SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON,Washington, D.C. 20549


                                   FORM 10-Q



[X]  Quarterly Report pursuant to Section 13 or 15(d) of the Securities and
     Exchange Act of 1934 for the quarter ended JuneSeptember 30, 1996 or
                                                -------------------------------   

[ ]  Transition report pursuant to Section 13 or 15(d) of the Securities
     Exchange Act of 1934 for the transition period from _______ to .
                                              ----------   ----------_______.

                     Commission File Number       0-22844
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                         SYLVAN LEARNING SYSTEMS, INC.
                         -----------------------------
             (Exact name of registrant as specified in its charter)


              Maryland                                  52-1492296
    ---------------------                       ------------------------------------------------               ----------------------
    (State or other jurisdiction of                    (I.R.S. Employer
    incorporation or organization)                    Identification No.)


          9135 Guilford Road, Columbia, Maryland             21046
          ------------------------------------------------------------------------------           -----
          (Address of principal executive offices)         (Zip Code)

     Registrant's telephone number, including area code:  (410)880-0889
                                                          ---------------------------

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 [X]. No [ ].


The registrant had 15,424,70415,548,782 shares of Common Stock outstanding as of JulyOctober
31, 1996.

 
                         SYLVAN LEARNING SYSTEMS, INC.
                         -----------------------------


                                     INDEX
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                                                                    Page No.
                                                                    --------
PART I. - FINANCIAL INFORMATION


      Item 1.   Financial Statements (Unaudited)
 
                .  Balance Sheets - December 31, 1995 and
                   September 30, 1996...................................3

                .  Statements of Operations - Three months ended
                   September 30, 1995, three months ended
                   September 30, 1996...................................5

                .  Statements of Operations - Nine months ended
                   September 30, 1995, nine months ended
                   September 30, 1996...................................6

                .  Statements of Cash Flows - Nine months ended
                   September 30, 1995, nine months ended
                   September 30, 1996...................................7

                .  Notes to Unaudited Financial Statements -
                   September 30, 1996...................................8

      Item 2.   Management's Discussion and Analysis of Financial
                 Condition and Results of Operations...................11

PART II. - OTHER INFORMATION

      Item 6.   Exhibits and Reports on Form 8-K.......................18


      SIGNATURES.......................................................18

 
PART I:  FINANCIAL INFORMATION
ITEM 1:  FINANCIAL STATEMENTS
- -----------------------------

Sylvan Learning Systems, Inc. and Subsidiaries
Consolidated Balance Sheets

PAGE NO. ---------- PART I.--FINANCIAL INFORMATION Item 1. Financial Statements (Unaudited) . Balance Sheets--DecemberDecember 31, 1995 and June 30, 1996 . . 3 . Statements of Operations--Three months ended June 30, 1995, three months ended June 30, 1996 . . . . . . . . . 5 . Statements of Operations--Six months ended June 30, 1995, six months ended June 30, 1996 . . . . . . . . . . . . . 6 . Statements of Cash Flows--Six months ended June 30, 1995, six months ended June 30, 1996 . . . . . . . . . . . . . 7 . Notes to Unaudited Financial Statements-June 30,1996 . . 8 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations . . . . . . . . . . 11 PART II.--OTHER INFORMATION Item 6. Exhibits and Reports on Form 8-K . . . . . . . . . . . . 17 SIGNATURES . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
SYLVAN LEARNING SYSTEMS, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS
DECEMBER 31, JUNESeptember 30, 1995 1996 ------------ ------------- (UNAUDITED)=============== =============== (Unaudited) ASSETSAssets Current assets: Cash and cash equivalents $ 2,528,865 $ 7,058,0468,935,129 Available-for-sale securities 30,379,065 18,225,37016,268,291 Receivables: Accounts receivable 20,578,345 25,781,96825,835,745 Costs and estimated earnings in excess of billings on uncompleted contracts 3,028,558 4,671,6033,128,809 Notes receivable 1,583,843 1,306,343 ------------ ------------2,214,783 --------------- --------------- 25,190,746 31,759,91431,179,337 Allowance for doubtful accounts (1,466,027) (1,528,938) ------------ ------------(1,427,227) --------------- --------------- 23,724,719 30,230,97629,752,110 Inventory 3,639,392 3,832,3573,968,694 Deferred income taxes 1,271,925 1,271,925 Prepaid expenses 1,942,806 2,838,374 ------------ ------------2,533,786 --------------- --------------- Total current assets 63,486,772 63,457,04862,729,935 Notes receivable, less current portion 1,875,359 1,958,919991,316 Costs and estimated earnings in excess of billings on uncompleted contracts, less current portion 673,181 186,497572,848 Property and equipment: Furniture and equipment 19,564,005 21,859,43123,804,179 Leasehold improvements 1,958,236 2,260,537 ------------ ------------2,410,372 --------------- --------------- 21,522,241 24,119,96826,214,551 Accumulated depreciation (6,142,009) (8,030,597) ------------ ------------(9,196,312) --------------- --------------- 15,380,232 16,089,37117,018,239 Intangible assets: Goodwill 74,653,356 81,202,04981,612,524 Contract rights 7,857,346 7,857,346 Other 2,451,091 2,451,091 ------------ --------------------------- --------------- 84,961,793 91,510,48691,920,961 Accumulated amortization (4,640,450) (7,974,870) ------------ ------------(9,220,722) --------------- --------------- 80,321,343 83,535,61682,700,239 Deferred contract costs, net of accumulated amortization of $684,177 as of December 31, 1995 and $1,105,021$1,391,129 as of JuneSeptember 30, 1996 2,528,029 7,066,4107,460,596 Other assets 1,141,755 1,489,575 ------------ ------------4,945,857 --------------- --------------- Total assets $165,406,671 $173,783,436 ============ ============$ 165,406,671 $ 176,419,030 =============== ===============
3 SYLVAN LEARNING SYSTEMS, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETSSylvan Learning Systems, Inc. and Subsidiaries Consolidated Balance Sheets
DECEMBERDecember 31, JUNESeptember 30, 1995 1996 ------------- -------------- (UNAUDITED)================ ================ (Unaudited) LIABILITIES AND STOCKHOLDERS' EQUITYLiabilities and stockholders' equity Current liabilities: Accounts payable and accrued expenses $ 12,253,614 $ 16,873,10216,450,231 Bank lines of credit 3,500,000 --- Current portion of long-term debt and capital lease obligations 1,895,567 1,316,4331,182,023 Billings in excess of costs and estimated earnings on uncompleted contracts 237,644 262,06125,068 Deferred revenue 6,487,134 7,707,0787,120,161 Other current liabilities 795,967 670,828 ------------ ------------644,840 ---------------- ---------------- Total current liabilities 25,169,926 26,829,50225,422,323 Long-term debt, less current portion 2,465,399 1,840,0001,600,000 Capital lease obligations, less current portion 55,113 --- Deferred income taxes 884,612 884,612 Other long-term liabilities 367,790 338,695348,096 Commitments and contingent liabilities -- --- - Stockholders' equity: Common stock, par value $.01 per share--authorized 40,000,000 shares, issued and outstanding shares of 13,953,462 as of December 31, 1995 and 14,234,22814,237,980 as of JuneSeptember 30, 1996 139,534 142,342142,380 Additional paid-in capital 139,863,681 142,515,764142,572,522 Foreign currency translation adjustments 70,000 30,859(94,651) Retained earnings (accumulated deficit) (3,609,384) 1,201,662 ------------ ------------5,543,748 ---------------- ---------------- Total stockholders' equity 136,463,831 143,890,627 ------------ ------------148,163,999 ---------------- ---------------- Total liabilities and stockholders' equity $165,406,671 $173,783,436 ============ ============$ 165,406,671 $ 176,419,030 ================ ================
See accompanying notes. 4 SYLVAN LEARNING SYSTEMS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONSSylvan Learning Systems, Inc. and Subsidiaries Consolidated Statements of Operations
THREE MONTHS ENDED JUNEThree months ended September 30, --------------------------============================= 1995 1996 ----------- ------------ (UNAUDITED) (UNAUDITED)============================= (Unaudited) (Unaudited) REVENUESRevenues Franchise royalties $ 2,403,4782,582,473 $ 2,988,5423,186,677 Franchise sales fees 504,185 152,386 Testing services 5,742,703 23,259,302708,935 521,884 Company-owned learning center services 2,876,726 4,030,4053,263,374 4,327,668 Product sales 726,096 812,442 Contract educational services 6,598,595 8,266,243 Product sales 907,330 872,852 -----------6,721,087 5,768,954 Testing services 6,449,664 23,067,751 ------------ ------------ Total revenues 19,033,017 39,569,730 COST AND EXPENSES Testing services expense 4,414,980 19,366,48920,451,629 37,685,376 Cost and expenses Company-owned learning center expense 2,521,381 3,289,7922,701,665 3,445,616 Cost of product sales 570,749 666,022 Contract educational services expense 5,698,531 6,979,756 Cost of product sales 702,737 735,9135,882,286 5,114,236 Testing services expense 4,610,837 17,296,004 General and administrative expense 3,321,458 4,728,607 -----------3,436,859 4,290,901 Loss on impairment of assets 3,200,876 - ------------ ------------ Total expenses 16,659,087 35,100,557 -----------20,403,272 30,812,779 ------------ ------------ Operating income 2,373,930 4,469,173 OTHER INCOME (EXPENSE)48,357 6,872,597 Other income (expense) Investment and other income 188,991 346,272175,360 231,992 Interest expense (133,126) (70,593)(154,556) (61,550) Equity in net income of Sylvan National Advertising Committee, Inc. 72,192 161,268 -----------184,588 196,047 ------------ ------------ Income from continuing operations before income taxes 2,501,987 4,906,120253,749 7,239,086 Income taxes (482,052) (1,874,000) -----------(106,393) (2,897,000) ------------ ------------ Net income $ 2,019,935147,356 $ 3,032,120 ===========4,342,086 ============ PER COMMON AND COMMON EQUIVALENT SHARE============ Per common and common equivalent share Net income $0.20 $0.19 ===========$0.01 $0.27 ============ ============
See accompanying notes. 5 SYLVAN LEARNING SYSTEMS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONSSylvan Learning Systems, Inc. and Subsidiaries Consolidated Statements of Operations
SIX MONTHS ENDED JUNENine months ended September 30, --------------------------======================================== 1995 1996 ----------- ------------ (UNAUDITED) (UNAUDITED)======================================== (Unaudited) (Unaudited) REVENUESRevenues Franchise royalties $ 4,528,4087,110,881 $ 5,511,0258,697,702 Franchise sales fees 877,970 364,871 Testing services 11,001,901 41,059,4511,586,905 886,755 Company-owned learning center services 5,338,349 7,398,5078,601,723 11,726,175 Product sales 2,487,240 2,795,117 Contract educational services 12,528,501 17,810,353 Product sales 1,761,144 1,982,675 ----------- -----------19,249,588 23,579,307 Testing services 17,451,565 64,127,202 ----------------- ------------------- Total revenues 36,036,273 74,126,882 COST AND EXPENSES Testing services expense 9,030,569 34,524,80956,487,902 111,812,258 Cost and expenses Company-owned learning center expense 4,777,719 6,323,8697,479,384 9,769,485 Cost of product sales 1,923,869 2,306,104 Contract educational services expense 10,945,650 15,297,884 Cost of product sales 1,353,120 1,640,08216,827,936 20,412,120 Testing services expense 13,641,406 51,820,813 General and administrative expense 6,182,052 9,003,419 ----------- -----------9,618,911 13,294,320 Loss on impairment of assets 3,200,876 - ----------------- ------------------- Total expenses 32,289,110 66,790,063 ----------- -----------52,692,382 97,602,842 ----------------- ------------------- Operating income 3,747,163 7,336,819 OTHER INCOME (EXPENSE)3,795,520 14,209,416 Other income (expense) Investment and other income 367,958 742,035543,318 974,027 Interest expense (263,673) (178,376)(418,229) (239,926) Equity in net income of Sylvan National Advertising Committee, Inc. 44,525 253,568 ----------- -----------229,113 449,615 ----------------- ------------------- Income from continuing operations before income taxes 3,895,973 8,154,0464,149,722 15,393,132 Income taxes (593,607) (3,343,000) ----------- -----------(700,000) (6,240,000) ----------------- ------------------- Net income $ 3,302,366 $4,811,0476 =========== =========== PER COMMON AND COMMON EQUIVALENT SHARE3,449,722 $ 9,153,132 ================= =================== Per common and common equivalent share Net Income $ 0.32 $ 0.30 =========== ===========income $0.33 $0.57 ================= ===================
See accompanying notes. 6 SYLVAN LEARNING SYSTEMS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWSSylvan Learning Systems, Inc. and Subsidiaries Consolidated Statements of Cash Flows
SIX MONTHS ENDED JUNENine months ended September 30, ---------------------------------------------------------- 1995 1996 ------------ -------------------------------------------- (Unaudited) (Unaudited) OPERATING ACTIVITIESOperating activities Net income $ 3,302,3663,449,722 $ 4,811,0469,153,132 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Depreciation 1,597,290 2,171,3312,289,060 3,337,046 Amortization 819,095 3,755,2641,247,127 5,287,224 Loss on impairment of assets 3,200,876 -- Provision for doubtful accounts 107,579 60,000-- 158,724 Equity in net income of unconsolidated affiliate (44,525) (253,568)(229,113) (449,615) Changes in operating assets and liabilities: Accounts and notes receivable (5,954,269) (5,003,800)(8,634,232) (5,154,991) Costs and estimated earnings in excess of billings on uncompleted contracts (465,837) (853,696)(896,045) 82 Inventory (10,689) (453,115)(402,851) (328,826) Prepaid expenses (678,661) (653,314)(973,496) (458,462) Other assets (375,916) (173,291)(411,483) (1,138,822) Accounts payable and accrued expenses 979,802 2,287,947(85,152) 1,815,551 Billings in excess of costs and estimated earnings on uncompleted contracts (696,341) (312,418)(578,749) (251,474) Other current liabilities (596,515) (27,571)(821,386) (342,349) Deferred revenue and other long-term liabilities 480,179 1,300,144 ----------- ------------1,387,082 681,475 ------------- ------------- Net cash provided by (used in) operating activities (1,536,442) 6,654,959 ----------- ------------ INVESTING ACTIVITIES Investment in and changes in advances to unconsolidated affiliates 90,871 (26,207)(1,458,640) 12,308,695 ------------- ------------- Investing activities Purchase of available-for-sale securities -- (12,819,592)(30,242,741) Proceeds from sale of available-for-sale securities 1,378,408 24,973,2871,367,063 44,353,515 Purchase of property and equipment (2,107,449) (2,880,966)(3,200,471) (4,975,547) Contract Terminationtermination fee paid to Drake Authorized Testing Centers -- (4,177,748)(4,432,512) Purchase of assets and contract rights from NASD -- (4,774,000)(4,871,832) Cash received upon acquisition of PACE 682,411 -- Cash received upon acquisition of Drake Prometric, L.P. 3,514,000 -- Expenditures for deferred contract costs and other assets (749,623) (185,623) ----------- ------------(784,473) (3,243,638) ------------- ------------- Net cash used inprovided by (used in) investing activities (705,382) 109,151 ----------- ------------ FINANCING ACTIVITIES1,578,530 (3,412,755) ------------- ------------- Financing activities Proceeds from exercise of options and warrants 15,661 2,117,073351,078 2,171,023 Proceeds from issuance of common stock -- 440,250 Payments on long-term debt (566,526) (809,596)and capital lease obligations (1,378,572) (1,437,085) Proceeds from (paydown of) borrowings on line of credit 600,0002,500,000 (3,500,000) Payments on capital lease obligations (391,263) (444,301) ----------- ------------------------- ------------- Net cash used inprovided by (used in) financing activities (342,128) (2,196,574) ----------- ------------1,472,506 (2,325,812) ------------- ------------- Effects of exchange rate changes on cash -- (38,355) ----------- ------------(163,864) ------------- ------------- Net increase (decrease) in cash and cash equivalents (2,583,952) 4,529,1811,592,396 6,406,264 Cash and cash equivalents at beginning of period 3,719,657 2,528,865 ----------- ------------------------- ------------- Cash and cash equivalents at end of period $ 1,135,7055,312,053 $ 7,058,046 =========== ============8,935,129 ============= =============
See accompanying notes. 7 SYLVAN LEARNING SYSTEMS, INC. NOTES TO UNAUDITED FINANCIAL STATEMENTS JUNENotes to Unaudited Financial Statements September 30, 1996 NOTE A--BASIS OF PRESENTATIONNote A - Basis of Presentation --------------------- The accompanying unaudited financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three months and sixnine months ended JuneSeptember 30, 1996 are not necessarily indicative of the results that may be expected for the year ended December 31, 1996. For further information, refer to the financial statements and footnotes thereto included in the Company's annual report on Form 10-K for the year ended December 31, 1995. NOTE B--ACQUISITIONS ------------ The PACE Group Effective February 28, 1995, the Company purchased the assets and liabilities of The PACE Group ("PACE"), a provider of educational services to corporations. The initial consideration for the acquisition was 174,964 shares of the Company's common stock having an aggregate market value of $3,160,861. The acquisition was accounted for using the purchase method of accounting. Additional contingent consideration is payable in an amount equal to 6.5 times PACE's earnings before interest and income taxes (EBIT) in 1997, determined in accordance with generally accepted accounting principles. If EBIT is less than $2.7 million in 1997, the PACE shareholders may elect to have the payment calculation based on EBIT for either calendar year 1998 or 1999. The contingent payment is payable two-thirds in cash and one third in shares of Sylvan common stock, unless the PACE shareholders determine that a smaller cash payment is required for their tax purposes. The Company will record any additional consideration payable to the PACE shareholders as additional goodwill, and will amortize that amount over the remaining amortization period. Drake Prometric, L.P. Effective September 30, 1995, the Company acquired Drake Prometric, L.P. ("Drake"), a Minneapolis based provider of computer-based certification, licensure and assessment testing programs. The acquisition was accounted for using the purchase method of accounting. The Company acquired Drake for an initial purchase price of $20 million in cash and 3,809,524 restricted shares of Common Stock (the "Initial Shares"). Of the Initial Shares, 1,190,476 shares (the "Revenue Escrow Shares") were placed in escrow and will be released to the sellers to the extent that certain 8 revenue targets relating to portions of the combined computer-based testing business of Sylvan and Drake are achieved from 1996 through 1998. The sellers may receive up to an additional $40 million (payable 12.5% in cash and the balance in either cash or restricted shares of Common Stock, at Sylvan's option) to the extent other revenue targets relating to portions of the combined computer-based testing business of Sylvan and Drake are achieved in 1998 or 1999 (with the measuring year selected by the sellers). The Company will record the contingent consideration consisting of the 1,190,476 Revenue Escrow Shares and the additional contingent payment of up to $40 million when the contingencies are resolved and the additional consideration is payable. In June 1996, also in connection with the acquisition, the Company paid and accrued $6.4 million in contract termination fees to certain Drake Authorized Testing Centers that had contracts to provide computer based testing delivery. These cancellation costs were recorded as additional costs related to the Drake acquisition and are being amortized over the remaining amortization period. NOTE C--INCOME TAXESNote B - Income Taxes ------------ At December 31, 1995 the Company had net operating loss carryforwards of approximately $2,500,000$2.5 million for income tax purposes that expire in years 2007 and 2008. The operation of certain provisions of the Internal Revenue Code will limit the amount of the net operating loss carryforwards available to offset taxable income in any one year. During 1996, approximately $2.5 million of net operating loss carryforwards are available to offset taxable income. The Company's effective tax rate has increased from 15%17% during the first sixnine months of 1995 to 41% during the first sixnine months of 1996 mainly due to non-deductible amortization expense of intangible assets related to the Drake acquisition and a lower net operating loss carryforward available for use in 1996. The Company's income tax provision of $3,343,000$6,240,000 for the sixnine month period ended JuneSeptember 30, 1996 consists of federal, state, and foreign income taxes. NOTE D--CREDIT LINENote C - Credit Line ----------- The Company has entered into a loan agreement with a bank, hereinafter the "credit line", that provides an unsecured revolving line of credit. The credit line allows the Company to borrow a maximum of $15 million on a revolving basis through May 31, 1998, with the option to repay any balance at that date over two years through May 31, 2000. The credit line bears interest at a floating rate equal to the 30 day London Interbank Offered Rate ("LIBOR") plus 1.15% per annum. During the sixnine months ended JuneSeptember 30, 1996, all outstanding borrowings under the line of credit were repaid in their entirety. NOTE E--EARNINGS PER SHARE8 Note D - Earnings Per Share ------------------ EarningEarnings per common and common equivalent share is computed using the weighted average number of common and common equivalent shares outstanding during each period presented. The weighted average number of shares used for the three months ended JuneSeptember 30, 1996 and 1995 was 15,826,21115,800,767 and 10,253,552,10,663,262, respectively. The weighted average number of shares used for the six month periodsnine months ended JuneSeptember 30, 1996 and 1995 was 15,727,82815,749,854 and 10,194,231,10,360,391, respectively. The difference between the number of shares used to determine earnings per common and common equivalent share 9 and earnings per common share assuming full dilution is immaterial. Common stock equivalents consist of stock options and warrants (usingusing the treasury stock method). NOTE F -- CONTINGENT MATTERS ------------------ During 1993,method in 1996 and the modified treasury stock method in 1995. Note E - Subsequent Events ----------------- The Company committed to purchase and license instructional learning system software fromhas authorized a company (the "Seller")3 for 2 stock split of its Common Stock to be usedeffective in the Company's contract education sites and to be sold to its franchised Sylvan Learning Centers. The agreement requires the acquisitionform of a minimumstock dividend, which will be distributed on November 7, 1996 to shareholders of $4.0 millionrecord at the close of coursewarebusiness on October 7, 1996. The holders of the Company's Common Stock will receive a stock dividend at the rate of 1/2 share of Common Stock for each share of Common Stock owned. Shareholders will not be entitled to receive any resulting fractional shares, but will receive the value of any such fractional shares in CD ROM format. As of Junecash. The September 30, 1996 financial statements do not reflect the additional shares. On October 24, 1996, the Company had paidannounced that it has formed a new venture with MCI Communications Corporation ("MCI") to provide an international distribution network for adult professional education services. The capital structure of the new venture, called Caliber Learning Network, Inc. ("Caliber"), will be as follows: Sylvan will invest $1.3 million for Jr. Preferred stock for 10% of Caliber's equity and accepted deliverywill have a call option beginning January 1998 to purchase 42.1% of $3.0 million in courseware. PriorCaliber's equity held by an independent investor. Douglas Becker and Chris Hoehn-Saric, the Company's Co-CEOs, will invest, through an entity controlled by them, $350,000 each for Common stock of Caliber for 28% of the equity. MCI will hold a 19.9% equity interest. Additionally, MCI and Sylvan will provide credit to August 31,finance the buildout of Caliber's communications and computing infrastructure. On November 11, 1996, the Company is required to placeannounced that it will make a minimum orderminority investment in Josten's Learning Corporation ("Jostens"), a leading provider of $1.0 million. As stipulatedtechnology-based educational programs for students from kindergarten through twelfth grade level. The Company will make a $20.6 million investment in the contract, management currently intends to offset the commitment for future orders against certain obligations the Seller may have to the Company as described below. In 1993, the Company purchased from the Seller the rights to certain testing contractsJosten's preferred stock through a payment of $5.0 million in cash and agreed to pay the Seller a royalty equal to 27%$15.6 million of the excess testing contract revenues earnedCompany's common stock. The number of shares to be issued will be determined by August 31, 1997 over $7.4 million. Conversely,dividing $16.07 million by the Seller agreed to pay the Company a reverse royalty equal to 27% of any testing contract revenue deficiency under $7.4 million that may occur by August 31, 1997. An installment payment of no more than $1 million is payable to the Company under the reverse royalty agreement in October 1996 in the event that testing contract revenues are less than $5.5 million, with any remaining amount due in October 1997 basedCompany's stock price on the August 31, 1997 calculation, howeverregistration date of the total reverse royalty can not exceed $2.0 million.shares (estimated to be on or about November 20, 1996). This initial investment will equate to a 16.5% ownership interest in 9 Josten's. The Company expects, based onwill also earn a $2.0 million dividend annually, which will increase the amountCompany's ownership percentage of revenue earned on these testing contracts through June 30, 1996 and projectionsJosten's to 19.9% at the end of additional testing contract revenue through August 31, 1996, that the Seller will owe the Company approximately $1 million in October 1996. No amounts have been recorded related to the royalty arrangement at June 30, 1996. NOTE G -- RECLASSIFICATIONSsecond year of ownership. Note F - Reclassifications ----------------- Certain amounts in the 1995 financial statements have been reclassified to conform with the 1996 presentation. 10 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF --------------------------------------- FINANCIAL CONDITION AND --------------------------------------------------------------- RESULTS OF OPERATIONS ------------------------------------------------------------------- All statements contained herein that are not historical facts, including but not limited to, statements regarding the anticipated impact of uncollectible accounts receivable on future liquidity, expenditures to develop licensing and certification tests under existing contracts, amounts payable to or by the Company in connection with a 1993 software agreement, the Company's contingent payment obligations relating to the PACE and Drake acquisitions, future capital requirements and the Company's future development plans are based on current expectations. These statements are forward looking in nature and involve a number of risks and uncertainties. Actual results may differ materially. Among the factors that could cause actual results to differ materially are the following: Changes in the financial resources of the Company's clients; timing and extent of testing clients' conversions to computer-based testing; amount of revenues earned pursuant to certain testing contracts acquired in connection with the 1993 software agreement and revenues earned by the Company's PACE and Drake operations; the availability of sufficient capital to finance the Company's business plan on terms satisfactory to the Company; general business and economic conditions; and the other risk factors described in the Company's reports filed from time to time with the Commission. The Company wishes to caution readers not to place undue reliance on any such forward looking statements, which statements are made pursuant to the Private Securities Litigation Reform Act of 1995 and, as such, speak only as of the date made. The Company generates revenue from three business segments: Core educational services which primarily consists of franchise sales, royalties, and Company-owned Learning Center revenue; testing services, which consists of computer-based testing fees paid to the Company primarily by test administrators; and contract educational services, which consists of revenue attributable to providing supplemental and remedial education services to school districts and major corporations. RESULTS OF OPERATIONSResults of Operations Comparison of results for the quarter and sixnine months ended JuneSeptember 30, 1996 to results for the quarter and sixnine months ended JuneSeptember 30, 1995. Revenue. Total revenues increased by $20.5$17.2 million, or 108%84% to $39.6$37.7 million for the quarter ended JuneSeptember 30, 1996 and increased by $38.1$55.3 million, or 106%98%, to $74.1$111.8 million for the sixnine months ended JuneSeptember 30, 1996 compared to the same respective periods in 1995. These increases resulted from higher revenues in all business segments --corecore educational services testing services, and contract educationaltesting services. Core educational services revenue increased by $1.3$1.6 million, or 20%22%, to $8.0$8.8 million during the secondthird quarter of 1996 and by $2.8$4.3 million, or 22%, to $15.3$24.1 million for the first sixnine months of 1996 compared to the comparable 1995 periods. Franchise royalties increased $585,000,$604,000, or 24%23%, to $3.0$3.2 million for the quarter ended JuneSeptember 30, 1996 and by $983,000,$1.6 million, or 22%, to $5.5$8.7 million for the first six monthsnine month period of 1996 compared to the comparable 1995 periods. This increase in franchise royalties was due to an overall 18%16% and 17%19% increase in revenues at existing Learning Centers open for more than one year, for the three months and sixnine months ended JuneSeptember 30, 1996, respectively, combined with a net increase of 198 new full and satellite Centers opened in 11 the quarter ended JuneSeptember 30, 1996, and 3442 new full and satellite Centers opened in the first sixnine months of 1996. A satellite Center is a center operating within an existing franchise territory. 11 Franchise sales fees decreased by $352,000,$187,000, or 70%26%, to $152,000$522,000 for the quarter ended JuneSeptember 30, 1996, and by $513,000,$700,000, or 58%44%, to $365,000$887,000 for the sixnine months ended JuneSeptember 30, 1996, compared to the comparable periods in 1995. For the quarter ended JuneSeptember 30, 1996, there were three13 franchise Center licenses sold, compared to 1411 franchise Center licenses and a $260,000 area development agreement sold in the 1995 quarter. For the sixnine months ended JuneSeptember 30, 1996, there were nine22 franchise Center licenses sold compared to 1728 franchise Center licenses and a $270,000two area development agreementagreements totaling $530,000 sold for the sixnine months ended JuneSeptember 30, 1995. Revenue from Company-owned Learning Centers increased by $1.2$1.1 million, or 40%33%, to $4.0$4.3 million during the secondthird quarter of 1996 and by $2.1$3.1 million, or 39%36%, to $7.4$11.7 million during the first sixnine months of 1996 compared to the comparable periods in 1995. Revenue growth related to student enrollment increases for Centers operating over 12 months as of JuneSeptember 30, 1996 resulted in $815,000,$803,000, or 28%25%, of the increase for the quarter ended JuneSeptember 30, 1996, and $1.5$2.5 million, or 28%29%, of the increase for the first sixnine months of 1996 compared to the comparable 1995 periods. The opening of threetwo new Centers after JuneSeptember 30, 1995 resulted in an additional $339,000$261,000 of revenue during the secondthird quarter of 1996 and $574,000$638,000 during the first sixnine months of 1996. Product sales in the secondthird quarter of 1996 were comparable to the secondthird quarter of 1995 and increased $222,000,$308,000, or 13%12% to $2.0$2.8 million in the first sixnine months of 1996 compared to the same period in 1995 due to overall student enrollment increases at franchised Centers. Testing services revenue increased by $17.5$16.6 million, or 305%258%, to $23.3$23.1 million during the secondthird quarter of 1996, and increased by $30$46.7 million, or 273%267%, to $41$64.1 million for the first sixnine months of 1996, compared to the comparable periods in 1995. The significant increase in testing services revenues resulted primarily from the acquisition of Drake which provided increased revenues from Information Technology (IT) clients. Increased services under the cost-plus Educational Testing Service (ETS) international contract and the implementation of a management contract with the National Association of Securities Dealers, Inc. (NASD) also contributed to the increase in testing services revenues. Effective March 1, 1996, the Company entered into a management contract with the NASD to operate their testing centers delivering computer-based testing to securities brokers and dealers. The management contract continues through August 30, 1996 at which time most NASD testing centers could be closed if it is cost beneficial. The company has a 10 year contract to provide testing for the NASD. Contract educational services revenue increaseddecreased by $1.7$1.0 million, or 25%,14% to $8.3$5.8 million for the quarter ended JuneSeptember 30, 1996, and increased by $5.3$4.3 million, or 42%,22% to $17.8$23.6 million for the sixnine months ended JuneSeptember 30, 1996 compared to the comparable 1995 periods.periods in 1995. Revenue from public and non-public schoolTitle I contracts increaseddecreased by $1.9 million$800,000 for the quarter ended JuneSeptember 30, 1996, and increased by $4.1$3.3 million for the sixnine months ended JuneSeptember 30, 1996. Revenue from PACE and Sylvan at Work contracts decreased by $208,000$200,000 for the quarter ended JuneSeptember 30, 1996, and increased by $1.2$1.0 12 million for the sixnine months ended JuneSeptember 30, 1996. The PACE and Sylvan at Work increase for the sixnine months ended JuneSeptember 30, 1996 results from the fact that the Pace acquisition, accounted for as a purchase, was effective February 28, 1995. Revenue from existing public and non-public schoolTitle I contracts decreased by $400,000 for the quarter ended June 30, 1996, and decreased by $800,000 for the six months ended June 30, 1996 due to reduced funding levels on certain contracts. Revenue from public and non-public school contracts 12 obtained after JuneSeptember 30, 1995 contributed $2.3 million$300,000 to revenue for the quarter ended JuneSeptember 30, 1996, and $4.9$500,000 for the nine months ended September 30, 1996. Revenue from existing Title I contracts decreased by $1.1 million for the sixquarter ended September 30, 1996, and increased by $2.8 million for the nine months ended JuneSeptember 30, 1996. The increasedRevenue from existing Title I contracts decreased for the third quarter of 1996 since the third quarter of 1995 included $1.5 million in revenue from new public and non-public schoolone time summer contracts, is primarily dueoffset by $400,000 attributed to contracts with 15 new schools in Baltimore City, 10 schools in Chicago, Illinois, and five schools in St. Paul, Minnesota.existing prior to the third quarter of 1995. Cost and Expenses. Company-owned Learning Center expenses increased by $768,000,$744,000, to $3.3$3.4 million, or 82%80% of total Company-owned Learning Center services revenue in the secondthird quarter of 1996, compared to $2.5$2.7 million, or 88%83% of total Company-owned Learning Center services revenue in the secondthird quarter of 1995. Company-owned Learning Center expenses increased by $1.5$2.3 million, to $6.3$9.8 million, or 85%83% of total Company-owned Learning Center services revenue for the sixnine months ended JuneSeptember 30, 1996, compared to $4.8$7.5 million, or 89%87% of total Company-owned Learning Center services revenue for the sixnine months ended JuneSeptember 30, 1995. The increased expenses were primarily advertising and labor associated with increased center enrollment. Expenses for Centers operating over 12 months as of JuneSeptember 30, 1996 accounted for $460,000$543,000 of the increase for the secondthird quarter of 1996, and represent 56%68% of incremental same Center revenue. Expenses for Centers operating over 12 months as of JuneSeptember 30, 1996 accounted for $986,000$1.7 million of the increase for the first sixnine months of 1996, and represent 66%69% of incremental same Center revenue. The opening of threetwo new Company-owned Learning Centers since JuneSeptember 30, 1995 increased expenses by $308,000,$201,000, or 91%77% of the revenue of those Centers for the secondthird quarter of 1996, and by $560,000,$575,000, or 98%90% of the revenue of those Centers for the first sixnine months of 1996. Testing services expenses for the secondthird quarter of 1996 increased by $15$12.7 million to $19.4$17.3 million, or 83%75% of total testing services revenue, compared to $4.4$4.6 million, or 77%71% of total testing services revenue for the secondthird quarter of 1995. Testing services expense for the first sixnine months of 1996 increased by $25.5$38.2 million to $34.5$51.8 million, or 84%81% of total testing services revenue, compared to $9$13.6 million, or 82%78% of total testing services revenue for the same period in 1995. The increase resulted primarily from the acquisition of Drake and the increased registration and delivery costs associated with additional volume of tests. The increase in testing services expense as a percentage of revenues was primarily a result of high margin development revenues from the Armed Services Vocational Aptitude Battery (ASVAB) beta test which decreased the percentage of delivery cost to revenue in 1995. Also, the Company sold the development rights for testing center's providing computer-based tests in India for $500,000 in the third quarter of 1995. The percentage of expenses to revenue, adjusted for the ASVAB development revenue would have been 88% for both the secondthird quarter and sixfor ASVAB and India rights revenue for the nine months ended JuneSeptember 30, 1996 are higher than the percentages for the same periods in 1995. 13 Contract educational services expense increaseddecreased by $1.3 million$800,000 to $7.0$5.1 million, or 84%,89% of contract educational services revenue for the quarter ended JuneSeptember 30, 1996, compared to $5.7$5.9 million or 86%,88% of contract educational services revenue for the secondthird quarter of 1995, and increased by $4.4$3.6 million to $15.3$20.4 million, or 86%,87% of contract educational services revenue during the sixnine months ended JuneSeptember 30, 1996, compared to $10.9$16.8 million or 87%, of contract educational services revenue during the first sixnine months of 1995. Operating expenses for public and non-public school contracts increased by $1.5 million, or 79% of the related revenue increaseTitle I schools decreased $700,000 for the quarter ended JuneSeptember 30, 1996 and by $3.3increased $2.5 million or 79% of the related revenue increase for the sixnine months ended JuneSeptember 30, 1996. Expenses from Title I contracts decreased for the third quarter of 1995 since the third quarter of 1995 included expenses from one time summer contracts. Operating expenses for PACE and Sylvan at Work decreased by $192,000, or 92% of the related revenue decrease$100,000 for the quarter ended JuneSeptember 30, 1996 and increased by $1.1 million or 95% of the related revenue increase for the sixnine months ended JuneSeptember 30, 1996. The PACE and Sylvan at Work increase for the sixnine months ended JuneSeptember 30, 1996, 13 results from the fact that the Pace acquisition, which was accounted for as a purchase, was effective February 28, 1995. General and administrative expenses increased by $1.4 million$900,000 to $4.7$4.3 million during the secondthird quarter of 1996 compared to the secondthird quarter of 1995, but decreased as a percentage of revenue from 17% to 12%11%; general and administrative expenses increased by $2.8$3.7 million to $9.0$13.3 million during the first sixnine months of 1996, compared to the same period in 1995, but decreased as a percentage of revenue from 17% to 12%. These percentage declines resulted from increased revenues primarily from franchise royalties, testing services, and contract and Company-owned Learning Center services without corresponding increases in administrative staff salaries and expenses. LIQUIDITY AND CAPITAL RESOURCESDuring the third quarter of 1995, the Company recorded a non-recurring loss on impairment of assets of $3.2 million associated with the Drake acquisition. The loss on impairment resulted from the determination that the fair market value of certain assets in the Sylvan Testing division were less than the book value. The Drake acquisition and the pending consolidation of operations resulted in the determination that certain assets in this division are not recoverable, and therefore these assets have been written down to their net realizable value. Liquidity and Capital Resources Cash provided by operating activities was $6.7$12.3 million for the sixnine months ended JuneSeptember 30, 1996 as compared to cash used in operating activities of $1.5 million in the comparable period of 1995. Cash flow from operations before working capital changes increased from $5.8$10.0 million in the 1995 period to $10.5$17.5 million in the 1996 period, primarily as a result of significant earnings from Company operations.operations net of the loss on impairment of assets recognized in the 1995 period. The $5.0$5.2 million of cash used due to the increase in accounts and notes receivable was substantiallypartially offset by the $3.6$2.5 million of cash provided by the increase in accounts payable and accrued expenses, and deferred revenue. These increases resulted primarily from the significant growth of the testing division, including the effects of the Drake acquisition.growth of Information Technology testing. 14 During the first sixnine months of 1996, the Company sold a net of $12.1$14.1 million of available-for-sale securities. The Company used cash to pay off the outstanding line of credit borrowings of $3.5 million, to purchase $2.9$5.0 million of property and equipment, and to acquire certain contract rights and other assets of $4.8$9.3 million as described below. The Company continues to incur expenditures for additions to property and equipment, which totaled $2.9$5.0 million inthrough the secondthird quarter of 1996. These additions primarily consisted of furniture and equipment for general business expansion, including expenditures for new public and non-public school classrooms and equipment needed for overseas testing centers operated by the Company. Under the international testing contract with ETS, the Company is reimbursed for overseas equipment expenditures as the equipment is depreciated. This reimbursement includes a financing charge over the reimbursement period. The Company may spend up to $2 million over the next 15 months to develop licensing and certification tests under contracts with various testing organizations. The Company paid the NASD $4.8$4.9 million in early Aprilduring the nine months ended September 30, 1996 pursuant to an asset transfer agreement related to the management of the NASD testing centers and the acquisition of contract rights to provide testing based on a ten year contract with the NASD. The assets transferred by the NASD consisted mainly of computer equipment in the NASD testing centers. During the sixnine months ended JuneSeptember 30, 1996, the Company paid $4.2$4.4 million in contract termination fees to certain Drake Authorized Testing Centers that had contracts to provide computer 14 based testing delivery. These cancellation costs were recorded as additional costs related to the Drake acquisition and are being amortized over the remaining amortization period. The Company has entered into a loan agreement with a bank, hereinafter the "credit line" that provides an unsecured revolving line of credit. The credit line allows the Company to borrow a maximum of $15 million on a revolving basis through May 31, 1998, with the option to repay any balance at that date over two years through May 31, 2000. There were no outstanding borrowings under the credit line at JuneSeptember 30, 1996. The credit line bears interest at a floating rate equal to the 30 day London Interbank Offered Rate ("LIBOR") plus 1.15% per annum. During the sixnine months ended JuneSeptember 30, 1996, the Company received $2.1$2.2 million of cash as a result of the exercise of stock options and warrants to purchase 258,266262,018 shares of Common Stock. On October 24, 1996, the Company announced that it has formed a new venture with MCI Communications Corporation ("MCI") called Caliber Learning Network, Inc. ("Caliber"), to provide an international distribution network for adult professional education services. The Company will invest $1.3 million for Jr. Preferred stock of Caliber and will loan $3.0 million to Caliber. The Company does not expect to make further significant investments in or loans to Caliber in the next 24 months. 15 On November 11, 1996, the Company announced that it will make a minority investment in Josten's Learning Corporation ("Jostens"), a leading provider of technology-based educational programs for students from kindergarten through twelfth grade level. The Company will make a $20.6 million investment in Josten's preferred stock through a payment of $5.0 million in cash and $15.6 million of the Company's common stock. The number of shares to be issued will be determined by dividing $16.07 million by the Company's stock price on the registration date of the shares (estimated to be on or about November 20, 1996). This initial investment will equate to a 16.5% ownership interest in Josten's. The Company will also earn a $2.0 million dividend annually, which will increase the Company's ownership percentage of Josten's to 19.9% at the end of the second year of ownership. The Company believes that its capital resources will be sufficient on a short-term basis and over the next 24 months to fund the continued expansion of the business and Caliber, including working capital needs and expected investments in property and equipment. CONTINGENT MATTERS During 1993, the Company committed to purchase and license instructional learning system software from a company (the "Seller") to be used in the Company's contract education sites and to be sold to its franchised Sylvan Learning Centers. The agreement requires the acquisition of a minimum of $4.0 million of courseware in CD ROM format. As of June 30, 1996, the Company had paid for and accepted delivery of $3.0 million in courseware. Prior to August 31, 1996, the Company is required to place a minimum order of $1.0 million. As stipulated in the contract, management currently intends to offset the commitment for future orders against certain obligations the Seller may have to the Company as described below. In 1993 the Company purchased from the Seller the rights to certain testing contracts and agreed to pay the Seller a royalty equal to 27% of the excess contract revenues earned through August 31, 1997 over $7.4 million. Conversely, the Seller agreed to pay the Company a reverse royalty equal to 27% of any revenue deficiency below $7.4 million through August 31, 1997. An installment payment of no more than $1 million is payable by the Seller in October 1996 to the Company under the reverse royalty agreement in the event that revenues are less than $5.5 million through August 31, 1996, with any remaining amount due in October 1997 based on the August 31, 1997 calculation, however the total reverse royalty can not exceed $2.0 million. The Company expects, based on the amount of revenue earned on these contracts through June 30, 1996 and projections of additional revenues through August 31, 1996, that the Seller will owe the Company approximately $1 million in October 1996. No amounts have been recorded related to the royalty arrangement at June 30, 1996.Contingent Matters In connection with the PACE acquisition, the Company will be required to make a contingent payment equal to 6.5 times PACE's 1997 earnings before interest and income taxes ("EBIT"). If PACE's EBIT is less than $2.7 million for 1997, the PACE shareholders may elect to have the payment calculation based on EBIT for either calendar year 1998 or 1999. The contingent payment is payable partially in cash and partially in Common Stock. The amount of any contingent payment to the PACE Stockholders will be capitalized as goodwill when paid and amortized over the 15 remaining estimated recovery period. PACE is expected to meet its cash needs from its operations. PACE provides most of its services to large corporations with favorable credit histories. PACE operations are not capital intensive and historically PACE has generated positive cash flow from operations. The agreement with Drake provides for future contingent payments based on the achievement of certain specified revenue targets between 1997 and 1998 (or 1999 at election of the Sellers). and would be paid in the first quarter of 1999 or 2000. The contingent payments of up to $40 million, if earned, are payable 12.5% in cash (or more at the discretion of the Company) with the remainder in shares of Common Stock. The amount of any contingent payments will be capitalized as goodwill when paid and amortized over the remaining estimated recovery period. QUARTERLY FLUCTUATIONSQuarterly Fluctuations The Company's revenues and operating results have varied substantially from quarter to quarter and may continue to vary, depending upon the timing of implementation of new computer-based testing contracts and contracts funded under the public and non-public school programs or similar programs. Based on the Company's limited experience, revenue generated by computer based testing services may vary based 16 on the frequency or timing of delivery of individual tests and the speed of test administrators' conversion of tests to computer-based format. Revenue or profits in any period will not necessarily be indicative of results in subsequent periods. 1617 PART II --- OTHER INFORMATION ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K -------------------------------- (A) REPORTS ON FORM 8-K The Company did not file any reports(a) Reports on Form 8-K duringDuring the three months ended JuneSeptember 30, 1996.1996, the Company filed a Report on Form 8-K dated September 27, 1996 with respect to the Shareholder Rights Plan and the 3 for 2 stock split of its Common Stock to be effective in the form of a stock dividend. SIGNATURES - ---------- Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on behalf by the undersigned thereunto duly authorized. Sylvan Learning Systems, Inc. Date: August 12,November 11, 1996 /s/B. Lee McGee ------------------------------------------------------------ B. Lee McGee, Vice President and Chief Financial Officer 17 18