margins related to the increased proportion of revenue from hardware sales which generate lower gross margins than our software sales.

 

Other income. Other income increased $1.9 million to $3.5 million in 2005, from $1.6 million in 2004, primarily due to the sale of our Madison, Wisconsin office building which generated a $1.8 million pre-tax gain in 2005.

 

Income Tax Expense — Continuing Operations. Income tax expense of $13.2 million, from continuing operations, was recorded in 2005 at an effective income tax rate of 35.3% of pre-tax income, compared to $15.0 million, or 37.0% of pre-tax income for 2004. In 2005, we recognized a tax benefit of approximately $0.8 million related to the favorable resolution of certain state and federal tax positions which was the primary reason for the 1.7 point decrease in the effective tax rate.

 

Discontinued Operations. We recorded a gain on the sale of Generation21 of approximately $0.7 million, including a one-time tax benefit of $1.3 million. When combined with the operating losses incurred in January and February 2005 for that subsidiary, the net income from discontinued operations totaled approximately $0.6 million in 2005. The net operating loss from Generation21 in 2004 was approximately $2.9 million.

 

Liquidity and Capital Resources

 

As of December 31, 2006, our cash, cash equivalents and investment securities were $30.1 million, down $4.5 million from the December 31, 2005 total of $34.6 million. During 2006, we generated operating cash flow of $22.3 million and $5.9 million in proceeds from a mortgage note, on our former facility in Madison, Wisconsin, that was prepaid to us in October 2006.

 

At December 31, 2006, we had a $15.0 million unsecured revolving line of credit with a bank which is available until May 31, 2008. The line of credit bears interest at either a floating rate based on the prime rate less 1.0%, or a fixed rate for a period of up to 90 days based on LIBOR plus 1.25%. 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, 2008. The line of credit bears interest based on the prime rate less 1.0%. As of December 31, 2006, the lines of credit had not been used.

 

On April 17, 2002, our Board of Directors authorized the repurchase of up to 5,000,000 shares of our common stock. On February 9, 2005, our Board of Directors authorized the repurchase of an additional 3,000,000 shares under the stock repurchase program. No time limit was placed on the duration of the repurchase program. Repurchased shares will become treasury shares and will be used for stock-based employee benefit plans and for other general corporate purposes. During the period of January 1, 2006 through December 31, 2006, we repurchased 1.4 million shares at a cost of $22.5 million. Since the original authorization in 2002, we have repurchased 7.6 million shares at a cost of $133.3 million under this repurchase program. Depending on our stock valuation, cash availability and other factors, we may repurchase additional shares as a beneficial use of our cash to enhance shareholder value.

 

We declared a special cash dividend of $2.15 per share on January 28, 2004, quarterly cash dividends of $0.04 per share for each of the four quarters of 2004 and quarterly cash dividends of $0.05 for each of the four quarters of 2005 and 2006. We intend to continue to pay quarterly cash dividends, subject to capital availability and a determination that cash dividends continue to be in the best interests of the company and our shareholders.

 

We believe our strong cash position coupled with cash flow from operations will be sufficient to meet both our short-term and long-term working capital requirements.

 

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 limit our exposure to many of the risks of owning commercial property, particularly with regard to international operations. These agreements generally, are 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. For each of the years ended December 31, 2006, 2005 and 2004, we incurred expenses of approximately $2.0 million, $0.9 million, and $1.1 million, respectively, related to these operating leases.

 

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

 

As of December 31, 2006, our approximate contractual obligations for operating leases and purchase obligations (by period due) were as follows:

 

 

Retirement Plan. We have established a Supplemental Executive Retirement Plan (“SERP”) for the provision of retirement benefits to members of our senior management. Under the terms of the plan, participants elect to defer receipt of a portion of their compensation and to hypothetically invest it in certain mutual fund investments. Upon a participant’s retirement (or certain other events), the Company has an obligation to repay the participant’s account balance, which is the net of the deferred compensation, a defined matching company contribution and the hypothetical market gain or loss of each participant’s investment selections. As of December 31, 2006, we have fully funded the $1.6 million aggregate contractual obligation for future payments to SERP participants. The SERP is more fully described in Note 11 of our Notes to Consolidated Financial Statements.

 

Other Obligations. As of December 31, 2006, we did not hold any long-term debt obligations, long-term purchase obligations or material capital lease obligations.

 

Critical Accounting Policies and Estimates

 

The foregoing discussion is based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements 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. The following is a list of our critical accounting policies defined as those policies that we believe are the most important to the portrayal of our financial condition and results of operations and/or require management’s significant judgments and estimates. This is not intended to be a comprehensive list of all of our accounting policies. Our significant accounting policies are more fully described in Note 5 of our Notes to Consolidated Financial Statements.

 

Revenue Recognition. We recognize revenue from our software products in accordance with Statement of Position No. 97-2 “Software Revenue Recognition” issued by the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants. Under this accounting standard, revenue is recognized when the following have occurred: persuasive evidence of an arrangement exists, product delivery and acceptance has occurred or a service has been performed, pricing is fixed and determinable, and collectibility is probable. Revenue is recognized as follows: (i) at the time of shipment to customers for perpetually licensed off-the-shelf software products and related telephone support with a duration of 12 months or less sold with the product, (ii) on the percentage-of-completion basis for software products which require significant customization or modification, (iii) as seminars are performed for training, (iv) straight-line over the term of the support agreement for other software support agreements, (v) as the service is performed or on a straight-line basis over the contractual period for technical and consulting services, and (vi) straight-line over the subscription period for subscription based products. Accordingly, management is required to make judgments as to whether pricing is fixed and determinable, whether collectibility is reasonably assured and what the percentage of completion is as of the financial reporting date.

 

Expenses are recognized and matched against revenues for the reporting period presented in the financial statements. We record accruals for sales returns and doubtful accounts at the time of revenue recognition based upon

historical experience as well as other factors that in our judgment could reasonably be expected to cause sales returns or doubtful accounts to differ from historical experience. Changes in such allowances may be required if future returns or bad debt activity differs from our estimates.

 

Impairment or Disposal of Long-Lived Assets. We evaluate the recoverability of the carrying amount of long-lived assets whenever events or changes in circumstances indicate that the carrying amount of an asset may not be fully recoverable. We evaluate the recoverability of goodwill and other intangible assets with indefinite useful lives annually or more frequently if events or circumstances indicate that an asset may be impaired. Management uses judgment when applying impairment rules to determine when an impairment test is necessary. Examples of factors which could trigger an impairment review include a significant decrease in the market value of an asset, a significant change in the extent or manner in which an asset is used, and significant adverse changes in legal factors or the business climate that impact the value of an asset.

 

Impairment losses are measured as the amount by which the carrying value of an asset exceeds its estimated fair value. Estimating fair value requires that we forecast future cash flows related to the asset subject to review. These forecasts require assumptions about demand for our products and services, future market conditions and technological developments. Other assumptions include determining the discount rate and future growth rates. Changes to these assumptions could result in an impairment charge in future periods.

 

Software Support and Product Warranty Obligations. We record a liability for the estimated cost of software support and hardware warranties at the time of sale. Estimated costs are based upon our historical cost experience of fulfilling these obligations as well as other factors that in our judgment could reasonably be expected to affect those costs, such as trends in the cost of providing telephone support and product return rates. If the actual costs of fulfilling these obligations differ from our estimates, it could result in additional charges to cost of sales in future periods.

 

Software Development Costs. We capitalize certain software development costs incurred after technological feasibility is achieved. Capitalized software development costs are amortized on a product-by-product basis using the straight-line method over the estimated economic life of the products, which is generally estimated to be 24 months. Amortization begins when the products are available for general release to customers. If the actual economic life of our products is shorter than our estimates, it could result in an impairment charge in future periods.

 

Taxes. At the end of each interim reporting period, we estimate the effective income tax rate expected to be applicable for the full fiscal year. The estimated effective income tax rate contemplates the expected jurisdiction where income is earned (e.g., United States compared to non-United States), the estimated amount of certain tax credits, as well as tax planning strategies. If the actual distribution of taxable income by jurisdiction varies from our expectations, if the actual amount of tax credits varies from our estimates, or if the results of tax planning strategies are different from our estimates, adjustments to the effective income tax rate may be required in the period such determination is made.

 

We record a liability for potential tax assessments based on our estimate of the potential exposure. Due to the subjectivity and complex nature of the underlying issues, actual payments or assessments may differ from our estimates and require tax provision adjustments in future periods.

 

Recent Accounting Pronouncement

 

In June 2006, the Financial Accounting Standards Board (FASB) issued Financial Interpretation No. 48 (FIN 48), “Accounting for Uncertainty in Income Taxes.” This interpretation provides specific guidance on how enterprises recognize and measure tax benefits associated with uncertain tax positions. FIN 48 is effective for us on January 1, 2007. We have evaluated FIN 48 and have determined that its adoption will not have a significant impact on our financial statements.

 

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 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 our 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) maximization of 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 (see Note 11 of our Notes to Consolidated Financial Statements). As of December 31, 2006, our investment securities had a market value of approximately $4.1 million and a carrying value of $4.1 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 on 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 currency.

 

To the Board of Directors and Shareholders of

Renaissance Learning, Inc. and Subsidiaries

 

We have audited the accompanying consolidated balance sheets of Renaissance Learning, Inc. and subsidiaries (the “Company”) as of December 31, 2006 and 2005, and the related consolidated statements of income, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2006. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Renaissance Learning, Inc. and subsidiaries as of December 31, 2006 and 2005, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2006, in conformity with accounting principles generally accepted in the United States of America.

 

As described in note 5 to the consolidated financial statements, on January 1, 2006, the Company adopted Statement of Financial Accounting Standard No. 123R, Accounting for Stock Based Compensation.

 

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006, based on the criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 23, 2006 expressed an unqualified opinion on management’s assessment of the effectiveness of the Company’s internal control over financial reporting and an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.

 

 

Milwaukee, Wisconsin

February 23, 2006

RENAISSANCE LEARNING, INC. AND SUBSIDIARIES

 

CONSOLIDATED BALANCE SHEETS

As of December 31, 2006 and 2005

 

 

The accompanying notes to the consolidated financial statements are an integral part of these balance sheets.

RENAISSANCE LEARNING, INC. AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF INCOME

For the Years Ended December 31, 2006, 2005 and 2004

 

 

The accompanying notes to the consolidated financial statements are an integral part of these statements.

RENAISSANCE LEARNING, INC. AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

For the Years Ended December 31, 2006, 2005 and 2004

 

 

 

 

The accompanying notes to the consolidated financial statements are an integral part of these statements.

RENAISSANCE LEARNING, INC. AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

For the Years Ended December 31, 2006, 2005 and 2004