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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 March 31, 2005



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)



|                                           |  |           
|------------------------------------------ |  | ----------
|1850 M Street, Suite 1150 Washington, D.C. |  | 20036     
|(Address of Principal Executive Offices)   |  | (Zip Code)



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





(Former Name, Former Address and Former Fiscal Year, if Changed, Since Last Report.)



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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 an accelerated filer (as defined in Rule 12b-2 of the Exchange Act)    Yes ̈No  x



As of May 9, 2005, the registrant had 16,788,829 shares of common stock outstanding.



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##### Table of Contents

VARSITY GROUP INC. AND SUBSIDIARIES



QUARTERLY REPORT ON FORM 10-Q

For the quarter ended March 31, 2005



INDEX



|        |  |                                                                                                    |  |            
|------- |  | -------------------------------------------------------------------------------------------------- |  | -----------
|        |  |                                                                                                    |  | Page Number
|        |  | PART I.
FINANCIAL INFORMATION                                                                      |  |            
|        |  |                                                                                                   
|Item 1. |  | Financial Statements                                                                               |  |            
|        |  |                                                                                                   
|        |  | Condensed consolidated balance sheets as of March 31, 2005 and December 31, 2004                   |  | 3          
|        |  |                                                                                                   
|        |  | Condensed consolidated statements of operations for the three months ended March 31, 2005 and 2004 |  | 4          
|        |  |                                                                                                   
|        |  | Condensed consolidated statements of cash flows for the three months ended March 31, 2005 and 2004 |  | 5          
|        |  |                                                                                                   
|        |  | Notes to condensed consolidated financial statements                                               |  | 6          
|        |  |                                                                                                   
|Item 2. |  | Managements Discussion and Analysis of Financial Condition and Results of Operations              |  | 9          
|        |  |                                                                                                   
|Item 3. |  | Quantitative and Qualitative Disclosures About Market Risk                                         |  | 15         
|        |  |                                                                                                   
|Item 4. |  | Controls and Procedures                                                                            |  | 15         
|        |  |                                                                                                   
|        |  | PART II.
OTHER INFORMATION                                                                         |  |            
|        |  |                                                                                                   
|Item 1. |  | Legal Proceedings                                                                                  |  | 16         
|        |  |                                                                                                   
|Item 2. |  | Unregistered Sales of Equity Securities and Use of Proceeds                                        |  | 16         
|        |  |                                                                                                   
|Item 3. |  | Defaults Upon Senior Securities                                                                    |  | 16         
|        |  |                                                                                                   
|Item 4. |  | Submission of Matters to a Vote of Security Holders                                                |  | 16         
|        |  |                                                                                                   
|Item 5. |  | Other Information                                                                                  |  | 16         
|        |  |                                                                                                   
|Item 6. |  | Exhibits                                                                                           |  | 16         



2



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##### Table of Contents

PART I.

FINANCIAL INFORMATION



Item 1:Financial Statements



VARSITY GROUP INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)

(in thousands)



|                                                                                                                                                                                         |  |                |         |   |                   |   |         |  
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | -------------- | ------- | - | ----------------- | - | ------- | -
|                                                                                                                                                                                         |  | March 31, 2005 |         |   | December 31, 2004 |  
|ASSETS                                                                                                                                                                                   |  |                |         |   |                   |   |         |  
|Current Assets:                                                                                                                                                                          |  |                |         |   |                   |   |         |  
|Cash and cash equivalents                                                                                                                                                                |  | $              | 856     |   |                   | $ | 4,865   |  
|Short-term investments                                                                                                                                                                   |  |                | 4,000   |   |                   |   | 7,000   |  
|Accounts receivable, net of allowance for doubtful accounts of $20 at March 31, 2005 and $15 at December 31, 2004,
respectively                                                          |  |                | 513     |   |                   |   | 1,251   |  
|Inventory                                                                                                                                                                                |  |                | 2,296   |   |                   |   | 2,463   |  
|Other                                                                                                                                                                                    |  |                | 395     |   |                   |   | 1,248   |  
|                                                                                                                                                                                         |  |                |         |   |                   |   |         |  
|Total current assets                                                                                                                                                                     |  |                | 8,060   |   |                   |   | 16,827  |  
|                                                                                                                                                                                         |  |               
|Property, plant and equipment, net of depreciation                                                                                                                                       |  |                | 266     |   |                   |   | 252     |  
|Software developed for internal use, net of amortization                                                                                                                                 |  |                | 783     |   |                   |   | 708     |  
|Deferred income taxes                                                                                                                                                                    |  |                | 6,209   |   |                   |   | 5,901   |  
|Long term investments                                                                                                                                                                    |  |                | 13,381  |   |                   |   | 6,993   |  
|Other assets                                                                                                                                                                             |  |                | 26      |   |                   |   | 31      |  
|                                                                                                                                                                                         |  |                |         |   |                   |   |         |  
|Total assets                                                                                                                                                                             |  |                | 28,725  |   |                   |   | 30,712  |  
|                                                                                                                                                                                         |  |                |         |   |                   |   |         |  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                                                                                     |  |                |         |   |                   |   |         |  
|Current Liabilities:                                                                                                                                                                     |  |                |         |   |                   |   |         |  
|Accounts payable                                                                                                                                                                         |  | $              | 468     |   |                   | $ | 696     |  
|Other accrued expenses and other current liabilities                                                                                                                                     |  |                | 415     |   |                   |   | 1,569   |  
|Taxes payable                                                                                                                                                                            |  |                | 422     |   |                   |   | 459     |  
|                                                                                                                                                                                         |  |                |         |   |                   |   |         |  
|Total current liabilities                                                                                                                                                                |  |                | 1,305   |   |                   |   | 2,724   |  
|                                                                                                                                                                                         |  |                |         |   |                   |   |         |  
|Commitments and contingencies                                                                                                                                                            |  |                |         |   |                   |   |         |  
|Stockholders equity:                                                                                                                                                                    |  |                |         |   |                   |   |         |  
|Preferred stock: $.0001 par value, 20,000 shares authorized; 0 shares issued and outstanding at March 31, 2005 and December 31, 2004,
respectively                                       |  |                |        |   |                   |   |        |  
|Common stock, $.0001 par value, 60,000 shares authorized, 18,004 and 17,969 shares issued and 16,789 and 16,754 shares outstanding at March
31, 2005 and December 31, 2004, respectively |  |                | 2       |   |                   |   | 2       |  
|Additional paid-in capital                                                                                                                                                               |  |                | 88,319  |   |                   |   | 88,273  |  
|Unrealized loss                                                                                                                                                                          |  |                | (119    | ) |                   |   | (7      | )
|Deferred compensation                                                                                                                                                                    |  |                |        |   |                   |   |        |  
|Accumulated deficit                                                                                                                                                                      |  |                | (59,049 | ) |                   |   | (58,547 | )
|Treasury stock, $.0001 par value, 1,215 shares at March 31, 2005 and December 31, 2004, respectively                                                                                     |  |                | (1,733  | ) |                   |   | (1,733  | )
|                                                                                                                                                                                         |  |                |         |   |                   |   |         |  
|Total stockholders equity                                                                                                                                                               |  |                | 27,420  |   |                   |   | 27,988  |  
|                                                                                                                                                                                         |  |                |         |   |                   |   |         |  
|Total liabilities and stockholders equity                                                                                                                                               |  | $              | 28,725  |   |                   | $ | 30,712  |  
|                                                                                                                                                                                         |  |                |         |   |                   |   |         |  



See accompanying notes
to condensed consolidated financial statements.



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VARSITY GROUP INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)

(in thousands, except per share data)



|                            |  |                              |        |   |      |   |        |  
|--------------------------- |  | ---------------------------- | ------ | - | ---- | - | ------ | -
|                            |  | Three Months Ended March 31, |       
|                            |  | 2005                         |        |   | 2004 |  
|Net sales:                  |  |                              |        |   |      |   |        |  
|Product                     |  | $                            | 2,146  |   |      | $ | 1,659  |  
|Shipping                    |  |                              | 198    |   |      |   | 168    |  
|                            |  |                              |        |   |      |   |        |  
|Total net sales             |  |                              | 2,344  |   |      |   | 1,827  |  
|                            |  |                              |        |   |      |   |        |  
|Operating expenses:         |  |                              |        |   |      |   |        |  
|Cost of product             |  |                              | 1,436  |   |      |   | 1,199  |  
|Cost of shipping            |  |                              | 161    |   |      |   | 137    |  
|Sales and marketing         |  |                              | 849    |   |      |   | 552    |  
|Product development         |  |                              | 129    |   |      |   | 25     |  
|General and administrative  |  |                              | 730    |   |      |   | 524    |  
|Non-cash stock compensation |  |                              |       |   |      |   | 23     |  
|                            |  |                              |        |   |      |   |        |  
|Total operating expenses    |  |                              | 3,305  |   |      |   | 2,460  |  
|                            |  |                              |        |   |      |   |        |  
|Loss from operations        |  |                              | (961   | ) |      |   | (633   | )
|                            |  |                              |        |   |      |   |        |  
|Other income, net:          |  |                              |        |   |      |   |        |  
|Interest income             |  |                              | 142    |   |      |   | 60     |  
|Other income (expense), net |  |                              | 9      |   |      |   |       |  
|                            |  |                              |        |   |      |   |        |  
|Other income, net           |  |                              | 151    |   |      |   | 60     |  
|                            |  |                              |        |   |      |   |        |  
|Loss before income taxes    |  |                              | (810   | ) |      |   | (573   | )
|                            |  |                              |        |   |      |   |        |  
|Income tax benefit          |  |                              | 310    |   |      |   | 222    |  
|                            |  |                              |        |   |      |   |        |  
|Net loss                    |  | $                            | (502   | ) |      | $ | (351   | )
|                            |  |                              |        |   |      |   |        |  
|Net loss per share:         |  |                              |        |   |      |   |        |  
|Basic and diluted           |  | $                            | (0.03  | ) |      | $ | (0.02  | )
|                            |  |                              |        |   |      |   |        |  
|Weighted average shares:    |  |                              |        |   |      |   |        |  
|Basic and diluted           |  |                              | 16,769 |   |      |   | 16,631 |  
|                            |  |                              |        |   |      |   |        |  



See accompanying notes
to condensed consolidated financial statements.



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VARSITY GROUP INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

(in thousands)



|                                                                                                |  |                              |        |   |      |   |        |  
|----------------------------------------------------------------------------------------------- |  | ---------------------------- | ------ | - | ---- | - | ------ | -
|                                                                                                |  | Three Months Ended March 31, |       
|                                                                                                |  | 2005                         |        |   | 2004 |  
|CASH FLOWS FROM OPERATING ACTIVITIES:                                                           |  |                              |        |   |      |   |        |  
|Net loss                                                                                        |  | $                            | (502   | ) |      | $ | (351   | )
|Adjustments to reconcile net loss to net cash used in operating activities:                     |  |                              |        |   |      |   |        |  
|Depreciation and amortization                                                                   |  |                              | 76     |   |      |   | 22     |  
|Bad debt expense                                                                                |  |                              | 26     |   |      |   |       |  
|Deferred income taxes                                                                           |  |                              | (308   | ) |      |   | (222   | )
|Non-cash stock compensation                                                                     |  |                              |       |   |      |   | 23     |  
|Changes in operating assets and liabilities:                                                    |  |                              |        |   |      |   |        |  
|Accounts receivable, net                                                                        |  |                              | 712    |   |      |   | (259   | )
|Inventory                                                                                       |  |                              | 167    |   |      |   | (149   | )
|Other current assets                                                                            |  |                              | 865    |   |      |   | (93    | )
|Accounts payable                                                                                |  |                              | (228   | ) |      |   | (90    | )
|Other accrued expenses and other current liabilities                                            |  |                              | (1,155 | ) |      |   | (695   | )
|Taxes payable                                                                                   |  |                              | (37    | ) |      |   | (32    | )
|                                                                                                |  |                              |        |   |      |   |        |  
|Net cash used in operating activities                                                           |  |                              | (384   | ) |      |   | (1,846 | )
|                                                                                                |  |                              |        |   |      |   |        |  
|CASH FLOWS FROM INVESTING ACTIVITIES:                                                           |  |                              |        |   |      |   |        |  
|Purchases of property, equipment and capitalization of software developed for internal use, net |  |                              | (165   | ) |      |   | (131   | )
|Purchases of long-term investments                                                              |  |                              | (6,507 | ) |      |   |       |  
|Sales of short-term investments                                                                 |  |                              | 3,000  |   |      |   | 1,800  |  
|                                                                                                |  |                              |        |   |      |   |        |  
|Net cash (used in) provided by investing activities                                             |  |                              | (3,672 | ) |      |   | 1,669  |  
|                                                                                                |  |                              |        |   |      |   |        |  
|CASH FLOWS FROM FINANCING ACTIVITIES:                                                           |  |                              |        |   |      |   |        |  
|Proceeds from exercise of warrants and stock options                                            |  |                              | 47     |   |      |   | 37     |  
|                                                                                                |  |                              |        |   |      |   |        |  
|Net cash provided by financing activities                                                       |  |                              | 47     |   |      |   | 37     |  
|                                                                                                |  |                              |        |   |      |   |        |  
|Net decrease in cash and cash equivalents                                                       |  |                              | (4,009 | ) |      |   | (140   | )
|Cash and cash equivalents at beginning of period                                                |  |                              | 4,865  |   |      |   | 904    |  
|                                                                                                |  |                              |        |   |      |   |        |  
|Cash and cash equivalents at end of period                                                      |  | $                            | 856    |   |      | $ | 764    |  
|                                                                                                |  |                              |        |   |      |   |        |  



See accompanying notes
to condensed consolidated financial statements



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VARSITY GROUP INC. AND SUBSIDIARIES



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS



Note
1: Description of Operations



Varsity Group Inc. (the Company)
is an Internet-based retailer of textbooks and educational materials targeting private middle and high schools, small colleges and distance and continuing education markets. Varsity Group Inc. was incorporated on December 16, 1997 and launched its
website in August 1998, at which time the Company began generating revenues.



The Company is an online retailer of textbooks and educational materials targeting private middle and high schools, small colleges, distance, and continuing education markets through its eduPartners program. As an Internet-based retailer of
textbooks, the Company uses its website, www.varsitybooks.com, to sell textbooks and other learning materials to students nationwide. Through eduPartners, the Company partners directly with educational institutions to outsource traditional brick and
mortar bookstore operations and sell textbooks and learning materials directly to parents and students via the VarsityBooks.com website.



Note 2: Basis of Presentation



The condensed consolidated financial statements of Varsity Group Inc. and subsidiaries 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, 2004. Our business is seasonal and thus operating results for the interim periods are not necessarily indicative of results for an entire
year.



Recent Accounting Standards



In November of 2004, FASB issued Statement No 151, Inventory Costs, an amendment
of Accounting Research Bulletin No. 43, Chapter 4 (SFAS 151). The amendments made by SFAS 151 clarify that abnormal amounts of idle facility expense, freight, handling costs, and wasted materials (spoilage) should be recognized as
current period charges and require the allocation of fixed production overheads to inventory based on the normal capacity of the production facilities. The FASBs goal is to promote convergence of accounting standards internationally by
adopting language similar to that used in the International Accounting Standard 2, Inventories adopted by the International Accounting Standards Board (IASB). The Boards noted that the wording of the original standards were similar but
were concerned that the differences would lead to inconsistent application of those similar requirements. The guidance is effective for inventory costs incurred during the fiscal year beginning January 1, 2006. We do not believe that the adoption of
the new standard will have a material impact on our financial position.



In
December 2004, the FASB issued SFAS No. 123 (revised 2004), Share-Based Payment (SFAS No. 123R), which replaces SFAS No. 123 and supercedes APB Opinion No. 25 and requires all share-based payments to employees, including
grants of employee stock options, to be recognized in the financial statements based on their fair values. In April 2005, the Securities and Exchange Commission (SEC) delayed the effective date of SFAS No. 123R for public companies until
fiscal years beginning after June 15, 2005. Accordingly, we expect to adopt the standard on January 1, 2006. The pro forma disclosures previously permitted under SFAS 123 no longer will be an alternative to financial statement recognition. Under
SFAS No. 123R, we must determine the appropriate fair value model to be used for valuing share-based payments, the amortization method for compensation cost and the transition method to be used at date of adoption. The transition methods include
modified prospective and modified retrospective adoption options. Under the modified retrospective option, prior periods may be restated either as of the beginning of the year of adoption or for all periods presented. The modified prospective method
requires that compensation expense be recorded for all unvested stock options and restricted stock at the beginning of the first quarter of adoption of SFAS No. 123R, while the modified retrospective methods would record compensation expense for all
unvested stock options and restricted stock beginning with the first period restated. We are evaluating the requirements of SFAS No. 123R and we expect that the adoption of SFAS 123R will materially impact our consolidated results of operations and
earnings per share. We have not yet determined the method of adoption or the effect of adopting SFAS No. 123R, and have not determined whether the adoption will result in future expenses that are similar to the current pro forma disclosures under
SFAS No. 123.



Certain reclassifications of prior year amounts have been made
to conform to the current year presentation.



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Note 3: Stock-Based Compensation



The Company accounts for its stock-based compensation plans in accordance with Accounting Principles Board (APB) Opinion No. 25,
Accounting for Stock Issued to Employees, and related interpretations using the intrinsic value based method of accounting. If the Company accounted for its stock-based compensation plan using the fair value based method of
accounting in accordance with the provisions as required by Statement of Financial Accounting Standards No. 123 (SFAS 123), Accounting for Stock-Based Compensation, as amended by Statement of Financial Accounting
Standards No. 148 (SFAS 148), Accounting for Stock-Based Compensation  Transition and Disclosure, the Companys net loss and loss per basic and diluted share amounts would have been as follows, in thousands:



|                                                   |  |                             |        |   |      |   |       |  
|-------------------------------------------------- |  | --------------------------- | ------ | - | ---- | - | ----- | -
|                                                   |  | Three Months EndedMarch 31, |       
|                                                   |  | 2005                        |        |   | 2004 |  
|Net loss as reported                               |  | $                           | (502   | ) |      | $ | (351  | )
|Add: SFAS No. 123 stock-based compensation expense |  |                             | (757   | ) |      |   | (241  | )
|Less: APB No. 25 stock-based compensation expense  |  |                             |       |   |      |   | 23    |  
|                                                   |  |                             |        |   |      |   |       |  
|Pro forma net loss                                 |  | $                           | (1,259 | ) |      | $ | (569  | )
|                                                   |  |                             |        |   |      |   |       |  
|Net loss per share as reported                     |  |                             |        |   |      |   |       |  
|Basic and diluted                                  |  | $                           | (0.03  | ) |      | $ | (0.02 | )
|Pro forma net loss per share                       |  |                             |        |   |      |   |       |  
|Basic and diluted                                  |  | $                           | (0.08  | ) |      | $ | (0.03 | )



The weighted-average fair value of
options granted during the three months ended March 31, 2005 and 2004 was approximately, $2.74 and $1.51, respectively, based on the Black-Scholes option pricing model. The fair value of each option is estimated on the date of grant using the
Black-Scholes option pricing model. The following weighted-average assumptions used for grants during the three months ended:



| |  |  | 2005: dividend yield 0.0%; expected volatility 50.0%; risk-free interest rate 3.60%; expected term 2 to 6 years;
| | - |  | ----------------------------------------------------------------------------------------------------------------



| |  |  | 2004: dividend yield 0.0%; expected volatility 90.0%; risk-free interest rate 3.60%; expected term 2 to 6 years.
| | - |  | ----------------------------------------------------------------------------------------------------------------



Note 4: Net Loss Per Share



Basic net loss per share is computed using the weighted average number of shares of common
stock outstanding. Diluted net 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 options and warrants to acquire 1.7 million shares and 0.7 million shares for the three month periods ended March 31, 2005 and 2004, respectively, 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.



Note 5: Other Comprehensive Loss



Other comprehensive loss
relates to unrealized losses on investments short-term and long-term investments. The following table sets forth the comprehensive loss for the three months ended March 31, 2005 and 2004 (amounts in thousands):



|                               |  |                             |      |   |      |   |      |  
|------------------------------ |  | --------------------------- | ---- | - | ---- | - | ---- | -
|                               |  | Three Months EndedMarch 31, |     
|                               |  | 2005                        |      |   | 2004 |  
|Net loss as reported           |  | $                           | (502 | ) |      | $ | (351 | )
|Other comprehensive loss       |  |                             |      |   |      |   |      |  
|Unrealized loss on investments |  |                             | (112 | ) |      |   |     |  
|                               |  |                             |      |   |      |   |      |  
|Total comprehensive loss       |  | $                           | (614 | ) |      | $ | (351 | )
|                               |  |                             |      |   |      |   |      |  



Note 6: 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, the Companys 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



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managements assessment of all available evidence, including the Companys cumulative net income for recent
fiscal years, estimates of current and future profitability and the overall prospects of our business, management concluded in its fourth quarter of fiscal 2003 and again in its second and third quarters of 2004 that it was more likely than not that
a portion of the recorded deferred tax benefits would be realized.



The Company
will continue to monitor all available evidence and reassess the potential realization of our deferred tax assets. If we continue to meet our financial projections and improve upon our results of operations, it is reasonably possible that we may
release all, or a portion, of the remaining valuation allowance in the future. Any such release would result in recording a tax benefit that would increase net income in the period the allowance is released.



Note 7: Inventories



Inventories, consisting of products available for sale, are accounted for using the FIFO method and are valued at the lower of cost or
market value. The Companys inventory balance as of March 31, 2005 and December 31, 2004 consists of (in thousands):



|               |  |                |       |                   |   |      
|-------------- |  | -------------- | ----- | ----------------- | - | -----
|               |  | March 31, 2005 |       | December 31, 2004
|Inventory      |  |                |       |                   |   |      
|New textbooks  |  | $              | 989   |                   | $ | 1,324
|Used textbooks |  |                | 924   |                   |   | 621  
|On-campus      |  |                | 383   |                   |   | 518  
|               |  |                |       |                   |   |      
|               |  | $              | 2,296 |                   | $ | 2,463
|               |  |                |       |                   |   |      



The components of inventory are as
follows:



| |  |  | New textbooks consist of new textbooks held at Baker & Taylor (B&T), our fulfillment partner, which they were unable to return for publisher credit after the
fall back to school season and new textbooks held at other locations;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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



| |  |  | On-campus textbooks consist mainly of new and used textbooks located at the Companys two on-campus bookstore facilities.
| | - |  | -------------------------------------------------------------------------------------------------------------------------



Under the Companys agreement with B&T in which B&T provides the Companys
order fulfillment and drop shipment services, B&T only assumes ownership of new textbooks that they are able to return to publishers for credit, which historically is about 90% of all new textbook inventory. B&T does not assume ownership of
the used products it processes for the Companys and per the agreement with B&T, the Company buys back from B&T the cost of all new textbooks that B&T cannot return for publisher credit after the fall back to school season. The
Company writes down its inventory for estimated excess and obsolete or unmarketable inventory equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions on a
quarterly basis.



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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, 2004. 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, 2004 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 a leading online retailer of textbooks and educational materials targeting the
private middle and high school, college, distance, and continuing education markets. Through eduPartners, our program serving schools and organizations directly, we provide an opportunity for educational institutions to maximize their resources and
offer increased convenience and value to their students by outsourcing to us the sale of textbooks and other learning materials.



We were incorporated in December 1997 and began offering books for sale on our website on August 10, 1998. To date, our revenues have consisted primarily of sales of new
textbooks. 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.



With the creation of eduPartners, we began focusing our eCommerce experience and brand on
building a program whereby we became the exclusive provider of new books and learning materials to a variety of learning institutions. This program is a cost-effective model that enables us to increase the number of customers to our website and
generate book sales that does not require the significant marketing and brand building expenses associated with our earlier model which focused on building a broad consumer brand offering promotions and deeply discounted textbook prices.



During 2000, we began to focus resources on the growth and development of our eduPartner
program and it is the foundation of our business today. In the quarter ending September 30, 2004, revenues from eduPartners accounted for approximately 98% of total book-related revenues. The number of eduPartners schools has grown from
approximately 20 schools during the 1999 Fall back-to-school season to over 315 schools in 2004.



We expect eduPartners to remain the primary source of textbook revenues in 2005. Net sales consist of sales of books and charges to customers for outbound shipping and are net of allowances for returns, promotional
discounts and coupons. Revenues from sales of textbooks are recognized at the time products are received by the customer.



During the early development stage of our Company, we also provided marketing services for other businesses seeking to reach the college and private middle and high
school demographics by marketing to students online through our website and on college campuses utilizing a nationwide network of student marketing representatives. These campaigns were developed to meet the goals of each client. Marketing
activities included online marketing, traditional flyering and postering, peer-to-peer marketing, on-campus events, product trial and demonstrations, and sponsorship opportunities.



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During 2001, we made a strategic decision to focus our resources on the growth and development of the eduPartners
program. We determined that the eduPartners model presented the greatest prospects for long-term growth and shareholder value creation and elected to concentrate the resources and energy of the entire organization on maximizing this opportunity. We
completed all outstanding on-campus marketing services contracts during 2001 and ceased new development of on-campus marketing services programs. We anticipate future marketing services revenue, if any, will be focused on delivering solutions
compatible with our target eduPartners market.



Recording the first profitable
fiscal year in the history of our company, the year ended December 31, 2002 marked a significant milestone for the Company. This was accomplished through a combination of revenue growth, margin enhancement and cost reduction efforts initiated during
2000. As part of this transformation we successfully lowered our overall expense structure and improved the margins of our retail book business while growing eduPartners revenues.



Throughout 2004, we continued to demonstrate the profitability and scalability of the core eduPartners model. The number of schools served
by eduPartners during the critical Fall back-to-school season increased to over 315 in 2004, compared to approximately 210 during the similar period in 2003. Revenue growth tracked closely with school growth as revenues expanded by 49%, from $25.2
million in fiscal 2003 to $37.7 million in fiscal 2004. During the same period, income before taxes increased by 30%, from $2.4 million in fiscal 2003 to $3.1 million in fiscal 2004. The year ended December 31, 2004 represented our third consecutive
profitable fiscal year and fourth consecutive year generating positive cash flow from operations.



Our ability to sustain annual operating profitability depends on our ability to maintain and grow net revenues while containing expenses. We base our current and future expense levels on our operating plans and
estimates of future revenues. 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



The accompanying discussion and analysis of our financial condition and results of operations are based upon our unaudited condensed consolidated financial statements,
which have been prepared in accordance with accounting principles generally accepted in the United States. For a comprehensive discussion of our accounting policies, 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, 2004. We do not have any ownership interest in any special purpose or similar entities and do not have any significant related party transactions.



We have identified the accounting policies that are critical to understanding our historical
and future performance, as these policies affect the more significant areas involving managements judgments and estimates. These critical accounting policies relate to deferred income taxes and stock-based compensation plans. These policies,
and our procedures related to these policies, are described in detail below.



Revenue Recognition



We recognize revenue from textbook sales,
including sales under our eduPartners program, net of any discounts and coupons, when the textbooks are received by our customers. For online sales of new textbooks, we take title to the textbooks sold upon transfer to the shipper and assume the
risks and rewards of ownership including the risk of loss for collection. We take title to used textbooks and inventory held at our two on-campus stores at the time of purchase from the publisher, supplier or buyback customer and place them in
inventory as available for sale. We do not function as an agent or broker for our supplier. Outbound shipping charges are included in net sales. We provide allowances for sales returns, promotional discounts and coupons based on historical
experience in the period of the sale. To date, our revenues have consisted primarily of sales of textbooks.



Deferred Income Taxes



We account 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, 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 carryforwards pursuant to Internal Revenue Code section 382, future income projections and the overall prospects of our business. Based upon managements
assessment of all



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##### Table of Contents

available evidence, including our cumulative net income for fiscal 2002, 2003 and 2004, estimates of future profitability
and the overall prospects of our business, we concluded that it is more likely than not that the recorded portion of the deferred tax benefits will be realized. We will continue to monitor all available evidence and reassess the potential
realization of our deferred tax assets on an annual basis, coinciding with our fiscal year end, or on an interim basis if circumstances change. If we continue to meet our financial projections and improve upon our results of operations, it is
reasonably possible that we may release all, or a portion, of the remaining valuation allowance in the future. Any such release would result in recording a tax benefit that would increase net income in the period the allowance is released.



Stock-Based Compensation Plans



We account for our stock-based compensation plans in accordance with Accounting Principles
Board (ABP) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations using the intrinsic value based method of accounting. We estimate that if we used the fair value method outlined by Statement
of Financial Accounting Standards No. 123 (SFAS 123), Accounting for Stock-Based Compensation, and Statement of Financial Accounting Standards No. 148 (SFAS 148), Accounting for Stock-Based Compensation
 Transition and Disclosure, our reported amounts of net income would have been reduced by approximately $0.8 million for the three months ended March 31, 2005 and by approximately $0.2 million for the three months ended March 31, 2004.
Our reported amounts of net loss per basic and diluted share would have been increased by approximately $0.05 and $0.01 for the three months ended March 31, 2005 and 2004, respectively.



Valuation of Inventories



Inventories, consisting of products available for sale, are accounted for using the FIFO method and are valued at the lower of cost or market value. Our inventory balance
as of March 31, 2005 consists mainly of used textbooks that we purchased in fiscal 2004 and during our first quarter of fiscal 2005, new and used textbooks located at our two on-campus bookstores and new titles that we are able to procure at better
terms than B&T. Historically, approximately 90% of the unsold new textbook inventory held by B&T in support of our eduPartners program has been returned for full credit with publishers, which substantially reduces our risk of inventory
obsolescence. We take title to the remaining unsold inventory and write down this balance, as well as any remaining used book inventory, for estimated excess and obsolete or unmarketable inventory equal to the difference between the cost of
inventory and the estimated market value based upon assumptions about future demand and market conditions on a quarterly basis.



Valuation of Long-Lived Assets



We assess the impairment of long-lived assets, including software developed for internal use, in accordance with Statement of Financial Accounting Standards No. 144
(SFAS 144) Accounting for the Impairment of Long-Lived Assets, whenever events or changes in circumstances indicate that the carrying value may not be fully recoverable. When we determine that the carrying value of such
assets may not be recoverable, we generally measure any impairment based on a projected discounted cash flow method using a discount rate determined by management to be commensurate with the risk inherent in our current business model. In addition,
at each reporting date, we compare the net realizable value of capitalized software development costs to the unamortized capitalized costs. To the extent the unamortized capitalized costs exceed the net realizable value, the excess amount is written
off.



Evaluating long-lived assets for impairment involves judgments as to when
an asset may potentially be impaired. We consider there to be a risk of impairment if there is a significant decrease in the market value of an asset or if there is a significant change in the extent or intended use of an asset.



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##### Table of Contents

Results of Operations:



The following table includes the condensed consolidated statements of operations data for the three months ended March 31, 2005 and March 31, 2004, expressed as a
percentage of total net sales:



|                           |  |                             |    |  |       |   
|-------------------------- |  | --------------------------- | -- |  | ----- | --
|                           |  | Three Months EndedMarch 31, |   
|                           |  | 2005                        |    |  | 2004  |   
|Net sales:                 |  |                             |    |  |       |   
|Product                    |  | 91.5                        | %  |  | 90.8  | % 
|Shipping                   |  | 8.5                         | %  |  | 9.2   | % 
|                           |  |                             |    |  |       |   
|Total net sales            |  | 100.0                       | %  |  | 100.0 | % 
|                           |  |                             |    |  |       |   
|Operating expenses         |  |                             |    |  |       |   
|Cost of product            |  | 61.3                        | %  |  | 65.6  | % 
|Cost of shipping           |  | 6.9                         | %  |  | 7.5   | % 
|Sales and marketing        |  | 36.2                        | %  |  | 30.2  | % 
|Product development        |  | 5.5                         | %  |  | 1.4   | % 
|General and administrative |  | 31.1                        | %  |  | 28.7  | % 
|Non-cash compensation      |  |                            |    |  | 1.2   | % 
|                           |  |                             |    |  |       |   
|Total operating expenses   |  | 141.0                       | %  |  | 134.6 | % 
|                           |  |                             |    |  |       |   
|Loss from operations       |  | (41.0                       | )% |  | (34.6 | )%
|                           |  |                             |    |  |       |   
|Other income, net          |  | 6.4                         | %  |  | 3.2   | % 
|                           |  |                             |    |  |       |   
|Loss before income taxes   |  | (34.6                       | )% |  | (31.4 | )%
|                           |  |                             |    |  |       |   
|Income tax benefit         |  | 13.1                        | %  |  | 12.2  | % 
|                           |  |                             |    |  |       |   
|Net loss                   |  | (21.4                       | )% |  | (19.2 | )%
|                           |  |                             |    |  |       |   



Seasonality:



We experience significant seasonality in our results of operations. Consistent with our
focus on the expansion of eduPartners and its current concentration of private middle and high school institutions, since the year ended December 31, 2000, our peak selling period is the July/August/September back-to-school season. During fiscal
2004 and 2003, approximately 85% of our revenues were recognized in this period. We expect this trend to continue as we expand our eduPartners program in the private middle and high school market. 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. Part of our strategy is to extend eduPartners more deeply into the college and
distance learning markets. This would result in more balanced selling seasons between fall and winter. However, based upon our current eduPartners school mix, we will continue to experience significant fluctuations in quarterly operating results.
Please see Forward-Looking Statements.



Net Sales:



Net sales increased 28.4%, or $0.5 million, to $2.3 million for the
three months ended March 31, 2005 compared to the same period in 2004. This increase was attributable to the Companys success in increasing the number of schools served by our eduPartners program.



Operating Expenses:



Cost of Products.Cost of products consists of the cost of products sold to
customers. Cost of products increased approximately 19.8%, or $0.2 million, to $1.4 million for the three months ended March 31, 2005 compared to the same period in 2004. This increase was attributable to our increased sales volume. Expressed as a
percentage of related revenue, cost of products was 66.9% and 72.3%, in the three months ended March 31, 2005 and 2004, respectively. Improved gross margins were the result of a more favorable product mix of online sales compared to the prior year
period. Cost of products varies with product revenue and we expect these costs to increase in absolute dollars as our customer base and number of eduPartners served expands. Please see Forward-Looking Statements.



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Cost of Shipping. Cost of shipping consists of outbound shipping to our customers. Cost of shipping increased
approximately 17.9%, or $25,000, to $161,000 for the three months ended March 31, 2005 compared to the same period in 2004. This increase was attributable to our increased sales volume. Expressed as a percentage of related revenue, cost of shipping
was 81.3% and 81.5% for the three months ended March 31, 2005 and 2004, respectively.



Sales and Marketing.Sales and marketing expense consists primarily of promotional expenditures, credit card processing fees, travel expense, expenses associated with contracting with our eduPartners schools, seasonal overhead
associated with performing inventory purchases at eduPartner schools, and payroll and related expenses for personnel engaged in sales and marketing, account management and eduPartners operations. Sales and marketing expense increased 53.8%, or
approximately $0.3 million, to $0.8 million for the three months ended March 31, 2005 compared to the same period in 2004. This increase was attributable to increases in payroll and related expenses and other costs resulting from an increase in the
number of sales and marketing employees compared to the prior year period, as well as an increase in Baker & Taylor promotional costs and credit card processing fees resulting from an overall increase in business.



We expect certain aspects of sales and marketing expense, including credit card expenses,
certain expenses associated with contracting with our eduPartners schools, and sales expenses associated with our agreement with B&T, will continue to increase at levels consistent with revenue growth. We anticipate that staffing and related
expenses will continue to increase in absolute dollars as we expand operations to support expected short and longer-term revenue growth. Please see Forward-Looking Statements.



Product Development. Product development expense includes payroll and related expenses
for our development and systems personnel, costs associated with the upgrade and maintenance of our website and outside consultant expense, and are reported net of costs capitalized for software developed for internal use. The following table sets
forth product development costs for the three months ended March 31, 2005 and 2004 (in thousands):



|                                          |  |                                  |      |   |                                  |   |     |  
|----------------------------------------- |  | -------------------------------- | ---- | - | -------------------------------- | - | --- | -
|                                          |  | Three MonthsEnded March 31, 2005 |      |   | Three MonthsEnded March 31, 2004 |  
|Gross product development costs           |  | $                                | 241  |   |                                  | $ | 129 |  
|Percentage of total revenue               |  |                                  | 10.3 | % |                                  |   | 7.1 | %
|Less: Software developed for internal use |  | $                                | 112  |   |                                  | $ | 104 |  
|Percentage of total revenue               |  |                                  | 4.8  | % |                                  |   | 5.7 | %
|                                          |  |                                  |      |   |                                  |   |     |  
|Product development expense, as reported  |  | $                                | 129  |   |                                  | $ | 25  |  
|Percentage of total revenue               |  |                                  | 5.5  | % |                                  |   | 1.4 | %



Product development expense increased
418%, or approximately $0.1 million, for the three months ended March 31, 2005 from the prior year period. The increase in the three months ended March 31, 2005 compared to the prior year period was due to an increase in maintenance costs associated
with the costs we capitalized for software developed for internal use in fiscal 2004 and our first quarter fiscal 2005. We are currently upgrading our website, which includes substantially all aspects of transaction processing, including order
management, cash and credit card processing, purchasing, inventory management and shipping in order to accommodate the large increase in the volume of traffic we have recently experienced on our website.



We are capitalizing certain of these 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. We began to amortize the capitalized costs on our balance
sheet as of June 30, 2004 on a straight-line basis over a period of five years beginning in our third quarter of fiscal 2004 when the website was placed into service, and we will continue to capitalize the costs of new functionality related to the
website upgrade during fiscal 2005 in accordance with SOP 98-1. We expect system upgrade efforts to continue in our remaining quarters of fiscal 2005 and, therefore, expect capitalization and maintenance costs associated with this effort to
increase. Please see Forward-Looking Statements.



General
and Administrative. General and administrative expense consists of payroll and related expenses for executive and administrative personnel, facilities expenses, professional services expenses, travel and other general corporate expenses. General
and administrative expense increased 39.2%, or $0.2 million, during the three months ended March 31, 2005 compared to the prior year period. This increase was due to increased personnel needed to support the growth of our business.



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We anticipate incurring significant increases in general and administrative expenses in the remainder of fiscal 2005 as
we take the necessary steps to comply with the numerous reporting and control requirements imposed by the Sarbanes Oxley Act, including Section 404. Please see Forward-Looking Statements.



Non-Cash Compensation.Non-cash compensation expense consists of expenses related to
previous grants of employee options based on the intrinsic value of the stock option and was fully amortized as of September 30, 2004. Non-cash compensation was approximately $23,000 for the three months ended March 31, 2004.



Other income (expense), net



Other income (expense), net consists primarily of interest income on our cash and cash
equivalents and investments. Other income was $151,000 for the three months ended March 31, 2005 compared to $60,000 for the three months ended March 31, 2004. The increase was due to higher average cash invested in long-term investments and higher
average interest rates during the three months ended March 31, 2005 as compared to the prior year period.



Income Taxes



Income tax benefit
for the three months ended March 31, 2005 was approximately $0.3 million. We account for income taxes in accordance with SFAS 109. 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, 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. During fiscal 2004 and 2003, management
reassessed the potential realization of its remaining valuation allowance based on its financial projections, estimates of future profitability and the overall prospects of the Companys business and concluded that it was more likely than not
that a portion of the recorded deferred tax benefits would be realized. Consequently, we released $5.0 million and approximately $2.9 million of the valuation allowance in fiscal 2004 and 2003, respectively.



We will continue to monitor all available evidence and reassess the potential realization of
our deferred tax assets. If we continue to meet our financial projections and improve upon our results of operations, it is reasonably possible that we may release all, or a portion, of the remaining valuation allowance in the future. Any such
release would result in recording a tax benefit that would increase net income in the period the allowance is released. Please see Forward-Looking Statements.



Liquidity and Capital Resources



As of March 31, 2005, we had $4.9 million of cash, cash equivalents and short-term investments in auction rate marketable securities. As of that date, our principal
commitments consisted of obligations outstanding under accrued liabilities, accounts payable and operating leases. During 2004 and in the three months ended March 31, 2005, we began an initiative to upgrade our internally developed system for our
website. In the remainder of 2005, we expect to experience additional expenditures related to the website upgrade. We also may experience additional increases in our capital expenditures and lease commitments consistent with anticipated growth in
operations, infrastructure and personnel.



Net cash used in operating
activities was approximately $0.4 million for the three months ended March 31, 2005 compared to approximately $1.8 million net cash used in operations for the three months ended March 31, 2004. This decrease in cash used was the result of:



| |  |  | the collection of increased amounts of accounts receivables due to higher fiscal 2004 year end and first quarter 2005 revenues as compared to the same period in the prior year; and
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | a decrease in other current assets related to year-end accruals and deposits we had with B&T.
| | - |  | ---------------------------------------------------------------------------------------------



These decreases were partially offset by: increased payments against 2004 year-end accrued compensation and increased payments against
eduPartner incentive accruals which was due to increased revenues in 2004 as compared to 2003.



Investing activities consist of capitalization of software developed for internal use, purchases of property and equipment, purchases of software and purchases and sales of short-term and long-term investments. Net
cash used in investing activities was approximately $3.6 million for the three months ended March 31, 2005 compared to net cash provided by investing activities of approximately $1.7 million for the three months ended March 31, 2004. Total purchases
of property, equipment and software, including capitalization of software, was $165,000 during the three months ended March 31, 2005, an increase of approximately $34,000 over the comparable period in 2004 primarily due to infrastructure growth and
our initiative to upgrade our internal software system for our website. During the three months ended March 31, 2005, we purchased $6.5 million of long-term investments and sold $3.0 million of short-term investments.



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Net cash provided by financing activities was approximately $47,000 for the three months ended March 31, 2005 and
approximately $37,000 for the three months ended March 31, 2004. Net cash provided by financing activities during both periods consisted of net proceeds from the exercise of warrants and employee stock options.



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



|                            |  |                                     |     |            |   |  
|--------------------------- |  | ----------------------------------- | --- | ---------- | - | -
|Contractual Obligations     |  | Nine Months EndingDecember 31, 2005 |     | Thereafter
|Operating Lease Obligations |  | $                                   | 206 |            | $ | 
|Total                       |  | $                                   | 206 |            | $ | 



As of the date of this filing, we
currently lease approximately 9,000 square feet pursuant to leases that are month-to-month or are scheduled to expire in November and December 2005.



Based upon our current and expected cost structure and recent growth levels within the eduPartners program, we believe that we are positioned to improve upon the
financial performance of 2004. However, we intend to increase spending on the development of eduPartners and related infrastructure and we anticipate incurring significant increases in general and administrative expenses in fiscal 2005 as we take
the necessary steps to comply with the numerous reporting and control requirements imposed by the Sarbanes-Oxley Act, including Section 404 reporting requirements. Failure to generate sufficient revenues or, if necessary, reduce discretionary
spending could harm our results of operations and financial condition. Please see Forward-Looking Statements.



We are currently considering and may in the future, pursue acquisitions of complementary businesses. In addition, we may make strategic investments in businesses and
enter into joint ventures that complement our existing business strategy. Any future acquisition or investment may result in a dilution to existing shareholders to the extent we issue shares of our common stock as consideration or reduced liquidity
and capital resources to the extent we use cash as consideration



We believe
that our existing liquidity and expected cash flows from operations will satisfy the capital requirements of our current business for the foreseeable future. We believe that the combination of cash, cash equivalents, short-term and long-term
investments and anticipated cash flows from operations will be sufficient to fund expected capital expenditures, capital lease obligations and working capital needs for at least the next twelve months. 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.



Interest Rate Risk. Our cash equivalents and short-term investments 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 held was $18.2 million and $18.9 million at March 31, 2005 and December 31, 2004, 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.



The weighted average yield on interest-bearing investments held as of March 31, 2005 was approximately 3.5% per annum. Based on our
investment holdings at March 31, 2005, a 100 basis point decline in the average yield would have reduced our annual interest income by $0.2 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



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Exchange Commissions rules and forms and that such information is accumulated and communicated to our management,
including our Chief Executive Officer and Chief Financial 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 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 and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and
procedures as of the end of the period covered by this report. Based on the foregoing, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective at the reasonable assurance level.
There has been no change in our internal controls over financial reporting during our most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal controls over financial reporting.



PART II.

OTHER INFORMATION



Item 1:Legal Proceedings



Not Applicable



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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##### Table of Contents

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: May 16, 2005



Varsity Group Inc.By:

/s/ JACK M BENSONJack M BensonChief Financial Officer




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