The following discussion analyzes the changes in our results of operations during the three years in the period ended December 31, 2007 and comments on our financial position as of December 31, 2007. This discussion should be read together with the consolidated financial statements and the accompanying notes and other financial information included in this Form 10-K for the year ended December 31, 2007.
Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted (“GAAP”) in the United States of America. As such, some accounting policies have a significant impact on the amounts reported in these financial statements. Preparing financial statements requires management to make estimates and assumptions that affect the reported amount of assets and liabilities, the level of contingent assets and liabilities disclosed at the dates of our financial statements, and the reported amounts of revenue and expenses during the reporting periods. On a periodic basis, we evaluate our estimates, including those related to revenue recognition, goodwill, capitalized software and income taxes. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Our actual results may differ materially from those estimates. We believe the following critical accounting policies include our more significant judgments and estimates used in the preparation of our consolidated financial statements.
We follow specific and detailed guidelines in determining the proper amount of revenue to be recorded. We recognize revenues in accordance with Statement of Position (“SOP”) 97-2 Software Revenue Recognition as amended by SOP 98-9 Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions.
We recognize revenue from software license agreements when the following have been met:
In software arrangements that include more than one element, we allocate the total arrangement fee among the elements based on the vendor-specific objective evidence (“VSOE”) of the relative fair value of each deliverable, using the price charged when that element is sold separately. For software arrangements in which we do not have VSOE for undelivered elements, revenue is deferred until the earlier of when VSOE is determined for the undelivered elements or when all elements for which we do not have VSOE have been delivered.
We also generate revenue by providing professional services which consist of consulting, training and implementation support. The revenue for these services is recognized as the services are performed.
In accordance with SFAS No. 86, Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed, we have capitalized certain computer software development costs upon the establishment of technological feasibility. The majority of our product development costs qualify for capitalization due to the concentration of our development efforts on the content of our software. We stop capitalizing costs when the product is released for sale to our customers, at which time amortization of the capitalized costs begins. We amortize capitalized software development costs on a product-by-product basis at the greater of the ratio that the product’s current gross revenue bears to the its total of current and anticipated future gross revenues or the straight-line method over the estimated economic life of the products, which is generally estimated to be 48 months.
On an annual basis, we review each capitalized project to determine if the unamortized balance exceeds its estimated net realizable value. Estimated net realizable value requires us to use judgment in projecting future revenues. Actual amounts realized could differ materially from those estimated. Future events such as market conditions, customer demand or technological obsolescence could cause us to conclude that the carrying value of the software at a given point in time is impaired, and the amount of the impairment so determined would be required to be written off against the carrying value of the asset and charged as an expense against operations at the time such determination is made.
We account for income taxes according to the provisions of SFAS No. 109, Accounting for Income Taxes (“SFAS 109”). SFAS 109 requires recognition of deferred tax assets and liabilities to reflect the expected future tax consequences of temporary differences between the financial statement and tax basis of assets and liabilities. Deferred tax assets are reduced by a valuation allowance when it is more likely than not that some or all of the deferred tax asset will not be realized.
Based upon our continued assessment of the realization of our net deferred tax asset and our third year of historical operating losses, we concluded that it was appropriate to establish a full valuation allowance for our net deferred tax asset in the amount of $966,000 during 2007. In future periods, our earnings or losses will not be tax-effected until such time as the certainty of future tax benefits can be reasonably assured.
In accordance with SFAS No. 142, Goodwill and Other Intangible Assets, which addresses the financial accounting and reporting standards for goodwill and other intangible assets subsequent to their acquisition, we test goodwill for impairment annually or more frequently if certain events or changes in circumstances indicate that the carrying value may not be recoverable.
We reviewed our goodwill as of December 31, 2007 and determined that no impairment existed. Future events such as market conditions or operational performance could cause us to conclude that impairment exists. Any resulting impairment loss would be written off against the carrying value of the asset and charged as an expense against operations at the time such determination is made and could have a material adverse impact on our financial condition and results of operations.
See Notes 1 and 12 to our consolidated financial statements for a discussion of recent accounting pronouncements, including the impact of adopting FIN 48, Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement 109, on January 1, 2007.
In December 2007, the FASB ratified EITF Issue 07-1, Accounting for Collaborative Arrangements (“EITF 07-1”). EITF 07-1 defines collaborative arrangements and establishes reporting requirements for transactions between collaborators and between participants in the arrangement and third parties. We have concluded that our agreement with Edumatics would qualify as a collaborative arrangement and we believe that our presentation of costs is consistent with EITF 07-1. EITF 07-1 is effective for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years, with retrospective application to all prior periods presented for all collaborative arrangements existing as of the effective date. See Note 5 Collaborative Arrangement, to our consolidated financial statements for more information.
Our principal subsidiary, Siboney Learning Group, Inc., publishes standards-based educational software products for reading, language, mathematics, science, writing and English as a Second Language, primarily for K-12 students and adult learners. We publish four comprehensive software product lines, Orchard Software for Your State; GAMCO Educational Software, Educational Activities Software and PracticePlanet. This strategy allows us to appeal to the various budgets and spending patterns found in classrooms, schools, school districts and adult learning centers.
Orchard accounted for 80% of the Company’s sales in 2007. Orchard is sold through a network of 22 independent territorial dealers who employ field sales representatives to sell comprehensive instructional software solutions. In addition, we employ three direct sales representatives and six inside sales representatives to promote and sell our four product lines, with a primary emphasis on Orchard and PracticePlanet.
Orchard is delivered as a server-based product with unlimited network/site licenses and no required recurring fees. Orchard has undergone continuous instructional content and technological improvement. Orchard is currently used in approximately 9,000 schools out of an estimated 120,000 in the United States. Approximately one-third of Orchard sales are repeat business from customers who benefit from Orchard’s scalability by acquiring additional Skill Trees or bundles.
For the year ended December 31, 2007, our consolidated revenues decreased 11% to $5.6 million from $6.3 million recorded in 2006. Siboney Learning Group accounts for substantially all of our consolidated revenues and experienced an overall decline in software product sales of 15% from 2006 levels. Sales of our Orchard Home product to a direct-to-home marketer of educational products were 18% lower and sales made through our dealer network were 15% lower. Typically we experience an increase in sales when we release a new version of Orchard, which historically occurs in early spring. We decided to delay our Orchard 4.3 update to incorporate enhancements to provide compatibility with Microsoft Vista, Mac OS X 10.4 and the new Intel Mac hardware. The release occurred in November 2007 and we believe we missed sales opportunities due to the late release. Our product sales during the fourth quarter of 2007 were lower than what we historically experience, which we believe was due to schools being cautious about committing to purchases given the overall concern with the economy and funding being redirected to other types of purchases such as smart-boards, handheld input devices and assessment tools. We had orders placed on hold from schools in Florida and California due to a spending freeze and cutbacks in December 2007.
We experienced an increase in our professional development and installation service revenue as a higher percentage of our Orchard customers have purchased installation or professional development training during 2007. Service revenues increased to $344,000 during 2007 from $182,000 during 2006.
Cost of products sold decreased 4% to $1.7 million in 2007 from $1.8 million in 2006. This decrease was primarily a result of lower royalty expense and material costs due to lower product sales offset by the fixed amortization of our capitalized software. Due to the release of Orchard 4.3, the upcoming new version of Orchard Home and lower overall product sales, we increased our reserve for inventory obsolescence which increased costs of product sold during 2007 by $50,000.
Selling, general and administrative expenses decreased 26% to $4.4 million in 2007 from $6.0 million in 2006. This decrease was due to aggressive cost reduction initiatives we implemented during the summer of 2006 which resulted in lower salaries and related costs. In addition, we had lower commission expense during 2007 compared to 2006 due to lower sales. We also received reimbursement for a portion of our operating expenses due to the strategic alliance and joint development agreement we entered into with Edumatics in February 2007, which reduced our 2007 selling, general and administrative expenses by approximately $228,000.
As a result of the foregoing, our loss from operations decreased to $542,858 for 2007 compared to a loss from operations of $1,497,225 for 2006.
Based upon our continued assessment of the realization of our net deferred tax asset and our third year of historical operating losses, we concluded that it was appropriate to establish a full valuation allowance for our net deferred tax asset. The establishment of the valuation allowance increased our income tax expense by $966,000 during 2007. The valuation allowance did not affect our cash position. In future periods, our earnings or losses will not be tax-effected until such time as the certainty of future tax benefits can be reasonably assured.
In 2007 we recorded an extraordinary gain of $624,725 due to the sale of a claim that arose out of natural resources interests held in Cuba which were expropriated by the Cuban government. The gain included the cash we were paid of $1,018,725 offset by $10,000 in direct costs and $384,000 in income tax expense that was allocated to the gain in accordance with SFAS 109.
We reported a net loss of $853,676 for 2007 after income tax expense of $715,099 and the extraordinary gain of $624,725 compared to a net loss of $1,012,772 after an income tax benefit of $654,000 for 2006. Our net loss per share for 2007 was $0.05 compared to a loss per share of $0.06 in 2006.
For the year ended December 31, 2006, our consolidated revenues decreased 17% to $6.3 million from $7.5 million recorded in 2005. This decrease was the result of lower sales by Siboney Learning Group in 2006 primarily attributable to an overall industry-wide slowdown in supplemental educational curriculum software sales.
Sales of our single title products, GAMCO and Teacher Support Software, decreased 31% compared to 2005, primarily due to decreased sales from several national software catalog dealers. Sales of Educational Activities Software decreased 22% compared to 2005 due to decreased sales from several dealers and independent representatives. Partially offsetting the decreases in revenue, we saw a 4% increase in sales through a distributor specializing in direct to home sales.
We generated more than $175,000 of sales of professional development and premium support services in 2006, compared to approximately $150,000 of such sales in 2005.
Cost of products sold decreased 15% to $1.8 million in 2006 from $2.1 million in 2005. This decrease was primarily a result of lower product sales and lower royalty expense due to the removal of the Merit Software (“Merit”) content from our current product. The majority of our product packaging was redesigned in 2006 to reduce packaging and shipping costs and to improve the look-and-feel.
Selling, general and administrative expenses decreased 19% to $6.0 million in 2006 from $7.4 million in 2005. This decrease was a result of cost reduction initiatives resulting in lower salaries, professional fees and sales and marketing expenses.
As a result of the foregoing, our loss from operations decreased to $1,497,225 for 2006 compared to a loss from operations of $1,969,221 for 2005.
Our loss from operations in 2006 and 2005 resulted in a significant operating loss carryforward and a long-term deferred tax asset. In assessing the realization of deferred tax assets, we consider whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Based upon the level of historical taxable income and projections for future taxable income over the periods in which the deferred tax assets are deductible, we believe it is more likely than not that we will realize the benefits of these deductible differences. Accordingly, we have not recognized a valuation allowance against our deferred tax assets.
Consequently, net loss for the year ended December 31, 2006 was $1,012,772 after an income tax benefit of $654,000, compared to net loss for 2005 of $1,236,394 after an income tax benefit of $772,000. We reported a loss per share of $0.06 in 2006 compared to a loss per share of $0.07 in 2005.
We continue in our efforts to improve our liquidity. The following describes events and our actions to make changes to address this situation.
In December 2007, Siboney Corporation sold for $1,018,725 a claim that arose out of natural resources interests held in Cuba which were expropriated by the Cuban government. We used $300,000 of the proceeds to reduce our term loan with our bank, $425,000 reduced our line of credit and the balance was used for working capital needs.
In March 2007, we issued $200,000 of subordinated debt and warrants to two Directors, the proceeds of which we used for working capital needs as well as investing in our short-term sales and marketing efforts.
In February 2007, we entered into a joint software development agreement with Edumatics. The agreement calls for Edumatics and Siboney to jointly fund the development of a new online test practice product which is marketed under the name PracticePlanet™. We received a payment of $240,632 from Edumatics in February 2007, a payment of $70,423 in March 2007 and a payment of $79,120 in October 2007. We used the funds that we received from Edumatics to offset half of the costs we incurred in the development of PracticePlanet™ and a portion of our operating costs during 2007. We expect that revenue from this new product, launched in August 2007, will help to improve our liquidity during 2008.
In 2005, we incurred losses that were unusual for Siboney related to a litigation settlement, the termination of the former President and starting a content development department. We settled litigation with Merit Software which resulted in settlement expense and professional fees of approximately $700,000. We were required to remove all of the Merit content from our software by December 31, 2005. In order to replace the Merit content, a team of highly skilled educational curriculum consultants and PhDs were hired to create the new product specifications. We estimate that this department cost us over $1.0 million per year to run including all salary, benefits, travel, rent and subcontracting fees. The content development department was closed in March 2006 and salary and benefit costs were incurred until June 2006. The severance costs related to the former President were approximately $274,000. These events, along with a decrease in sales, adversely affected our liquidity.
We had anticipated that the new products released in late 2005 and mid-2006 would generate sales sufficient to fund our working capital requirements. However, it became clear in early 2006 that the demand for supplemental educational software was not as strong as anticipated so we implemented cost cutting measures throughout 2006. The cost reductions enabled us to reduce our loss from operations to $542,858 for 2007 compared to a loss from operations of $1,497,225 for 2006.
Cash decreased 4% or $8,643 to $217,843 at December 31, 2007 compared to $226,486 at December 31, 2006. Our accounts receivable decreased $189,070 or 25% to $557,388 at December 31, 2007 compared to $746,458 at December 31, 2006 as a result of lower sales in the fourth quarter of 2007 as compared to 2006.
We generated cash from operations and from the sale of the claim during 2007 that improved our liquidity. Our total debt decreased $591,700 or 23% to $2,033,300 at December 31, 2007 from $2,625,000 at December 31, 2006 due to a $425,000 payment on our line of credit in December 2007, principal payments of $369,091 on our term loan during 2007, offset by the $200,000 in borrowing on the subordinated debt in March 2007. We had $425,000 available on the line of credit as of December 31, 2007.
In March 2008, we renewed and extended the maturity of our debt agreement with our bank. We were able to classify our line of credit and a portion of our term loan to a long-term liability on our balance sheet as of December 31, 2007. The maturity dates of our line of credit and term loan were extended to January 1, 2009 from April 1, 2008.
As a result of lower accounts receivable due to decreased sales, the reduction in current deferred tax assets due to our establishment of a valuation allowance and lower inventory levels, our working capital decreased to $335,408 at December 31, 2007 from $726,249 at December 31, 2006.
As of the date of the filing of this Form 10-K we have borrowed the $425,000 that was available under our bank line of credit as of December 31, 2007. We have taken, or are currently taking, the following actions to allow us to continue as a going concern:
Both the line of credit and the term loan require us to pay interest monthly on the outstanding balance at our bank’s prime rate which was 7.25% as of December 31, 2007. Accounts receivable, inventory, property and equipment are pledged as collateral.
We renewed our bank loan in March 2008 under the following terms:
If we breach any term or condition in the agreements, as amended, our bank has the option to declare the loans due and payable.
As of December 31, 2007, we did not comply with the financial covenants specified in our bank credit agreement. Under the credit agreement, the financial covenants are measured at the end of each quarter. We are to maintain a ratio of liabilities to stockholders’ equity plus subordinated debt no greater than 1.25:1.00. Our ratio as of December 31, 2007 was 1.36:1.00. In addition we are to maintain a net worth, plus subordinated debt, of not less than $2,700,000; our net worth plus subordinated debt was $1,999,066 as of December 31, 2007. We have obtained a waiver for this non-compliance as of December 31, 2007. Although we continue to be out of compliance with these financial covenants as of the date of this filing, we do not anticipate that the bank will exercise its right to declare the notes due and payable. However, we can provide no assurance that we will be able to obtain a waiver from the bank of future non-compliance with these or any other financial covenants.
As required by our bank to renew our loans in March 2007, we issued $200,000 of secured subordinated debt to two Directors in March 2007. The subordinated debt is secured by a junior lien on substantially all of our assets and is subordinated to our bank debt. The subordinated debt matures in March 2009 and bears interest at 10% per annum (which we can pay in cash or in-kind). As an inducement to the subordinated lenders, we issued them five-year warrants to purchase 400,000 shares of our common stock at $0.01 per share. Under applicable accounting rules, we issued the subordinated debt at a discount of approximately $22,000, which is amortized over the terms of the debt.
We have the following contractual obligations at December 31, 2007:
| Payments Due By Period | |||||
|---|---|---|---|---|---|
| Contractual Obligations | Total | Less Than 1 Year | 1-3 Years | 3-5 Years | 5+ Years |
| Long-term debt | $2,047,163 | $103,125 | $1,944,038 | - | - |
| Capital lease obligations | - | - | - | - | - |
| Operating lease obligations | 714,513 | 304,083 | 410,430 | - | - |
| Purchase Obligations | 26,300 |
26,300 |
- |
- |
- |
| Off-balance sheet arrangements | - |
- |
- |
- |
- |
| Other long-term liabilities reflected on the Company's GAAP balance sheet | - | - | - | - | - |
| Total | $2,787,976 | $433,508 | $2,354,468 | - | - |
We did not have any off-balance sheet arrangements as of December 31, 2007 or 2006.
We do not use any derivative financial instruments to hedge our exposure to adverse fluctuations in interest rates, foreign exchange rates, fluctuations in commodity prices or other market risks, nor do we invest in speculative financial instruments. Borrowings with the bank bear interest at a variable rate based on prime rate, currently 5.25% per annum. Due to the nature of our borrowings, we have concluded that there is no material market risk exposure and, therefore, no quantitative tabular disclosures are required.