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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-Q



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(MARK ONE)

|x | QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ---------------------------------------------------------------------------------------

For the quarterly period ended September 30, 2007

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 0-28977



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VARSITY GROUP INC.

(Exact Name of Registrant as Specified in Its Charter)



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|                                           |  |                                     
|------------------------------------------ |  | ------------------------------------
|Delaware                                   |  | 54-1876848                          
|(State of Incorporation)                   |  | IRS Employer (Identification Number)
|                                           | 
|2677 Prosperity Ave, Suite 250 Fairfax, VA |  | 22031                               
|(Address of Principal Executive Offices)   |  | (Zip Code)                          

Registrants telephone number, including area code: (202) 667-3400

(Formerly of 1300 19thStreet, NW 8thFloor, Washington D.C.)



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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 ̈

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a
non-accelerated filer. See the definitions of accelerated filer and large accelerated filer in Rule 12b-2 of the Act. (Check one):

Large accelerated filer ̈Accelerated filer ̈Non-accelerated filer  x

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

As of
November 8, 2007, the registrant had 18,960,655 shares of common stock outstanding.



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##### Table of Contents

VARSITY GROUP INC.

QUARTERLY REPORT ON FORM 10-Q

For the quarter ended September 30, 2007

INDEX



|         |  |                                                                                                                 |  |            
|-------- |  | --------------------------------------------------------------------------------------------------------------- |  | -----------
|         |  |                                                                                                                 |  | Page Number
|         |  | PART I. FINANCIAL INFORMATION                                                                                   |  |            
|         |  |                                                                                                                
|Item 1.  |  | Financial Statements                                                                                            |  |            
|         |  |                                                                                                                
|         |  | Condensed consolidated balance sheets as of September 30, 2007 and December 31, 2006                            |  | 3          
|         |  |                                                                                                                
|         |  | Condensed consolidated statements of operations for the three and nine months ended September 30, 2007 and 2006 |  | 4          
|         |  |                                                                                                                
|         |  | Condensed consolidated statements of cash flows for the nine months ended September 30, 2007 and 2006           |  | 5          
|         |  |                                                                                                                
|         |  | Notes to condensed consolidated financial statements                                                            |  | 6          
|         |  |                                                                                                                
|Item 2.  |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                           |  | 13         
|         |  |                                                                                                                
|Item 3.  |  | Quantitative and Qualitative Disclosures About Market Risk                                                      |  | 20         
|         |  |                                                                                                                
|Item 4.  |  | Controls and Procedures                                                                                         |  | 20         
|         |  |                                                                                                                
|         |  | PART II. OTHER INFORMATION                                                                                      |  |            
|         |  |                                                                                                                
|Item 1.  |  | Legal Proceedings                                                                                               |  | 21         
|         |  |                                                                                                                
|Item 1A. |  | Risk Factors                                                                                                    |  | 21         
|         |  |                                                                                                                
|Item 2.  |  | Unregistered Sales of Equity Securities and Use of Proceeds                                                     |  | 21         
|         |  |                                                                                                                
|Item 3.  |  | Defaults Upon Senior Securities                                                                                 |  | 21         
|         |  |                                                                                                                
|Item 4.  |  | Submission of Matters to a Vote of Security Holders                                                             |  | 21         
|         |  |                                                                                                                
|Item 5.  |  | Other Information                                                                                               |  | 21         
|         |  |                                                                                                                
|Item 6.  |  | Exhibits                                                                                                        |  | 21         
|         |  |                                                                                                                
|         |  | Signatures                                                                                                      |  | 22         



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##### Table of Contents

PART I.

FINANCIAL INFORMATION



|Item 1: | Financial Statements
|------- | --------------------

VARSITY GROUP INC.

CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)

(in thousands)



|                                                                                                                                                                                             |  |                   |         |   |                  |   |         |  
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ----------------- | ------- | - | ---------------- | - | ------- | -
|                                                                                                                                                                                             |  | September 30,2007 |         |   | December 31,2006 |  
|ASSETS                                                                                                                                                                                       |  |                   |         |   |                  |   |         |  
|Current Assets:                                                                                                                                                                              |  |                   |         |   |                  |   |         |  
|Cash and cash equivalents                                                                                                                                                                    |  | $                 | 70      |   |                  | $ | 436     |  
|Restricted cash                                                                                                                                                                              |  |                   | 2,050   |   |                  |   |        |  
|Short-term investments                                                                                                                                                                       |  |                   |        |   |                  |   | 2,498   |  
|Accounts receivable, net of allowance for doubtful accounts of $270 at September 30, 2007 and $203 at December 31, 2006,
respectively                                                        |  |                   | 3,243   |   |                  |   | 1,673   |  
|Inventory                                                                                                                                                                                    |  |                   | 8,550   |   |                  |   | 8,636   |  
|Other                                                                                                                                                                                        |  |                   | 3,451   |   |                  |   | 2,532   |  
|                                                                                                                                                                                             |  |                   |         |   |                  |   |         |  
|Total current assets                                                                                                                                                                         |  |                   | 17,364  |   |                  |   | 15,775  |  
|Property, plant and equipment, net of depreciation                                                                                                                                           |  |                   | 697     |   |                  |   | 1,156   |  
|Software developed for internal use, net of amortization                                                                                                                                     |  |                   | 2,326   |   |                  |   | 2,090   |  
|Intangible assets, net of amortization                                                                                                                                                       |  |                   | 5       |   |                  |   | 8       |  
|Goodwill                                                                                                                                                                                     |  |                   | 511     |   |                  |   | 511     |  
|Long-term investments                                                                                                                                                                        |  |                   |        |   |                  |   | 3,949   |  
|Other assets                                                                                                                                                                                 |  |                   | 209     |   |                  |   | 159     |  
|                                                                                                                                                                                             |  |                   |         |   |                  |   |         |  
|Total assets                                                                                                                                                                                 |  | $                 | 21,112  |   |                  | $ | 23,648  |  
|                                                                                                                                                                                             |  |                   |         |   |                  |   |         |  
|                                                                                                                                                                                             |  |                  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                                                                                         |  |                   |         |   |                  |   |         |  
|Current Liabilities:                                                                                                                                                                         |  |                   |         |   |                  |   |         |  
|Accounts payable                                                                                                                                                                             |  | $                 | 4,329   |   |                  | $ | 2,384   |  
|Line of credit                                                                                                                                                                               |  |                   | 2,172   |   |                  |   |        |  
|Margin loan                                                                                                                                                                                  |  |                   |        |   |                  |   | 4,205   |  
|Other accrued expenses and other current liabilities                                                                                                                                         |  |                   | 2,209   |   |                  |   | 2,654   |  
|Taxes payable                                                                                                                                                                                |  |                   | 480     |   |                  |   | 56      |  
|                                                                                                                                                                                             |  |                   |         |   |                  |   |         |  
|Total current liabilities                                                                                                                                                                    |  |                   | 9,190   |   |                  |   | 9,299   |  
|Long-term liabilities:                                                                                                                                                                       |  |                   |         |   |                  |   |         |  
|Other non-current liabilities                                                                                                                                                                |  |                   | 190     |   |                  |   | 157     |  
|                                                                                                                                                                                             |  |                   |         |   |                  |   |         |  
|Total liabilities                                                                                                                                                                            |  |                   | 9,380   |   |                  |   | 9,456   |  
|                                                                                                                                                                                             |  |                   |         |   |                  |   |         |  
|Commitments and contingencies                                                                                                                                                                |  |                   |         |   |                  |   |         |  
|Stockholders equity:                                                                                                                                                                        |  |                   |         |   |                  |   |         |  
|Preferred stock: $.0001 par value, 20,000 shares authorized; 0 shares issued and outstanding at September 30, 2007 and December 31,
2006, respectively                                       |  |                   |        |   |                  |   |        |  
|Common stock, $.0001 par value, 60,000 shares authorized, 20,176 and 19,575 shares issued and 18,961 and 18,360 shares outstanding at
September 30, 2007 and December 31, 2006, respectively |  |                   | 2       |   |                  |   | 2       |  
|Additional paid-in capital                                                                                                                                                                   |  |                   | 91,171  |   |                  |   | 90,721  |  
|Accumulated unrealized loss on securities                                                                                                                                                    |  |                   |        |   |                  |   | (2      | )
|Accumulated deficit                                                                                                                                                                          |  |                   | (77,708 | ) |                  |   | (74,796 | )
|Treasury stock, $.0001 par value, 1,215 shares at September 30, 2007 and December 31, 2006, respectively                                                                                     |  |                   | (1,733  | ) |                  |   | (1,733  | )
|                                                                                                                                                                                             |  |                   |         |   |                  |   |         |  
|Total stockholders equity                                                                                                                                                                   |  |                   | 11,732  |   |                  |   | 14,192  |  
|                                                                                                                                                                                             |  |                   |         |   |                  |   |         |  
|Total liabilities and stockholders equity                                                                                                                                                   |  | $                 | 21,112  |   |                  | $ | 23,648  |  
|                                                                                                                                                                                             |  |                   |         |   |                  |   |         |  

See accompanying notes to condensed consolidated financial statements.



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VARSITY GROUP INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)

(in thousands, except per share data)



|                                     |  |                                 |        |   |                                |   |         |      |  |   |        |   |  |   |         |  
|------------------------------------ |  | ------------------------------- | ------ | - | ------------------------------ | - | ------- | ---- |  | - | ------ | - |  | - | ------- | -
|                                     |  | Three Months EndedSeptember 30, |        |   | Nine Months EndedSeptember 30, |  
|                                     |  | 2007                            |        |   | 2006                           |   |         | 2007 |  |   | 2006   |  
|Net sales:                           |  |                                 |        |   |                                |   |         |      |  |   |        |   |  |   |         |  
|Textbooks                            |  | $                               | 32,377 |   |                                | $ | 38,564  |      |  | $ | 34,261 |   |  | $ | 40,721  |  
|Uniforms                             |  |                                 | 3,825  |   |                                |   | 5,131   |      |  |   | 5,048  |   |  |   | 6,740   |  
|Solutions                            |  |                                 |       |   |                                |   | 126     |      |  |   |       |   |  |   | 217     |  
|Shipping                             |  |                                 | 2,856  |   |                                |   | 3,344   |      |  |   | 3,119  |   |  |   | 3,659   |  
|                                     |  |                                 |        |   |                                |   |         |      |  |   |        |   |  |   |         |  
|Total net sales                      |  |                                 | 39,058 |   |                                |   | 47,165  |      |  |   | 42,428 |   |  |   | 51,337  |  
|                                     |  |                                 |        |   |                                |   |         |      |  |   |        |   |  |   |         |  
|Operating expenses:                  |  |                                 |        |   |                                |   |         |      |  |   |        |   |  |   |         |  
|Cost of textbooks                    |  |                                 | 21,730 |   |                                |   | 25,998  |      |  |   | 22,827 |   |  |   | 27,506  |  
|Cost of uniforms                     |  |                                 | 2,015  |   |                                |   | 3,004   |      |  |   | 2,696  |   |  |   | 3,736   |  
|Cost of solutions                    |  |                                 |       |   |                                |   | 68      |      |  |   |       |   |  |   | 104     |  
|Cost of shipping                     |  |                                 | 2,888  |   |                                |   | 3,294   |      |  |   | 3,235  |   |  |   | 3,675   |  
|Sales and marketing                  |  |                                 | 6,517  |   |                                |   | 9,064   |      |  |   | 10,035 |   |  |   | 12,617  |  
|General and administrative           |  |                                 | 2,602  |   |                                |   | 3,282   |      |  |   | 6,362  |   |  |   | 7,373   |  
|Amortization of acquired intangibles |  |                                 |       |   |                                |   | 66      |      |  |   |       |   |  |   | 163     |  
|                                     |  |                                 |        |   |                                |   |         |      |  |   |        |   |  |   |         |  
|Total operating expenses             |  |                                 | 35,752 |   |                                |   | 44,776  |      |  |   | 45,155 |   |  |   | 55,174  |  
|                                     |  |                                 |        |   |                                |   |         |      |  |   |        |   |  |   |         |  
|Income (loss) from operations        |  |                                 | 3,306  |   |                                |   | 2,389   |      |  |   | (2,727 | ) |  |   | (3,837  | )
|                                     |  |                                 |        |   |                                |   |         |      |  |   |        |   |  |   |         |  
|Other (expense) income, net:         |  |                                 |        |   |                                |   |         |      |  |   |        |   |  |   |         |  
|Interest (expense) income, net       |  |                                 | (34    | ) |                                |   | 48      |      |  |   | (80    | ) |  |   | 265     |  
|Other (expense), net                 |  |                                 | (51    | ) |                                |   | (8      | )    |  |   | (90    | ) |  |   | (7      | )
|                                     |  |                                 |        |   |                                |   |         |      |  |   |        |   |  |   |         |  
|Other (expense), income, net         |  |                                 | (85    | ) |                                |   | 40      |      |  |   | (170   | ) |  |   | 258     |  
|                                     |  |                                 |        |   |                                |   |         |      |  |   |        |   |  |   |         |  
|Income (loss) before income taxes    |  |                                 | 3,221  |   |                                |   | 2,429   |      |  |   | (2,897 | ) |  |   | (3,579  | )
|Income tax expense                   |  |                                 | (1     | ) |                                |   | (18,031 | )    |  |   | (16    | ) |  |   | (15,574 | )
|                                     |  |                                 |        |   |                                |   |         |      |  |   |        |   |  |   |         |  
|Net income (loss)                    |  | $                               | 3,220  |   |                                | $ | (15,602 | )    |  | $ | (2,913 | ) |  | $ | (19,153 | )
|                                     |  |                                 |        |   |                                |   |         |      |  |   |        |   |  |   |         |  
|Net income (loss) per share:         |  |                                 |        |   |                                |   |         |      |  |   |        |   |  |   |         |  
|Basic                                |  | $                               | 0.17   |   |                                | $ | (0.86   | )    |  | $ | (0.16  | ) |  | $ | (1.09   | )
|                                     |  |                                 |        |   |                                |   |         |      |  |   |        |   |  |   |         |  
|Diluted                              |  | $                               | 0.17   |   |                                | $ | (0.86   | )    |  | $ | (0.16  | ) |  | $ | (1.09   | )
|                                     |  |                                 |        |   |                                |   |         |      |  |   |        |   |  |   |         |  
|Weighted average shares:             |  |                                 |        |   |                                |   |         |      |  |   |        |   |  |   |         |  
|Basic                                |  |                                 | 18,961 |   |                                |   | 18,254  |      |  |   | 18,682 |   |  |   | 17,646  |  
|                                     |  |                                 |        |   |                                |   |         |      |  |   |        |   |  |   |         |  
|Diluted                              |  |                                 | 19,001 |   |                                |   | 18,254  |      |  |   | 18,682 |   |  |   | 17,646  |  
|                                     |  |                                 |        |   |                                |   |         |      |  |   |        |   |  |   |         |  

See accompanying notes to condensed consolidated financial statements.



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VARSITY GROUP INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

(in thousands)



|                                                                            |  |                                |        |   |      |   |         |  
|--------------------------------------------------------------------------- |  | ------------------------------ | ------ | - | ---- | - | ------- | -
|                                                                            |  | Nine Months EndedSeptember 30, |       
|                                                                            |  | 2007                           |        |   | 2006 |  
|CASH FLOWS FROM OPERATING ACTIVITIES:                                       |  |                                |        |   |      |   |         |  
|Net loss                                                                    |  | $                              | (2,913 | ) |      | $ | (19,153 | )
|Adjustments to reconcile net loss to net cash used in operating activities: |  |                                |        |   |      |   |         |  
|Depreciation and amortization                                               |  |                                | 887    |   |      |   | 934     |  
|Provision for bad debt                                                      |  |                                | (132   | ) |      |   | 39      |  
|Deferred income tax expense                                                 |  |                                |       |   |      |   | 15,524  |  
|Non-cash stock compensation                                                 |  |                                | 327    |   |      |   | 379     |  
|Changes in operating assets and liabilities:                                |  |                                |        |   |      |   |         |  
|Accounts receivable                                                         |  |                                | (1,438 | ) |      |   | (2,230  | )
|Inventory                                                                   |  |                                | 86     |   |      |   | (8,506  | )
|Other current and non-current assets                                        |  |                                | (927   | ) |      |   | 4,672   |  
|Accounts payable                                                            |  |                                | 1,945  |   |      |   | 4,069   |  
|Other accrued expenses and other current liabilities                        |  |                                | (436   | ) |      |   | 2,028   |  
|Taxes payable                                                               |  |                                | 424    |   |      |   | 934     |  
|                                                                            |  |                                |        |   |      |   |         |  
|Net cash used in operating activities                                       |  |                                | (2,177 | ) |      |   | (1,310  | )
|                                                                            |  |                                |        |   |      |   |         |  
|CASH FLOWS FROM INVESTING ACTIVITIES:                                       |  |                                |        |   |      |   |         |  
|Payments for acquisitions and intangible asset                              |  |                                |       |   |      |   | (1,327  | )
|Purchases of property, equipment and software developed for internal use    |  |                                | (719   | ) |      |   | (2,481  | )
|Proceeds from sales of equipment                                            |  |                                | 92     |   |      |   |        |  
|Increase in restricted cash                                                 |  |                                | (2,050 | ) |      |   |        |  
|Sales of investments                                                        |  |                                | 6,406  |   |      |   | 3,350   |  
|                                                                            |  |                                |        |   |      |   |         |  
|Net cash provided by (used in) investing activities                         |  |                                | 3,729  |   |      |   | (458    | )
|                                                                            |  |                                |        |   |      |   |         |  
|CASH FLOWS FROM FINANCING ACTIVITIES:                                       |  |                                |        |   |      |   |         |  
|Payments for capital lease obligations                                      |  |                                | (9     | ) |      |   | (15     | )
|Net borrowings under line of credit                                         |  |                                | 2,172  |   |      |   |        |  
|Payments against margin loan                                                |  |                                | (4,205 | ) |      |   |        |  
|Proceeds from exercise of employee stock options                            |  |                                | 124    |   |      |   | 745     |  
|                                                                            |  |                                |        |   |      |   |         |  
|Net cash (used in) provided by financing activities                         |  |                                | (1,918 | ) |      |   | 730     |  
|                                                                            |  |                                |        |   |      |   |         |  
|Net decrease in cash and cash equivalents                                   |  |                                | (366   | ) |      |   | (1,038  | )
|Cash and cash equivalents at beginning of period                            |  |                                | 436    |   |      |   | 2,733   |  
|                                                                            |  |                                |        |   |      |   |         |  
|Cash and cash equivalents at end of period                                  |  | $                              | 70     |   |      | $ | 1,695   |  
|                                                                            |  |                                |        |   |      |   |         |  
|Supplemental disclosure of cash flow information:                           |  |                                |        |   |      |   |         |  
|Cash paid for income taxes                                                  |  | $                              | 35     |   |      | $ | 155     |  
|Cash paid for interest                                                      |  | $                              | 149    |   |      | $ | 40      |  
|                                                                            |  |                               
|Non-cash investing and financing activities                                 |  |                                |        |   |      |   |         |  
|Reduction in goodwill recorded in the acquisition of Campus Outfitters      |  | $                              |       |   |      | $ | 23      |  
|Acquisition of capital leased equipment                                     |  | $                              | 36     |   |      | $ |        |  
|                                                                            |  |                               
|Acquisitions of IQ Digital (May 2006)                                       |  |                                |        |   |      |   |         |  
|Fair value fixed assets and other assets acquired                           |  | $                              |       |   |      | $ | (444    | )
|Identified intangible assets                                                |  |                                |       |   |      |   | (136    | )
|Goodwill                                                                    |  |                                |       |   |      |   | (706    | )
|Fair value of liabilities assumed                                           |  |                                |       |   |      |   | 34      |  
|                                                                            |  |                                |        |   |      |   |         |  
|Cash expended for acquisitions                                              |  |                                |       |   |      |   | (1,252  | )
|                                                                            |  |                                |        |   |      |   |         |  
|Cash paid against acquisition accruals and adjustments to goodwill          |  |                                |       |   |      |   | (50     | )
|                                                                            |  |                                |        |   |      |   |         |  
|Total cash paid for acquisitions                                            |  | $                              |       |   |      | $ | (1,302  | )
|                                                                            |  |                                |        |   |      |   |         |  

See accompanying notes to condensed consolidated financial statements



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VARSITY GROUP INC. AND SUBSIDIARIES

NOTES TO CONDENSED (UNAUDITED) CONSOLIDATED FINANCIAL STATEMENTS

Note 1: Description of Operations

Varsity Group Inc.
(the Company) was incorporated on December 16, 1997 and launched its website, www.varsitybooks.com, in August 1998, at which time the Company began generating revenues. Varsity Group is an outsourcing solutions provider for the
education community. Varsity Group offers schools a comprehensive eCommerce solution for their textbook procurement operations and is a provider of uniform apparel needs for schools and businesses with physical retail locations in Indiana, Maryland,
Michigan, North Carolina, New Jersey, New York, Ohio and Texas.

Note 2: Basis of Presentation

The condensed consolidated financial statements of Varsity Group Inc. included herein have been prepared by the Company without audit, pursuant to the rules and
regulations of the Securities and Exchange Commission and reflect all adjustments which are, in the opinion of management, necessary for a fair presentation of the results for the interim period in conformity with generally accepted accounting
principles.

Certain information and footnote disclosure normally included in the financial statements prepared in accordance with generally accepted
accounting principles have been condensed or omitted. The interim financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Companys Annual Report on Form 10-K for the
fiscal year ended December 31, 2006. Our business is seasonal and thus operating results for the interim periods are not necessarily indicative of results for an entire year.

The year-end condensed consolidated balance sheet data was derived from audited financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States of
America.

Recent Accounting Standards

In June 2006, the FASB
issued Financial Interpretation No. 48, Accounting for Uncertainty in Income Taxes (FIN 48) which clarifies the accounting for uncertainty in income taxes recognized in a companys financial statements in accordance
with SFAS No. 109, Accounting for Income Taxes. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax
return. The Company adopted FIN 48 as of January 1, 2007 and the adoption did not result in the recording of any adjustments related to tax positions previously taken and did not have an effect on its financial position or results of
operations.

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (SFAS 157), which defines fair
value, establishes a framework for using fair value to measure assets and liabilities, and expands disclosures about fair value measurements. SFAS 157 applies whenever other statements require or permit assets or liabilities to be measured at
fair value. SFAS 157 is effective for fiscal years beginning after November 15, 2007. The Company is currently evaluating the impact this statement will have, if any, on its condensed consolidated financial statements.

In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities Including an Amendment of FASB
Statement No. 115 (SFAS 159). SFAS 159 permits entities to choose to measure many financial instruments and certain other items at fair value, with unrealized gains and losses related to these financial instruments
reported in earnings at each subsequent reporting date. SFAS 159 is effective for fiscal years beginning after November 15, 2007. The Company is currently evaluating the impact this statement will have, if any, on its condensed
consolidated financial statements.

Note 3: Stock-Based Compensation

1998 Stock Plan

On October 2, 1998, the Company adopted the 1998 Stock Plan, which was amended and restated in
fiscal year 2000 and further amended in 2003, and under which incentive stock options, non-qualified stock options, restricted stock or stock rights, or any combination thereof may be granted to the Companys employees and directors. There
presently are 9.1 million shares authorized under the 1998 Stock Plan, subject to increase annually on the date of our annual meeting of stockholders by (i) three percent of the Companys outstanding common stock on such date,
(ii) 750,000 shares, or (iii) such lesser amount as the Companys Board may determine. The Company has reserved an additional 1.0 million shares of its common stock for future option grants. The Compensation Committee of the
Board of Directors administers the Plan and determines the individuals to whom options will be granted, the number of options granted, the exercise price and vesting schedule. Options are exercisable at prices established at the date of grant and
have a term of ten years and vesting periods between one and 60 months. Vested options held at the date of



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termination may be exercised within three months. Shares issued under the plan upon option exercise or granting of restricted stock are generally issued from
authorized but previously unissued shares. The Board of Directors may terminate the Plan at anytime.

Adoption of SFAS No. 123R

On January 1, 2006, the Company adopted the provisions of SFAS No. 123 (revised 2004), Share-Based Payment (SFAS 123R), which
establishes accounting for stock-based awards made to employees and directors. Accordingly, stock-based compensation expense is measured at grant date, based on the fair value of the award, and is recognized as expense over the remaining requisite
service period. The Company previously applied APB Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations and provided the required pro forma disclosures of SFAS 123. The adoption of SFAS 123R resulted
in stock-based compensation expense of approximately $135,000 and $327,000 for the three and nine months ended September 30, 2007, respectively, and $182,000 and $379,000 for the three and nine months ended September 30, 2006,
respectively. This stock-based compensation expense negatively impacted basic and diluted earnings per share by approximately $0.01 per share for the three months ended September 30, 2007 and 2006, respectively, and by approximately $0.02 per
share for the nine months ended September 30, 2007 and 2006, respectively.

The weighted-average grant date fair value of options granted during the
three and nine months ended September 30, 2007 was $0.76, compared to $2.34 for the nine months ended September 30, 2006. The fair value of each option is estimated on the date of grant using the Black-Scholes option-pricing model. The
application of this valuation model involves assumptions that are highly subjective, judgmental and sensitive in the determination of compensation expense. The following weighted-average assumptions were used for grants during the three and nine
months ended September 30:



|                    |  |                                 |   |                                |      |  |           |   |  |            |  
|------------------- |  | ------------------------------- | - | ------------------------------ | ---- |  | --------- | - |  | ---------- | -
|                    |  | Three Months EndedSeptember 30, |   | Nine Months EndedSeptember 30, |     
|                    |  | 2007                            |   |                                | 2006 |  | 2007      |   |  | 2006       |  
|Expected volatility |  | 62.95                           | % |                                |     |  | 62.95     | % |  | 51.14      | %
|Risk-free rate      |  | 4.85                            | % |                                |     |  | 4.85      | % |  | 4.86       | %
|Expected term       |  | 6.3 years                       |   |                                |     |  | 6.3 years |   |  | 6.18 years |  
|Dividend yield      |  | 0.0                             | % |                                |     |  | 0.0       | % |  | 0.0        | %

The Companys computation of expected volatility for grants during the three and nine months ended
September 30, 2007 was based on the historical volatility of the Companys stock. The Companys computation of expected term for grants during the three and nine months ended September 30, 2007, is estimated based on the
simplified method provided by Staff Accounting Bulletin No. 107, Share-Based Payment (SAB 107). The risk-free interest rate for periods within the contractual life of the option is based on the U.S.
Treasury yield curve in effect at the time of grant. The Company currently recognizes stock-based compensation expense for the fair values of these awards on a straight-line basis over the requisite service period of each of these awards.

A summary of activity of all options is as follows (in thousands, except per share data and contractual term):



|                                |  |                       |   |  |                               |  |                                |  |                         |    
|------------------------------- |  | --------------------- | - |  | ----------------------------- |  | ------------------------------ |  | ----------------------- | ---
|                                |  | Number ofStockOptions |   |  | WeightedAverageExercise Price |  | WeightedAverageContractualTerm |  | AggregateIntrinsicValue
|Outstanding, December 31, 2006  |  | 3,513                 |   |  | 4.73                          |  | 7.00                           |  | $                       | 392
|Granted                         |  | 1,235                 |   |  | 1.20                          |  |                                |  |                         |    
|Exercised                       |  | (98                   | ) |  | 1.27                          |  |                                |  |                         |    
|Forfeited                       |  | (429                  | ) |  | 4.84                          |  |                                |  |                         |    
|                                |  |                       |   |  |                               |  |                                |  |                         |    
|Outstanding, September 30, 2007 |  | 4,221                 |   |  | 3.77                          |  | 7.22                           |  | $                       | 43 
|                                |  |                       |   |  |                               |  |                                |  |                         |    
|Exercisable, September 30, 2007 |  | 2,571                 |   |  | 5.08                          |  | 5.72                           |  | $                       | 43 
|                                |  |                       |   |  |                               |  |                                |  |                         |    

The aggregate intrinsic value in the above table reflects the total pre-tax intrinsic value (the difference
between the Companys closing stock price on the last trading day of the period and the exercise price of the options, multiplied by the number of in-the-money stock options) that would have been received by the option holders had all option
holders exercised their options on the last day of the period. The intrinsic value of the Companys stock options changes based on the closing price of the Companys stock. The closing price per share of the Companys common stock on
September 30, 2007 was $1.08. The total intrinsic value of options exercised during the nine months ended September 30, 2007 was approximately $0.1 million. The intrinsic value is calculated as the difference between the market value as of
the date of exercise and the exercise price of the shares.



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##### Table of Contents

As of September 30, 2007, unrecognized stock-based compensation expense related to stock options of approximately
$1.6 million is expected to be recognized over a weighted-average period of 3.83 years.

Because of the Companys net operating losses, the Company
did not realize any tax benefits from the tax deductions from share-based payment arrangements during the nine months ended September 30, 2007.

Restricted Stock

As of September 30, 2007, there were no shares of restricted stock outstanding.

Note 4: Net Income (Loss) Per Share

Basic income (loss) per share is
computed using the weighted average number of shares of common stock outstanding for the period. Diluted income (loss) per share is computed using the weighted average number of shares of common stock and, when dilutive, potential common shares from
options and warrants to purchase common stock using the treasury stock method. The effect of stock options for the nine month period ended September 30, 2007 and for the three and nine month periods ended September 30, 2006 were excluded
from the calculation of diluted net loss per share because including these shares would be anti-dilutive due to the Companys reported net loss.

The
following table sets forth the computation of basic and diluted income (loss) per share (in thousands, except per share data):



|                                                                                |  |                                 |        |      |                                |         |      |  |   |        |   |  |   |         |  
|------------------------------------------------------------------------------- |  | ------------------------------- | ------ | ---- | ------------------------------ | ------- | ---- |  | - | ------ | - |  | - | ------- | -
|                                                                                |  | Three Months EndedSeptember 30, |        |      | Nine Months EndedSeptember 30, |        
|                                                                                |  | 2007                            |        | 2006 |                                |         | 2007 |  |   | 2006   |  
|Numerator:                                                                      |  |                                 |        |      |                                |         |      |  |   |        |   |  |   |         |  
|Net income (loss)                                                               |  | $                               | 3,220  |      | $                              | (15,602 | )    |  | $ | (2,913 | ) |  | $ | (19,153 | )
|                                                                                |  |                                 |        |      |                                |         |      |  |   |        |   |  |   |         |  
|Denominator:                                                                    |  |                                 |        |      |                                |         |      |  |   |        |   |  |   |         |  
|Denominator for basic income per share                                          |  |                                 |        |      |                                |         |      |  |   |        |   |  |   |         |  
|Weighted average shares outstanding                                             |  |                                 | 18,961 |      |                                | 18,254  |      |  |   | 18,682 |   |  |   | 17,646  |  
|Employee stock options and other                                                |  |                                 | 40     |      |                                |        |      |  |   |       |   |  |   |        |  
|                                                                                |  |                                 |        |      |                                |         |      |  |   |        |   |  |   |         |  
|Denominator for diluted income per share                                        |  |                                 |        |      |                                |         |      |  |   |        |   |  |   |         |  
|Adjusted weighted average shares, assuming exercise of common equivalent shares |  |                                 | 19,001 |      |                                | 18,254  |      |  |   | 18,682 |   |  |   | 17,646  |  
|                                                                                |  |                                 |        |      |                                |         |      |  |   |        |   |  |   |         |  
|Net income (loss) per share                                                     |  |                                 |        |      |                                |         |      |  |   |        |   |  |   |         |  
|Basic                                                                           |  | $                               | 0.17   |      | $                              | (0.86   | )    |  | $ | (0.16  | ) |  | $ | (1.09   | )
|Diluted                                                                         |  | $                               | 0.17   |      | $                              | (0.86   | )    |  | $ | (0.16  | ) |  | $ | (1.09   | )

Note 5: Other Comprehensive Loss

Other comprehensive loss relates to unrealized losses on short-term and long-term investments. The following table sets forth the comprehensive loss for the three and nine months ended September 30, 2007 and 2006
(amounts in thousands):



|                                                                   |  |                                 |       |      |                                |         |      |  |   |        |   |  |   |         |  
|------------------------------------------------------------------ |  | ------------------------------- | ----- | ---- | ------------------------------ | ------- | ---- |  | - | ------ | - |  | - | ------- | -
|                                                                   |  | Three Months EndedSeptember 30, |       |      | Nine Months EndedSeptember 30, |        
|                                                                   |  | 2007                            |       | 2006 |                                |         | 2007 |  |   | 2006   |  
|Net income (loss) as reported                                      |  | $                               | 3,220 |      | $                              | (15,602 | )    |  | $ | (2,913 | ) |  | $ | (19,153 | )
|Unrealized gain on investments, net of reclassification adjustment |  |                                 |      |      |                                | 53      |      |  |   | 2      |   |  |   | 37      |  
|                                                                   |  |                                 |       |      |                                |         |      |  |   |        |   |  |   |         |  
|Total comprehensive income (loss)                                  |  | $                               | 3,220 |      | $                              | (15,549 | )    |  | $ | (2,911 | ) |  | $ | (19,116 | )
|                                                                   |  |                                 |       |      |                                |         |      |  |   |        |   |  |   |         |  

Note 6: Other Current Assets

The following is a summary of other current assets as of September 30, 2007 and December 31, 2006 (in thousands):



|                          |  |                   |       |                  |   |      
|------------------------- |  | ----------------- | ----- | ---------------- | - | -----
|                          |  | September 30,2007 |       | December 31,2006
|Rebates due from B&T, net |  | $                 | 3,040 |                  | $ | 1,357
|Returns in transit        |  |                   |      |                  |   | 605  
|Other                     |  |                   | 411   |                  |   | 570  
|                          |  |                   |       |                  |   |      
|                          |  | $                 | 3,451 |                  | $ | 2,532
|                          |  |                   |       |                  |   |      



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##### Table of Contents

| |  |  | Amounts due from B&T result from Company owned textbooks that B&T has returned to publishers for credit net of amounts payable that the Company owes to
B&T;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Returns-in-transit consists of new textbooks that the Company returned to publishers for credit during the fourth quarter of fiscal 2006 that had not yet been
processed by the publishers as of December 31, 2006; and
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Other consists of prepaids and other assets.
| | - |  | --------------------------------------------

Note 7: Intangible Assets and Goodwill

There were no changes in the amount of carrying value of goodwill in the nine months ended
September 30, 2007. Amortization expense related to the Companys acquired intangible assets was $1,000 and $2,500 during the three and nine months ended September 30, 2007, respectively, compared to $66,000 and $163,000 during the
three and nine months ended September 30, 2006, respectively. Amortization expense for the three and nine months ended September 30, 2007, is reported as part of general and administrative expense.

Note 8: Acquisitions and Purchase of Assets

On May 1, 2006, the
Company acquired substantially all the assets of IQ Digital Studios (IQ Digital) from White Hat Ventures, LLC for approximately $1.3 million cash plus the assumption of certain liabilities. IQ Digital was based in Akron, Ohio and was an
advertising agency focused on educational branding, communications and marketing. The purchase price allocation was as follows: $706,000 to goodwill, $444,000 to fixed assets and other assets, $136,000 to other acquired intangibles and $34,000 to
assumed liabilities. The goodwill and most of the acquired intangible assets associated with the purchase were fully impaired during the Companys fourth quarter of fiscal 2006.

On March 29, 2006, the Company purchased the assets of Lydia Learn (www.lydialearn.com) from White Hat On Campus, LLC, for cash of approximately $0.4 million. Approximately $350,000 was allocated to acquired
software and $25,000 was allocated to a non-compete agreement, and the remaining balance of the purchase price was allocated to various fixed or current assets. In late November 2006, efforts to launch service offerings outside the book and uniform
areas were terminated or suspended and accordingly, the Lydia Learn asset was fully impaired.

On May 26, 2005, the Company acquired substantially all
of the assets of privately held Campus Outfitters, LLC, for cash of approximately $3.1 million and 123,967 shares of common stock valued at approximately $0.7 million, for an aggregate purchase price of approximately $3.8 million, plus the
assumption of certain liabilities. The Company may be required to make additional contingent payments if the common stock recipients do not sell, pledge, or in any way transfer the common stock before the two year anniversary of the acquisition
close date and the value of the Companys common stock is not equal to or greater than the per share purchase price on the two year anniversary date. The additional contingent payments, if any, would be payable in cash or shares of the
Companys common stock. Accordingly, on June 1, 2007, the Company made an additional payment, in shares of the Companys stock, of 502,776 shares.

Note 9: Income Taxes

The Company accounts for income taxes in accordance with Statement of Financial Accounting Standards No. 109
(SFAS 109,) Accounting for Income Taxes. Under SFAS No. 109, deferred tax assets and liabilities are determined based on differences between the financial reporting and tax basis of assets and liabilities and are
measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. A valuation allowance is established when necessary to reduce deferred tax assets to the amount expected to be realized. In
determining the need for a valuation allowance, our management reviews both positive and negative evidence pursuant to the requirements of SFAS No. 109, including current and historical results of operations, the annual limitation on
utilization of net operating loss carry forwards pursuant to Internal Revenue Code section 382, future income projections and the overall prospects of our business. Based upon managements assessment of all current available evidence, including
the current year operating loss, we have concluded that none of the deferred tax benefits should be recognized at this time. Consequently, we have reserved all deferred tax assets. We will continue to monitor all available evidence and reassess the
potential realization of our deferred tax assets. Approximately $1.9 million of the valuation allowance relates to net operating losses resulting from stock option windfall benefits, e.g. disqualifying dispositions. Reductions in the valuation
allowance for those assets will result in an increase to additional paid-in capital after the valuation allowance related to all other deferred tax assets amounts have been reduced.

In July 2006, the FASB issued FIN 48, which clarifies the accounting for uncertainty in income taxes by prescribing the minimum recognition threshold a tax position is required to meet before being recognized in
the financial statements. FIN 48 also provides guidance on de-recognition, measurement, classification, interest and penalties, accounting for interim periods and disclosures for uncertain tax positions. FIN 48 is effective for fiscal years
beginning after December 15, 2006. The Companys adoption of FIN 48 on January 1, 2007, did not result in the recording of any previously unrecognized tax positions and did not have an effect on its financial position or results
of operations.



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##### Table of Contents

The Company files a U.S. federal income tax return and returns in various state jurisdictions. The Company is subject to
U.S. federal tax and state tax examinations for the tax years 2003 to 2006. The Company is subject to certain state tax examinations for the tax years 2002 to 2006 for those states with longer statutes of limitation than the Federal three-year
statute. The Company does not believe there will be any material changes in its unrecognized tax positions over the next 12 months.

During the three
months and nine months ended September 30, 2006, the Company recorded income tax benefits of $18.0 million and $15.5 million, respectively. In the third quarter of 2006, we determined that deferred tax assets would not be realized and we ceased
recording income tax benefits. For the three months and nine months ended September 30, 2007, all income tax benefits were fully reserved.

Note
10: Inventories

Inventories, consisting of products available for sale, are valued at the lower of cost or market value and are accounted for
principally using the FIFO method. The Companys inventory balance as of September 30, 2007 and December 31, 2006 consists of (in thousands):



|                     |  |                   |       |                  |   |      
|-------------------- |  | ----------------- | ----- | ---------------- | - | -----
|Inventory            |  | September 30,2007 |       | December 31,2006
|New textbooks        |  | $                 | 3,538 |                  | $ | 3,739
|Used textbooks       |  |                   | 1,530 |                  |   | 1,724
|Uniforms and apparel |  |                   | 3,482 |                  |   | 3,173
|                     |  |                   |       |                  |   |      
|                     |  | $                 | 8,550 |                  | $ | 8,636
|                     |  |                   |       |                  |   |      

The components of inventory are as follows:



| |  |  | New textbooks consist of new book inventory held at Baker & Taylor (B&T), our fulfillment partner, acquired by B&T in support of our
Varsity Partners textbook program for which they generally do not enjoy standard return privileges with the publisher. New textbooks also include inventory held at Campus Outfitters retail locations and new textbooks held at other locations;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Used textbooks consist of used textbooks held at B&T, Campus Outfitters retail locations, or other locations; and
| | - |  | -----------------------------------------------------------------------------------------------------------------



| |  |  | Uniforms and apparel consists of school uniform related inventory held at our Campus Outfitters warehouses or retail locations.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------

Under the Companys agreement with B&T in which B&T provides most of the Companys order fulfillment and drop shipment services, B&T generally only
assumes ownership of new textbooks that they are able to return to publishers for credit, which historically has approximated 90% of all new textbook inventories. B&T does not assume ownership of the used products it processes for the Company,
and consistent with the agreement with B&T, the Company purchases from B&T at cost new textbooks that B&T procured in support of our textbook program and cannot return for publisher credit at the conclusion of each selling season. This
inventory has typically been held by B&T for fulfillment in subsequent periods. On a quarterly basis, the Company assesses its inventory for potential write-down for estimated excess and obsolete or unmarketable inventory and records write-downs
equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions.

Note 11: Business Segments

The Companys operations are aggregated into two reportable business segments: textbook trade and uniform
trade.

The business segments reported below are the segments of the Company for which discrete financial information was available and for which the
Companys chief operating decision maker evaluated gross margins in its first, second and third quarters of fiscal 2007 and 2006 (amounts in thousands):



|                      |  |                                  |        |          |   |        |           |   |       |   |  |      |       |      |  |      |       |  |      |        |  |   |        |   |  |   |       
|--------------------- |  | -------------------------------- | ------ | -------- | - | ------ | --------- | - | ----- | - |  | ---- | ----- | ---- |  | ---- | ----- |  | ---- | ------ |  | - | ------ | - |  | - | ------
|                      |  | Three months ended September 30,
|                      |  | Textbooks                        |        | Uniforms |   |        | Corporate |   | Total
|                      |  | 2007                             |        | 2006     |   | 2007   |           |   | 2006  |   |  | 2007 |       | 2006 |  | 2007 |       |  | 2006
|Sales                 |  | $                                | 32,377 |          | $ | 38,564 |           | $ | 3,825 |   |  | $    | 5,131 |      |  | $    |      |  | $    | 126    |  | $ | 36,202 |   |  | $ | 43,821
|Product gross margin  |  | $                                | 10,647 |          | $ | 12,566 |           | $ | 1,810 |   |  | $    | 2,127 |      |  | $    |      |  | $    | 58     |  | $ | 12,457 |   |  | $ | 14,751
|                      |  |                                  |        |          |   |        |           |  
|Shipping revenue      |  | $                                | 2,838  |          | $ | 3,305  |           | $ | 18    |   |  | $    | 39    |      |  | $    |      |  | $    |       |  | $ | 2,856  |   |  | $ | 3,344 
|Shipping gross margin |  | $                                | 50     |          | $ | 220    |           | $ | (82   | ) |  | $    | (170  | )    |  | $    |      |  | $    |       |  | $ | (31    | ) |  | $ | 50    
|                      |  |                                  |        |          |   |        |           |  
|Total sales           |  | $                                | 35,215 |          | $ | 41,869 |           | $ | 3,843 |   |  | $    | 5,170 |      |  | $    |      |  | $    | 126    |  | $ | 39,058 |   |  | $ | 47,165
|Blended gross margin  |  | $                                | 10,697 |          | $ | 12,786 |           | $ | 1,728 |   |  | $    | 1,957 |      |  | $    |      |  | $    | 58     |  | $ | 12,425 |   |  | $ | 14,801
|                      |  |                                  |        |          |   |        |           |  
|Goodwill              |  | $                                | 511    |          | $ | 511    |           | $ |      |   |  | $    | 1,893 |      |  | $    |      |  | $    | 706    |  | $ | 511    |   |  | $ | 3,110 
|Total assets          |  | $                                | 13,251 |          | $ | 16,585 |           | $ | 5,656 |   |  | $    | 6,932 |      |  | $    | 2,444 |  | $    | 10,263 |  | $ | 21,112 |   |  | $ | 33,780



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|                      |  |                                 |        |          |      |   |           |  |       |       |   |  |      |       |      |  |      |       |  |      |        |  |   |        |   |  |   |        |  
|--------------------- |  | ------------------------------- | ------ | -------- | ---- | - | --------- |  | ----- | ----- | - |  | ---- | ----- | ---- |  | ---- | ----- |  | ---- | ------ |  | - | ------ | - |  | - | ------ | -
|                      |  | Nine months ended September 30, |       
|                      |  | Textbooks                       |        | Uniforms |      |   | Corporate |  | Total |      
|                      |  | 2007                            |        |          | 2006 |   | 2007      |  |       | 2006  |   |  | 2007 |       | 2006 |  | 2007 |       |  | 2006 |       
|Sales                 |  | $                               | 34,261 |          |      | $ | 40,720    |  | $     | 5,048 |   |  | $    | 6,740 |      |  | $    |      |  | $    | 217    |  | $ | 39,309 |   |  | $ | 47,678 |  
|Product gross margin  |  | $                               | 11,434 |          |      | $ | 13,214    |  | $     | 2,352 |   |  | $    | 3,004 |      |  | $    |      |  | $    | 113    |  | $ | 13,786 |   |  | $ | 16,332 |  
|                      |  |                                 |        |          |      |   |           | 
|Shipping revenue      |  | $                               | 3,089  |          |      | $ | 3,610     |  | $     | 30    |   |  | $    | 49    |      |  | $    |      |  | $    |       |  | $ | 3,119  |   |  | $ | 3,659  |  
|Shipping gross margin |  | $                               | (5     | )        |      | $ | 208       |  | $     | (111  | ) |  | $    | (224  | )    |  | $    |      |  | $    |       |  | $ | (116   | ) |  | $ | (16    | )
|                      |  |                                 |        |          |      |   |           | 
|Total sales           |  | $                               | 37,350 |          |      | $ | 44,330    |  | $     | 5,078 |   |  | $    | 6,789 |      |  | $    |      |  | $    | 217    |  | $ | 42,428 |   |  | $ | 51,337 |  
|Blended gross margin  |  | $                               | 11,429 |          |      | $ | 13,423    |  | $     | 2,241 |   |  | $    | 2,780 |      |  | $    |      |  | $    | 113    |  | $ | 13,670 |   |  | $ | 16,316 |  
|                      |  |                                 |        |          |      |   |           | 
|Goodwill              |  | $                               | 511    |          |      | $ | 511       |  | $     |      |   |  | $    | 1,893 |      |  | $    |      |  | $    | 706    |  | $ | 511    |   |  | $ | 3,110  |  
|Total assets          |  | $                               | 13,251 |          |      | $ | 16,585    |  | $     | 5,656 |   |  | $    | 6,932 |      |  | $    | 2,444 |  | $    | 10,264 |  | $ | 21,112 |   |  | $ | 33,780 |  

Note 12: Related Party Transaction

Connected with the acquisition of Campus Outfitters, the Company assumed the lease to the Campus Outfitters 16,800 square foot corporate headquarters building in College Park, MD which was owned by 5112 Berwyn LLC, a
Maryland limited liability company whose controlling shareholders are Adam Hanin, the founder of Campus Outfitters and Executive Vice President of Sales of the Company until June 15, 2006. Under terms of the lease, the Company is obligated to
pay 5112 Berwyn LLC $18,000 a month through May 2015. In July 2006, 5112 Berwyn LLC sold the Campus Outfitters headquarters building to an unrelated party. The Companys total related party payments in fiscal 2006 until the time of sale was
$126,000.

Note 13: Financing Arrangements  Line of Credit

On March 8, 2007, the Company entered into a Revolving Line of Credit Loan Agreement and Security Agreement with Bank of America, N.A. (BOA) in which BOA will lend up to a maximum amount of $5 million
to assist in funding the Companys seasonal cash requirements. Under the facility, the Company may use up to $1 million of the $5 million borrowing ceiling to issue letters of credit.

Interest on outstanding balances is calculated and paid monthly in arrears based on the 30 day LIBOR rate then in effect plus 2.25%. The interest rate at
September 30, 2007 was 7.53%. A daily commitment fee of 0.25% per annum is paid monthly in arrears on the unused portion of the facility.

Borrowing ceiling levels are established monthly by establishing a Borrowing Base calculated as the sum of the following percentages of asset groupings: 100% of eligible restricted cash investments; 80% of eligible commercial accounts
receivable; 50% of the eligible value of new book inventory; 25% of the eligible value of used book inventory and 50% of the eligible value of apparel inventory. The Borrowing Base on September 30, 2007 exceeded the borrowing ceiling therefore
the borrowing ceiling on September 30, 2007 was limited to the maximum $5 million. As of September 30, 2007, the amount of borrowings under the facility, including $587,000 in outstanding checks not included in the Companys cash
balance, was $2,172,000, with $2,828,000 remaining available to borrow.



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##### Table of Contents

A $2.0 million restricted cash investment is required to be maintained at all times with BOA as the investment collateral
portion of the borrowing base. The facility is secured by substantially all of the Companys assets. The agreement terminates on April 30, 2008.

The agreement is subject to various restrictive covenants, which include restrictions on the use of loan proceeds, the sale or transfer of assets, incurring additional indebtedness, acquisitions of assets and other business, investments of
assets, loans made by us, repurchases of Company securities and change of control. The agreement is subject to our compliance with a minimum tangible net worth covenant. At September 30, 2007, we were not in compliance with the minimum
tangible net worth covenant. We have requested a waiver of non-compliance with this covenant from BOA. We cannot assure you that the waiver will be received or that BOA will not place material conditions on it.

Note 14: Subsequent Events

On October 3, 2007, the Company
received the approval of the Nasdaq Listing Staff to transfer the listing of its shares from the Nasdaq Global Market to the Nasdaq Capital Market, effective with the market opening of business on October 5, 2007. As mentioned in a press
release dated August 24, 2007, the Company was notified by Nasdaq that it did not comply with the minimum of $10,000,000 stockholders equity requirement for continued listing on the Nasdaq Global Market set forth in Marketplace
Rule 4450(a)(3). As of June 30, 2007, the Companys stockholders equity was $8,378,000. Since the Company meets all the listing requirements of the Nasdaq Capital Market, it opted to transfer to that market.

On November 9, 2007, the Company requested a waiver from BOA for its non-compliance with the minimum tangible net worth covenant as of September 30, 2007. At
time of this filing, the Company has yet to hear back from BOA.



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##### Table of Contents

|Item 2: | Managements Discussion and Analysis of Financial Condition and Results of Operations
|------- | -------------------------------------------------------------------------------------

Forward Looking Statements

The following discussion and
analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2006.
This discussion contains forward-looking statements that involve risks and uncertainties that could cause our actual results to differ materially. These statements relate to future events or our future financial performance and are based on
information available to us as of the date hereof, and we assume no obligation to update any forward-looking statement. In some cases, you can identify forward-looking statements by terminology such as may, will,
should, except, plan, anticipate, intend, seek, expect, believe, estimate, predict, potential or
continue, the negative of such terms or other comparable terminology. These statements are only predictions. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of certain
factors, including but not limited to, those discussed in Risk Factors included in the Companys Annual Report on Form 10-K for the year ended December 31, 2006 and other reports and filings made with the Securities and
Exchange Commission.

The following discussion provides additional information to the accompanying consolidated financial statements and notes to
help provide an understanding of our financial condition, changes in financial condition and results of operations. This discussion is organized as follows:



| |  |  | Overview. This section provides a general description of our business, economic and industry-wide factors relevant to us and material opportunities,
challenges and risks in our business.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Critical Accounting Policies. This section discusses those accounting policies that contain uncertainties and require significant judgment in their
application.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Results of Operations. This section provides an analysis of our results of operations for all three years presented in the accompanying consolidated
statements of operations.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Liquidity and Capital Resources. This section provides an analysis of our sources and uses of cash, capital expenditures and the amount of financial
capacity available to fund our future commitments.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Overview

We are an outsourcing solutions provider for the education community. Under the VarsityBooks and Campus Outfitters brands, we provide textbooks, uniforms and school supplies to private K-12
schools, colleges, and distance and continuing education markets. Through our textbook and uniform outsource solutions, schools are released from the operational and financial challenges associated with managing highly seasonal retail operations and
are free to focus on their core educational mission. Parents and students benefit from the increased convenience and value associated with our comprehensive textbook and uniform programs.

We were incorporated in December 1997 and began offering books for sale on our website on August 10, 1998. Prior to 2005, our revenues consisted primarily of sales
of new textbooks. In May 2005, we acquired Campus Outfitters, a retailer of school uniforms to the private K-12 school marketplace, and introduced school uniforms as a second revenue stream into our business. To date, the primary channel for
textbook sales has been through online eCommerce transactions, while the majority of uniform sales have been recognized through retail stores and on-campus sales events.

Our original sales model focused on building a broad consumer brand, offering promotions and deeply discounted textbook prices to entice college students to visit our website and purchase their textbooks from us.
However, during 2000 we began to focus resources on the growth and development of our eduPartners program, whereby we became a provider of new textbooks and learning materials to private middle and high school, college, distance, and continuing
education markets. This model represents the overwhelming majority of our textbook business today.

Within our textbook solution, we create a customized
virtual bookstore for each partner school which is hosted on our website, www.varsitybooks.com. This site contains the required and optional educational materials and supplies selected by the school organized by grade, academic discipline and course
name. Students and parents from each of our partner schools access their customized bookstore to place their orders via a direct link from their schools homepage or by searching for their school bookstore by region and state on our homepage.
Once an order has been submitted, it is typically picked, packed and shipped within one business day from one of three distribution centers nationwide.

Member schools leverage our textbook solution to lower their operating overhead by outsourcing their bookstore operation while delivering a more efficient and flexible bookstore solution to their community. In addition, our partner schools
have access to our unique program administration website that provides them with sales and inventory reports, among other valuable features. Student and parent customers value the convenience of our online shopping experience and take comfort in the
knowledge that



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##### Table of Contents

our posted booklists have been reviewed for content and accuracy and approved by their school. As a further convenience to parents, students and school
officials, to the extent any of our partner schools adopt textbooks to be used in the next school term, we will typically offer parents and students several options to sell back their textbooks to us at the end of the school year, helping to lower
their total cost of textbook ownership. These used textbooks are offered for sale the following school year providing our student and parent customers lower cost pricing alternatives.

In May 2005, as part of our strategy to expand the number of services and products we offer our customers, we acquired Campus Outfitters. Through the Campus Outfitters brand, Varsity Group owns and operates eight
retail locations serving private K-12 school communities as their official school uniform provider. Parents and students are also able to purchase uniforms and related items via on-campus sales events which are held at eligible schools as well as
online through customized virtual stores which are created on www.campusoutfitters.com for each partner school containing all required uniform components. We believe with the Campus Outfitters acquisition, we now have the opportunity to begin
cross-selling our textbook and uniform model between our combined network of existing customers.

Beginning in the second quarter of 2006, we moved
aggressively to launch service offerings outside our core book and uniform offerings. Significant costs were incurred in this effort. In November 2006, due to the financial impact of cost increases together with limited new revenue generation from
non-book/uniform service offerings, efforts to launch service offerings outside the book and uniform areas were terminated or suspended. Significant cost reductions have been implemented, and our current strategy includes only the book, uniform and
school supplies businesses. Our August 2006 partnership with Office Depot enables us to provide School Supplies solutions to parents and students and Office Supplies solutions to schools.

During our third quarter of fiscal 2007, we served fewer schools with our textbook solutions than the prior year and total dollar revenue and unit sales for the majority
of retained schools declined from the prior year. These factors caused a 16.1% decrease in textbook revenue from the prior year. Fewer schools were served with our textbook solutions primarily due to the loss of a slightly greater number of online
books schools than were acquired for 2007 plus the impact of losing the book revenue from schools served with both books and uniforms who dropped the uniform solution (and therefore the book solution as well) as a result of the difficulties in
uniform operations during 2006. The decline in total dollar revenue and unit sales for the majority of retained schools was caused primarily by consumers acquiring an increased percentage of books from sources other than us. While we are the
endorsed provider of textbooks to the schools we serve, we are not the exclusive source of textbooks for the consumers associated with the schools. We believe the cause of the decline in revenue per school retained from 2006 to 2007 relates to a
decline in the customer service experience in 2006 which impacted school satisfaction and consumer loyalty in 2007, our online retail book pricing in 2007 and finally, higher book backorder levels in 2007 than 2006. To address these issues, we
replaced our outsource customer service provider for 2007 and thereby experienced improved performance over 2006 and improved school survey responses, which we believe will result in improved school retention rates for 2008. We also intend to more
aggressively price our book product in 2008 to discourage online price shopping. We will work closely with Baker & Taylor and our schools to further refine our supply chain elements with the goal in 2008 to reduce out-of-stock situations.

As expected, uniform revenue declined in the third quarter of fiscal 2007 from the prior year mainly due to a decline in the number of schools served.
While poor performance in 2006 resulted in significant school losses for 2007, problems encountered in 2006 were largely corrected for 2007. Operational performance and school satisfaction were significantly improved in 2007, which we believe will
result in greater levels of account retention and new sales for 2008.

Our overall success and ability to maintain and increase profitability from
operations will depend, in part, upon our ability to retain our current customers, attract additional schools to our programs, provide a compelling and satisfying shopping experience to our retail customers, and manage our relationship with our
primary fulfillment partner, Baker and Taylor, Inc. (B&T), a leading distributor of books, videos and music products.

In view of the
rapidly evolving nature of our business and our limited operating history, we have limited experience forecasting our revenues. Therefore we believe that period-to-period comparisons of our financial results might not necessarily be meaningful and
you should not rely on them as an indication of future performance.

CRITICAL ACCOUNTING POLICIES

Pursuant to guidance published by the SEC regarding disclosure about critical accounting policies, we have identified the following accounting policies as critical to the
understanding of our financial statements.

Our consolidated financial statements are prepared in conformity with accounting principles generally accepted
in the United States. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, sales, and expenses, and related disclosure of contingent assets and
liabilities. We re-evaluate our estimates on an on-going basis. Our estimates and judgments are based on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Actual results may differ
from these estimates or judgments under different assumptions or conditions.

We believe the following are the critical accounting policies which affect
our more significant judgments and estimates used in the preparation of our unaudited condensed consolidated financial statements:



| |  |  | Revenue Recognition;
| | - |  | --------------------



| |  |  | Deferred Income Taxes;
| | - |  | ----------------------



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##### Table of Contents

| |  |  | Stock-Based Compensation Plans;
| | - |  | -------------------------------



| |  |  | Valuation of Inventories;
| | - |  | -------------------------



| |  |  | Business Acquisition and Valuation and Impairment Review of Long-Lived Assets
| | - |  | -----------------------------------------------------------------------------

A complete discussion of these policies is contained in our Form 10-K filed with the Securities and Exchange Commission for the period ending December 31, 2006. There were no significant changes to the
critical accounting policies discussed in the Companys 10-K filed for December 31, 2006, except for the adoption of FIN 48 which is discussed in Note 1 to the condensed, consolidated financial statements.

Results of Operations:

The following table includes the condensed
consolidated statements of operations data for the three and nine months ended September 30, 2007 and September 30, 2006, expressed as a percentage of total net sales:



|                                     |  |                                  |    |  |                                 |    |  |       |    |  |       |   
|------------------------------------ |  | -------------------------------- | -- |  | ------------------------------- | -- |  | ----- | -- |  | ----- | --
|                                     |  | Three Months Ended September 30, |    |  | Nine Months Ended September 30, |   
|                                     |  | 2007                             |    |  | 2006                            |    |  | 2007  |    |  | 2006  |   
|Net sales:                           |  |                                  |    |  |                                 |    |  |       |    |  |       |   
|Textbooks                            |  | 82.9                             | %  |  | 81.7                            | %  |  | 80.8  | %  |  | 79.4  | % 
|Uniforms                             |  | 9.8                              | %  |  | 10.9                            | %  |  | 11.9  | %  |  | 13.1  | % 
|Solutions                            |  | 0.0                              | %  |  | 0.3                             | %  |  | 0.0   | %  |  | 0.4   | % 
|Shipping                             |  | 7.3                              | %  |  | 7.1                             | %  |  | 7.3   | %  |  | 7.1   | % 
|                                     |  |                                  |    |  |                                 |    |  |       |    |  |       |   
|Total net sales                      |  | 100.0                            | %  |  | 100.0                           | %  |  | 100.0 | %  |  | 100.0 | % 
|                                     |  |                                  |    |  |                                 |    |  |       |    |  |       |   
|Operating Expenses:                  |  |                                  |    |  |                                 |    |  |       |    |  |       |   
|Cost of textbooks                    |  | 55.6                             | %  |  | 55.1                            | %  |  | 53.8  | %  |  | 53.6  | % 
|Cost of uniforms                     |  | 5.2                              | %  |  | 6.4                             | %  |  | 6.4   | %  |  | 7.3   | % 
|Cost of solutions                    |  | 0.0                              | %  |  | 0.1                             | %  |  | 0.0   | %  |  | 0.2   | % 
|Cost of shipping                     |  | 7.4                              | %  |  | 7.0                             | %  |  | 7.6   | %  |  | 7.2   | % 
|Sales and marketing                  |  | 16.7                             | %  |  | 19.2                            | %  |  | 23.6  | %  |  | 24.6  | % 
|General and administrative           |  | 6.6                              | %  |  | 7.0                             | %  |  | 15.0  | %  |  | 14.3  | % 
|Amortization of acquired intangibles |  | 0.0                              | %  |  | 0.1                             | %  |  | 0.0   | %  |  | 0.3   | % 
|                                     |  |                                  |    |  |                                 |    |  |       |    |  |       |   
|Total operating expenses             |  | 91.5                             | %  |  | 94.9                            | %  |  | 106.4 | %  |  | 107.5 | % 
|                                     |  |                                  |    |  |                                 |    |  |       |    |  |       |   
|Income (loss) from operations        |  | 8.5                              | %  |  | 5.1                             | %  |  | (6.4  | )% |  | (7.5  | )%
|Other (expense) income, net          |  | (0.3                             | )% |  | 0.1                             | %  |  | (0.4  | )% |  | 0.5   | % 
|                                     |  |                                  |    |  |                                 |    |  |       |    |  |       |   
|Income (loss) before income taxes    |  | 8.2                              | %  |  | 5.2                             | %  |  | (6.8  | )% |  | (7.0  | )%
|Income tax expense                   |  | 0.0                              | %  |  | (38.2                           | )% |  | 0.0   | %  |  | (30.3 | )%
|                                     |  |                                  |    |  |                                 |    |  |       |    |  |       |   
|Net income (loss) income             |  | 8.2                              | %  |  | (33.0                           | )% |  | (6.8  | )% |  | (37.3 | )%
|                                     |  |                                  |    |  |                                 |    |  |       |    |  |       |   

Seasonality:

We experience significant seasonality in our results of operations and our peak selling period is the July/August/September back-to-school season. During fiscal 2006 and 2005, approximately 88% and 86% of our revenues, respectively, were
recognized in this period. We expect this trend to continue during 2007. While many private middle and high school institutions have an active book-buying season in December/January, the volume of purchases are typically significantly lower than the
initial back-to-school season. Historically, Campus Outfitters has experienced the same seasonality in its results of operations. Consistent with its current concentration of private elementary, middle and high schools, Campus Outfitters peak
selling season has been July/August/September back-to-school season. Part of our strategy is to extend our textbook program more deeply into the college and distance learning markets, expand our uniform model to more broadly incorporate branded
apparel and identify profitable new products or services to market to our existing customer base. This could result in more balanced revenues throughout the year. However, based upon our current program, product and school mix, we will continue to
experience significant fluctuations in quarterly operating results. Please see Forward-Looking Statements.



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##### Table of Contents

Net Sales:

Net sales decreased 17.2%, or $8.1 million, to $39.1 million, and decreased 17.4%, or $8.9 million, to $42.4 million for the three and nine-month periods ended September 30, 2007, respectively, compared to the same periods in 2006. The
decrease during the three and nine-month periods was primarily the result of a decrease in both number of schools served and sales per school for the textbook business and decrease in the number of schools served by the uniform business.

Operating Expenses:

Cost of Textbooks -Cost of
textbooks consists of the cost of textbooks and related education materials sold to customers. Cost of textbooks decreased 16.4%, or approximately $4.3 million, to approximately $21.7 million, and decreased 17.0%, or approximately $4.7 million, to
approximately $22.8 million, for the three and nine months ended September 30, 2007, respectively, compared to the same periods in 2006. This decrease in absolute dollars was attributable to our decreased sales volume. Expressed as a percentage
of related revenue, cost of textbooks was 67.2% and 67.5% for the three months ended September 30, 2007 and 2006, respectively, and 66.6% and 67.8% for the nine months ended September 30, 2007 and 2006, respectively. The improved margins
in the three and nine months ended September 30, 2007 were the result of improvements in product sourcing and inventory management, and an increase in the sale of used textbooks in proportion to new textbooks over the prior year period.
Improved margins were partially offset by approximately $0.5 million in benefits provided by Baker and Taylor resulting from prompt payment discounts we could not fully take advantage of due to lower cash balances over the prior year period and
lower volume discounts due to lower sales as compared to the prior year periods. Cost of textbooks varies with textbook revenue and we expect these costs to increase in absolute dollars as our customer base and number of partner schools served
expands. Please see Forward-Looking Statements.

The following table sets forth online textbook sales for the three and nine months ended
September 30, 2007 and 2006 (in thousands):



|                         |  |                                  |  |                                 |  |       |  |      
|------------------------ |  | -------------------------------- |  | ------------------------------- |  | ----- |  | -----
|                         |  | Three Months Ended September 30, |  | Nine Months Ended September 30,
|                         |  | 2007                             |  | 2006                            |  | 2007  |  | 2006 
|Total online unit sales: |  |                                  |  |                                 |  |       |  |      
|New textbooks sold       |  | 893                              |  | 1,002                           |  | 941   |  | 1,047
|Used textbooks sold      |  | 107                              |  | 104                             |  | 116   |  | 110  
|                         |  |                                  |  |                                 |  |       |  |      
|Total textbooks sold     |  | 1,000                            |  | 1,106                           |  | 1,057 |  | 1,157
|                         |  |                                  |  |                                 |  |       |  |      

Cost of Uniforms - Cost of uniforms consists of the cost of uniforms and apparel sold to customers. Cost of
uniforms decreased approximately $1.0 million, or 32.9%, to approximately $2.0 million, and decreased approximately $1.0 million, or 27.8%, to approximately $2.7 million for the three and nine months ended September 30, 2007, respectively.
Expressed as a percentage of related revenue, cost of uniforms was 52.7% and 58.5% for the three months ended September 30, 2007 and 2006, respectively, and 53.4% and 55.4% for the nine months ended September 30, 2007 and 2006,
respectively.

The improved margins in the three and nine month periods ended September 30, 2007 were largely attributable to decreased sales volume
and integration issues related to the acquisition of Campus Outfitters in fiscal 2006 that did not recur in fiscal 2007. Before our acquisition of Campus Outfitters in May 2005, Campus had been privately owned and operated. In order to accommodate
the Campus acquisition, we began in fiscal 2006 upgrading virtually all aspects of its transaction processing systems, including order management, cash and credit card processing, purchasing, inventory management and shipping. While many of the
systems were upgraded in time, we did experience delays in fiscal 2006 in the release of our new order management and inventory management software systems, which contributed to operational difficulties and caused increased cost of uniforms during
our quarter ended September 30, 2006. These difficulties were largely overcome for fiscal 2007, contributing to a reduced cost of uniforms and apparel sold to customers in 2007.

Cost of uniforms varies with uniform revenue and we expect these costs to increase in absolute dollars as our customer base expands. Please see Forward-Looking Statements.

Cost of Shipping. Cost of shipping consists of outbound shipping to our customers. Cost of shipping decreased $0.4 million, or 12.3%, to $2.9 million, and
decreased approximately $0.4 million, or 12.0%, to approximately $3.2 million for the three and nine months ended September 30, 2007, respectively. Expressed as a percentage of related revenue, cost of shipping was 101.1% and 98.5% for the
three months ended September 30, 2007 and 2006, respectively, and 103.7% and 100.4% for the nine months ended September 30, 2007 and 2006, respectively. This cost decrease was largely attributable to decreased sales volume.



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##### Table of Contents

Sales and Marketing:

Sales and marketing expense consists primarily of promotional expenditures, credit card processing fees, travel expense, expenses associated with contracting with our textbook partner schools, expenses associated with our Campus Outfitters
retail locations and road shows, seasonal overhead associated with performing inventory purchases at textbook programs schools, and payroll and related expenses for personnel engaged in sales and marketing, account management, and our textbook,
uniform and solutions operations. Sales and marketing expense decreased approximately $2.5 million, or 28.1%, to approximately $6.5 million, and decreased approximately $2.6 million or 20.5%, to approximately $10 million for the three and nine
months ended September 30, 2007, respectively.

The following table sets forth sales and marketing expense for the three and nine months ended
September 30, 2007 and 2006 (in thousands):



|                                         |  |                                  |       |   |                                 |   |       |      |  |   |        |   |  |   |        |  
|---------------------------------------- |  | -------------------------------- | ----- | - | ------------------------------- | - | ----- | ---- |  | - | ------ | - |  | - | ------ | -
|                                         |  | Three months ended September 30, |       |   | Nine months ended September 30, |  
|                                         |  | 2007                             |       |   | 2006                            |   |       | 2007 |  |   | 2006   |  
|Variable sales and marketing expense     |  | $                                | 4,303 |   |                                 | $ | 5,296 |      |  | $ | 4,692  |   |  | $ | 5,738  |  
|Percentage of total revenue              |  |                                  | 11.0  | % |                                 |   | 11.2  | %    |  |   | 11.1   | % |  |   | 11.2   | %
|Other sales and marketing expense        |  | $                                | 2,212 |   |                                 | $ | 3,768 |      |  | $ | 5,343  |   |  | $ | 6,879  |  
|Percentage of total revenue              |  |                                  | 5.7   | % |                                 |   | 8.0   | %    |  |   | 12.6   | % |  |   | 13.4   | %
|                                         |  |                                  |       |   |                                 |   |       |      |  |   |        |   |  |   |        |  
|Sales and marketing expense, as reported |  | $                                | 6,515 |   |                                 | $ | 9,064 |      |  | $ | 10,035 |   |  | $ | 12,617 |  
|Percentage of total revenue              |  |                                  | 16.7  | % |                                 |   | 19.2  | %    |  |   | 23.7   | % |  |   | 24.7   | %

Variable sales and marketing expense consists of credit card expenses, certain expenses associated with
contracting with our textbook and apparel program schools, and sales expenses associated with our agreement with B&T. Variable sales and marketing expense decreased by approximately $1.0 million and $1.1 million, respectively, for the three and
nine months ended September 30, 2007 due to the decreased sales volume discussed earlier. We expect that variable sales and marketing expense will increase during our peak selling period in each July/August/September back-to-school season.
Please see Forward-Looking Statements.

Other sales and marketing expense consists of primarily payroll and related expenses for personnel
engaged in sales and marketing, account management, textbook, uniform and solutions operations, travel expense, expenses associated with our Campus Outfitters retail locations and road shows and seasonal overhead associated with performing inventory
purchases at textbook program schools. Other sales and marketing expense decreased 39.3%, or approximately $1.5 million, to approximately $2.3 million, and decreased 21.2%, or approximately $1.5 million, to approximately $5.4 million for the three
and nine months ended September 30, 2007, respectively. The decrease in the three and nine months ended September 30, 2007 was largely attributable to the termination or suspension of all non-textbook / uniforms / school supply service
offerings in our fourth quarter of fiscal 2006. Please see Forward-Looking Statements.

General and Administrative:

General and administrative expense consists of payroll and related expenses for executive, administrative, and our development and systems personnel, facilities
expenses, costs associated with our agreement with SchoolOne which is developing our new technology and providing services and support for our processes and systems, costs associated with the upgrade and maintenance of our website, outside
consultant and professional services expenses, travel, and other general corporate expenses. General and administrative expense, reported net of $0.2 million and $0.3 million of costs capitalized for software developed or purchased for internal use
during the three months ended September 30, 2007 and 2006, respectively, decreased 20.7% or approximately $0.7 million, to approximately $2.6 million. General and administrative expense, reported net of $0.7 million and $1.4 million of costs
capitalized for software developed or purchased for internal use during the nine months ended September 30, 2007 and 2006, respectively, decreased 14.4% or approximately $1.0 million, to approximately $6.4 million for the nine months ended
September 30, 2007. These decreases were primarily attributable to the termination or suspension of all non-textbook / uniforms / school supply service offerings in our fourth quarter of fiscal 2006. Included in the three and nine month periods
ended September 30, 2007 were approximately $0.3 million of lease expense related to the sublease of our space in our former headquarters in Washington, D.C., and estimated lease termination expenses of our space in Akron, OH. Please see
Forward-Looking Statements.



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We are capitalizing development costs in accordance with American Institute of Certified Public Accountants
(AICPA) Statement of Position No. 98-1 (SOP 98-1), Accounting for the Costs of Computer Software Developed or Obtained for Internal Use. Please see Forward-Looking Statements.

Amortization of Acquired Intangibles

Our
acquisitions of Campus Outfitters in May 2005 and IQ Digital in May 2006 were accounted for under the purchase method of accounting. As a result, we recorded intangible assets at their applicable fair values of the net tangible assets acquired.
Intangible assets are amortized over periods ranging from one to ten years. Amortization of acquired intangibles was approximately $66,000 and $163,000 during the three and nine months ended September 30, 2006. During our fourth quarter 2006,
we recorded impairment charges against all of our acquired intangibles except for the IQ Digital trademark. As a result, future amortization for acquired intangibles is immaterial. Please see Forward-Looking Statements.

Other (expense) income, net

Other (expense) income, net
consists primarily of interest income on our cash and cash equivalents and investments, and interest expense related to our outstanding margin loan and line of credit. Other expense was approximately $(85,000) and $(0.2) million for the three and
nine months ended September 30, 2007, respectively, compared to other income of $40,000 and $0.3 million for the three and nine months ended September 30, 2006, respectively. The decrease was due to lower average invested cash and
increasing borrowings under the revolving line of credit during the three and nine months ended September 30, 2007 as compared to the prior year periods and a recognized loss of approximately $41,000 during the nine months ended
September 30, 2007 due to the sale of a long-term security before its maturity date.

Income Taxes

During the three months and nine months ended September 30, 2006, the Company recorded income tax benefits of $18.0 million and $15.6 million, respectively. In the
third quarter of 2006, we determined that deferred tax assets would not be realized and we ceased recording income tax benefits. For the three months and nine months ended September 30, 2007, all income tax benefits were fully reserved.

In July 2006, the FASB issued FIN 48, which clarifies the accounting for uncertainty in income taxes by prescribing the minimum recognition threshold
a tax position is required to meet before being recognized in the financial statements. FIN 48 also provides guidance on de-recognition, measurement, classification, interest and penalties, accounting for interim periods and disclosures for
uncertain tax positions. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Companys adoption of FIN 48 on January 1, 2007, did not result in the recording of any previously unrecognized tax positions
and did not have an effect on its financial position or results of operations.

The Company files a U.S. federal income tax return and returns in various
state jurisdictions. The Company is subject to U.S. federal tax and state tax examinations for the tax years 2003 to 2006. The Company is subject to certain state tax examinations for the tax years 2002 to 2006 for those states with longer
statutes of limitation than the Federal three-year statute. The Company does not believe there will be any material changes in its unrecognized tax positions over the next 12 months.

The Companys policy is to recognize interest and penalties accrued on any unrecognized tax positions as a component of income tax expense. As of the date of
adoption of FIN 48, the Company did not have any accrued interest or penalties associated with any unrecognized tax positions, and there was no related interest or penalties recognized during the three months and nine months ended
September 30, 2007.

Liquidity and Capital Resources

As of September 30, 2007, we had approximately $2.1 million of cash, cash equivalents, and restricted cash and our net working capital was approximately $8.2 million compared to approximately $2.6 million of cash, cash equivalents and
short-term investments and net working capital of approximately $6.5 million at December 31, 2006. As of September 30, 2007, we did not have any cash invested in long-term investments compared to approximately $3.9 million at
December 31, 2006. The decrease in cash, cash equivalents, restricted cash and short-term investments during the nine months ended September 30, 2007 was primarily attributable to cash payments for our school partner incentive accruals,
used textbooks we acquired during our fiscal 2007 buyback campaign and cash used to fund operating losses. This decrease was partially offset by the collection of certain receivables due from B&T.

As of September 30, 2007, our principal commitments consisted of borrowings under our line of credit agreement with Bank of America, obligations outstanding under
operating leases, our service agreement with SchoolOne, and accounts payable. Beginning in the second quarter of 2006, we moved aggressively to launch service offerings outside our core book and uniform offerings. Significant costs and cash
expenditures were incurred in this effort. In November 2006, due to the financial impact of cost increases together with limited new revenue generation from non-book/uniform service offerings, efforts to launch service



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offerings outside the book and uniform areas were terminated or suspended. Significant cost reductions have been implemented, and our current strategy
includes only the book, uniform and school supplies businesses. As a result, we anticipate a reduction in cash used in fiscal 2007. However, the seasonal nature of our business requires that we manage our liquidity carefully in advance of the fall
selling season. Please see Forward-Looking Statements.

Net cash used in operating activities was approximately $2.2 million for the nine
months ended September 30, 2007 compared to net cash used in operating activities of approximately $1.3 million for the nine months ended September 30, 2006. The change was primarily due to an increase in payments made against accounts
payable and accrued expenses, and a smaller decrease in other current assets related to year-end rebates received from B&T compared to the prior year period. This was partially offset by a decrease in cash expended for inventory and a decreased
net loss in the nine months ended September 30, 2007.

Investing activities consist of acquisitions of businesses, capitalization of software
developed for internal use, purchases of property, plant and equipment, purchases of software, purchases and sales of short-term and long-term investments and restricted cash, and proceeds from sales of property plant and equipment. Net cash
provided by investing activities was approximately $3.7 million for the nine months ended September 30, 2007 compared to net cash used in investing activities of approximately $0.4 million for the nine months ended September 30, 2006.
During the nine months ended September 30, 2007 we had sales of short-term and long-term investments of approximately $6.4 million, which we used to payoff our margin loan outstanding as of December 31, 2006, and to purchase a restricted
cash investment with BOA to use as collateral against our line of credit, compared to net sales of short-term and long-term investments of $3.4 million during the comparable reporting period. Total purchases of property, equipment and software,
including capitalization of software, was approximately $0.7 million during the nine months ended September 30, 2007, a decrease of approximately $1.8 million over the comparable period in 2006. During fiscal 2006, we made significant
investments in our people, processes and systems to accelerate the growth of our business, including approximately $1.3 million for payments of acquisitions during the nine months ended September 30, 2006. As a result, we expect our total
fiscal 2007 expenditures for property, equipment and software, including capitalization of software, to be significantly lower in fiscal 2007. Also during the nine months ended September 30, 2007, we received cash proceeds of approximately $0.1
million resulting from sales of fixed assets no longer in service due to the closure of our iQ Digital Studios office in Akron, Ohio.

Net cash used in
financing activities was approximately $1.9 million for the nine months ended September 30, 2007 compared to net cash provided by financing activities of approximately $0.7 for the nine months ended September 30, 2006. During the nine
months ended September 30, 2007, we made a full payment of approximately $4.2 million against our margin loan outstanding as of December 31, 2006. This was offset by actual cash borrowings of approximately $1.5 million under our line of
credit agreement with Bank of America as well as prospective cash borrowings of approximately $0.6 million to cover outstanding checks at September 30, 2007.

The following table provides an overview or our aggregate contractual obligations as of September 30, 2007, and the effect these obligations are expected to have on our liquidity and cash flows for the remainder of fiscal 2007 and in
future periods are as follows (in thousands):



|                                  |  |      |       |   |      |   |       |      |  |   |       |   |  |      |      |            |  |       |     |  |   |     |  |   |        |  
|--------------------------------- |  | ---- | ----- | - | ---- | - | ----- | ---- |  | - | ----- | - |  | ---- | ---- | ---------- |  | ----- | --- |  | - | --- |  | - | ------ | -
|Contractual Obligations           |  | 2007 |       |   | 2008 |   |       | 2009 |  |   | 2010  |   |  | 2011 |      | Thereafter |  | Total |    
|Capital lease obligations & other |  | $    | 4     |   |      | $ | 10    |      |  | $ | 8     |   |  | $    | 8    |            |  | $     | 8   |  | $ |    |  | $ | 38     |  
|Line of credit obligations        |  |      |      |   |      |   | 1,585 |      |  |   |      |   |  |      |     |            |  |       |    |  |   |    |  |   | 1,585  |  
|SchoolOne (1)                     |  |      | 532   |   |      |   |      |      |  |   |      |   |  |      |     |            |  |       |    |  |   |    |  |   | 532    |  
|Operating lease obligations (2)   |  |      | 775   |   |      |   | 1,370 |      |  |   | 1,213 |   |  |      | 802  |            |  |       | 398 |  |   | 738 |  |   | 5,296  |  
|Sub lease income (3)              |  |      | (86   | ) |      |   | (585  | )    |  |   | (621  | ) |  |      | (319 | )          |  |       |    |  |   |    |  |   | (1,611 | )
|                                  |  |      |       |   |      |   |       |      |  |   |       |   |  |      |      |            |  |       |     |  |   |     |  |   |        |  
|Total                             |  | $    | 1,225 |   |      | $ | 2,380 |      |  | $ | 600   |   |  | $    | 491  |            |  | $     | 406 |  | $ | 738 |  | $ | 5,840  |  
|                                  |  |      |       |   |      |   |       |      |  |   |       |   |  |      |      |            |  |       |     |  |   |     |  |   |        |  

---

|(1) | Second amended agreement signed in August 2007 for services from July 2007 through December 2007.
|--- | -------------------------------------------------------------------------------------------------

|(2) | As of the date of this filing we currently lease approximately 92,000 square feet pursuant to leases that are month-to-month or are schedule to expire between October 2007 and May
2015. We are currently trying to sublease our space in Akron, OH (former headquarters of iQ Digital) and in Ft. Lauderdale, Fl. Remaining contractual obligations for these spaces as of September 30, 2007 are approximately $0.3 million through
April 2011 and $0.6 million through December 2011, respectively.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) | Sub lease income to be received from our former headquarters space in Washington, D.C.
|--- | --------------------------------------------------------------------------------------

Our business is presently highly seasonal, with the vast bulk of our revenues from the sale of books and apparel being earned during the back to school season in the third quarter of each year. In addition, beginning
in the second quarter of 2006, we moved aggressively to launch service offerings outside our core book and uniform offerings. We experienced significant cash expenditures in this effort. In November 2006, due to the financial impact of cost
increases and cash expenditures together with



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limited new revenue generation from non-book/uniform service offerings, efforts to launch service offerings outside the book and uniform areas were
terminated or suspended. Significant cost reductions have been implemented, and our current strategy includes only the book and uniform businesses, however, as a result of this, our net cash and investments position was approximately $9.8 million
lower as of December 31, 2006 compared to December 31, 2005. In March 2007, we entered into a Revolving Line of Credit Loan Agreement and Security Agreement with Bank of America, N.A. (BOA) in which BOA will lend up to a
maximum amount of $5 million to assist in funding the Companys seasonal cash requirements. The Company may also issue letters of credit under the facility. Borrowing ceiling levels are established monthly utilizing a borrowing base formula
based on percentages of month-end inventory, receivable and investment collateral values. A $2 million restricted cash investment is required to be maintained at all times as the investment collateral portion of the borrowing base. The facility is
secured by substantially all of our assets. The agreement terminates on April 30, 2008.

We presently believe that our cash, cash equivalents and
investments may not be sufficient to fund our operating needs until the 2008 back to school season. We are in discussions with BOA regarding expansion of and other changes to the credit facility, considering additional spending reductions
and considering additional external financings to meet our liquidity needs. In order to meet out liquidity needs we will need to obtain capital from one of these sources. Please see Forward-Looking Statements.



|Item 3. | Quantitative and Qualitative Disclosures About Market Risk
|------- | ----------------------------------------------------------

We are exposed to market risk for the effect of interest rate changes and changes in the market values of our investments and for our balances outstanding under our line of credit agreement with BOA.

Interest Rate Risk. Our cash equivalents, restricted cash, short-term and long-term investments, and our balances outstanding under our line of credit agreement
with BOA are subject to interest rate risk. We manage this risk by maintaining an investment portfolio of instruments with high credit quality and relatively short average maturities. These instruments are designated as available-for-sale and,
accordingly, are presented at fair value on our balance sheets and include, but are not limited to, commercial paper, money-market instruments, bank time deposits and variable rate and fixed rate obligations of corporations and national, state and
local governments and agencies. These instruments are denominated in U.S. dollars. The fair market value of cash equivalents, short-term and long-term investments and restricted cash subject to interest rate risk was $2.0 million and
$6.4 million at September 30, 2007 and December 31, 2006, respectively. We also hold cash balances in accounts with commercial banks in the United States. These cash balances represent operating balances only and are invested in
short-term deposits of the local bank and are not included in the amounts above.

The weighted average yield on interest-bearing investments held as of
September 30, 2007 was approximately 4.7% per annum. A 100 basis point increase in the 30-day LIBOR rate would have increased our annual interest expense by approximately $0.1 million.



|Item 4. | Controls and Procedures
|------- | -----------------------

We maintain
disclosure controls and procedures that are designed to ensure that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange
Commissions rules and forms and that such information is accumulated and communicated to our management, including our Chief Executive Officer/Chief Financial Officer and Chief Accounting Officer, as appropriate, to allow for timely decisions
regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving
the desired control objectives, and management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

As of the end of the period covered by this report, as required by SEC Rule 13a-15(b), we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer/Chief Financial
Officer and Chief Accounting Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on and as of the date of such evaluation, our Chief Executive Officer/Chief Financial Officer and Chief
Accounting Officers have concluded that, as of the end of the period covered by this report, our disclosure controls and procedures were effective, including the correction of the material weakness that management identified in our Annual Report on
Form 10-K for the fiscal year ended December 31, 2006 (see below).

In our Annual Report on Form 10-K for the fiscal year ended December 31,
2005, management identified a material weakness in internal control over financial reporting. Specifically, we did not maintain effective controls over the accuracy of the calculation of diluted shares outstanding used in our earnings per share
calculation. The source of the error was an error in the functioning of a spreadsheet used to make the underlying computations. Accordingly, management concluded that our internal control over financial reporting was not effective as of
December 31, 2006 and 2005. Since that time we have taken appropriate steps to



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remediate the identified material weakness by acquiring a third-party software product in our first quarter of fiscal 2006 to automate this process, with the
new product to be run in parallel with the existing system. While the remediation measures immediately improved the design effectiveness of our internal control over financial reporting, we were not able to test the newly designed controls until the
current quarter ended September 30, 2007 as it was the first quarter that we reported net income since the material weakness was first reported and thereby, the calculation of diluted shares outstanding was not required. Accordingly, management
has now concluded that our internal controls over financial reporting are effective as of September 30, 2007.

Changes in Internal Control over
Financial Reporting

Management has evaluated, with the participation of our Chief Executive Officer / Chief Financial Officer and Chief Accounting
Officer, whether any changes in our internal control over financial reporting that occurred during our last fiscal quarter have materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. During
our last fiscal quarter management has implemented internal controls described above as a result of the material weakness identified as of December 31, 2006 and 2005. Management believes the measures that we have implemented to remediate the
material weakness relating to the calculation of diluted shares outstanding have had a material impact on our internal control over financial reporting during fiscal 2006 and the first three quarters of 2007 and anticipates that these measures and
other ongoing enhancements will continue to have a material impact on our internal control over financial reporting in future periods.

PART II.

OTHER INFORMATION



|Item 1: | Legal Proceedings
|------- | -----------------

Not
Applicable



|Item 1A: | Risk Factors
|-------- | ------------

For a
comprehensive discussion of our risk factors, please refer to the audited financial statements and notes included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2006.



|Item 2: | Unregistered Sales of Equity Securities and Use of Proceeds
|------- | -----------------------------------------------------------

Not Applicable



|Item 3: | Defaults Upon Senior Securities
|------- | -------------------------------

Not Applicable



|Item 4: | Submission of Matters to a Vote of Security Holders
|------- | ---------------------------------------------------

Not Applicable



|Item 5: | Other Information
|------- | -----------------

Not
Applicable



|Item 6: | Exhibits
|------- | --------



| | (a) | Exhibits
| | --- | --------



| | 31.1 | Certification of the Companys Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
| | ---- | -----------------------------------------------------------------------------------------------------------------



| | 31.2 | Certification of the Companys Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
| | ---- | -----------------------------------------------------------------------------------------------------------------



| | 32.1 | Certification of the Companys Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
| | ---- | -----------------------------------------------------------------------------------------------------------------



| | 32.2 | Certification of the Companys Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
| | ---- | -----------------------------------------------------------------------------------------------------------------



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SIGNATURES

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

Date: November 14, 2007



Varsity Group Inc.By:

/s/ JAMES CRAIGJames CraigChief Executive OfficerVarsity Group Inc.By:

/s/ JOHN GRIFFINJohn GriffinChief Accounting Officer




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