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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, 2006



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)
|                                             | 
|1300 19thStreet NW 8thFloor Washington, D.C. |  | 20036                               
|(Address of Principal Executive Offices)     |  | (Zip Code)                          

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



(Formerly of 1850 M Street NW, Suite 1150, 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 October 26, 2006, the registrant had 18,514,872 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, 2006

INDEX



|        |  |                                                                                                                             |  |           
|------- |  | --------------------------------------------------------------------------------------------------------------------------- |  | ----------
|        |  |                                                                                                                             |  | PageNumber
|        |  | PART I. FINANCIAL INFORMATION                                                                                               |  |           
|        |  |                                                                                                                            
|Item 1. |  | Financial Statements (unaudited)                                                                                            |  |           
|        |  |                                                                                                                            
|        |  | Condensed consolidated balance sheets as of September 30, 2006 and December 31, 2005 (unaudited)                            |  | 3         
|        |  |                                                                                                                            
|        |  | Condensed consolidated statements of operations for the three and nine months ended September 30, 2006 and 2005 (unaudited) |  | 4         
|        |  |                                                                                                                            
|        |  | Condensed consolidated statements of cash flows for the nine months ended September 30, 2006 and 2005 (unaudited)           |  | 5         
|        |  |                                                                                                                            
|        |  | Notes to condensed consolidated financial statements (unaudited)                                                            |  | 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                                                                  |  | 22        
|        |  |                                                                                                                            
|Item 4. |  | Controls and Procedures                                                                                                     |  | 22        
|        |  |                                                                                                                            
|        |  | PART II. OTHER INFORMATION                                                                                                  |  |           
|        |  |                                                                                                                            
|Item 1. |  | Legal Proceedings                                                                                                           |  | 23        
|        |  |                                                                                                                            
|Item 1A |  | Risk Factors                                                                                                                |  | 23        
|        |  |                                                                                                                            
|Item 2. |  | Unregistered Sales of Equity Securities and Use of Proceeds                                                                 |  | 23        
|        |  |                                                                                                                            
|Item 3. |  | Defaults Upon Senior Securities                                                                                             |  | 23        
|        |  |                                                                                                                            
|Item 4. |  | Submission of Matters to a Vote of Security Holders                                                                         |  | 23        
|        |  |                                                                                                                            
|Item 5. |  | Other Information                                                                                                           |  | 23        
|        |  |                                                                                                                            
|Item 6. |  | Exhibits                                                                                                                    |  | 23        
|        |  |                                                                                                                            
|        |  | Signatures                                                                                                                  |  | 24        



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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 30,2006 |         |   | December 31,2005 |  
|ASSETS                                                                                                                                                                                       |  |                   |         |   |                  |   |         |  
|Current Assets:                                                                                                                                                                              |  |                   |         |   |                  |   |         |  
|Cash and cash equivalents                                                                                                                                                                    |  | $                 | 1,695   |   |                  | $ | 2,733   |  
|Short-term investments                                                                                                                                                                       |  |                   | 2,485   |   |                  |   | 3,336   |  
|Accounts receivable, net of allowance for doubtful accounts of $93 at September 30, 2006 and $80 at December 31, 2005,
respectively                                                          |  |                   | 4,426   |   |                  |   | 2,188   |  
|Inventory                                                                                                                                                                                    |  |                   | 12,982  |   |                  |   | 4,476   |  
|Deferred income taxes                                                                                                                                                                        |  |                   |        |   |                  |   | 367     |  
|Other                                                                                                                                                                                        |  |                   | 470     |   |                  |   | 5,211   |  
|                                                                                                                                                                                             |  |                   |         |   |                  |   |         |  
|Total current assets                                                                                                                                                                         |  |                   | 22,058  |   |                  |   | 18,311  |  
|                                                                                                                                                                                             |  |                  
|Property, plant and equipment, net of depreciation                                                                                                                                           |  |                   | 1,521   |   |                  |   | 495     |  
|Software developed for internal use, net of amortization                                                                                                                                     |  |                   | 2,259   |   |                  |   | 1,188   |  
|Intangible assets, net of amortization                                                                                                                                                       |  |                   | 717     |   |                  |   | 719     |  
|Goodwill                                                                                                                                                                                     |  |                   | 3,110   |   |                  |   | 2,427   |  
|Deferred income taxes                                                                                                                                                                        |  |                   |        |   |                  |   | 15,157  |  
|Long-term investments                                                                                                                                                                        |  |                   | 3,945   |   |                  |   | 6,406   |  
|Other assets                                                                                                                                                                                 |  |                   | 170     |   |                  |   | 101     |  
|                                                                                                                                                                                             |  |                   |         |   |                  |   |         |  
|Total assets                                                                                                                                                                                 |  |                   | 33,780  |   |                  | $ | 44,804  |  
|                                                                                                                                                                                             |  |                   |         |   |                  |   |         |  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                                                                                         |  |                   |         |   |                  |   |         |  
|Current Liabilities:                                                                                                                                                                         |  |                   |         |   |                  |   |         |  
|Accounts payable                                                                                                                                                                             |  | $                 | 5,924   |   |                  | $ | 1,874   |  
|Deferred revenue                                                                                                                                                                             |  |                   | 243     |   |                  |   | 61      |  
|Other accrued expenses and other current liabilities                                                                                                                                         |  |                   | 3,186   |   |                  |   | 1,452   |  
|Taxes payable                                                                                                                                                                                |  |                   | 1,270   |   |                  |   | 336     |  
|                                                                                                                                                                                             |  |                   |         |   |                  |   |         |  
|Total current liabilities                                                                                                                                                                    |  |                   | 10,623  |   |                  |   | 3,723   |  
|                                                                                                                                                                                             |  |                   |         |   |                  |   |         |  
|Long-term liabilities:                                                                                                                                                                       |  |                   |         |   |                  |   |         |  
|Other non-current liabilities                                                                                                                                                                |  |                   | 154     |   |                  |   | 30      |  
|                                                                                                                                                                                             |  |                   |         |   |                  |   |         |  
|Total liabilities                                                                                                                                                                            |  |                   | 10,777  |   |                  |   | 3,753   |  
|                                                                                                                                                                                             |  |                   |         |   |                  |   |         |  
|Commitments and contingencies                                                                                                                                                                |  |                   |         |   |                  |   |         |  
|Stockholders equity:                                                                                                                                                                        |  |                   |         |   |                  |   |         |  
|Preferred stock: $.0001 par value, 20,000 shares authorized; 0 shares issued and outstanding at September 30, 2006 and December 31,
2005, respectively                                       |  |                   |        |   |                  |   |        |  
|Common stock, $.0001 par value, 60,000 shares authorized, 19,732 and 18,353 shares issued and 18,517 and 17,138 shares outstanding at
September 30, 2006 and December 31, 2005, respectively |  |                   | 2       |   |                  |   | 2       |  
|Additional paid-in capital                                                                                                                                                                   |  |                   | 90,373  |   |                  |   | 89,307  |  
|Accumulated unrealized loss on securities                                                                                                                                                    |  |                   | (70     | ) |                  |   | (107    | )
|Accumulated deficit                                                                                                                                                                          |  |                   | (65,569 | ) |                  |   | (46,418 | )
|Treasury stock, $.0001 par value, 1,215 shares at September 30, 2006 and December 31, 2005, respectively                                                                                     |  |                   | (1,733  | ) |                  |   | (1,733  | )
|                                                                                                                                                                                             |  |                   |         |   |                  |   |         |  
|Total stockholders equity                                                                                                                                                                   |  |                   | 23,003  |   |                  |   | 41,051  |  
|                                                                                                                                                                                             |  |                   |         |   |                  |   |         |  
|Total liabilities and stockholders equity                                                                                                                                                   |  | $                 | 33,780  |   |                  | $ | 44,804  |  
|                                                                                                                                                                                             |  |                   |         |   |                  |   |         |  

See accompanying notes to condensed consolidated financial statements.



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##### Table of Contents

VARSITY GROUP INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)

(in thousands, except per share data)



|                                     |  |                                  |         |                                 |      |   |        |  |   |         |   |  |   |       
|------------------------------------ |  | -------------------------------- | ------- | ------------------------------- | ---- | - | ------ |  | - | ------- | - |  | - | ------
|                                     |  | Three Months Ended September 30, |         | Nine Months Ended September 30,
|                                     |  | 2006                             |         |                                 | 2005 |   | 2006   |  |   | 2005   
|Net sales:                           |  |                                  |         |                                 |      |   |        |  |   |         |   |  |   |       
|Textbooks                            |  | $                                | 38,564  |                                 |      | $ | 35,584 |  | $ | 40,721  |   |  | $ | 38,831
|Uniforms                             |  |                                  | 5,131   |                                 |      |   | 4,274  |  |   | 6,740   |   |  |   | 4,821 
|Solutions                            |  |                                  | 126     |                                 |      |   |       |  |   | 217     |   |  |   |      
|Shipping                             |  |                                  | 3,344   |                                 |      |   | 3,179  |  |   | 3,659   |   |  |   | 3,457 
|                                     |  |                                  |         |                                 |      |   |        |  |   |         |   |  |   |       
|Total net sales                      |  |                                  | 47,165  |                                 |      |   | 43,037 |  |   | 51,337  |   |  |   | 47,109
|                                     |  |                                  |         |                                 |      |   |        |  |   |         |   |  |   |       
|Operating expenses:                  |  |                                  |         |                                 |      |   |        |  |   |         |   |  |   |       
|Cost of textbooks                    |  |                                  | 25,998  |                                 |      |   | 24,672 |  |   | 27,506  |   |  |   | 26,789
|Cost of uniforms                     |  |                                  | 3,004   |                                 |      |   | 1,868  |  |   | 3,736   |   |  |   | 2,087 
|Cost of solutions                    |  |                                  | 68      |                                 |      |   |       |  |   | 104     |   |  |   |      
|Cost of shipping                     |  |                                  | 3,294   |                                 |      |   | 2,397  |  |   | 3,675   |   |  |   | 2,620 
|Sales and marketing                  |  |                                  | 9,064   |                                 |      |   | 5,619  |  |   | 12,617  |   |  |   | 7,711 
|General and administrative           |  |                                  | 3,282   |                                 |      |   | 1,689  |  |   | 7,373   |   |  |   | 3,481 
|Amortization of acquired intangibles |  |                                  | 66      |                                 |      |   | 35     |  |   | 163     |   |  |   | 47    
|                                     |  |                                  |         |                                 |      |   |        |  |   |         |   |  |   |       
|Total operating expenses             |  |                                  | 44,776  |                                 |      |   | 36,280 |  |   | 55,174  |   |  |   | 42,735
|                                     |  |                                  |         |                                 |      |   |        |  |   |         |   |  |   |       
|Income (loss) from operations        |  |                                  | 2,389   |                                 |      |   | 6,757  |  |   | (3,837  | ) |  |   | 4,374 
|                                     |  |                                  |         |                                 |      |   |        |  |   |         |   |  |   |       
|Other income, net:                   |  |                                  |         |                                 |      |   |        |  |   |         |   |  |   |       
|Interest income, net                 |  |                                  | 48      |                                 |      |   | 84     |  |   | 265     |   |  |   | 348   
|Other (expense) income, net          |  |                                  | (8      | )                               |      |   | 20     |  |   | (7      | ) |  |   | 14    
|                                     |  |                                  |         |                                 |      |   |        |  |   |         |   |  |   |       
|Other income, net                    |  |                                  | 40      |                                 |      |   | 104    |  |   | 258     |   |  |   | 362   
|                                     |  |                                  |         |                                 |      |   |        |  |   |         |   |  |   |       
|Income (loss) before income taxes    |  |                                  | 2,429   |                                 |      |   | 6,861  |  |   | (3,579  | ) |  |   | 4,736 
|                                     |  |                                  |         |                                
|Income tax (expense) benefit         |  |                                  | (18,031 | )                               |      |   | 7,311  |  |   | (15,574 | ) |  |   | 8,119 
|                                     |  |                                  |         |                                 |      |   |        |  |   |         |   |  |   |       
|Net (loss) income                    |  | $                                | (15,602 | )                               |      | $ | 14,172 |  | $ | (19,153 | ) |  | $ | 12,855
|                                     |  |                                  |         |                                 |      |   |        |  |   |         |   |  |   |       
|Net (loss) income per share:         |  |                                  |         |                                 |      |   |        |  |   |         |   |  |   |       
|Basic                                |  | $                                | (0.86   | )                               |      | $ | 0.84   |  | $ | (1.09   | ) |  | $ | 0.75  
|                                     |  |                                  |         |                                 |      |   |        |  |   |         |   |  |   |       
|Diluted                              |  | $                                | (0.86   | )                               |      | $ | 0.80   |  | $ | (1.09   | ) |  | $ | 0.71  
|                                     |  |                                  |         |                                 |      |   |        |  |   |         |   |  |   |       
|Weighted average shares:             |  |                                  |         |                                 |      |   |        |  |   |         |   |  |   |       
|Basic                                |  |                                  | 18,254  |                                 |      |   | 16,895 |  |   | 17,646  |   |  |   | 17,050
|                                     |  |                                  |         |                                 |      |   |        |  |   |         |   |  |   |       
|Diluted                              |  |                                  | 18,254  |                                 |      |   | 17,808 |  |   | 17,646  |   |  |   | 18,175
|                                     |  |                                  |         |                                 |      |   |        |  |   |         |   |  |   |       

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, |        
|                                                                                                |  | 2006                           |         |   | 2005 |  
|CASH FLOWS FROM OPERATING ACTIVITIES:                                                           |  |                                |         |   |      |   |        |  
|Net (loss) income                                                                               |  | $                              | (19,153 | ) |      | $ | 12,855 |  
|Adjustments to reconcile net loss to net cash used in operating activities:                     |  |                                |         |   |      |   |        |  
|Depreciation and amortization                                                                   |  |                                | 934     |   |      |   | 358    |  
|Provision for bad debt                                                                          |  |                                | 39      |   |      |   | 169    |  
|Deferred income tax benefit                                                                     |  |                                | 15,524  |   |      |   | (8,134 | )
|Non-cash stock compensation                                                                     |  |                                | 379     |   |      |   |       |  
|Changes in operating assets and liabilities:                                                    |  |                                |         |   |      |   |        |  
|Accounts receivable                                                                             |  |                                | (2,230  | ) |      |   | (7,131 | )
|Inventory                                                                                       |  |                                | (8,506  | ) |      |   | (4,280 | )
|Other current and non-current assets                                                            |  |                                | 4,672   |   |      |   | 711    |  
|Accounts payable                                                                                |  |                                | 4,069   |   |      |   | 1,434  |  
|Other accrued expenses and other current liabilities                                            |  |                                | 2,028   |   |      |   | 1,380  |  
|Taxes payable                                                                                   |  |                                | 934     |   |      |   | 505    |  
|                                                                                                |  |                                |         |   |      |   |        |  
|Net cash used in operating activities                                                           |  |                                | (1,310  | ) |      |   | (2,133 | )
|                                                                                                |  |                                |         |   |      |   |        |  
|CASH FLOWS FROM INVESTING ACTIVITIES:                                                           |  |                                |         |   |      |   |        |  
|Payments for acquisitions                                                                       |  |                                | (1,302  | ) |      |   | (3,083 | )
|Purchases of property, equipment and capitalization of software developed for internal use, net |  |                                | (2,481  | ) |      |   | (874   | )
|Payments for intangible asset                                                                   |  |                                | (25     | ) |      |   |       |  
|Sales of short-term investments                                                                 |  |                                | 3,350   |   |      |   | 3,000  |  
|Sales of long-term investments                                                                  |  |                                |        |   |      |   | 500    |  
|                                                                                                |  |                                |         |   |      |   |        |  
|Net cash used in investing activities                                                           |  |                                | (458    | ) |      |   | (457   | )
|                                                                                                |  |                                |         |   |      |   |        |  
|CASH FLOWS FROM FINANCING ACTIVITIES:                                                           |  |                                |         |   |      |   |        |  
|Payments for capital lease obligations                                                          |  |                                | (15     | ) |      |   | (6     | )
|Proceeds from exercise of employee stock options                                                |  |                                | 745     |   |      |   | 304    |  
|                                                                                                |  |                                |         |   |      |   |        |  
|Net cash provided by financing activities                                                       |  |                                | 730     |   |      |   | 298    |  
|                                                                                                |  |                                |         |   |      |   |        |  
|Net decrease in cash and cash equivalents                                                       |  |                                | (1,038  | ) |      |   | (2,292 | )
|Cash and cash equivalents at beginning of period                                                |  |                                | 2,733   |   |      |   | 4,865  |  
|                                                                                                |  |                                |         |   |      |   |        |  
|Cash and cash equivalents at end of period                                                      |  | $                              | 1,695   |   |      | $ | 2,573  |  
|                                                                                                |  |                                |         |   |      |   |        |  
|Supplemental disclosure of cash flow information:                                               |  |                                |         |   |      |   |        |  
|Cash paid for income taxes                                                                      |  | $                              | 155     |   |      |   | 51     |  
|Cash paid for interest                                                                          |  |                                | 40      |   |      |   | 26     |  
|                                                                                                |  |                               
|Non-cash investing activities                                                                   |  |                                |         |   |      |   |        |  
|Reduction in goodwill recorded in the acquisition of Campus Outfitters                          |  |                                | 23      |   |      |   |       |  
|Acquisitions of IQ Digital (May 2006) and Campus Outfitters (May 2005)                          |  |                                |         |   |      |   |        |  
|Fair value of inventory acquired                                                                |  | $                              |        |   |      | $ | (2,642 | )
|Fair value fixed assets and other assets acquired                                               |  |                                | (444    | ) |      |   | (161   | )
|Identified intangible assets                                                                    |  |                                | (136    | ) |      |   | (850   | )
|Goodwill                                                                                        |  |                                | (706    | ) |      |   | (2,392 | )
|Fair value of liabilities assumed                                                               |  |                                | 34      |   |      |   | 2,434  |  
|Issuance of stock for acquisition                                                               |  |                                |        |   |      |   | 695    |  
|                                                                                                |  |                                |         |   |      |   |        |  
|Cash expended for acquisitions                                                                  |  |                                | (1,252  | ) |      |   | (2,916 | )
|                                                                                                |  |                                |         |   |      |   |        |  
|Cash paid against acquisition accruals and adjustments to goodwill                              |  |                                | (50     | ) |      |   | (167   | )
|                                                                                                |  |                                |         |   |      |   |        |  
|Total cash paid for acquisitions                                                                |  | $                              | (1,302  | ) |      | $ | (3,083 | )
|                                                                                                |  |                                |         |   |      |   |        |  

See accompanying notes to condensed consolidated financial statements



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##### Table of Contents

VARSITY GROUP INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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 a premier outsource solution provider to
education institutions nationwide. Under the elite brand VarsityBooks, Varsity Group offers schools a comprehensive eCommerce solution for their textbook procurement operations. Through its Campus Outfitters brand, Varsity Group is a full-service
provider of uniform apparel needs for schools and businesses with physical retail locations in Indiana, Maryland, Michigan, North Carolina, New Jersey, New York, Ohio, Texas and Virginia. Through its VarsitySolutions brand, Varsity Group focuses on
educational branding, communications and marketing. And through its VarsityFinance brand, Varsity Group will provide tuition financing options.

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, 2005. 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 2004, the Financial Accounting Standards Board (FASB) issued FASB Statement No. 151, Inventory Costs  an amendment of ARB No. 43, Chapter 4 (SFAS 151), which is the result of its
efforts to converge U.S. accounting standards for inventories with International Accounting Standards. SFAS No. 151 requires abnormal amounts of idle facility expense, freight, handling costs and wasted material or spoilage to be recognized as
current-period charges. It also requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. SFAS No. 151 was effective for inventory costs incurred beginning
January 1, 2006. The adoption of this standard did not have any impact on the Company in the current quarter nor is it anticipated to have a significant impact on the Company for the entire year.

In December 2004, the FASB issued SFAS No. 123 (revised 2004), Share-Based Payment (SFAS 123(R)), which replaces SFAS No. 123
Accounting for Stock-Based Compensation and supercedes APB Opinion No. 25 (ABP 25) Accounting for Stock Issued to Employees and requires all share-based payments to employees and directors, including grants
of employee and director stock options, to be recognized in the financial statements based on their fair values. The pro forma disclosures previously permitted under SFAS 123 no longer will be an alternative to financial statement recognition. This
statement was effective beginning with our first quarter of fiscal 2006. The Company adopted SFAS 123(R) using the modified prospective application transition method and recognized $182,000 and $379,000 in expense related to the adoption of the new
accounting standard in the three and nine months ended September 30, 2006 (see Note 3).

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 is required to adopt FIN 48
as of January 1, 2007 and is in the process of determining the impact, if any, the adoption of FIN 48 will have on its consolidated financial statements and related disclosures.

In September 2006, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin No. 108 (SAB 108), Considering the Effects of Prior Year Misstatements when Quantifying
Misstatements in Current Year Financial Statements, to address diversity in practice in quantifying financial statement misstatements. SAB 108 provides interpretive guidance on the consideration of the effects of prior year misstatements in
quantifying current year misstatements for the purpose of a materially assessment. SAB 108 is effective for the Companys year ended December 31, 2006, and allows a one-time transitional cumulative effect adjustment to retained earnings as of
January 1, 2006 for errors that were not previously deemed material, but are material under the guidance in SAB 108. The Company is in the process of determining the effects, if any, that SAB 108 will have on its financial position, results of
operations or cash flows.

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
8.6 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 965,883 shares of its common stock for future option grants. The Board of Directors, or a Committee appointed by the Board,
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 12 and 60 months. Vested options held at the date of termination may be exercised within three months. The Board of Directors may terminate the Plan at anytime.



6



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Adoption of SFAS No. 123R

On January 1, 2006, the Company adopted the provisions of 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 $182,000 and $379,000 for the three and nine months ended September 30, 2006.
This stock-based compensation expense negatively impacted basic and diluted earnings per share by approximately $0.01 per share and $0.02 per share for the three and nine months ended September 30, 2006. As disclosed in prior period financial
statements, in 2005 the Board of Directors approved the accelerated vesting of certain outstanding options.

Had the Company accounted for its stock-based
compensation plan in fiscal 2005 using the fair value based method of accounting in accordance with the provisions as required SFAS 123, as amended by Statement of Financial Accounting Standards No. 148 (SFAS 148),
Accounting for Stock-Based Compensation  Transition and Disclosure, the Companys net income and income per basic and diluted share amounts would have been as follows, in thousands:



|                                                   |  |                                      |        |   |                                     |   |        |  
|-------------------------------------------------- |  | ------------------------------------ | ------ | - | ----------------------------------- | - | ------ | -
|                                                   |  | Three Months Ended September 30,2005 |        |   | Nine Months Ended September 30,2005 |  
|Net income as reported                             |  | $                                    | 14,172 |   |                                     | $ | 12,855 |  
|Add: SFAS No. 123 stock-based compensation expense |  |                                      | (1,344 | ) |                                     |   | (2,710 | )
|Less: APB No. 25 stock-based compensation expense  |  |                                      |       |   |                                     |   |       |  
|                                                   |  |                                      |        |   |                                     |   |        |  
|Pro forma net income                               |  | $                                    | 12,828 |   |                                     | $ | 10,145 |  
|                                                   |  |                                      |        |   |                                     |   |        |  
|Net income per share as reported                   |  |                                      |        |   |                                     |   |        |  
|Basic                                              |  | $                                    | 0.84   |   |                                     | $ | 0.75   |  
|Diluted                                            |  | $                                    | 0.80   |   |                                     | $ | 0.71   |  
|Pro forma net income per share                     |  |                                      |        |   |                                     |   |        |  
|Basic                                              |  | $                                    | 0.76   |   |                                     | $ | 0.60   |  
|Diluted                                            |  | $                                    | 0.72   |   |                                     | $ | 0.56   |  

The weighted-average fair value of options granted during the nine months ended September 30, 2006 was $2.34,
compared to $2.37 and $2.10 for the three and nine months ended September 30, 2005, respectively. There were no options granted during the three 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 Ended September 30, |  |             | Nine Months Ended September 30, | 
|                    |  | 2006                             |  | 2005        |                                 |  | 2006       |   |  | 2005        |  
|Expected volatility |  |                                 |  | 50.0        | %                               |  | 51.14      | % |  | 50.0        | %
|Risk-free rate      |  |                                 |  | 3.60        | %                               |  | 4.86       | % |  | 3.60        | %
|Expected term       |  |                                 |  | 2  6 years |                                 |  | 6.18 years |   |  | 2  6 years |  
|Dividend yield      |  |                                 |  | 0.0         | %                               |  | 0.0        | % |  | 0.0         | %

The Companys computation of expected volatility for grants during the nine months ended September 30,
2006 is based on the historical volatility of the Companys stock. The Companys computation of expected term for grants during the nine months ended September 30, 2006, represents managements determination of such term after
accessing the available historical experience. 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 of StockOptions |   |  | WeightedAverageExercise Price |  | WeightedAverageContractualTerm |  | AggregateIntrinsicValue
|Outstanding, December 31, 2005  |  | 4,805                  |   |  | 4.19                          |  | 7.02                           |  | $                       | 6,112
|Granted                         |  | 585                    |   |  | 4.20                          |  |                                |  |                         |      
|Exercised                       |  | (1,066                 | ) |  | 0.67                          |  |                                |  |                         |      
|Forfeited                       |  | (505                   | ) |  | 5.50                          |  |                                |  |                         |      
|                                |  |                        |   |  |                               |  |                                |  |                         |      
|Outstanding, September 30, 2006 |  | 3,819                  |   |  | 5.02                          |  | 7.29                           |  | $                       | 1,860
|                                |  |                        |   |  |                               |  |                                |  |                         |      
|Exercisable, September 30, 2006 |  | 3,265                  |   |  | 5.16                          |  | 6.92                           |  | $                       | 1,865
|                                |  |                        |   |  |                               |  |                                |  |                         |      



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##### Table of Contents

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 September 30, 2006. 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, 2006 was $3.82. The total intrinsic value of options exercised during the nine months ended September 30, 2006 was approximately $4.5 million. The intrinsic value of stock options exercised is calculated as the difference
between the market value on the date of exercise and the exercise price of the shares.

As of September 30, 2006, unrecognized stock-based
compensation expense related to stock options of approximately $1.3 million is expected to be recognized over a weighted-average period of 3.5 years.

Because of the Companys net operating losses, the Company did not realize any tax benefits for the tax deductions from share-based payment arrangements during the three and nine months ended September 30, 2006.

Restricted Stock

As of December 31, 2005, there were no
unvested shares of restricted stock outstanding. The Company issued 300,000 shares of restricted stock awards during the nine months ended September 30, 2006. Restricted stock awards are amortized to compensation expense over the life of the
vesting period. Restricted stock awards issued during the nine months ended September 30, 2006 had a weighted average grant date fair value of $4.19 per share, amounting to total compensation expense over the life of the award of approximately
$1.3 million. Restricted stock awards issued during the nine months ended September 30, 2006 vest over a four-year period and are expensed on a straight-line basis over the vesting period. At September 30, 2006, 256,250 shares remained
unvested and there was approximately $1.1 million of unrecognized compensation cost related to restricted stock. There were no forfeitures of restricted stock during the nine months ended September 30, 2006.

Note 4: Net (Loss) Income Per Share

Basic (loss) income per share is computed using the weighted average number of shares of common stock outstanding for the period. Diluted (loss) income 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, warrants and restricted stock 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 (loss) income per share (in thousands, except per share data):



|                                                                                |  |                                  |         |                                 |      |   |        |  |   |         |   |  |   |       
|------------------------------------------------------------------------------- |  | -------------------------------- | ------- | ------------------------------- | ---- | - | ------ |  | - | ------- | - |  | - | ------
|                                                                                |  | Three Months Ended September 30, |         | Nine Months Ended September 30,
|                                                                                |  | 2006                             |         |                                 | 2005 |   | 2006   |  |   | 2005   
|Numerator:                                                                      |  |                                  |         |                                 |      |   |        |  |   |         |   |  |   |       
|Net (loss) income                                                               |  | $                                | (15,602 | )                               |      | $ | 14,172 |  | $ | (19,153 | ) |  | $ | 12,855
|Denominator:                                                                    |  |                                  |         |                                 |      |   |        |  |   |         |   |  |   |       
|Denominator for basic income per share                                          |  |                                  |         |                                 |      |   |        |  |   |         |   |  |   |       
|Weighted average shares outstanding                                             |  |                                  | 18,254  |                                 |      |   | 16,895 |  |   | 17,646  |   |  |   | 17,050
|Employee stock options and other                                                |  |                                  |        |                                 |      |   | 913    |  |   |        |   |  |   | 1,125 
|                                                                                |  |                                  |         |                                 |      |   |        |  |   |         |   |  |   |       
|Denominator for diluted income per share                                        |  |                                  |         |                                 |      |   |        |  |   |         |   |  |   |       
|Adjusted weighted average shares, assuming exercise of common equivalent shares |  |                                  | 18,254  |                                 |      |   | 17,808 |  |   | 17,646  |   |  |   | 18,175
|Net (loss) income per share                                                     |  |                                  |         |                                 |      |   |        |  |   |         |   |  |   |       
|Basic                                                                           |  | $                                | (0.86   | )                               |      | $ | 0.84   |  | $ | (1.09   | ) |  | $ | 0.75  
|Diluted                                                                         |  | $                                | (0.86   | )                               |      | $ | 0.80   |  | $ | (1.09   | ) |  | $ | 0.71  

Note 5: Other Comprehensive Income (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, 2006 and 2005
(amounts in thousands):



|                                      |  |                                  |         |   |                                 |   |        |      |  |   |         |   |  |   |        |  
|------------------------------------- |  | -------------------------------- | ------- | - | ------------------------------- | - | ------ | ---- |  | - | ------- | - |  | - | ------ | -
|                                      |  | Three Months Ended September 30, |         |   | Nine Months Ended September 30, |  
|                                      |  | 2006                             |         |   | 2005                            |   |        | 2006 |  |   | 2005    |  
|Net loss as reported                  |  | $                                | (15,602 | ) |                                 | $ | 14,172 |      |  | $ | (19,153 | ) |  | $ | 12,855 |  
|Other comprehensive loss              |  |                                  |        |   |                                 |   |        |      |  |   |        |   |  |   |        |  
|Unrealized gain (loss) on investments |  |                                  | 53      |   |                                 |   | (48    | )    |  |   | 37      |   |  |   | (87    | )
|                                      |  |                                  |         |   |                                 |   |        |      |  |   |         |   |  |   |        |  
|Total comprehensive loss              |  | $                                | (15,549 | ) |                                 | $ | 14,124 |      |  | $ | (19,116 | ) |  | $ | 12,768 |  



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##### Table of Contents

Note 6: Other Current Assets

The following is a summary of other current assets as of September 30, 2006 and December 31, 2005 (in thousands):



|                     |  |                   |     |                  |   |      
|-------------------- |  | ----------------- | --- | ---------------- | - | -----
|                     |  | September 30,2006 |     | December 31,2005
|Other Current Assets |  |                   |     |                  |   |      
|Rebates due from B&T |  | $                 |    |                  | $ | 4,108
|Returns in transit   |  |                   |    |                  |   | 762  
|Other                |  |                   | 470 |                  |   | 341  
|                     |  |                   |     |                  |   |      
|                     |  | $                 | 470 |                  | $ | 5,211
|                     |  |                   |     |                  |   |      



| |  |  | Rebates due from B&T are amounts due to the Company for meeting certain thresholds during the year;
| | - |  | ---------------------------------------------------------------------------------------------------



| |  |  | Returns-in-transit consists of new textbooks that the Company returned to publishers for credit during the fourth quarter of fiscal 2005 that had not yet been processed by the
publishers as of December 31, 2005; and
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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

Note 7: Intangible
Assets and Goodwill

Intangible assets as of September 30, 2006, consisting of i) the purchase price allocation of the May 2005 Campus Outfitters
acquisition; ii) the non-compete agreement associated with the purchase of the LydiaLearn assets in March 2006; and iii) the preliminary purchase price allocation of the May 2006 IQ-Digital acquisition, were as follows (in thousands):



|                        |  |           |  |              |     |                         |   |            |  |   |    
|----------------------- |  | --------- |  | ------------ | --- | ----------------------- | - | ---------- |  | - | ---
|                        |  | Life      |  | Gross Assets |     | AccumulatedAmortization |   | Net Assets
|Trademarks              |  | 3 yrs     |  | $            | 150 |                         | $ | 63         |  | $ | 87 
|Customer related assets |  | 1-10 yrs  |  |              | 567 |                         |   | 97         |  |   | 470
|Non-compete agreements  |  | 2 - 4 yrs |  |              | 253 |                         |   | 93         |  |   | 160
|                        |  |           |  |              |     |                         |   |            |  |   |    
|Total                   |  |           |  | $            | 970 |                         | $ | 253        |  | $ | 717
|                        |  |           |  |              |     |                         |   |            |  |   |    

The changes in the amount of carrying value of goodwill in the nine months ended September 30, 2006 were as
follows (amounts in thousands):



|                                                                                                           |  |            |       |  
|---------------------------------------------------------------------------------------------------------- |  | ---------- | ----- | -
|                                                                                                           |  | Net Assets |      
|Balance as of December 31, 2005                                                                            |  | $          | 2,427 |  
|IQ-Digital acquisition                                                                                     |  |            | 706   |  
|Reduction in goodwill related to changes in estimated liabilities assumed in Campus Outfitters acquisition |  |            | (23   | )
|                                                                                                           |  |            |       |  
|Balance as of September 30, 2006                                                                           |  | $          | 3,110 |  
|                                                                                                           |  |            |       |  

Amortization expense related to the Companys acquired intangible assets was $66,000 and $163,000 during the
three and nine months ended September 30, 2006, respectively. Estimated aggregate future amortization expense for intangible assets remaining as of September 30, 2006 is as follows: (amounts in thousands):



|                     |  |      |    |      |   |      |  |      |     |      |   |            |  |       |    |  |   |     |  |   |    
|-------------------- |  | ---- | -- | ---- | - | ---- |  | ---- | --- | ---- | - | ---------- |  | ----- | -- |  | - | --- |  | - | ---
|                     |  | 2006 |    | 2007 |   | 2008 |  | 2009 |     | 2010 |   | Thereafter |  | Total
|Amortization expense |  | $    | 66 |      | $ | 215  |  | $    | 111 |      | $ | 56         |  | $     | 51 |  | $ | 218 |  | $ | 717
|                     |  |      |    |      |   |      |  |      |     |      |   |            |  |       |    |  |   |     |  |   |    



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##### Table of Contents

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 is based in Akron, Ohio and is an advertising agency focused on educational branding, communications and marketing. IQ Digital Studios also specializes in eLearning content design and development, end-to-end streaming video
solutions including TV on the Web and custom branded streaming video player technology. The IQ Digital acquisition enables the Company to improve its speed to market as it adds new products and services and also strengthens the Companys
strategy of becoming a one-source solution for educational institutions by providing a new line of services that the Company can offer to its existing school client base. The results of operations for IQ Digital have been included in the
Companys operations since the acquisition date. The purchase price has been allocated to the assets acquired and liabilities assumed based on managements estimates of their applicable fair value. The initial weighted average amortization
period for all intangible assets acquired in this transaction that are subject to amortization is 2.6 years.

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. Management determined under the guidance of EITF 98-3 that the assets acquired did not constitute a business combination
and therefore the assets will be recorded at relative fair values of the assets acquired and liabilities assumed. Accordingly, approximately $350,000 was allocated to acquired software and $25,000 was allocated to a non-compete agreement, which will
be amortized over four years. The remaining balance of the purchase price was allocated to various fixed or current assets.

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 Campus Outfitters acquisition allows the Company to offer a comprehensive solution to provide textbooks, uniforms and school supplies to school communities and allows the
Company to leverage relationships with schools partnered with Varsity Books and Campus Outfitters to cross-promote the other product lines.

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. The Company performed its regular assessment of realization of its net deferred tax assets as of September 30, 2006.
Statement of Financial Accounting Standards (SFAS) No. 109, Accounting for Income Taxes (SFAS No. 109), requires that all available evidence, both positive and negative, be considered in determining whether a valuation allowance is
needed relating to net deferred tax assets. Cumulative losses in recent years represent significant negative evidence under SFAS No.109. After considering the companys pretax losses for the nine months ended September 30, 2006 and the
expectation of a pre-tax loss for the full year of 2006 the Company concluded, based on the criteria outlined in SFAS No. 109, that the significance of the negative evidence of cumulative losses from the most recent years could not be overcome as
there was insufficient objective evidence at this time that the deferred tax assets would be realized through future taxable income or available tax planning strategies. Accordingly, the company recorded a non-cash charge in the third quarter of
2006 of $18.0 million to increase the valuation allowance against net deferred tax assets. With this increase, the company has a full valuation allowance against its net deferred tax assets. This non-cash charge has been recorded in the provision
for income taxes in the accompanying consolidated statement of income. The company expects to continue to record a full valuation allowance on future tax benefits until other positive evidence is sufficient to justify realization. Any increase or
decrease in the valuation allowance would result in additional or lower income tax expense in such period and could have a significant impact on that periods earnings.



10



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##### Table of Contents

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, 2006 and
December 31, 2005 consists of (in thousands):



|                     |  |                   |        |                  |   |      
|-------------------- |  | ----------------- | ------ | ---------------- | - | -----
|                     |  | September 30,2006 |        | December 31,2005
|Inventory            |  |                   |        |                  |   |      
|New textbooks        |  | $                 | 8,169  |                  | $ | 1,708
|Used textbooks       |  |                   | 1,650  |                  |   | 1,191
|Uniforms and apparel |  |                   | 3,163  |                  |   | 1,577
|                     |  |                   |        |                  |   |      
|                     |  | $                 | 12,982 |                  | $ | 4,476
|                     |  |                   |        |                  |   |      

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. B&T is able to return a significant amount of these books on behalf of the Company, but the Company must first take title to these books. In
aggregate, we expect that approximately $4.0 to $5.0 million of new textbooks will be returned to publishers during our fourth quarter fiscal 2006 and first quarter fiscal 2007. 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.

Prior to its acquisition of Campus Outfitters in May 2005, the Company was primarily an Internet retailer of
textbooks and educational materials targeting private middle and high schools, small colleges and distance and continuing education markets. The Companys chief operating decision maker reviewed financial information presented on a consolidated
basis. Accordingly, the Company considered itself to be in a single industry segment. In May 2005, the Company added a second product line with its acquisition of Campus Outfitters, a leading provider of uniform apparel needs to schools and
businesses, and in May 2006, the Company added a third business line with its acquisition of IQ-Digital, an advertising agency focused on educational branding, communications, marketing and eLearning content design and development. Accordingly, the
Companys operations are aggregated into three reportable business segments: textbook trade, uniform trade and solutions.

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 three quarters of fiscal 2006 (amounts in
thousands):



|                      |  |                                       |        |          |   |           |  |           |       |       |      |   |       |  |      |       |      |   |      |  |      |       |  |   |        |  |   |        |  |   |       
|--------------------- |  | ------------------------------------- | ------ | -------- | - | --------- |  | --------- | ----- | ----- | ---- | - | ----- |  | ---- | ----- | ---- | - | ---- |  | ---- | ----- |  | - | ------ |  | - | ------ |  | - | ------
|                      |  | Three months ended September 30, 2006
|                      |  | Textbooks                             |        | Uniforms |   | Solutions |  | Corporate |       | Total
|                      |  | 2006                                  |        | 2005     |   | 2006      |  |           | 2005  |       | 2006 |   | 2005  |  | 2006 |       | 2005 |   | 2006 |  | 2005
|Sales                 |  | $                                     | 38,564 |          | $ | 35,584    |  | $         | 5,131 |       |      | $ | 4,274 |  | $    | 126   |      | $ |     |  | $    |      |  | $ |       |  | $ | 43,821 |  | $ | 39,858
|Product gross margin  |  | $                                     | 12,565 |          | $ | 10,912    |  | $         | 2,127 |       |      | $ | 2,406 |  | $    | 58    |      | $ |     |  | $    |      |  | $ |       |  | $ | 14,750 |  | $ | 13,318
|                      |  |                                       |        |          |   |           |  |           |       |      
|Shipping revenue      |  | $                                     | 3,305  |          | $ | 3,179     |  | $         | 39    |       |      | $ |      |  | $    |      |      | $ |     |  | $    |      |  | $ |       |  | $ | 3,344  |  | $ | 3,179 
|Shipping gross margin |  | $                                     | 220    |          | $ | 782       |  | $         | (170  | )     |      | $ |      |  | $    |      |      | $ |     |  | $    |      |  | $ |       |  | $ | 50     |  | $ | 782   
|Total sales           |  | $                                     | 41,869 |          | $ | 38,763    |  | $         | 5,170 |       |      | $ | 4,274 |  | $    | 126   |      | $ |     |  | $    |      |  | $ |       |  | $ | 47,165 |  | $ | 43,037
|Blended gross margin  |  | $                                     | 12,785 |          | $ | 11,694    |  | $         | 1,957 |       |      | $ | 2,406 |  | $    | 58    |      | $ |     |  | $    |      |  | $ |       |  | $ | 14,800 |  | $ | 14,100
|                      |  |                                       |        |          |   |           |  |           |       |      
|Goodwill              |  | $                                     | 511    |          | $ |          |  | $         | 1,893 |       |      | $ | 1,881 |  | $    | 706   |      | $ |     |  | $    |      |  | $ |       |  | $ | 3,110  |  | $ | 1,881 
|Total assets          |  | $                                     | 16,585 |          | $ | 11,753    |  | $         | 6,932 |       |      | $ | 4,488 |  | $    | 1,905 |      | $ |     |  | $    | 8,359 |  | $ | 33,851 |  | $ | 33,780 |  | $ | 50,092



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|                      |  |                                      |        |          |   |           |  |           |       |       |      |   |       |  |      |       |      |   |      |  |   |       |  |   |        |  |   |        |   |  |   |       
|--------------------- |  | ------------------------------------ | ------ | -------- | - | --------- |  | --------- | ----- | ----- | ---- | - | ----- |  | ---- | ----- | ---- | - | ---- |  | - | ----- |  | - | ------ |  | - | ------ | - |  | - | ------
|                      |  | Nine months ended September 30, 2006
|                      |  | Textbooks                            |        | Uniforms |   | Solutions |  | Corporate |       | Total
|                      |  | 2006                                 |        | 2005     |   | 2006      |  |           | 2005  |       | 2006 |   | 2005  |  | 2006 |       | 2005 |   | 2006 |  |   | 2005 
|Sales                 |  | $                                    | 40,720 |          | $ | 38,831    |  | $         | 6,740 |       |      | $ | 4,821 |  | $    | 217   |      | $ |     |  | $ |      |  | $ |       |  | $ | 47,677 |   |  | $ | 43,652
|Product gross margin  |  | $                                    | 13,214 |          | $ | 12,042    |  | $         | 3,004 |       |      | $ | 2,734 |  | $    | 113   |      | $ |     |  | $ |      |  | $ |       |  | $ | 16,331 |   |  | $ | 14,776
|                      |  |                                      |        |          |   |           |  |           |       |      
|Shipping revenue      |  | $                                    | 3,610  |          | $ | 3,457     |  | $         | 49    |       |      | $ |      |  | $    |      |      | $ |     |  | $ |      |  | $ |       |  | $ | 3,659  |   |  | $ | 3,457 
|Shipping gross margin |  | $                                    | 208    |          | $ | 837       |  | $         | (224  | )     |      | $ |      |  | $    |      |      | $ |     |  | $ |      |  | $ |       |  | $ | (16    | ) |  | $ | 837   
|                      |  |                                      |        |          |   |           |  |           |       |      
|Total sales           |  | $                                    | 44,331 |          | $ | 42,288    |  | $         | 6,789 |       |      | $ | 4,821 |  | $    | 217   |      | $ |     |  | $ |      |  | $ |       |  | $ | 51,337 |   |  | $ | 47,109
|Blended gross margin  |  | $                                    | 13,422 |          | $ | 12,879    |  | $         | 2,780 |       |      | $ | 2,734 |  | $    | 113   |      | $ |     |  | $ |      |  | $ |       |  | $ | 16,315 |   |  | $ | 15,613
|                      |  |                                      |        |          |   |           |  |           |       |      
|Goodwill              |  | $                                    | 511    |          | $ |          |  | $         | 1,893 |       |      | $ | 1,881 |  | $    | 706   |      | $ |     |  | $ |      |  | $ |       |  | $ | 3,110  |   |  | $ | 1,881 
|Total assets          |  | $                                    | 16,585 |          | $ | 11,753    |  | $         | 6,932 |       |      | $ | 4,488 |  | $    | 1,905 |      | $ |     |  | $ | 8,359 |  | $ | 33,851 |  | $ | 33,780 |   |  | $ | 50,092

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 is 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.



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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, 2005. 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, 2005 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

Varsity Group Inc. was founded in 1997. We are a Delaware corporation with our principal executive offices located at 1300 19thStreet, NW, 8thFloor, Washington, D.C. 20036, and our telephone number is
(202) 667-3400.

Varsity Group is a premier outsourcing solutions provider for the education community. Through Varsity Groups four divisions,
we offer a broad array of solutions to K-20 schools across the nation that enables schools to focus on their core mission of educating students (see www.GoVarsity.com.) Our Varsity Books division provides comprehensive-outsourcing solutions
including textbook managed services, school supplies solutions, and software products at education discount pricing. Our Campus Outfitters division provides innovative school uniform and branded apparel solutions, sports and spirit wear, and other
branded products solutions. Our Varsity Solutions division, formed in the second quarter with the acquisition of iQ Digital and LydiaLearn, provides school marketing services, security and access solutions, information technology solutions, testing
and assessment consulting, graduation products, class and championship rings programs and office supply programs. Our Varsity Finance Division began operation with on-line K-20 student loan programs in October of 2006. Each of our programs are
designed to relieve our partner schools from the operational, technical and financial challenges associated with managing the highly seasonal and highly specialized functions of their school operations. This enables our client schools to focus their
valuable resources on their core educational mission. Please see Note 11 to our condensed consolidated financial statements for financial information on our business segments.

Through Varsity Groups solutions, students and families enjoy the convenience of purchasing learning materials, school uniforms, software, and other supplies through our convenient online stores (located at
www.Govarsity.com, www.varsitybooks.com and www.campusoutfitters.com), at select retail locations, or at our managed on-campus sales events. To date, the primary channel for textbook sales has been through online eCommerce transactions, while the
majority of our uniform sales have been recognized through retail stores and on-campus sales events.

Within our Varsity Books division, 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, software and supplies selected by each school, organized by grade,
academic discipline and course name. Students and parents from 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. Through the national partnership agreement with Office Depot signed in
August 2006, we now include school supply kits in our schools online stores enabling parents the



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added one click convenience of adding their needed school supplies to their order. And, through the national agreement
with CampusTech signed in August 2006, we are now offering software and other related products at education discounted prices to our schools and their students.

Our client schools leverage Varsitys 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 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 textbook alternatives.

As part of our
strategy to expand the number of services and products we offer our customers, we acquired Campus Outfitters in May 2005, creating a single source solution for school textbook and uniform needs. Our acquisition of Campus Outfitters allows us to
leverage relationships with schools partnered under either our Varsity Books or Campus Outfitters divisions by cross-promoting the other product lines. Through the Campus Outfitters division, we own and operate nine retail locations serving school
communities as their official school uniform provider. As a further convenience to our uniform customers, we travel to eligible schools and conduct on-campus sales events during which families can purchase and take home all necessary uniform
components the same day. Parents and students also have the ability to shop online through customized virtual stores which are created on www.campusoutfitters.com for each partner school containing all required and optional uniform components.
Similar to our textbook solution, partner uniform schools leverage their relationship with us to lower their operating overhead by outsourcing their school uniform operation while delivering a more flexible uniform solution to their community.

With the acquisition of iQ Digital in May 2006, our recently formed Varsity Solutions division provides innovative school marketing and online solutions
to our client schools. As a further part of our Varsity Solutions growth strategy, we have recently partnered with several leading companies that specialize in education solutions of particular value to schools and that fit our outsourced solutions
model. Our August 2006 partnership with Office Depot enables us to provide Office Supplies solutions to schools and School Supplies solutions to parents and students. Through our recent partnership with SchoolOne, a leading school technology and
solutions company, we now offer turnkey and customized information technology solutions to our client schools. In August 2006, we entered into agreements with Lange Consultants, a nationally recognized academic program evaluation and design firm and
TCS, a school security and access solutions specialist and are beginning to offer these services to our schools. In September 2006, we entered into an agreement with Collegiate Pacific (NASDAQ: BOO) to provide schools with a comprehensive solution
for sports equipment and sporting goods, further simplifying their purchasing process and providing additional single source benefits to schools. During the third quarter 2006, we established programs offering schools graduation products
including caps, gowns, and diploma frames, and a class rings and championship rings program. We have designed and developed all of these programs to leverage our existing technology, account management, distribution and customer service
infrastructure to provide added convenience and cost savings to our schools and consumers.

Our newest division, Varsity Finance, was launched early in our
fourth quarter of fiscal 2007 to provide tuition financing options to schools across the country. Through our programs, we will market student loans enabling schools to enroll, retain and better serve their student populations. We have licensed the
nations leading college and career planning technology from Envictus to provide such services as online college research and selection, financial aid research, locating summer camps and summer jobs, and career planning and research all through
Varsity Finance. Effective August 2006, we have partnered with Bank of America to provide schools with financing options for our technology and security solutions which also establishes an opportunity for Varsity to earn financing income on each
transaction.

These many new offerings across our four divisions may provide additional revenue in those quarters that Varsity Group revenue has been
relatively limited, diminishing the extremely seasonal nature of our business.

We believe a key aspect of our textbook and uniform models are the
underlying school, parent and student relationships we build with each new partner school. The addition of Campus Outfitters in 2005 added approximately 300 additional school relationships to our network, focused primarily in the K-12 private
education marketplace, increasing our total number of school relationships to over 700. During fiscal 2005, we met the textbook or uniform needs of over 240,000 parent and student customers. Approximately 90% of our textbook accounts are currently
private elementary and secondary schools and virtually all of our uniform accounts are currently private elementary and secondary schools.

Our overall
success and ability to maintain and increase profitability from operations will depend, in part, upon our ability to retain our current customers, successfully integrate acquisitions, 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.



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We provide website access to our periodic and current SEC filings and press releases, free of charge, on our website
located at http://www.varsitygroup.com as soon as reasonably practicable after the materials are filed with the SEC or otherwise made public.

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, 2005. 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. Other than noted below, there have been no significant changes during the first two quarters of 2006 to the items disclosed as our critical
accounting policies and estimates in the Managements Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the year ended December 31, 2005.

Stock-Based Compensation Plans

On January 1, 2006, we adopted
the provisions of SFAS No. 123 (revised 2004), Share-Based Payment (SFAS 123(R)), which requires the measurement and recognition of non-cash compensation expense for all share-based payment awards made to employees
and directors based on estimated fair values. SFAS No. 123R supersedes our previous accounting under Accounting Principles Board Opinion No. 25 Accounting for Stock Issued to Employees (ABP 25), for periods
beginning in fiscal 2006. In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107, or SAB 107, relating to SFAS No. 123R. We have applied the provisions of SAB 107 in our adoption of SFAS
No. 123R.

Prior to the adoption of SFAS No. 123R, we previously accounted for our stock-based compensation plans under the recognition and
measurement provisions of APB 25 and related interpretations, and provided the disclosure-only provisions of SFAS No. 123, Accounting for Stock-Based Compensation.

We adopted SFAS No. 123R using the modified prospective transition method. Under that transition method, non-cash compensation expense was recognized in the first quarter of fiscal 2006 and included the
following: (a) compensation expense related to stock-based payments granted prior to, but not yet vested, as of January 1, 2006, and (b) compensation expense for stock-based payments granted subsequent to January 1, 2006, based
on the grant-date fair value estimated in accordance with the provisions of SFAS No. 123R. We recognize non-cash compensation expense for the fair values of these stock-based awards on a straight-line basis over their requisite service periods.
Because non-cash stock compensation expense is based on awards ultimately expected to vest, SFAS No. 123R requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ
from those estimates. Our financial statements as of and for the nine months ended September 30, 2006 reflect the impact of SFAS No. 123R. In accordance with the modified prospective transition method, our financial statements for prior
periods have not been restated to reflect, and do not include, the impact of SFAS No. 123R.

As a result of adopting SFAS No. 123R, we recognized
stock-based compensation expense of $182,000 and $379,000 during the three and nine months ended September 30, 2006, which primarily increased our general and administrative expenses. We calculated this expense based on the fair values of the
stock-based compensation awards. Use of this model requires us to make assumptions about expected future volatility of our stock price and the expected term of the options that we grant. Calculating stock-based compensation expense under SFAS
No. 123R also requires us to make assumptions about expected future forfeiture rates for our option awards. As of September 30, 2006, total unrecognized compensation expense related to unvested stock-based compensation arrangements
previously granted under our various plans was $1.3 million, which we expect to recognize over a weighted-average period of 3.5 years. However, it is difficult to predict the actual amount of share-based compensation expense that we will recognize
in future periods as that expense can be affected by changes in the amount or terms of our share-based compensation awards issued in the future, changes in the assumptions used in our model to value those future awards, changes in our stock price,
and changes in interest rates, among other factors.

For more information on stock-based compensation expense recorded for the quarter ended
September 30, 2006, please refer to Note 3: Stock Based Compensation in the notes to our condensed consolidated financial statements.

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

We accounted for our purchase of IQ Digital in accordance SFAS 141 and accounted
for the related acquired intangible assets in accordance with Statement of Financial Accounting Standards No. 142 Goodwill and Other Intangible Assets (SFAS 142). In



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accordance with SFAS 141, we allocated the cost of IQ Digital to the identifiable tangible and intangible assets and
liabilities assumed, with the remaining amount being classified as goodwill. Managements estimates of the fair value of the identifiable intangible assets acquired included significant estimates about future performance. As required by SFAS
142, in lieu of amortizing goodwill, we will test goodwill for impairment annually and any time a triggering indicator exists. During our second quarter of fiscal 2006, we performed our initial goodwill impairment tests for our textbook and uniform
reporting units by applying a fair value-based test and we believed that goodwill was not impaired and therefore, no impairment losses have been recorded. This conclusion is based on our judgment, taking into consideration expectations regarding
future profitability and the status of the reporting units that have reported goodwill. However, changes in strategy or adverse changes in market conditions could impact this judgment and require an impairment loss to be recognized for the amount
that the carrying value of goodwill exceeds its fair value. The determination of the value of such intangible assets and the annual impairment tests required by SFAS 142 requires management to make estimates of future revenues, customer
retention rates, estimated useful lives and other assumptions that affect our consolidated financial statements.

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.

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. We performed our regular assessment of realization of our net deferred tax assets as of September 30, 2006. Statement of Financial Accounting Standards (SFAS) No. 109, Accounting for Income Taxes (SFAS
No. 109), requires that all available evidence, both positive and negative, be considered in determining whether a valuation allowance is needed relating to net deferred tax assets. Cumulative losses in recent years represent significant negative
evidence under SFAS No.109. After considering our pretax losses for the nine months ended September 30, 2006 and the expectation of a pre-tax loss for the full year of 2006, we concluded, based on the criteria outlined in SFAS No. 109, that the
significance of the negative evidence of cumulative losses from the most recent years could not be overcome as there was insufficient objective evidence at this time that the deferred tax assets would be realized through future taxable income or
available tax planning strategies. Accordingly, we recorded a non-cash charge in the third quarter of 2006 of $18.0 million to increase the valuation allowance against net deferred tax assets. With this increase, we have a full valuation allowance
against our net deferred tax assets. This non-cash charge has been recorded in the provision for income taxes in the accompanying consolidated statement of income. We expect to continue to record a full valuation allowance on future tax benefits
until other positive evidence is sufficient to justify realization. Any increase or decrease in the valuation allowance would result in additional or lower income tax expense in such period and could have a significant impact on that periods
earnings.

Results of Operations:

The following table
includes the condensed consolidated statements of operations data for the three and nine months ended September 30, 2006 and September 30, 2005, expressed as a percentage of total net sales:



|                                     |  |                                  |    |  |                                 |   |  |       |    |  |       |  
|------------------------------------ |  | -------------------------------- | -- |  | ------------------------------- | - |  | ----- | -- |  | ----- | -
|                                     |  | Three Months Ended September 30, |    |  | Nine Months Ended September 30, |  
|                                     |  | 2006                             |    |  | 2005                            |   |  | 2006  |    |  | 2005  |  
|Net sales:                           |  |                                  |    |  |                                 |   |  |       |    |  |       |  
|Textbooks                            |  | 81.7                             | %  |  | 82.7                            | % |  | 79.4  | %  |  | 82.5  | %
|Uniforms                             |  | 10.9                             | %  |  | 9.9                             | % |  | 13.1  | %  |  | 10.2  | %
|Solutions                            |  | 0.3                              | %  |  |                                |   |  | 0.4   | %  |  |      |  
|Shipping                             |  | 7.1                              | %  |  | 7.4                             | % |  | 7.1   | %  |  | 7.3   | %
|                                     |  |                                  |    |  |                                 |   |  |       |    |  |       |  
|Total net sales                      |  | 100.0                            | %  |  | 100.0                           | % |  | 100.0 | %  |  | 100.0 | %
|                                     |  |                                  |    |  |                                 |   |  |       |    |  |       |  
|Operating Expenses:                  |  |                                  |    |  |                                 |   |  |       |    |  |       |  
|Cost of textbooks                    |  | 55.1                             | %  |  | 57.3                            | % |  | 53.6  | %  |  | 56.9  | %
|Cost of uniforms                     |  | 6.4                              | %  |  | 4.3                             | % |  | 7.3   | %  |  | 4.4   | %
|Cost of solutions                    |  | 0.1                              | %  |  |                                |   |  | 0.2   | %  |  |      |  
|Cost of shipping                     |  | 7.0                              | %  |  | 5.6                             | % |  | 7.2   | %  |  | 5.6   | %
|Sales and marketing                  |  | 19.2                             | %  |  | 13.1                            | % |  | 24.6  | %  |  | 16.4  | %
|General and administrative           |  | 7.0                              | %  |  | 3.9                             | % |  | 14.3  | %  |  | 7.4   | %
|Amortization of acquired intangibles |  | 0.1                              | %  |  | 0.1                             | % |  | 0.3   | %  |  | 0.1   | %
|                                     |  |                                  |    |  |                                 |   |  |       |    |  |       |  
|Total operating expenses             |  | 94.9                             | %  |  | 84.3                            | % |  | 107.5 | %  |  | 90.7  | %
|                                     |  |                                  |    |  |                                 |   |  |       |    |  |       |  
|Income (loss) from operations        |  | 5.1                              | %  |  | 15.7                            | % |  | (7.5  | )% |  | 9.3   | %
|                                     |  |                                  |    | 
|Other income, net                    |  | 0.1                              | %  |  | 0.2                             | % |  | 0.5   | %  |  | 0.8   | %
|                                     |  |                                  |    |  |                                 |   |  |       |    |  |       |  
|Income (loss) before income taxes    |  | 5.2                              | %  |  | 15.9                            | % |  | (7.0  | )% |  | 10.1  | %
|                                     |  |                                  |    | 
|Income tax benefit                   |  | (38.2                            | )% |  | 17.0                            | % |  | (30.3 | )% |  | 17.2  | %
|                                     |  |                                  |    |  |                                 |   |  |       |    |  |       |  
|Net income (loss) income             |  | (33.1                            | )% |  | 32.9                            | % |  | (37.3 | )% |  | 27.3  | %
|                                     |  |                                  |    |  |                                 |   |  |       |    |  |       |  



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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 2005 and 2004, approximately 86% and 85% of our revenues, respectively, were
recognized in this period. We expect this trend to continue as we expand our textbook and uniform programs in the private middle and high school market during 2006. 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 similar 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 the 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.

Net Sales:

Net sales increased 9.6%, or $4.1 million, to
$47.2 million, and increased 9.0%, or $4.2 million, to $51.3 million for the three and nine-month periods ended September 30, 2006, respectively, compared to the same periods in 2005. The increase during the three and nine-month periods was the
result of an increase in the number of schools we serve. The increase during the nine-month period was also positively impacted by the acquisition of Campus Outfitters in May 2005, which contributed approximately $5.1 million and $6.7 million to
total revenue for the three and nine months ended September 30, 2006 as compared to a contribution of approximately $4.3 million and $4.8 million for the prior year periods. This increase in overall revenue was largely offset by the non-renewal
of an on-campus bookstore management agreement that represented approximately $36,000 and $1.2 million of revenue during the three and nine months ended September 30, 2005 and generated no revenue during the three and nine months ended
September 30, 2006.



|                |  |                                  |   |  |                                 |   |  |       |   |  |       |  
|--------------- |  | -------------------------------- | - |  | ------------------------------- | - |  | ----- | - |  | ----- | -
|                |  | Three Months Ended September 30, |   |  | Nine Months Ended September 30, |  
|                |  | 2006                             |   |  | 2005                            |   |  | 2006  |   |  | 2005  |  
|Net sales:      |  |                                  |   |  |                                 |   |  |       |   |  |       |  
|Textbooks       |  | 81.7                             | % |  | 82.7                            | % |  | 79.4  | % |  | 82.5  | %
|Uniforms        |  | 10.9                             | % |  | 9.9                             | % |  | 13.1  | % |  | 10.2  | %
|Solutions       |  | 0.3                              | % |  |                                |   |  | 0.4   | % |  |      |  
|Shipping        |  | 7.1                              | % |  | 7.4                             | % |  | 7.1   | % |  | 7.3   | %
|                |  |                                  |   |  |                                 |   |  |       |   |  |       |  
|Total net sales |  | 100.0                            | % |  | 100.0                           | % |  | 100.0 | % |  | 100.0 | %
|                |  |                                  |   |  |                                 |   |  |       |   |  |       |  



17



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##### Table of Contents

Operating Expenses:

Cost of Textbooks -Cost of textbooks consists of the cost of textbooks and related education materials sold to customers. Cost of textbooks increased 5.4%, or approximately $1.3 million, to approximately $26.0 million, and increased
2.7%, or approximately $0.7 million, to approximately $27.5 million, for the three and nine months ended September 30, 2006, respectively, compared to the same periods in 2005. This increase was attributable to our increased sales volume.
Expressed as a percentage of related revenue, cost of textbooks was 67.5% and 69.3% for the three months ended September 30, 2006 and 2005, respectively, and 67.8% and 69.0% for the nine months ended September 30, 2006 and 2005,
respectively. This decrease in the three and nine months ended September 30, 2006 was largely attributable to an 18.2% increase and a 20.9% increase, respectively, in sales of used books during 2006 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, 2006 and 2005 (in thousands):



|                         |  |                                  |  |                                 |  |       |  |      
|------------------------ |  | -------------------------------- |  | ------------------------------- |  | ----- |  | -----
|                         |  | Three Months Ended September 30, |  | Nine Months Ended September 30,
|                         |  | 2006                             |  | 2005                            |  | 2006  |  | 2005 
|Total online unit sales: |  |                                  |  |                                 |  |       |  |      
|New textbooks sold       |  | 1,002                            |  | 954                             |  | 1,047 |  | 1,011
|Used textbooks sold      |  | 104                              |  | 88                              |  | 110   |  | 91   
|                         |  |                                  |  |                                 |  |       |  |      
|Total textbooks sold     |  | 1,106                            |  | 1,042                           |  | 1,157 |  | 1,102

Cost of Uniforms - Cost of uniforms consists of the cost of uniforms and apparel sold to customers. Cost of
uniforms increased approximately $1.1 million, or 60.8%, to approximately $3.0 million, and increased approximately $1.6 million, or 79.0%, to approximately $3.7 million for the three and nine months ended September 30, 2006, respectively.
Expressed as a percentage of related revenue, cost of uniforms was 58.5% and 43.7% for the three months ended September 30, 2006 and 2005, respectively, and 55.4% and 43.3% for the nine months ended September 30, 2006 and 2005,
respectively.

The increase in the three and nine month periods ended September 30, 2006 was largely attributable to year over year price increases in
product which were not passed on to our customers and integration issues related to the acquisition of Campus Outfitters. Before our acquisition of Campus Outfitters in May 2005, Campus had been privately owned and operated and possessed minimal
inventory and purchasing management, data and controls. In order to integrate the Campus acquisition, we began 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 the release of our new order management and inventory management software systems, which contributed to operational
difficulties that we feel was a considerable factor contributing to the cause of the increase in cost of uniforms during our three and nine months, ended September 30, 2006.

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 increased $0.9 million, or 37.4%, to $3.3 million, and
increased approximately $1.1 million, or 40.3%, to approximately $3.7 million for the three and nine months ended September 30, 2006, respectively. Expressed as a percentage of related revenue, cost of shipping was 98.5% and 75.4% for the three
months ended September 30, 2006 and 2005, respectively, and 100.4% and 75.8% for the nine months ended September 30, 2006 and 2005, respectively. This increase was the result of Campus Outfitter integration issues mentioned earlier.
Uniforms and textbooks that are not in stock at Campus Outfitter on campus road shows or in retail stores for our customers are generally shipped directly to customers free of shipping charges. We anticipate that our shipping margins in our fourth
quarter of fiscal 2006 will decrease since generally all third quarter end backorders will be shipped directly to customers free of shipping charges. We expect that shipping margins will improve in fiscal 2007 once our new order management and
inventory management software systems are fully implemented.

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 increased
approximately $3.4 million, or 61.3%, to approximately $9.1 million, and increased approximately $4.9 million or 63.6%, to approximately $12.6 million for the three and nine months ended September 30, 2006, respectively.



18



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##### Table of Contents

The following table sets forth sales and marketing expense for the three and nine months ended September 30, 2006
and 2005 (in thousands):



|                                         |  |                                  |       |   |                                 |   |       |      |  |   |        |   |  |   |       |  
|---------------------------------------- |  | -------------------------------- | ----- | - | ------------------------------- | - | ----- | ---- |  | - | ------ | - |  | - | ----- | -
|                                         |  | Three months ended September 30, |       |   | Nine months ended September 30, |  
|                                         |  | 2006                             |       |   | 2005                            |   |       | 2006 |  |   | 2005   |  
|Variable sales and marketing expense     |  | $                                | 5,296 |   |                                 | $ | 4,027 |      |  | $ | 5,738  |   |  | $ | 4,325 |  
|Percentage of total revenue              |  |                                  | 11.2  | % |                                 |   | 9.4   | %    |  |   | 11.2   | % |  |   | 9.2   | %
|Other sales and marketing expense        |  | $                                | 3,768 |   |                                 | $ | 1,592 |      |  | $ | 6,879  |   |  | $ | 3,387 |  
|Percentage of total revenue              |  |                                  | 8.0   | % |                                 |   | 3.7   | %    |  |   | 13.4   | % |  |   | 7.2   | %
|                                         |  |                                  |       |   |                                 |   |       |      |  |   |        |   |  |   |       |  
|Sales and marketing expense, as reported |  | $                                | 9,064 |   |                                 | $ | 5,619 |      |  | $ | 12,617 |   |  | $ | 7,711 |  
|                                         |  |                                  |       |  
|Percentage of total revenue              |  |                                  | 19.2  | % |                                 |   | 13.1  | %    |  |   | 24.7   | % |  |   | 16.4  | %

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 increases during our peak selling period in the July/August/September back-to-school
season.

Other sales and marketing expense consists of primarily payroll and related expenses for personnel engaged in sales and marketing, account
management, customer service, 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 increased 137.8%, or approximately $2.2 million, to approximately $3.8 million, and increased 103.1%, or approximately $3.5 million, to approximately $6.9 million for the three and nine months ended
September 30, 2006, respectively. The acquisition of Campus Outfitters, which was purchased in May 2005, contributed to approximately $1.1 million of this increase for nine months ended September 30, 2006. The acquisition of IQ Digital in
May 2006 contributed approximately $0.2 million and $0.3 million of this increase for the three and nine months ended September 30, 2006, respectively. Also included in this increase was a non-cash charge of $23,000 and $81,000 for the three
and nine months ended September 30, 2006, respectively, for share-based compensation expense as a result of the adoption of SFAS 123(R), effective January 1, 2006.

In conjunction with our plans for to accelerate the growth of our current business and support the introduction of new businesses during the nine months ended September 30, 2006, we experienced significant
increases in sales and marketing headcount and overhead to accelerate the growth of our current business and support the introduction of new businesses. Accordingly, average sales and marketing full-time headcount increased from 59 to 78 employees
for the three months ended September 30, 2006, respectively and increased from 50 to 71 employees for the nine months ended September 30, 2006.

We anticipate that the increases we have made in people, processes and systems to accelerate the growth of our current business and support the introduction of new businesses during the nine months ended September 30, 2006 will not
result in increases in Sales and marketing expenses from our most recent quarters during our fourth quarter of fiscal 2006 and first quarter of fiscal 2007, however, we expect that our fourth quarter of fiscal 2006 and first quarter of fiscal 2007
will show increases as compared to prior year periods. Management is currently undertaking initiatives to reduce spending and realize benefits from the recent investments that we have made in our people, processes and systems. 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 $0.3 million and $0.2 million
of costs capitalized for software developed or purchased for internal use during the three months ended September 30, 2006 and 2005, respectively, increased 94.3% or approximately $1.6 million, to approximately $3.3 million for the three months
ended September 30, 2006 compared to the prior year period. General and administrative expense, reported net of $1.4 million and $0.6 million of costs capitalized for software developed or purchased for internal use during the nine months ended
September 30, 2006 and 2005, respectively, increased 111.8% or approximately $3.9 million, to approximately $7.4 million for the nine months ended September 30, 2006 compared to the prior year period. These increases were primarily
attributable to:



| |  |  | Increase in average headcount from 8 to 14 employees for the three months ended September 30, 2006, respectively and from 7 to 12 for the nine months ended September 30,
2006, respectively.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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##### Table of Contents

| |  |  | general increases in other infrastructure expenditures associated with the growth of our business;
| | - |  | --------------------------------------------------------------------------------------------------



| |  |  | approximately $0.7 million of additional costs in Campus Outfitters for the nine months ended September 30, 2006 and approximately $0.1 million and $0.2 million of additional
costs in IQ Digital for the three and nine months ended September 30, 2006, respectively, compared to the same periods in 2005 which only had four months associated with our acquisition of Campus Outfitters in late May 2005 and no months
associated with our acquisition of IQ Digital in May 2006;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | an increase in maintenance costs and amortization costs associated with the costs we have capitalized in prior periods for software developed for internal use; and
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | non-cash charges of $0.2 million and $0.3 million for the three and nine months ended September 30, 2006 for share-based compensation expense as a result of the adoption of
SFAS 123(R), effective January 1, 2006.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

We anticipate that the increases we have made in people, processes and systems to accelerate
the growth of our current business and support the introduction of new businesses during the nine months ended September 30, 2006 will not result in increases in general and administrative expenses from our most recent quarters during our
fourth quarter of fiscal 2006 and first quarter of fiscal 2007, however, we expect that our fourth quarter of fiscal 2006 and first quarter of fiscal 2007 will show increases as compared to prior year periods. Management is currently undertaking
initiatives to reduce spending and realize benefits from the recent investments that we have made in our people, processes and systems. 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, compared to $35,000 and $47,000
during the prior year periods.

Other income, net

Other income, net consists primarily of interest income on our cash and cash equivalents and investments. Other income was approximately $40,000 and $0.3 million for the three and nine months ended September 30, 2006, respectively,
compared to $0.1 million and $0.4 million for the three and nine months ended September 30, 2005, respectively. The decrease was due to lower average cash invested in short-term and long-term investments during the three and nine months ended
September 30, 2006 as compared to the prior year periods.

Income Taxes

Income tax expense for the three and nine months ended September 30, 2006 was approximately $18.0 million and $15.6 million, respectively, compared to income tax benefit of approximately $7.3 million and $8.1
million for the three and nine months ended September 30, 2005, respectively. 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. We performed our regular assessment
of realization of our net deferred tax assets as of September 30, 2006. Statement of Financial Accounting Standards (SFAS) No. 109, Accounting for Income Taxes (SFAS No. 109), requires that all available evidence, both positive and
negative, be considered in determining whether a valuation allowance is needed relating to net deferred tax assets. Cumulative losses in recent years represent significant negative evidence under SFAS No.109. After considering our pretax losses for
the nine months ended September 30, 2006 and the expectation of a pre-tax loss for the full year of 2006, we concluded, based on the criteria outlined in SFAS No. 109, that the significance of the negative evidence of cumulative losses from the most
recent years could not be overcome as there was insufficient objective evidence at this time that the deferred tax assets would be realized through future taxable income or available tax planning strategies. Accordingly, we recorded a non-cash
charge in the third quarter of 2006 of $18.0 million to increase the valuation allowance against net deferred tax assets. With this increase, we have a full valuation allowance against our net deferred tax assets. This non-cash charge has been
recorded in the provision for income taxes in the accompanying consolidated statement of income. We expect to continue to record a full valuation allowance on future tax benefits until other positive evidence is sufficient to justify realization.
Any increase or decrease in the valuation allowance would result in additional or lower income tax expense in such period and could have a significant impact on that periods earnings.



20

During
the third quarter of fiscal 2005, management reassessed the potential realization of its remaining valuation allowance based on its current financial projections for the remainder of fiscal 2005, 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. Accordingly, the Company released $10.0 million of its deferred tax asset valuation
allowance in the three months ended September 30, 2005. The $10 million deferred tax benefit recorded for the three months ended September 30, 2005 based on the decrease in valuation allowance was partially offset by the tax provision
recorded on the earnings of the period.



---

##### Table of Contents

Liquidity and Capital Resources

As of September 30, 2006, we had approximately $4.2 million of cash, cash equivalents and short-term investments and net working capital of approximately $11.4 million compared to approximately $6.1 million of
cash, cash equivalents and short-term investments and net working capital of approximately $14.6 million at December 31, 2005. As of September 30, 2006, we had approximately $3.9 million in long-term investments compared to approximately
$6.4 million at December 31, 2005. The decrease in cash, cash equivalents and short-term investments during the nine months ended September 30, 2006 was primarily attributable to cash payments for:



| |  |  | used textbooks we acquired during our fiscal 2006 buyback campaign;
| | - |  | -------------------------------------------------------------------



| |  |  | the purchase of LydiaLearn assets in March 2006 and the IQ Digital acquisition in May 2006;
| | - |  | -------------------------------------------------------------------------------------------



| |  |  | school partner incentive accruals paid primarily during our first quarter; and
| | - |  | ------------------------------------------------------------------------------



| |  |  | capital expenditures to support the growth in our operations, infrastructure and personnel.
| | - |  | -------------------------------------------------------------------------------------------

These cash payments were partially offset by collection of certain rebates and receivables from B&T and increased collections of accounts receivable.

As of September 30, 2006, our principal commitments consisted of obligations outstanding under operating leases, our service agreement with SchoolOne, and accounts payable. While we have made significant
expenditures in people, processes and systems during our first three quarters of fiscal 2006 to accelerate the growth of our current business and establish a foundation to support the introduction of new businesses and revenue streams in the future,
management has recently initiated actions to reduce overhead spending for our fourth quarter fiscal 2006 and we expect to continue to focus on aggressive overhead reductions during fiscal 2007. Please see Forward-Looking
Statements.

Net cash used in operating activities was approximately $1.3 million for the nine months ended September 30, 2006 compared to
net cash used in operating activities of approximately $2.1 million for the nine months ended September 30, 2005. The decrease in cash used in operating activities was primarily the result of a decrease in other current assets related to
year-end rebates we had with B&T related to fiscal 2005 activity compared to the prior year period, as well as an increase in accounts payables.

Investing activities consist of acquisitions of businesses, capitalization of software developed for internal use, purchases of property, plant and equipment, purchases of software, and purchases and sales of short-term and long-term
investments. Net cash used in investing activities was approximately $0.4 million for the nine months ended September 30, 2006 compared to net cash used in investing activities of approximately $0.4 million for the nine months ended
September 30, 2005. Total purchases of property, equipment and software, including capitalization of software, was approximately $2.5 million during the nine months ended September 30, 2006, an increase of approximately $1.6 million over
the comparable period in 2005 primarily due to the purchase of the LydiaLearn assets and infrastructure growth as we continue to make significant investments in our people, processes and systems the accelerate the growth of our business. Cash
payments for the IQ Digital acquisition was approximately $1.3 million during the nine months ended September 30, 2006, as compared to approximately $3.1 million for cash payments made during the comparable reporting period for Campus
Outfitters. During the nine months ended September 30, 2006 and 2005, we had net sales of short-term and long-term investments of approximately $3.4 million and $3.5 million, respectively, which we used to fund our business acquisitions,
infrastructure growth, and operations.

Net cash provided by financing activities was approximately $0.7 million for the nine months ended
September 30, 2006 and approximately $0.3 million for the nine months ended September 30, 2005. Net cash provided by financing activities during both periods consisted of net proceeds from the exercise of employee stock options.

We have the ability to borrow on margin against outstanding short and long-term investments. During the three months ended September 30, 2006, borrowings
totaled approximately $3.9 million and enabled the Company to capture certain inventory prepayment discounts. These borrowings were fully repaid during the three months ended September 30, 2006.

The following table provides an overview or our aggregate contractual obligations as of September 30, 2006, and the effect these obligations are expected to have on
our liquidity and cash flows for the remainder of fiscal 2006 and in future periods are as follows (in thousands):



|                                  |  |      |       |      |   |       |  |      |       |      |   |            |  |       |     |  |   |       |  |   |      
|--------------------------------- |  | ---- | ----- | ---- | - | ----- |  | ---- | ----- | ---- | - | ---------- |  | ----- | --- |  | - | ----- |  | - | -----
|Contractual Obligations           |  | 2006 |       | 2007 |   | 2008  |  | 2009 |       | 2010 |   | Thereafter |  | Total
|Capital lease obligations & other |  | $    | 6     |      | $ | 18    |  | $    | 5     |      | $ |           |  | $     |    |  | $ |      |  | $ | 29   
|SchoolOne (2)                     |  | $    | 952   |      | $ | 1,733 |  | $    |      |      | $ |           |  | $     |    |  | $ |      |  | $ | 2,685
|Operating lease obligations (1)   |  | $    | 345   |      | $ | 1,380 |  | $    | 1,334 |      | $ | 1,213      |  | $     | 802 |  | $ | 1,136 |  | $ | 6,210
|                                  |  |      |       |      |   |       |  |      |       |      |   |            |  |       |     |  |   |       |  |   |      
|Total                             |  | $    | 1,303 |      | $ | 3,131 |  | $    | 1,339 |      | $ | 1,213      |  | $     | 802 |  | $ | 1,136 |  | $ | 8,924
|                                  |  |      |       |      |   |       |  |      |       |      |   |            |  |       |     |  |   |       |  |   |      

---

|(1) | Includes payments made through December 2006 for month-to-month leases.
|--- | -----------------------------------------------------------------------



21



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##### Table of Contents

|(2) | On July 10, 2006, we entered into a Services and Management Agreement with SchoolOne.com LLC (SchoolOne) in which SchoolOne will develop the Companys new
technology and provide services and support for the Companys processes and systems to assist in accelerating the growth of the Companys current business and establish a foundation to support the introduction of new businesses and revenue
streams in the future. This agreement replaces all previous sources of development, technology, services and support the Company had relied on, both internal and external.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

As of the date of this filing, we currently lease approximately 87,000 square feet pursuant to leases that are month-to-month or are scheduled to expire between January 2007 and May 2015.

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, we have recently added additional infrastructure as we have expanded our service offerings. We presently believe that our cash, cash equivalents and investments may not be sufficient to fund our operating
needs until the 2007 back to school season. Accordingly, we are considering spending reductions and possible external financings to meet our liquidity needs. We cannot assure you that we will be able to access external capital if necessary or that
we will be able to meet our liquidity needs for the next twelve months. 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.

Interest Rate Risk. Our cash equivalents and
short-term and long-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 subject to interest rate risk was $6.6 million and
$9.8 million at September 30, 2006 and December 31, 2005, 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, 2006 was approximately 3.8% per annum. Based on our investment holdings at September 30, 2006, a 100 basis point decline in the average yield would have reduced our annual interest income 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 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 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 and Chief Financial 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 and Chief Financial Officers have concluded that, as of the end of the period covered by this report, our disclosure controls and procedures were
effective with the exception of the material weakness that management identified in our Annual Report on Form 10-K for the fiscal year ended December 31, 2005 (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



22



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##### Table of Contents

financial reporting was not effective as of December 31, 2005. Since that time we have taken appropriate steps
during the first quarter of 2006 to remediate the identified material weakness by acquiring a third-party software product to automate this process, with the new product to be run in parallel with the existing system. While the remediation measures
have improved the design effectiveness of our internal control over financial reporting, we have not been able to test the newly designed controls since we recorded a net losses in our three quarters of fiscal 2006 and thereby the calculation of
diluted shares outstanding was not required.

Changes in Internal Control over Financial Reporting

Management has evaluated, with the participation of our Chief Executive Officer and Chief Financial Officer, whether any changes in our internal control over financial
reporting that occurred during our last fiscal quarter have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. No such changes occurred during our last fiscal quarter, except for the
design changes management has implemented described above as a result of the material weakness identified. 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 the first three quarters of 2006 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, 2005.

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, 2006



Varsity Group Inc.By:

/s/ JAMES CRAIGJames CraigChief Financial Officer




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