**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

**FORM 10-Q**

 

|                                              | **(Mark One)**                                                                                |
|---------------------------------------------------|-----------------------------------------------------------------------------------------------|
|                                              |                                                                                          |
| **ý**                                        | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|                                              |
| **For the quarterly period ended March 31, 2003** |
|                                              |
| **or**                                            |
|                                              |
| **o**                                             | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                              |
| **Commission File Number 000-24289**              |
|                                                   |                                                                                               |  |

 

| **CLICK2LEARN,  INC.**                                         |
|----------------------------------------------------------------|
| (Exact name of registrant as specified in its charter)         |
|                                                           |
| **Delaware**                                                   |   | **91-1276003** |
|                                                           |   |   |
| (State or other jurisdiction of incorporation or organization) |   | (I.R.S. Employer Identification No.) |
|                                                           |   |   |
| **110-110th Avenue NE, Bellevue, Washington**                  |   | **98004** |
|                                                           |   |   |
| (Address of principal executive offices)                       |   | (Zip Code) |
|                                                           |   |   |
| **(425) 462-0501**                                             |
|                                                           |
| (Registrant’s telephone number, including area code)      |

 

Indicate bycheck mark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.  Yes ý      No o

 

Indicate bycheck mark whether the registrant is an accelerated filer (as defined in Rule12b-2 of the Exchange Act). Yes o Noý

 

The number ofshares outstanding of the issuer’s Common Stock, par value $0.01, as of April30, 2003 was 24,937,164 shares.

 

 

----

 

**CLICK2LEARN, INC.**

** **

**FORM 10 –Q**

** **

**For the Quarter Ended March 31, 2003**

** **

**TABLE OF CONTENTS**

 
| **PART I – FINANCIAL INFORMATION** |
|-----------------------------------------|
|                                    |
| Item 1.                                 | Financial Statements |
|                                    |   |
|                                    | Unaudited Condensed Consolidated Balance  Sheets as of March 31, 2003 and December 31, 2002 |
|                                    |   |
|                                    | Unaudited Condensed Consolidated Statements  of Operations for the three months ended March 31, 2003 and 2002 |
|                                    |   |
|                                    | Unaudited Condensed Consolidated Statements  of Cash Flows for the three months ended March 31, 2003 and 2002 |
|                                    |   |
|                                    | Notes to Unaudited Condensed Consolidated  Financial Statements |
|                                    |   |
| Item 2.                                 | Management’s Discussion and Analysis of  Financial Condition and Results of Operations |
|                                    |   |
| Item 3.                                 | Quantitative and Qualitative Disclosures  About Market Risk |
|                                    |   |
| Item 4.                                 | Controls and Procedures |
|                                    |
| **PART II – OTHER INFORMATION**    |
|                                    |
| Item 1.                                 | Legal Proceedings |
|                                    |   |
| Item 2.                                 | Change in Securities and Use of Proceeds |
|                                    |   |
| Item 3.                                 | Defaults upon Senior Securities |
|                                    |   |
| Item 4.                                 | Submission of Matters to a Vote of  Securities Holders |
|                                    |   |
| Item 5.                                 | Other Information |
|                                    |   |
| Item 6.                                 | Exhibits and Reports on Form 8-K |
|                                    |
| **SIGNATURES**                          |

 

2

----

 

**PARTI – FINANCIAL INFORMATION**

**Item1.  Financial Statements**

 

**CLICK2LEARN, INC. AND SUBSIDIARIES**

**UNAUDITED CONSOLIDATED BALANCE SHEETS**

**(In thousands except share data)**

 
|                                                                                                                                           |   | **March 31,  2003** |   | **December  31,  2002** |   |
|------------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------|--------|-------------------------|--------|
| **Assets**                                                                                                                                     |   |                |   |                    |   |
|                                                                                                                                           |   |                |   |                    |   |
| Current assets:                                                                                                                                |   |                |   |                    |   |
| Cash and cash equivalents                                                                                                                      |   | $                   | 4,058  |                    | $      | 3,586 |   |
| Accounts receivable, net of allowance for  returns and doubtful accounts of $726 in 2003 and $927 in 2002                                      |   | 9,176               |   | 10,785                  |   |
| Prepaid royalties and licenses                                                                                                                 |   | 103                 |   | 157                     |   |
| Other                                                                                                                                          |   | 1,634               |   | 1,619                   |   |
| Total current assets                                                                                                                           |   | 14,971              |   | 16,147                  |   |
| Property and equipment, net                                                                                                                    |   | 1,109               |   | 1,214                   |   |
| Goodwill                                                                                                                                       |   | 2,877               |   | 2,877                   |   |
| Intangible assets, net                                                                                                                         |   | 4,568               |   | 4,636                   |   |
| Other                                                                                                                                          |   | 632                 |   | 599                     |   |
| Total assets                                                                                                                                   |   | $                   | 24,157 |                    | $      | 25,473 |   |
|                                                                                                                                           |   |                |   |                    |   |
| **Liabilities and Stockholders’ Equity**                                                                                                  |   |                |   |                    |   |
|                                                                                                                                           |   |                |   |                    |   |
| Current liabilities:                                                                                                                           |   |                |   |                    |   |
| Accounts payable                                                                                                                               |   | $                   | 1,680  |                    | $      | 2,934 |   |
| Accrued compensation and benefits                                                                                                              |   | 2,355               |   | 2,294                   |   |
| Deferred revenue                                                                                                                               |   | 4,577               |   | 4,435                   |   |
| Short term debt                                                                                                                                |   | 2,639               |   | 2,400                   |   |
| Other                                                                                                                                          |   | 908                 |   | 1,184                   |   |
| Total current liabilities                                                                                                                      |   | 12,159              |   | 13,247                  |   |
| Other noncurrent liabilities                                                                                                                   |   | 366                 |   | —                  |   |
| Total liabilities                                                                                                                              |   | 12,525              |   | 13,247                  |   |
|                                                                                                                                           |   |                |   |                    |   |
| Stockholders’ equity:                                                                                                                     |   |                |   |                    |   |
| Preferred stock, $0.01 par value;  authorized 5,000,000 shares; issued and outstanding no shares in 2002 and  2003                             |   | —              |   | —                  |   |
| Common stock, $0.01 par value; authorized  100,000,000 shares, issued and outstanding 24,600,114 shares in 2002 and  24,937,164 shares in 2003 |   | 249                 |   | 246                     |   |
| Additional paid-in capital                                                                                                                     |   | 242,768             |   | 242,570                 |   |
| Accumulated deficit                                                                                                                            |   | (230,863            | )      | (230,008                | )      |
| Accumulated other comprehensive loss                                                                                                           |   | (522                | )      | (582                    | )      |
| Total stockholders’ equity                                                                                                                |   | 11,632              |   | 12,226                  |   |
| Total liabilities and stockholders’ equity                                                                                                |   | $                   | 24,157 |                    | $      | 25,473 |   |

 

See accompanying notes to unaudited condensed Consolidated FinancialStatements

 

3

----

 

**CLICK2LEARN, INC. AND SUBSIDIARIES**

**UNAUDITED CONSOLIDATED STATEMENTS OFOPERATIONS**

**(In thousands, except per share data)**

 
|                                                           |   | **Three  Months Ended March  31,** |   |
|----------------------------------------------------------------|--------|------------------------------------|--------|
|                                                           |   | **2003**                           |   | **2002** |   |
|                                                           |   |                               |   |   |   |
| Revenue:                                                       |   |                               |   |   |   |
| Platforms                                                      |   | $                                  | 6,552  |   | $ | 5,419 |   |
| Tools                                                          |   | 774                                |   | 1,258 |   |
| Content services                                               |   | 674                                |   | 633 |   |
| Total revenue                                                  |   | 8,000                              |   | 7,310 |   |
|                                                           |   |                               |   |   |   |
| Cost of revenue:                                               |   |                               |   |   |   |
| Platforms                                                      |   | 1,574                              |   | 1,574 |   |
| Tools                                                          |   | 125                                |   | 395 |   |
| Content services                                               |   | 572                                |   | 655 |   |
| Total cost of revenue                                          |   | 2,271                              |   | 2,624 |   |
| Gross margin                                                   |   | 5,729                              |   | 4,686 |   |
|                                                           |   |                               |   |   |   |
| Operating expenses:                                            |   |                               |   |   |   |
| Research and development                                       |   | 1,484                              |   | 2,282 |   |
| Sales and marketing                                            |   | 3,678                              |   | 4,432 |   |
| General and administrative                                     |   | 1,340                              |   | 1,602 |   |
| Total operating expenses                                       |   | 6,502                              |   | 8,316 |   |
| Operating loss from continuing operations                      |   | (773                               | )      | (3,630 | ) |
|                                                           |   |                               |   |   |   |
| Other income (expense)                                         |   | (47                                | )      | 16 |   |
| Equity in losses of affiliate                                  |   | (25                                | )      | (75 | ) |
| Loss from continuing operations before  income taxes           |   | (845                               | )      | (3,689 | ) |
|                                                           |   |                               |   |   |   |
| Income tax                                                     |   | (10                                | )      | — |   |
| Loss from continuing operations                                |   | (855                               | )      | (3,689 | ) |
|                                                           |   |                               |   |   |   |
| Loss from discontinued operations                              |   | —                             |   | (1,995 | ) |
| Net loss                                                       |   | $                                  | (855   | ) | $ | (5,684 | ) |
|                                                           |   |                               |   |   |   |
| Amounts per share, basic and diluted:                          |   |                               |   |   |   |
| Loss from continuing operations                                |   | $                                  | (0.03  | ) | $ | (0.15 | ) |
| Loss from discontinued operations                              |   | —                             |   | (0.08 | ) |
| Net loss                                                       |   | $                                  | (0.03  | ) | $ | (0.23 | ) |
|                                                           |   |                               |   |   |   |
| Weighted average common shares outstanding,  basic and diluted |   | 24,819                             |   | 24,199 |   |

 

See accompanying notes to unaudited condensed Consolidated FinancialStatements

 

4

----

 

**CLICK2LEARN, INC. AND SUBSIDIARIES**

**UNAUDITED CONSOLIDATED STATEMENTS OF CASHFLOWS**

**(In thousands)**

 
|                                                                                        |   | **Three  Months Ended  March 31,** |   |
|---------------------------------------------------------------------------------------------|--------|------------------------------------|--------|
|                                                                                        |   | **2003**                           |   | **2002** | ** ** |
| Cash flows from operating activities:                                                       |   |                               |   |   |   |
| Continuing operations:                                                                      |   |                               |   |   |   |
| Net loss                                                                                    |   | $                                  | (855   | ) | $ | (3,689 | ) |
| Adjustments to reconcile net loss to net  cash provided by continuing operating activities: |   |                               |   |   |   |
| Depreciation and amortization                                                               |   | 479                                |   | 662 |   |
| Write-off property and equipment                                                            |   | —                             |   | 270 |   |
| Provision for returns and doubtful accounts                                                 |   | 146                                |   | 702 |   |
| Amortization of discount on debt                                                            |   | 22                                 |   | — |   |
| Stock compensation expense                                                                  |   | —                             |   | 5 |   |
| Equity in losses of affiliate                                                               |   | 25                                 |   | 75 |   |
| Net change in certain operating assets and  liabilities                                     |   | 893                                |   | 3,461 |   |
| Net cash provided by continuing operating  activities                                       |   | 710                                |   | 1,486 |   |
| Discontinued operations:                                                                    |   |                               |   |   |   |
| Loss from discontinued operations                                                           |   | —                             |   | (1,995 | ) |
| Gain on sale of assets                                                                      |   | —                             |   | (927 | ) |
| Net cash used in discontinued operating  activities                                         |   | —                             |   | (2,922 | ) |
| Net cash provided by (used in) operating  activities                                        |   | 710                                |   | (1,436 | ) |
| Cash flows from investing activities:                                                       |   |                               |   |   |   |
| Continuing operations:                                                                      |   |                               |   |   |   |
| Purchase of property and equipment                                                          |   | (306                               | )      | (2,813 | ) |
| Other                                                                                       |   | (58                                | )      | 13 |   |
| Net cash used in continuing investing  activities                                           |   | (364                               | )      | (2,800 | ) |
| Discontinued operations:                                                                    |   |                               |   |   |   |
| Proceeds from sale of assets                                                                |   | —                             |   | 1,000 |   |
| Net cash provided by discontinued  activities                                               |   | —                             |   | 1,000 |   |
| Net cash used in investing activities                                                       |   | (364                               | )      | (1,800 | ) |
| Cash flows from financing activities:                                                       |   |                               |   |   |   |
| Repayment of notes payable                                                                  |   | —                             |   | — |   |
| Repayments on debt                                                                          |   | (5,120                             | )      | (138 | ) |
| Proceeds from borrowings                                                                    |   | 4,985                              |   | — |   |
| Proceeds from exercise of stock options                                                     |   | —                             |   | 43 |   |
| Net proceeds from sale of common stock                                                      |   | 201                                |   | 335 |   |
| Net cash provided by financing activities                                                   |   | 66                                 |   | 240 |   |
| Effect of foreign exchange rate changes on  cash                                            |   | 60                                 |   | (11 | ) |
| Net increase (decrease) in cash and cash  equivalents                                       |   | 472                                |   | (3,007 | ) |
| Cash and cash equivalents at beginning of  period                                           |   | 3,586                              |   | 9,553 |   |
| Cash and cash equivalents at end of period                                                  |   | $                                  | 4,058  |   | $ | 6,546 |   |

 

See accompanying notes to unaudited condensed Consolidated FinancialStatements

 

5

----

**CLICK2LEARN, INC.**

**NOTES TO UNAUDITED CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

 

**NOTE1:  SUMMARY OF SIGNIFICANT ACCOUNTINGPOLICIES**

 

(a)  Description of Business

 

Click2learn,Inc. (“Click2learn”) develops, markets, distributes, and supports an integratedsuite of enterprise learning software products.  Click2learn’s markets are worldwide and include a broad range ofindustries.

 

(b)  Basis of Presentation

 

Theaccompanying unaudited condensed consolidated financial statements ofClick2learn, Inc. (“Click2learn”) include the accounts of Click2learn and itswholly owned subsidiaries.  Allsignificant intercompany transactions have been eliminated in consolidation.

 

Thesestatements reflect all normal recurring adjustments, which are in the opinionof management, necessary for a fair presentation of the financial position andresults of operations for the periods presented.  Interim results of operations for the three months ended March 31,2003 are not necessarily indicative of the operating results for the fullfiscal year.  Factors that may affectsuch operating results, include, but are not limited to, those discussed in **“FactorsThat May Affect Future Results of Operations”**.  Certain information and footnote disclosuresnormally included in financial statements prepared in conformity withaccounting principles generally accepted in the United States of America havebeen condensed or omitted pursuant to the rules and regulations of theSecurities and Exchange Commission.

 

Thesecondensed consolidated financial statements should be read in conjunction withthe consolidated financial statements and related notes included inClick2learn’s Annual Report on Form 10-K for the year ended December 31, 2002.

 

(c)  Other Current Assets

 

The followingtable sets forth the components of other current assets (in thousands):

 
|                       |   | **March 31,  2003** |   | **December 31,  2002** |   |
|----------------------------|--------|---------------------|--------|------------------------|--------|
| Prepaid expense            |   | $                   | 666    |                   | $      | 430 |   |
| Prepaid insurance          |   | 642                 |   | 618                    |   |
| Other                      |   | 326                 |   | 571                    |   |
| Total other current assets |   | $                   | 1,634  |                   | $      | 1,619 |   |

 

(d)  Revenue Recognition

 

Click2learn recognizes revenue pursuant to the requirements ofStatement of Position No. 97-2, *SoftwareRevenue Recognition* (“SOP 97-2”), as amended by Statement ofPosition No. 98-9, *Software RevenueRecognition with Respect to Certain Arrangements.* Under SOP 97-2,revenue attributable to an element in a customer arrangement is recognized whenpersuasive evidence of an arrangement exists and delivery has occurred,provided the fee is fixed or determinable, collectibility is probable and thearrangement does not require significant customization of the software.

 

For all sales, Click2learn uses either a binding purchase order orsigned agreement, depending on the nature of the transaction, as evidence of anarrangement. Sales through its significant resellers are evidenced by a masteragreement governing the relationship.

 

6

----

 

For software license fees in single element arrangements and multipleelement arrangements, which do not include customization or consultingservices, delivery typically is deemed to occur when the product is shipped tocustomers.

 

At the time of each transaction, Click2learn assesses whether the feeassociated with its revenue is fixed and determinable and whether or notcollection is probable. Click2learn assesses whether the fee is fixed anddeterminable based on the payment terms associated with the transaction. If asignificant portion of a fee is due after Click2learn’s normal payment terms,based upon a variable matrix such as a minimum level of distribution or subjectto refund (other than refunds for warranty claims or its uncured defaults),Click2learn accounts for the fee as not being fixed and determinable. In thesecases, Click2learn defers revenue and recognize it when it becomes due andpayable.

 

Click2learn assesses the probability of collection based on a number offactors, including past transaction history with the customer and the currentfinancial condition of the customer. Click2learn does not request collateralfrom its customers. If Click2learn determines at the time of the transactionthat collection of a fee is not probable, it defers revenue until payment isreceived.

 

For multiple element arrangements, when company-specific objectiveevidence of fair value exists for all of the undelivered elements of thearrangement, but does not exist for one or more of the delivered elements inthe arrangement, Click2learn recognizes revenue under the residual method.Under the residual method, at the outset of the arrangement with a customer,Click2learn defers revenue for the fair value of its undelivered elements suchas consulting services and product support and upgrades, and recognizes therevenue for the remainder of the arrangement fee attributable to the elementsinitially delivered, such as software licenses, when the criteria in SOP 97-2have been met. Company-specific objective evidence is established for supportand upgrades of standard products for which no installation or customization isrequired based upon the amounts Click2learn charges when support and upgradesare sold separately. For multiple element arrangements involving installationor customization, company-specific objective evidence is established forsupport and maintenance arrangements if its customers have an optional annualrenewal rate specified in the arrangement and the rate is substantive.Company-specific objective evidence is established for consulting andinstallation services based on the hourly rates Click2learn charges for itsemployees when they are performing these services provided Click2learn has theability to accurately estimate the hours required to complete a project basedupon its experience with similar projects.

 

Professional services revenue is recognized from fixed price contractsas services are provided or by using the percentage-of-completion method ofaccounting, based on the ratio of labor costs incurred to the total estimatedproject cost, for individual fixed-price contracts. Provisions for anyestimated losses on uncompleted contracts are made in the period in which suchlosses become evident. Professional services revenue from time and materialscontracts and training services is recognized as revenue as services areperformed.

 

Click2learn recognizes revenue from non-refundable minimum royaltyagreements from distributors or resellers upon delivery of product to thedistributor or reseller, provided no significant obligations remain outstandingand the conditions of SOP 97-2 have been met. If minimum royalties are exceeded, the additional royalties arerecognized as revenue when earned, based on the contractual reportingobligations.

 

Revenue fromsubscription licenses, hosting agreements and support agreements is recognizedon a straight-line basis over the life of the contract.

 

(e)  Net Loss Per Share

 

Basic net lossper share is computed by dividing the net loss by the weighted average numberof common shares outstanding during the period.  Diluted per share amounts reflect the weighted average number ofcommon and dilutive shares outstanding during the period. As Click2learn had anet loss in each of the periods presented, basic and diluted net loss per shareare the same.

 

7

----

 

Excluded fromthe computation of diluted loss per share for the three months ended March 31,2003 are options to acquire approximately 6,110,430 shares of common stock witha weighted average exercise price of $4.00 and warrants to purchase 3,825,110shares of common stock with a weighted average exercise price of $5.33 becausetheir effects would be anti-dilutive. Options to acquire approximately5,570,735 shares of common stock with a weighted average exercise price of$6.23 and warrants to purchase 3,633,686 shares of common stock with a weightedexercise share price of $5.75 have been excluded from the computation ofdiluted earnings per share for the three months ended March 31, 2002 becausetheir effects would be anti-dilutive.

 

The change incommon stock and additional paid-in capital reflects the stock purchase for theEmployee Stock Purchase Plan.

 

(f)  Derivative Financial Instruments

 

Click2learnhad no derivative financial instruments outstanding at March 31, 2003 or December31, 2002.

 

(g)  Comprehensive Loss and Accumulated OtherComprehensive Loss

 

The followingtable sets forth the components of comprehensive loss for the periods presentedbelow (in thousands):

 
|                                    |   | **Three  Months Ended  March 31,** |       |
|-----------------------------------------|--------|------------------------------------|------------|
|                                    |   | **2003**                           |       | **2002** |   |
|                                    |   |                               | ** ** |   | ** ** |
| Net loss                                |   | $                                  | (855       | ) | $ | (5,684 | ) |
| Foreign currency translation adjustment |   | 60                                 |       | (10 | ) |
| Total comprehensive loss                |   | $                                  | (795       | ) | $ | (5,694 | ) |

 

Accumulatedother comprehensive loss at March 31, 2003 and 2002 consists of foreigncurrency translation adjustments.

 

(h)  Stock-Based Compensation

 

Click2learnapplies the intrinsic-value-based method of accounting prescribed by AccountingPrinciples Board Opinion No. 25 (“APB 25”), *Accountingfor Stock Issued to Employees,*and related interpretations includingFASB Interpretation No. 44 (“FIN 44”),*Accounting for Certain Transactions Involving Stock Compensation, aninterpretation of APB 25*, to account for its fixed-plan stockoptions.  Under this method,compensation expense is recorded only if the current market price of the underlyingstock exceeded the exercise price on the date of the grant.  Statement of Financial Accounting StandardsNo. 123 (“SFAS 123”), *Accounting forStock-Based Compensation*, established accounting and disclosurerequirements using a fair-value-based method of accounting for stock-basedemployee compensation plans.  As allowedby SFAS 123, Click2learn has elected to continue to apply theintrinsic-value-based method of accounting described above, and has adopted onlythe disclosure requirements of SFAS 123. The following table illustrates the effect on net loss if thefair-value-based method had been

 

8

----

 

applied to all outstanding andunvested awards in each period (in thousands):

 
|                                                                                                                         |   | **Three Months Ended  March 31,** |   |
|------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------------|--------|
|                                                                                                                         |   | **2003**                          |   | **2002** |   |
|                                                                                                                         |   |                              |   |   |   |
| Net loss, as reported                                                                                                        |   | $                                 | (855   | ) | $ | (5,684 | ) |
| Add stock-based employee compensation expenses  included in reported net loss, net of tax                                    |   | —                            |   | 5 |   |
| Deduct total stock-based employee compensation  expense determined under fair-value-based method for all rewards, net of tax |   | (1,143                            | )      | (1,595 | ) |
| Pro forma net loss                                                                                                           |   | $                                 | (1,998 | ) | $ | (7,274 | ) |
| Basic and diluted net loss per share:                                                                                        |   |                              |   |   |   |
| As reported                                                                                                                  |   | $                                 | (0.03  | ) | $ | (0.23 | ) |
| Pro forma                                                                                                                    |   | $                                 | (0.08  | ) | $ | (0.30 | ) |

 

(i) New Accounting Policies

 

In June 2002,the Financial Accounting Standards Board (“FASB”) issued Statement of FinancialStandards No. 146 (“SFAS 146”), *Accountingfor Costs Associated with Exit or Disposal Activities*. SFAS 146addresses financial accounting and reporting for costs associated with exit ordisposal activities and nullifies Emerging Issues Task Force (EITF)Issue 94-3, *Liability Recognition forCertain Employee Termination Benefits and Other Costs to Exit an Activity*.The provisions of this Statement are effective for exit or disposal activitiesthat are initiated after December 31, 2002. The adoption of SFAS 146 hasnot had a material effect on Click2learn’s financial statements.

 

9

----

 

In November2002, the EITF reached a consensus on Issue No. 00-21 ("EITF 00-21"),*Revenue Arrangements with MultipleDeliverables*.  EITF 00-21addresses certain aspects of the accounting by a vendor for arrangements underwhich the vendor will perform multiple revenue generating activities.  EITF 00-21 will be effective for periodsbeginning after June 15, 2003.  Theadoption of EITF 00-21 is not expected to have a material impact onClick2Learn's financial position and results of operations.

 

In November2002, the FASB issued Interpretation No. 45 (“FIN 45”), *Guarantor’s Accounting and Disclosure Requirementsfor Guarantees, Including Indirect Guarantees of Indebtedness to Others, aninterpretation of FASB Statements No. 5, 57 and 107 and a rescission of FASBInterpretation No. 34*.  FIN45 elaborates on the disclosures to be made by a guarantor in its interim andannual financial statements about its obligations under guarantees issued.  FIN 45 also clarifies that a guarantor isrequired to recognize, at inception of a guarantee, a liability for the fairvalue of the obligation undertaken.  Theinitial recognition and measurement provisions of FIN 45 are applicable toguarantees issued or modified after December 31, 2002 and have not had amaterial effect on Click2learn’s financial statements.  The disclosure requirements are effectivefor financial statements of interim and annual periods ending after December15, 2002 and are discussed at Note 4.

 

In December2002, the FASB issued Statement of Financial Accounting Standards No. 148(“SFAS 148”), *Accounting for Stock-BasedCompensation – Transition and Disclosure, an amendment of FASB StatementNo. 123*. SFAS 148 amends FASB Statement No. 123, *Accounting for Stock-Based Compensation,*to provide alternative methods of transition for a voluntary change to the fairvalue method of accounting for stock-based employee compensation. In addition,SFAS 148 amends the disclosure requirements of Statement No.123 to require moreprominent disclosures in both annual and interim financial statements. Certainof the disclosure modifications are required for fiscal years ending afterDecember 15, 2002 and are included in the notes to these unauditedcondensed consolidated financial statements.

 

In January2003, the FASB issued Interpretation No. 46 (“FIN 46”), *Consolidation of Variable Interest Entities, aninterpretation of ARB No. 51.* FIN 46 addresses the consolidation by business enterprises of variableinterest entities as defined in FIN 46. FIN 46 applies immediately to variable interests in variable interestentities created after January 31, 2003, and to variable interests in variableinterest entities obtained after January 31, 2003.  For public enterprises with a variable interest in a variableinterest entity created before February 1, 2003, FIN 46 applies to thatenterprise no later than the beginning of the first interim or annual reportingperiod beginning after June 15, 2003. The application of FIN 46 is not expectedto have a material effect on Click2learn’s financial statements.  FIN 46 requires certain disclosures infinancial statements issued after January 31, 2003 if it is reasonably possiblethat Click2learn will consolidate or disclose information about variableinterest entities when the Interpretation becomes effective. Click2learn has novariable interest entities as of March 31, 2003.

 

**NOTE  2: DISCONTINUED OPERATIONS**

 

During January2002, Click2learn sold certain assets of its content development business,including equipment and a customer list to NIIT under an Asset Purchaseagreement for $1 million, resulting in a gain of $927,000 based on the bookvalue of those assets. As a result of the transaction with NIIT, Click2learnsignificantly reduced its headcount of its custom content development businessand closed certain facilities.  Duringthe third quarter of 2002, Click2learn completed the discontinuation of itsremaining custom content development business by early termination of itscontract to develop content for the Washington Army National Guard. As part ofthe negotiation to terminate the contract, Click2learn agreed to forego thecollection of $4.5 million in accounts receivable.  Results related to its custom content development business forthe year ended December 31, 2002 and prior years have been reclassified asincome (loss) from discontinued operations. For the three months ended March31, 2002, we reclassified $221,000 of revenue, $1.6 million of costs related torevenue, $1.6 million of expenses, and $927,000 of other income as a loss fromdiscontinued operations of approximately $2.0 million.

 

10

----

 

Summaryoperating results of the discontinued operations were as follows (inthousands):

 
|                              |   | **For the Three  Months Ended  March 31,  2002** |   |
|-----------------------------------|--------|--------------------------------------------------|--------|
| Revenues                          |   | $                                                | 221    |   |
| Cost of revenues                  |   | $                                                | (1,560 | ) |
| Operating expenses                |   | $                                                | (1,583 | ) |
| Other income                      |   | $                                                | 927    |   |
| Loss from discontinued operations |   | $                                                | (1,995 | ) |

 

**NOTE 3: BANK CREDIT FACILITY**

 

In December2002, Click2learn consolidated its existing $4 million working capital line ofcredit and $1 million term loan facility with Silicon Valley Bank into a new$10 million working capital line.  Underthe new facility Click2learn will continue to repay the remaining balance ofthe term loan in accordance with the original terms (monthly payments of  $41,666.67 plus interest ending October 1, 2003), but the unpaid balance ofthe term loan will not be available under the line of credit.  The term loan and the working capital linewill bear interest at the greater of Silicon Valley Bank prime rate plus 2.25%or 7.0% and have minimum monthly interest of $8,500 per month regardless of theloan balances.

 

The creditfacility is collateralized by a security interest in all of Click2learn’sassets.  Covenants in the loanagreements include restrictions on Click2learn’s ability to pay dividends ormake other distributions, make acquisitions or investments, merge orconsolidate with others or dispose of assets, as well as financial covenantslimiting the amount of net losses during any three month period and requiringClick2learn to maintain certain levels of minimum tangible net worth.  If not renewed the working capital lineterminates and any advances made are due on December 6, 2004.

 

Under theworking capital line of credit, the principal amount of $2,150,000 wasoutstanding as of March 31, 2003. Borrowings outstanding under the term loan were $291,667 at March 31,2003 all of which is repayable in 2003. As of March 31, 2003, Click2learn was in compliance with the loan’scovenants.** **Click2learn reclassified $718,000 from accounts payable to a note payableof which $352,000 is current and reported as short term debt and $366,000 islong-term debt.  Aggregate shortterm debt of $2.6 million at March 31, 2003 is presented net of debt discountof $155,000 attributable to the issuance of common stock warrants.

 

**NOTE4:  GUARANTEES**

 

Click2learnadopted FIN 45 during the quarter ended December 31, 2002.  In the ordinary course of business,Click2learn is not subject to potential obligations under guarantees that fallwithin the scope of FIN 45 except for standard indemnification and warrantyprovisions that are contained within many of our customer license and serviceagreements, and give rise only to the disclosure requirements prescribed by FIN45*.*

 

Indemnificationand warranty provisions contained within our customer license and serviceagreements are generally consistent with those prevalent in our industry.  The duration of our product warrantiesgenerally does not exceed 90 days following delivery of our products.  We have not incurred significant obligationsunder customer indemnification or warranty provision historically and do notexpect to incur

 

11

----

 

significant obligations in thefuture.  Accordingly, we do not maintainaccruals for potential customer indemnification or warranty-relatedobligations.

 

**NOTE 5: SEGMENT INFORMATION**

 

Click2learn’sinternal reporting includes the three reportable segments:  Platforms, Tools, and Content Services.  Platforms include software licenses, subscriptionand hosting fees, implementation, customization, consulting, training andsupport for the Aspen suite as well as the Ingenium learning management system,which is the precursor product to the Aspen Learning Management Server, and thee-Learning Network, which is no longer, offered to new customers. Tools includesoftware licenses, technical support and training related to the ToolBook lineof products.  Content Services includesthe placement of Click2learn personnel at customer sites on a time and materialbasis, the resale of third party off the shelf training content and license andhosting fees for our Rapid e-Learning Development System, which is no longeroffered to new customers.

 

Click2learn’soperating committee, which includes its Chief Executive Officer and ChiefFinancial Officer, has been identified as the Chief Operating Decision Maker(CODM) as it assesses the performance of the business units and decides how toallocate resources to the business units. Segment income is the measure of profit and loss that the CODM uses toassess performance and make decisions. Segment income represents revenue less cost of revenue incurred withinthe operating segments as presented in Click2learn’s consolidated statements ofoperations.  Click2learn does notallocate operating expenses including research and development, sales andmarketing, general and administrative, or amortization of goodwill to itsoperating segments.  In addition, otherincome (expense) are also not allocated to operating segments.

 

There is nointersegment revenue.  Click2learn’sCODM does not review total assets or depreciation and amortization by operatingsegment.  The accounting policies forreported segments are the same as Click2learn as a whole.

 

Revenues bygeographic region which are based on the location of the customers are asfollows (in thousands):

 
|                                  |   | **For the Three  Months Ended  March 31,** |   |
|---------------------------------------|--------|--------------------------------------------|--------|
|                                  |   | **2003**                                   |   | **2002** |   |
| Revenue:                              |   |                                       |   |   |   |
| Domestic                              |   | $                                          | 7,196  |   | $ | 6,518 |   |
| International – primarily Europe |   | 804                                        |   | 792 |   |
|                                  |   | $                                          | 8,000  |   | $ | 7,310 |   |

 

Long-livedassets by geographic location are as follows (in thousands):

 
|                                  |   | **March 31,  2003** |   | **December 31,  2002** |   |
|---------------------------------------|--------|---------------------|--------|------------------------|--------|
| Long-lived assets                     |   |                |   |                   |   |
| Domestic                              |   | $                   | 8,377  |                   | $      | 8,596 |   |
| International – primarily Europe |   | 177                 |   | 131                    |   |
|                                  |   | $                   | 8,554  |                   | $      | 8,727 |   |

 

Long-lived assets representproperty, plant, and equipment, goodwill and other intangible assets, net ofaccumulated depreciation and amortization.

 

12

----

 

**Item 2. Management’s Discussion and Analysis of Financial Condition and Resultsof Operations**

 

*This QuarterlyReport includes “forward-looking statements” within the meaning of the PrivateSecurities Litigation Reform Act of 1995. This Act provides a “safe harbor” forforward-looking statements to encourage companies to provide prospectiveinformation about themselves so long as they identify these statements asforward-looking and provide meaningful cautionary statements identifyingimportant factors that could cause actual results to differ from the projectedresults. All statements other than statements of historical fact we make inthis Quarterly Report are forward-looking. Such forward-looking statementsinvolve risks and uncertainties, including, among other things, statementsregarding our anticipated costs and expenses and revenue mix. Suchforward-looking statements include, among others, those statements includingthe words “expect”, “anticipate”, “intend”, “believe” and similar language. Ouractual results may differ significantly from those projected in the forward-lookingstatements. Factors that might cause or contribute to such differences include,but are not limited to those discussed in the section “Management’s Discussionand Analysis of Financial Condition and Results of Operations — Factors ThatMay Affect Future Results of Operations.” You are cautioned not to place unduereliance on the forward-looking statements, which speak only as of the date ofthis Quarterly Report on Form 10-Q. We undertake no obligation to publiclyrelease any revisions to the forward-looking statements or reflect events orcircumstances after the date of this document.*

 

**Overview**

 

We are a leading developer and provider of enterprise learningsolutions for companies, government agencies and educational institutions. Wedesign, develop, market, license and support an integrated suite of enterprisesoftware products and related services that allow our customers tocost-effectively create, personalize and manage the delivery of learning andknowledge content. Our flagship product, the Aspen Enterprise ProductivitySuite, combines collaborative content development, comprehensive learningmanagement and virtual classroom systems into a single, integrated productsuite with a unified architecture and user experience. We provide our productsand services to customers across a broad range of industries includingfinancial services, accounting, healthcare, insurance, technology,manufacturing, telecommunications, transportation, utilities, government andeducation.

 

We report revenue in three separate categories related to the differentcomponents of our business:

 

•                       Platforms revenue includes software licenses,subscription and hosting fees, implementation, customization, consulting,training and support related to the Aspen suite, our Ingenium learningmanagement system, which is the precursor product to the Aspen LearningManagement Server, and our e-Learning Network, which is no longer offered tonew customers.

•                       Tools revenue includes software licenses,technical support and training related to our ToolBook line of products.

•                       Content Services revenue includes the placementof Click2learn personnel at customer sites on a time and material basis, theresale of third party off the shelf training content and license and hostingfees for our Rapid e-Learning Development System, which is no longer offered tonew customers.  During 2002 wediscontinued our custom content development business, which had been theprimary source of revenue from Content Services in prior years.  Current and prior years’ revenue andexpenses for this portion of the business have been reclassified as income orloss from discontinued operations.

 

**Critical Accounting Policies and Estimates**

 

Our critical accounting policies and estimates are as follows:

 

•                                          Revenue recognition

•                                          Estimating allowances for sales returns and theallowance for doubtful accounts

 

13

----

 

•                                          Valuation of goodwill

•                                          Valuation of long-lived assets

 

*RevenueRecognition.*Werecognize revenue pursuant to the requirements of Statement of Position No.97-2, *Software Revenue Recognition*(“SOP 97-2”), as amended by Statement of Position No. 98-9, *Software Revenue Recognition with Respect to CertainArrangements.* Under SOP 97-2, revenue attributable to an element ina customer arrangement is recognized when persuasive evidence of an arrangementexists and delivery has occurred, provided the fee is fixed or determinable,collectibility is probable and the arrangement does not require significantcustomization of the software.

 

For all sales, we use either a binding purchase order or signedagreement, depending on the nature of the transaction, as evidence of anarrangement. Sales through our significant resellers are evidenced by a masteragreement governing the relationship.

 

For software license fees in single element arrangements and multipleelement arrangements, which do not include customization or consultingservices, delivery typically is deemed to occur when the product is shipped tocustomers.

 

At the time of each transaction, we assess whether the fee associatedwith our revenue is fixed and determinable and whether or not collection isprobable. We assess whether the fee is fixed and determinable based on thepayment terms associated with the transaction. If a significant portion of afee is due after our normal payment terms, based upon a variable matrix such asa minimum level of distribution or subject to refund (other than refunds forwarranty claims or our uncured defaults), we account for the fee as not beingfixed and determinable. In these cases, we defer revenue and recognize it whenit becomes due and payable.

 

We assess the probability of collection based on a number of factors,including past transaction history with the customer and the current financialcondition of the customer. We do not request collateral from our customers. Ifwe determine at the time of the transaction that collection of a fee is notprobable, we defer revenue until payment is received.

 

For multiple element arrangements, when company-specific objectiveevidence of fair value exists for all of the undelivered elements of thearrangement, but does not exist for one or more of the delivered elements inthe arrangement, we recognize revenue under the residual method. Under the residualmethod, at the outset of the arrangement with a customer, we defer revenue forthe fair value of its undelivered elements such as consulting services andproduct support and upgrades, and recognize the revenue for the remainder ofthe arrangement fee attributable to the elements initially delivered, such assoftware licenses, when the criteria in SOP 97-2 have been met.Company-specific objective evidence is established for support and upgrades ofstandard products for which no installation or customization is required basedupon the amounts we charge when support and upgrades are sold separately. Formultiple element arrangements involving installation or customization,company-specific objective evidence is established for support and maintenancearrangements if our customers have an optional annual renewal rate specified inthe arrangement and the rate is substantive. Company-specific objectiveevidence is established for consulting and installation services based on thehourly rates we charge for our employees when they are performing theseservices provided we have the ability to accurately estimate the hours requiredto complete a project based upon our experience with similar projects.

 

Professional services revenue is recognized from fixed price contractsas services are provided or by using the percentage-of-completion method ofaccounting, based on the ratio of labor costs incurred to the total estimatedproject cost, for individual fixed-price contracts. Provisions for anyestimated losses on uncompleted contracts are made in the period in which suchlosses become evident. Professional services revenue from time and materialscontracts and training services is recognized as revenue as services areperformed.

 

14

----

 

We recognize revenue from non-refundable minimum royalty agreementsfrom distributors or resellers upon delivery of product to the distributor orreseller, provided no significant obligations remain outstanding and theconditions of SOP 97-2 have been met. If minimum royalties are exceeded, the additional royalties arerecognized as revenue when earned, based on the contractual reportingobligations.

 

Revenue from subscription licenses, hosting agreements and supportagreements is recognized on a straight-line basis over the life of thecontract.

* *

*Allowances forSales Returns and Doubtful Accounts.*The preparation of financial statements requiresus to make estimates and assumptions that affect the reported amount of assetsand disclosure of contingent assets and liabilities at the date of thefinancial statements and the reported amounts of revenue and expenses duringthe reported period. Specifically, we must make estimates of future productreturns related to current period product revenue. We analyze historicalreturns, current economic trends, and changes in customer demand and acceptanceof our products when evaluating the adequacy of the sales returns and otherallowances. Significant judgments and estimates must be made and used in connectionwith establishing reserves for sales returns and the allowance for doubtfulaccounts in any accounting period. Material differences may result in theamount and timing of our revenue for any period if we made different judgmentsor utilized different estimates. Similarly, we must make estimates of theuncollectability of our accounts receivable. We specifically analyze accountsreceivable greater than 90 days and analyze historical bad debts, customerconcentrations, customer credit-worthiness and current economic trends whenevaluating the adequacy of the allowance for doubtful accounts.

 

*Valuation ofGoodwill.*Weassess the impairment of goodwill on an annual basis or whenever events orchanges in circumstances indicate the fair value of a reporting unit to whichgoodwill relates is less than its carrying value. Factors we consider importantwhich could trigger an impairment review include poor economic performancerelative to expected historical or projected future operating results,significant negative industry, economic or company specific trends and changesin the manner of our use of the assets or the plans for our business. If wewere to determine that the fair value of a reporting unit was less than itscarrying value, including goodwill based upon the annual test or the existenceof one or more of the above indicators of impairment, then we would measureimpairment based on a comparison of the implied fair value of reporting unitgoodwill with the carrying amount of goodwill. The implied fair value ofgoodwill is determined by allocating the fair value of a reporting unit to itsassets (recognized and unrecognized) and liabilities in a manner similar to apurchase price allocation. The residual fair value after this allocation is theimplied fair value of reporting unit goodwill. To the extent the carryingamount of reporting unit goodwill is greater than the implied fair value ofreporting unit goodwill, we would record an impairment charge for thedifference.

 

*Valuation of Long-Lived Assets.*  SFAS 144 provides a single accounting modelfor disposal of long-lived assets.  SFAS144 also changes the criteria for classifying an asset as held for sale and broadensthe scope of businesses to be disposed of that qualify for reporting asdiscontinued operations and changes the timing of recognizing losses on suchoperations. We adopted SFAS 144 on January 1, 2002.  The adoption of SFAS 144 did not affect our consolidatedfinancial position or results of operations as of January 1, 2002.  The broadened definition of discontinuedoperations with SFAS 144 has affected the presentation and disclosure of ourresults of operations for the year ended 2002 and prior years presented forcomparison. In accordance with SFAS 144, we review long-lived assets, such asproperty, plant and equipment, and purchased intangibles subject toamortization, for impairment whenever events or changes in circumstancesindicate that the carrying amount of an asset may not be recoverable. Wemeasure recoverability of assets to be held and used by comparing the carryingamount of an asset to estimated undiscounted future cash flows expected to begenerated by the asset.  If the carryingamount of an asset exceeds its estimated future cash flows, we recognize animpairment charge as the amount by which the carrying amount of the assetexceeds the fair value of the asset. Assets to be disposed of would be separately presented in the balancesheet and reported at the lower of the carrying amount or fair value less coststo sell, and are no longer depreciated. The assets and liabilities of a disposal group classified as held forsale would be presented separately in the appropriate asset and liabilitysections of the balance sheet.

 

**Resultsof Operations for the Three Months Ended March 31, 2003 Compared to ThreeMonths Ended March 31, 2002**

 

In accordance with Statement of Financial Accounting Standards No. 144,*Accounting for the Impairment and Disposalof Long-lived Assets*, the financial statements and management’sdiscussion and analysis present results from continuing operations with revenueand expenses related to our discontinued custom content development business asloss from discontinued operations.  See“Loss from Discontinued Operations” for additional information regarding thediscontinuance of the custom content development business and the amount ofrevenue and costs that have been reclassified to loss from discontinuedoperations.

 

*Revenue.*  Total revenue was $8.0 million for the threemonths ended March 31, 2003, up 9% as compared to $7.3 million for the threemonths ended March 31, 2002.  Theseresults primarily reflect higher Platform revenue over the three months withslightly higher Content Services revenue from continuing operations, offset bya decline in Tools revenue.  We believethe Aspen platform offers the greatest opportunity for growth in the comingperiods and therefore have focused our sales and research and developmentefforts primarily on the Aspen platform.

 

15

----

 

Platformrevenue was $6.6 million for the period ended March 31, 2003, an increase of21% from $5.4 million for the three months ended March 31, 2002.  The increase is the result of increaseddemand for our Aspen suite of products and related services.  We believe that future Platforms revenuewill continue to be subject to general economic conditions and overall spendinglevels in the technology and enterprise software sectors and that the overalleconomy and spending in these sectors will continue to be uncertain during2003.

 

Tools revenuewas $774,000 for the three months ended March 31, 2003, down 38% as compared to$1.3 million for the three months ended March 31, 2002, reflecting the heavierfocus of sales and marketing on the Aspen platform.  We have recently increased our Tools-related research anddevelopment expenditures from their current levels to fund new development ofthe ToolBook products in 2003.  As aresult, we believe that Tools related revenue may normalize at current levelsor increase depending on the markets acceptance of these new products.

 

ContentServices revenue was $674,000 for the three months ended March 31, 2003, up 6%as compared to $633,000 for the three months ended March 31, 2002, primarily asa result of slightly higher hiring levels for flexible staffing.  We do not anticipate devoting significantsales and marketing resources to this segment. As a result, we do not expect Content Services revenue to continue toincrease and believe it is likely to decline.

 

*Cost of Revenue*.  Cost of revenue was $2.3 million for thethree months ended March 31, 2003, down 13% from $2.6 million for the threemonths ended March 31, 2002.  Cost as apercentage of revenue decreased to 28% from 35% for the three months endedMarch 31, 2003 as compared to the three months ended March 31, 2002.  The decrease is a result of flat or lowercosts of revenue for each revenue category.

 

Cost of Platforms revenue includes labor costs associated with softwareconsulting, implementations and support, costs of packaging and duplication andthe costs of providing the data center at which we host certainof our customers’ Aspen implementations. Cost of Platforms revenue was $1.6 million for the three months endedMarch 31, 2003, unchanged from the three months ended March 31, 2002.  Cost as a percentage of revenue decreased to24% from 29% for the three months ended March 31, 2003 compared to the threemonths ended March 31, 2002.  Thedecrease as a percentage of revenue resulted from the ability to completeimplementation services projects at a lower cost through use of personnellocated in Hyderabad, India, which was partially offset by an increase in costresulting from additional personnel related to our U.S. data center.

 

Cost of Tools revenue includes labor costs associated with training andsupport of ToolBook customers, costs of packaging, duplication, and royalties. Costof Tools revenue was $125,000 for the three months ended March 31, 2003, adecrease of 68% from $395,000 for the three months ended March 31, 2002.  The decrease is due to reduced Tools revenueand a higher percentage of lower-cost license revenue relative to servicesrevenue.  Cost as a percentage of revenuedecreased to 16% from 31% for the three months ended March 31, 2003 compared tothe three months ended March 31, 2002.

 

Cost of Content Services revenue includes personnel costs forprofessional services in connection with temporary placements and royalties onsales of third party content. Cost of Content Services revenuewas $572,000 for the three months ended March 31, 2003, a decrease of 13% from$655,000 for the three months ended March 31, 2002.  The decrease was due primarily to cost reductions fromeliminating staff that were under-utilized in the three months ended March 31,2002.  Cost as a percentage of revenuedecreased from 103% to 85% for the three months ended March 31, 2003 comparedto the three months ended March 31, 2002.

 

**OperatingExpenses**

 

*Research and Development*.  Research and development expenses include expensesassociated with the development of new products and new product versions andconsist primarily of salaries; amortization

 

16

----

 

of purchased software,depreciation of development equipment, supplies and overhead allocations.  Research and development expenses decreased35% from $2.3 million in the three months ended March 31, 2002 to $1.5 millionin the three months ended March 31, 2003. This decrease was due to cost control measures implemented in third andfourth quarters of 2002 and the use of personnel located in Hyderabad, India.Research and development expenses as a percentage of total revenue fromcontinuing operations decreased from 31% in the three months ended March 31,2002 to 19% in the three months ended March 31, 2003.  We expect research and development expenses to increase in thesecond quarter of 2003 when we begin to amortize purchased technology includedin our virtual classroom product and when costs related to increaseddevelopment efforts related to ToolBook are reflected.

 

*Sales and Marketing.* Sales and marketing expenses consistprimarily of sales, technical support and marketing personnel costs, salescommissions, travel, advertising, public relations, seminars, trade shows and othermarketing literature and overhead costs. Sales and marketing expenses decreased 17% from $4.4 million in thethree months ended March 31, 2002 to $3.7 million in the three months endedMarch 31, 2003.  This decrease was dueprimarily to cost control measures implemented in third and fourth quarters of2002.  Sales and marketing expenses as apercentage of total revenue from continuing operations decreased from 61% inthe three months ended March 31, 2002 to 46% in the three months ended March31, 2003.  We expect sales and marketingexpenses to decrease in the second quarter of 2003 as a result oforganizational changes in our European sales office.

 

*General and Administrative.* General and administrative expenses consistprimarily of salaries and other personnel-related expenses for administrative,executive and finance personnel as well as outside advisors.  General and administrative expensesdecreased 16% from $1.6 million in the three months ended March 31, 2002 to$1.3 million in the three months ended March 31, 2003.  This decrease was due primarily to costcontrol measures implemented in third and fourth quarters of 2002.  General and administrative expenses as apercentage of total revenue decreased from 22% in the three months ended March31, 2002 to 17% in the three months ended March 31, 2003.  General and administrative expenses mayincrease in future quarters as we incur additional professional services feesrelated to the adoption of compliance guidelines required under section 404 ofthe Sarbanes-Oxley Act.

 

*Other Income (Expense).*  Interestincome (expense), net, for the three months ended March 31, 2003 was ($47,000)as compared to $16,000 for the three months ended March 31, 2002. The changewas due to minimum interest expenses and loan availability fees related to ourSilicon Valley Bank line of credit offset by interest earned on investmentbalances.

 

*Equity in Losses ofAffiliate*.  Click2learn Japan K.K. is a joint ventureand we account for our interest using the equity method of accounting. Werecorded a loss from affiliate of $25,000 and $75,000 for the quarters endedMarch 31, 2003 and 2002, respectively, representing our equity share oflosses.  We anticipate in thenear term our portion of the joint venture’s losses will remain at currentlevels or decline slightly.  We do nothave obligations to provide future financing.

 

*Loss fromDiscontinued Operations*.  We discontinued our customcontent development business during 2002. Results related to our custom content development for 2002 have beenreclassified as income (loss) from discontinued operations.  For the three months ended March 31, 2002,we reclassified $221,000 of revenue, $1.6 million of costs related to revenue,$1.6 million of expenses, and $927,000 of gain from the sale of assets as acombined loss from discontinued operations of $2.0 million.  The bulk of these expenses reflect thetermination costs for personnel and facilities.

 

In October 2001, the FASB issued Statement of Financial AccountingStandards No. 144 (“SFAS 144”), *Accountingfor the Impairment or Disposal of Long-Lived Assets*, which iseffective for fiscal years beginning after December 15, 2001. SFAS 144supersedes certain provisions of APB Opinion No. 30, *Reporting the Results of Operations— Reporting the Effects of Disposalof a Segment of a Business, and Extraordinary, Unusual, and InfrequentlyOccurring Events and Transactions* and supersedes SFAS 121. Weadopted SFAS 144 as of January 1, 2002. The adoption of SFAS 144 did not affectour consolidated financial position or results of operations as of January 1,2002.  The broadened definition ofdiscontinued

 

17

----

 

operationswithin SFAS 144 has affected the presentation and disclosure of our results ofoperations for the three-month period ended March 31, 2002.

 

**Recent Accounting Pronouncements**

 

In June 2002,the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting StandardsNo. 146 (“SFAS 146”), *Accounting forCosts Associated with Exit or Disposal Activities*.  SFAS 146 addresses financial accounting andreporting for costs associated with exit or disposal activities and nullifiesEmerging Issues Task Force (“EITF”) Issue 94-3, *Liability Recognition for Certain Employee Termination Benefits andOther Costs to Exit an Activity*. The provisions of SFAS 146 areeffective for exit or disposal activities that are initiated afterDecember 31, 2002. The adoption of SFAS 146 has not had a material effecton our financial statements.

 

In November 2002, the EITF reached a consensus on Issue No. 00-21(“EITF 00-21”), *Revenue Arrangements withMultiple Deliverables*. EITF 00-21 addresses certain aspects of theaccounting by a vendor for arrangements under which the vendor will performmultiple revenue generating activities. EITF 00-21 will be effective for periods beginning after June 15, 2003.The adoption of EITF 00-21 is not expected to have a material impact onClick2learn’s financial position and results of operations.

 

In November2002, the FASB issued Interpretation No. 45 (“FIN 45”), *Guarantor’s Accounting and Disclosure Requirementsfor Guarantees, Including Indirect Guarantees of Indebtedness to Others, aninterpretation of FASB Statements No. 5, 57 and 107 and a rescission of FASB InterpretationNo. 34.*  FIN 45 elaborates onthe disclosures to be made by a guarantor in its interim and annual financialstatements about its obligations under guarantees issued.  FIN 45 also clarifies that a guarantor isrequired to recognize, at inception of a guarantee, a liability for the fairvalue of the obligation undertaken. The initial recognition and measurementprovisions of FIN 45 are applicable to guarantees issued or modified afterDecember 31, 2002 and are not expected to have a material effect on ourfinancial statements.  The disclosurerequirements are effective for financial statements of interim and annualperiods ending after December 15, 2002 and are not expected to have a materialeffect on our financial statements.

 

In December2002, the FASB issued Statement ofFinancial Accounting Standards No. 148 (“SFAS 148”), *Accounting for Stock-Based Compensation – Transitionand Disclosure, an amendment of FASB Statement No. 123*. SFAS148 amends FASB Statement No. 123 (“Statement 123”), *Accounting for Stock-Based Compensation,*to provide alternative methods of transition for a voluntary change to the fairvalue method of accounting for stock-based employee compensation. In addition,SFAS 148 amends the disclosure requirements of Statement 123 to require moreprominent disclosures in both annual and interim financial statements. Certainof the disclosure modifications are required for fiscal years ending afterDecember 15, 2002 and are included in the notes to our consolidatedfinancial statements.

 

18

----

 

In January2003, the FASB issued Interpretation No. 46 (“FIN 46”), *Consolidation of Variable Interest Entities, aninterpretation of ARB No. 51.* FIN 46 addresses the consolidation by business enterprises of variableinterest entities as defined in FIN 46. FIN 46 applies immediately to variable interests in variable interestentities created after January 31, 2003, and to variable interests in variableinterest entities obtained after January 31, 2003.  For public enterprises with a variable interest in a variableinterest entity created before February 1, 2003, FIN 46 applies to thatenterprise no later than the beginning of the first interim or annual reportingperiod beginning after June 15, 2003. The application of FIN 46 is not expectedto have a material effect on our financial statements.  FIN 46 requires certain disclosures in ourfinancial statements issued after January 31, 2003 if it is reasonably possiblethat we will consolidate or disclose information about variable interestentities when the Interpretation becomes effective.  We have no variable interest entities as of March 31, 2003.

 

**Liquidity and CapitalResources**

 

At March 31, 2003, our principal source of liquidity was $9.2 million ofaccounts receivable, down from $10.8 million on December 31, 2002, primarilydue to improved collection efforts.  Webelieve our risk on current Platform-related receivables is low given thegeneral financial strength of our customers. As of March 31, 2003, we had onesignificant account, a receivable of approximately $500,000 from aninternational customer, over 90 days past due for which we believecollectibility is at risk.   Weincreased our bad debt reserve for this account in 2002.  At March 31, 2003 we had no othercollectibility or billing problems with any major customers or classes ofcustomers.

 

Although we have not made any significant changes in our payment terms,as a result of the discontinuance of our custom content development business weare able to collect more quickly on our receivables generally than in priorperiods, when a significant portion of our revenue was from custom contentdevelopment contracts.  This is becausea typical custom development contract was invoiced on the achievement ofcontract milestones, although revenue was recognized using the percentage ofcompletion method as the services were performed.  As a result, there was often significant time elapsed between theperformance of the services and invoicing the client.  Thus, the receivables from such contracts remained uncollectedfor longer periods than those from software licenses or other services.  While we expect to be able to collect on ourreceivables more quickly going forward, we may offer extended payment terms tocustomers in certain circumstances from time to time.  To the extent that we offer such extended payment terms, theywill result in a longer collection period for accounts receivable and slowercash inflows from operations.

 

At March 31, 2003, we had cash and cash equivalents totaling $4.1million, up from $3.6 million at December 31, 2002.  The increase in cash was primarily the result ofpositive cash flows from operations during the three month period ended March31, 2003.  This is the result of discontinuingour custom content development operations as well as steps we took in the second half of 2002 to significantly reducecosts together with higher revenue.  Asa result, we believe we can continue to generate positive cash flow fromoperations at currently anticipated revenue levels and revenue mix.  Based on these trends, we anticipate thatour cash and cash equivalents will be sufficient to meet our working capitalneeds and capital expenditures for at least the next 12 months.   However, we will continue to monitor our cash and liquidity and will seekadditional financing or make additional expense reductions if it becomesrequired.

 

Net cash usedin investing activities was $364,000 in the three months ended March 31,2003.  Net cash used in investingactivities was primarily used for purchases of equipment. As of March 31, 2003,we had no material commitments for capital expenditures and had commitmentsunder non-cancelable operating leases with terms in excess of one year of $7.4million through 2008.

 

Cash providedby financing activities was $66,000 in the three months ended March 31, 2003,resulting primarily from draws against the Silicon Valley Bank credit facility,net of payments on debt, and amounts received from purchases under our EmployeeStock Purchase Plan. Cash used for payments on debt was $5.1 million in thethree months ended March 31, 2003.

 

19

----

 

In December2002 we consolidated our existing $4 million working capital line of credit and$1 million term loan facility with Silicon Valley Bank into a new $10 millionworking capital line.  Under the newfacility we will continue to repay the remaining balance of the term loan inaccordance with the original terms (monthly payments of $41,666.67 plus interest ending October 1, 2003),and the unpaid balance of the term loan will not be available for new loansunder the line of credit.  The term loanand the working capital line will bear interest at the greater of SiliconValley Bank prime rate plus 2.25% or 7.0% and have minimum monthly interest of$8,500 per month regardless of the loan balances.  The credit facility is collateralized by a security interest inall of our assets.  Covenants in theloan agreements include restrictions on our ability to pay dividends or makeother distributions, make acquisitions or investments, merge or consolidatewith others or dispose of assets, as well as financial covenants limiting theamount of net losses during any three-month period and requiring us to maintaincertain levels of minimum tangible net worth. The failure to meet those covenants could prevent us from accessing theworking capital line and result in the acceleration of any balances under theworking capital line and term loan. If not renewed the working capital lineterminates and any advances made are due on December 6, 2004.  At March 31, 2003, we had a balance of$292,000 on the term loan facility and $2.0 million on the working capitalline, net of debt discount of $155,000.

 

The amountavailable under the working capital line of credit as of March 31, 2003 is 65%of our eligible accounts receivable. This percentage may be adjusted up or down based on a quarterly analysisby the bank.  Eligible accountsreceivable are those accounts receivable that the bank determines in its goodfaith business judgment to include in the borrowing base.  Certain accounts, such as accounts that areover 90 days past due, unbilled receivables and foreign or government accounts,are not currently eligible.  Although wemay take steps to include foreign and government accounts in our borrowingbase, there is additional cost involved and we have not deemed it necessary todo so to date.  As a result of thislimitation on eligible accounts, the entire $10 million is not currentlyavailable to us under the line of credit and the entire $10 million may notbecome available in the future. Moreover, because the amount available for borrowing under our agreementis based on our eligible accounts receivable, we may from time to time becomeover-advanced under the line of credit if our eligible accounts receivabledecrease, either because they have been collected but not applied against theexisting obligations in the case of the term loan or because they have becomeineligible under the terms of the agreement. In such a case we may be required to immediately repay a portion of theamount borrowed sufficient to bring the total amount owed to no more than thetotal availability under the loan facility.

 

We anticipatethat as a result of the discontinuance of our custom content developmentbusiness and the steps we have taken to reduce expenses our business will becash flow positive at currently anticipated revenue levels and revenue mixduring 2003.  However, we cannot assureyou that anticipated revenue levels or revenue mix will be achieved or that ourbusiness will continue to generate the cash needed to finance our operations.

 

Our long-termliquidity will be affected by numerous factors, including demand for our Aspenplatform, the level and timing of revenue, the collection of our receivables,the availability of our line of credit, the extent to which we raise additionalfunds from investors, the timing and extent to which we invest in newtechnology, the expenses of sales and marketing and new product development,the extent to which competitors are successful in developing their own productsand services and increasing their own market share, acquisitions of businessesor technologies and other factors.  Tothe extent that our existing capital resources are insufficient to fund ouractivities, we may need to raise additional funds.  Such additional funding, if needed, may not be available onattractive terms or at all.  If adequatefunds are not available on acceptable terms, we may be required to make further expense reductions, which couldsignificantly restrict our operations and limit our ability to enhance ourproducts, fund expansion, respond to competitive pressures or take advantage ofbusiness opportunities.

 

Our contractual commitments at March 31, 2003 are substantially similarto those at December 31, 2002 disclosed in our annual report on Form 10-K.

 

20

----

 

**Factors That MayAffect Future Results of Operations**

 

*Our quarterly operating results are uncertainand may fluctuate significantly, which could negatively affect the value ofyour investment.*

 

Our operating results are difficult topredict accurately and have varied significantly from quarter to quarter andare likely to continue to fluctuate as a result of a variety of factors, manyof which we cannot control. Factors that may adversely affect our quarterlyoperating results include:

 

•                       the size and timing of product orders and thetiming and execution of professional services engagements;

•                       the mix of revenue from products and services;

•                       the mix of products sold;

•                       the ability to meet client project milestones;

•                       the market acceptance of our products andservices;

•                       our abilityto develop and market new or enhanced products and services in a timely mannerand the market acceptance of these products and services;

•                       the timing of revenue and expense recognition;and

•                       recognition of impairment of existing assets.

 

Our future revenue is difficult to predictand we may not be able to adjust spending in response to revenue shortfalls.Our limited operating history with our current enterprise learning solutionsand the emerging nature of the enterprise learning market make prediction offuture revenue and expenses difficult. Expense levels are based, in part, onexpectations as to future revenue and largely are fixed in the short term.  If we are unable to predict future revenueaccurately, we may be unable to adjust spending in a timely manner tocompensate for any unexpected revenue shortfall.

 

*Our business may notgenerate the cash needed to finance our**operations, and for that and other reasons we mayneed additional financing in**the future, which we may be unable to obtain.*

 

Although our business generated positive cashflow during the last two fiscal quarters and we expect to generate positivecash flow from operations at currently anticipated revenue levels and revenuemix during 2003, we may not achieve expected revenue levels or revenue mix andour business may not maintain positive cash flow.  If our business does not generate the cash needed to finance ouroperations, we may need to obtain additional financing or take steps torestrict our operations in order to conserve existing cash.  In addition, poor financial results orunanticipated expenses could give rise to additional financing requirements. Wemay be unable to obtain financing on terms favorable to us, or at all.  If we need to obtain financing and adequatefunds are not available or are not available on acceptable terms, we may berequired to make further expense reductions, which could significantly restrictour operations and limit our ability to enhance our products, fund expansion,respond to competitive pressures or take advantage of business opportunities.

 

*A deterioration ofgeneral economic conditions may materially and adversely**affect our business.*

 

Our revenue is subject to fluctuation as aresult of general economic conditions and overall spending in the technologyand enterprise software sectors. A significant portion of our revenue isderived from the sale of products and services to large companies or governmentagencies, which historically have reduced their expenditures for enterprisesoftware applications during economic downturns. In recent quarters, our salesforce has experienced increased delays, cancellations or reductions in scope ofsales opportunities as a result of the downturn in the economy.  Further war or acts of terrorism may causethe economy to weaken further, which could result in organizations furtherdelaying, canceling, or reducing capital expenditures generally and spending onenterprise software applications in particular.  Such delays, cancellations or reductions could adversely affectour business.

 

21

----

 

*We have a history oflosses and may have continued losses in the future.*

 

We incurred a net loss of approximately$855,000 for the three months ended March 31, 2003.  As of March 31, 2003, our accumulated deficit was $230.9million.  Although our businessgenerated positive cash flow during the three-month period, we have not yetachieved profitability and may not do so during 2003. Even if we do achieveprofitability, we may be unable to sustain or increase profitability on aquarterly or annual basis.

 

*We have a limitedoperating history with the Aspen suite, which makes it**difficult to predict our future performance.*

 

The primary focus of our business is and throughout 2003 will continueto be the Aspen suite.  We released thefirst version of the Aspen suite in September 2001 and released the first majorupgrade in September 2002. Accordingly, we have a limited operating history onwhich to evaluate our current business and future prospects. Our limited operatinghistory with the Aspen suite makes it difficult to predict our futureperformance and may not provide investors with a meaningful basis forevaluating an investment in our common stock.

 

*The enterpriselearning software market is in the early stages of development**and may not grow to a sufficient size or at asufficient rate to sustain our**business.*

 

The enterprise learning software market is in the early stages ofdevelopment, and may not grow to a sufficient size or at a sufficient rate forour business to succeed. Corporate training and education historically havebeen conducted primarily through classroom instruction. Althoughtechnology-based training applications have been available for many years, theycurrently account for only a small portion of the overall corporate learningmarket. Accordingly, our success will depend on the extent to which companiesimplement enterprise learning software solutions for the design, development,delivery and management of their corporate learning needs.

 

Many companies that have already invested substantial resources intraditional training methods may be reluctant to adopt a new strategy that maylimit or compete with their existing investments. Even if companies implemententerprise learning software solutions, they may still choose to develop suchsolutions internally. If the use of enterprise learning software does notbecome widespread or if companies choose to develop such software internallyrather than acquiring it from third parties, then our enterprise learningsoftware may not be commercially successful.

 

*We face risksencountered in emerging markets and may be unsuccessful in**addressing these risks.*

 

We face risks frequently encountered in new and rapidly evolvingmarkets. Specific risks we face relate to the demand for and market acceptanceof our enterprise learning solutions. We may fail to adequately address theserisks, and therefore our business may suffer. To address these risks, we must:

 

•                       effectively market our enterprise learningsoftware to new and existing customers;

•                       continue to enhance the technology upon which ourenterprise learning software is based;

•                       successfully implement our enterprise learningsoftware for our customers and generate continuing revenue from thosecustomers; and

•                       address and establish new technologies andtechnology standards.

 

*We face intensecompetition from other enterprise learning software providers**and may be unable to compete successfully.*

 

The enterprise learning software market is highly fragmented and competitive,with no single firm accounting for a dominant market share. Our competitorsvary in size, scope and the breadth of products

 

22

----

 

and services offered. We face competition from:

 

•                       other developers of enterprise learning systems;

•                       providers of other enterprise software solutions;

•                       large professional consulting firms and in-houseIT departments; and

•                       developers of web authoring tools.

 

There are relatively low barriers to entry in the enterprise learningmarket and new competitors may enter this market in the future. Increasedcompetition may result in price reductions, reduced gross margins and loss ofmarket share. We may not be able to contend effectively with such increasedcompetition.  In particular, vendors ofother enterprise software applications such as enterprise resource planning,human resource management or customer relationship management have begun tooffer learning delivery and management functionality to extend their currentproduct lines within their existing customer base.  Although these offerings may not offer the same functionality asour Aspen suite, bundling these offerings with the remainder of their solutionscould diminish our ability to sell our products and services to their customersand announcements by these companies of future products could delay purchasingdecisions by their customers and our prospects, either of which could adverselyaffect our business.

 

Certain of our existing and potential competitors have longer operatinghistories and significantly greater financial, technical, marketing and otherresources and therefore may be able to respond more quickly to new or changingopportunities, technologies, standards and customer requirements or to competemore aggressively on pricing. Price competition would likely result in reducedgross margins and may prevent the Aspen suite from yielding results sufficientfor our business to succeed.

 

Strategic relationships are important in expanding the distributionreach of companies in the enterprise learning market. If our competitors wereto establish strategic relationships to resell or distribute their productsthrough their strategic partners, our ability to market and sell products andservices successfully may be substantially diminished. In addition, theexistence or announcement of strategic relationships involving our competitorscould adversely affect our ability to attract and retain customers.

 

*Internationaloperations may impose substantial burdens on our resources, divert**management’s attention or otherwise harm ourbusiness.*

 

We rely on independent partners in foreigncountries to help conduct our international operations and sales and marketingefforts. Our success in international markets consequently will depend to alarge degree on the success of these independent partners, over which we havelittle control. If they are unwilling or unable to dedicate sufficientresources to our relationships, our international operations will suffer.

 

We rely on our operations in Hyderabad, Indiato enable us to complete customer implementation projects and new releases ofthe Aspen suite on time and within our established budgets.  Should our operations in Hyderabad bedisrupted for any significant period of time, it could prevent us fromcompleting customer implementations or new releases of the Aspen suite in atimely manner, which could cause our business to suffer.

 

Our efforts in Hyderabad and elsewhere abroadare subject to a number of risks inherent in international operations,including:

 

•                       diversion of management attention;

•                       difficulties and costs of staffing and managingforeign offices;

•                       different learning styles and cultures;

•                       numerous and potentially conflicting regulatoryrequirements;

•                       export controls, import tariffs and otherbarriers to trade;

•                       changes in laws or governmental policies;

 

23

----

 

•                       reduced protection of intellectual propertyrights;

•                       regional political and economic instability; and

•                       fluctuations in currency exchange rates.

 

*Our debt covenantsmay significantly restrict our operations.*

 

We are subject to numerous covenants in ouragreement with Silicon Valley Bank that impose financial and operatingrestrictions on our business if we wish to maintain availability of the creditfacility. These restrictions may affect our ability to operate our business,may limit our ability to take advantage of potential business opportunities asthey arise, and may adversely affect the conduct of our current business. Thesecovenants place restrictions on our ability to, among other things:

 

•                       incur debt with parties other than Silicon ValleyBank;

•                       pay dividends, redeem or repurchase our stock ormake other distributions;

•                       make acquisitions or investments;

•                       engage in new or different businesses;

•                       change our capital structure;

•                       use assets as security in other transactions;

•                       enter into transactions with affiliates oroutside the ordinary course of business;

•                       merge or consolidate with others or acquireassets outside the ordinary course of business;

•                       dispose of assets or use asset sale proceeds;

•                       create liens on our assets; and

•                       extend  orguaranty credit.

 

In addition, the terms of our indebtednessrequire that we meet certain financial covenants related to maximum net lossesand minimum tangible net worth. The covenants governing our existingindebtedness restrict our operations and those of our subsidiaries, and theselimitations could impair our ability to meet such financial covenants. Inaddition, our ability to meet these financial covenants and to comply withother provisions governing our indebtedness may be affected by changes ineconomic or business conditions or other events beyond our control. Moreover,failure to comply with our debt-related obligations could result in an event ofdefault that, if not cured or waived, could result in an acceleration of ourindebtedness.  We are currently incompliance with these covenants, but we cannot assure you that we will notviolate these covenants in the future. In the past, we have on occasion violated certain of the covenants underour loan agreements with Silicon Valley Bank and the bank has waived thoseviolations without cost to us.  However,we cannot assure you that the bank will waive any future violations at no costto us, or at all.

 

Moreover, because the amount available forborrowing under our agreement is based on our eligible accounts receivable, wemay from time to time become over-advanced under the line of credit if oureligible accounts receivable decrease, either because they have been collectedbut not applied against the existing obligations or because they have becomeineligible under the terms of the agreement. In such a case we may be required to immediately repay a portion of theamount borrowed sufficient to bring the total amount owed to no more than thetotal availability under the loan facility.

 

*The loss of theservices of our senior executives and key personnel would**likely cause our business to suffer.*

 

Our success depends to a significant degree on the performance of thesenior management team and other key employees. The loss of any of theseindividuals could harm our business. We do not have employment agreements withseveral of our executives or with any other key employees, and we do notmaintain key person life insurance for any officers or key employees.

 

24

----

 

Our success also depends on our ability to attract, integrate, motivateand retain highly skilled technical, sales and marketing and professionalservices personnel. Competition for qualified personnel in the enterprisesoftware industry is intense. To the extent we are unable to attract and retainskilled personnel our business will suffer.

 

*Our Aspen suite is anew product and may contain defects or otherwise**perform improperly.*

 

Our Aspen suite was initially released in September 2001, and the firstmajor version upgrade was released in September 2002.  We anticipate continuing to add new features, functionality andcomponents. Complex enterprise software products frequently contain errors orfailures, especially when first introduced or when new versions are released.Because the Aspen products are complex software packages with new features andfunctionality being added and new versions being released on a regular basis,there is a greater likelihood that they may contain such errors. In addition,since the Aspen suite is targeted at enterprise customers with large numbers ofusers, customers and potential customers may have a greater sensitivity toproduct defects or product integration than the market for software productsgenerally. To date we have experienced errors in the Aspen platform, inparticular when new versions or functionality is first released, although sucherrors have not had a material impact on our business and generally have beencorrected shortly after discovery. Although we have not experienced this to date, serious product errorscould result in loss of revenue or delay in market acceptance, diversion ofdevelopment resources, damage to our reputation, or increased service andwarranty costs.

 

*We may not be ableto adapt to rapidly changing technology and evolving**industry standards.*

 

The enterprise learning software market is characterized by rapidlychanging technologies, frequent new product and service introductions, shortdevelopment cycles and evolving industry standards. The introduction of newproducts and services embodying new technologies and the emergence of newindustry standards may render our products and services obsolete. Our successdepends on our ability to adapt to a rapidly changing landscape and to offernew products and services to address our customers’ changing demands. We mayexperience difficulties that delay or prevent the successful design,development, introduction or marketing of our products and services. To theextent we in fact experience such delays, we may experience difficulty inattracting new customers and may lose existing customers.

 

*If we are unable tobuild the Click2learn and Aspen brands, we may be unable to**grow our business.*

 

We believe that establishing and maintainingthe Click2learn and Aspen brands will be critical to the success of ourenterprise learning strategy and that the importance of brand recognition willincrease as the market for enterprise learning software products grows. If ourbrand building strategy is unsuccessful, our business could be materiallyharmed.

 

*We face the risk ofliability for failures to meet unique customer**requirements, and the risk of cost overruns onfixed-price projects.*

 

The failure or inability to meet a customer’sunique expectations or requirements in the performance of services could impairour reputation or result in a claim for damages, regardless of our responsibilityfor the failure. Although generally we attempt to limit contractually ourliability for damages arising from product defects and other mistakes inrendering professional services, these contractual protections are not alwaysobtained and may not be enforced or otherwise may not protect us fromliability. Our insurance may not be sufficient to cover these claims.  In addition, most of our professionalservices projects are performed on a fixed-price basis rather than on a timeand materials basis. If we do not complete fixed-price engagements withinbudget, on time and to clients’ satisfaction, we bear the risk of costoverruns.

 

25

----

 

*Security and privacybreaches could subject us to litigation and liability.*

 

We host certain of our customers’ enterpriselearning software implementations at our data center and provide access to thatsoftware using the Internet. The Internet is a public network and data is sentover this network from many sources. Although we take reasonable steps inaccordance with current industry practices to ensure the security of ourhosting systems and customer data, computer viruses could be introduced intoour systems or those of our customers, which could disrupt the operation of ourhosting systems or make them inaccessible to users. We depend on Internetservice providers and telecommunications companies and the efficient operationof their computer networks and other computer equipment to enable customers toaccess and use hosted software implementations. Each of these has experiencedsignificant outages in the past and could experience outages, delays and otherdifficulties due to system failures unrelated to our systems, which could causeour customers to believe we were at fault and withhold payments due to us.

 

We could become subject to litigation andliability if third parties penetrate security for our hosting systems orotherwise misappropriate our users’ confidential information or if customersare unable to access and use hosted software implementations. Advances incomputer capabilities, new discoveries in the field of cryptography or othertechnological events or developments could result in compromises or breaches ofour security systems. Anyone who circumvents our security measures couldmisappropriate proprietary information or cause interruptions in our servicesor operations. We may be required to expend significant capital and otherresources to protect against the threat of security breaches or serviceinterruptions or to alleviate problems caused by breaches or serviceinterruptions.

 

*Acquisitions orinvestments may drain capital and equity resources, divert**management’s attention or otherwise harm ourbusiness.*

 

In the future we may acquire or make investments in other businesses,products or technologies. Such acquisitions or investments may require that wepay significant cash, issue stock or incur substantial debt. In addition, suchacquisitions or investments may require significant managerial attention, whichmay be diverted from our other operations. These capital, equity and managerialcommitments may impair the operation of our business. Furthermore, acquiredbusinesses may not be effectively integrated, may be unable to maintain keypre-acquisition business relationships, may contribute to increased fixed costsand may expose us to unanticipated liabilities.

 

*Our intellectualproperty may become subject to legal challenges, unauthorized**use or infringement, any of which could diminish thevalue of our products and**services.*

 

Our success depends in large part on ourproprietary technology. We rely on a combination of copyrights, trademarks,trade secret laws, restrictions on disclosure and other methods to protect ourproprietary technology.  We do not havepatents for any of the technology underlying our Aspen platform. If we fail tosuccessfully enforce our intellectual property rights, the value of theserights, and consequently the value of our products and services to ourcustomers, could diminish substantially. It may be possible for third partiesto copy or otherwise obtain and use our intellectual property or trade secretswithout our authorization, and it may be possible for third parties toindependently develop substantially equivalent intellectual property.

 

Litigation may be necessary in the future toenforce our intellectual property rights, to protect trade secrets or todetermine the validity and scope of the proprietary rights of others. From timeto time we have received, and may in the future receive, notice of claims ofinfringement of other parties’ proprietary rights. Such claims could result incostly litigation and could divert management and technical resources. Theycould also delay product shipment or require us to develop non-infringing technologyor enter into royalty or licensing agreements, which agreements may not beavailable on reasonable terms, or at all.

 

26

----

 

*Our products includethird-party technology, the loss of which could materially**harm our business.*

 

We use some licensed third-party technology components in our products.Future licenses to this technology may not be available to us on commerciallyreasonable terms, or at all. The loss of or inability to obtain or maintain anyof these technology licenses could result in delays in the introduction of newproducts or could force us to discontinue offering portions of our enterpriselearning solutions until equivalent technology, if available, is identified,licensed and integrated. Furthermore, we may become subject to legal claimsrelated to licensed technology based on product liability, infringement ofintellectual property or other legal theories.

 

*Our stock price has been and may continue to be volatile.*

 

The tradingprice of our common stock has been and is likely to continue to be highlyvolatile.  For example, during the52-week period ended March 31, 2003, the price of our common stock ranged from$0.23 to $4.90 per share.  Our stockprice is subject to continued fluctuations in response to a number of factors,including:

 

•                       actual oranticipated variations in quarterly operating results;

•                       changes infinancial estimates or recommendations by securities analysts;

•                       conditionsor trends in the learning and enterprise software markets;

•                       announcementsby us or our competitors of significant customer wins, technologicalinnovations, new products or services;

•                       announcementsby us or our competitors of significant acquisitions, strategic partnerships,joint ventures or capital commitments;

•                       additionsor departures of key personnel;

•                       sales ofour common stock; and

•                       generalmarket conditions.

 

The stockmarket in general, and the market for enterprise software and technologycompanies in particular, recently has experienced extreme price and volumefluctuations that have been unrelated or disproportionate to the operatingperformance of many of the affected companies. These broad market and industry factors may depress our stock price,regardless of our operating performance.

 

In the past,companies that have experienced volatility in the market price of their stockhave been subject to securities class action litigation.  We may be the targets of this type oflitigation in the future.  Securitieslitigation against us could result in substantial costs and divert ourmanagement’s attention, which could seriously harm our business.

 

In addition,to maintain our listing the Nasdaq National Market we must continue to maintaina minimum bid price for our common stock of $1.00 per share or more. During2002, our common stock traded below the $1.00 minimum bid requirement for aperiod of time such that we no longer met the continued listing criteria forthe Nasdaq National Market.   Althoughwe have regained compliance with the listing criteria and are currently in goodstanding on the Nasdaq National Market, our minimum bid price may again dropbelow the $1.00 minimum bid price for a sufficient period of time that we donot meet the continued listing criteria. Loss of our Nasdaq National Market status could also make it moredifficult for us to raise capital or complete acquisitions.

 

**Item 3.Quantitative and Qualitative Disclosures about Market Risk**

 

*Market RateRisk.*We areexposed to market risk related to changes in interest rates and foreigncurrency exchange rates. We do not use derivative financial instruments forspeculative or trading purposes.

 

27

----

 

*Interest RateRisk.*We hold ourassets primarily in cash and cash equivalents, such as short-term marketabledebt securities, money market funds and other cash equivalents. We minimizerisk by investing in financial instruments with maturity of three months orless. As a result, if market interest rates were to increase immediately and uniformlyby 10% from levels at December 31, 2002, the fair value of cash and cashequivalents would not change by a material amount.

 

*ForeignCurrency Exchange Risk.*We have foreign currency risk as a result of foreign subsidiaryactivities. For the three months ended March 31, 2003, international revenuefrom foreign subsidiaries accounted for approximately 7% of total revenue. Allforeign subsidiaries use the local currency as their functional currency.

 

Our exposure to foreign exchange rate fluctuations arises in part fromintercompany accounts in which costs incurred in the United States are chargedto the foreign subsidiaries. These intercompany accounts are typicallydenominated in the functional currency of the foreign subsidiary in order tocentralize foreign exchange risk with the parent company in the United States.We are also exposed to foreign exchange rate fluctuations as the financialresults of foreign subsidiaries are translated in U.S. dollars inconsolidation. As exchange rates vary, these results, when translated, may varyfrom expectations and adversely impact overall expected profitability. Theeffect of foreign exchange rate fluctuations for the three months ended March31, 2003 was not material. Due to the substantial volatility of currencyexchange rates, among other factors, we cannot predict the effect of exchangerate fluctuations on our future operating results.

 

**Item4.  Controls and Procedures**

 

Click2learnmaintains a set of disclosure controls and procedures and internal controls designedto ensure that information required to be disclosed in filings made pursuant tothe Securities Exchange Act of 1934 (the “Exchange Act”) is recorded,processed, summarized and reported within the time periods specified in theSecurities and Exchange Commission’s rules and forms. Our principal executiveand financial officers have evaluated our disclosure controls and procedureswithin 90 days prior to the filing of this Quarterly Report on Form 10-Q andhave determined that such disclosure controls and procedures are effective.

 

Subsequent toour evaluation, there were no significant changes in internal controls or otherfactors that could significantly affect internal controls, including anycorrective actions with regard to significant deficiencies and materialweaknesses.

 

28

----

 

**PART II—OTHER INFORMATION**

 

**Item1.  Legal Proceedings**

 

Notapplicable.

 

**Item 2.**                    **Changes In Securities and Use ofProceeds**

 

Not applicable.

 

**Item3.  Defaults Upon Senior Securities**

 

Notapplicable.

 

**Item 4.**                    **Submission of Matters to a Vote ofSecurities Holders**

 

Notapplicable.

 

**Item 5.**                    **Other Information**

 

*Management Changes.*  In March 2003 Stephen Bennett resigned asSenior Vice President, Europe, Middle East, and Africa ("EMEA") topursue other opportunities.  In April2003 the Board appointed Gary Millrood, formerly Senior Vice President, NorthAmerican Sales as Executive Vice President, Worldwide Sales and Alliances totake over Mr. Bennett’s responsibilities with respect to sales in theregion.  Mr. Millrood’s appointment waseffective April 15, 2003.  The Boardalso approved the appointment of Grant Smuts, formerly Vice President, AsiaPacific as Vice President, EMEA to take over Mr. Bennett’s responsibilities foroperations in the region.  We anticipateMr. Smuts’ appointment will take effect by the end of June 2003.

 

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

 

(a)          Exhibits.

 
| 10.01  |   | Tenth Amendment to Lease Agreement dated as of March  3, 2003 by and between Click2learn and EOP-110 Atrium Place, L.L.C.                          |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                               |
| 99.01  |   | Certification of Chief Executive Officer pursuant to 18 U.S.C.  Section 1350, as adopted pursuant to Section 906 of the Sarbane-Oxley Act of  2002 |
|   |   |                                                                                                                                               |
| 99.02  |   | Certification of Chief Financial Officer pursuant to 18 U.S.C.  Section 1350, as adopted pursuant to Section 906 of the Sarbane-Oxley Act of  2002 |

 

(b)            Reports on Form 8-K.

 

A report on Form 8-K dated January 3, 2003 was filed announcing thedate of Click2learn’s conference call to discuss results for the three and 12months ended December 31, 2002. No financial statements were filed with suchreport.

 

A report on Form 8-K dated January 23, 2003 was filed announcing that,Microsoft Corporation accounted for more than 10% of Click2learn, Inc.’stotal revenue during fiscal year2002. No financial statements were filed with such report.

 

29

----

 

**SIGNATURES**

 

Pursuant tothe requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 
|         |   | **CLICK2LEARN, INC.**                                                                                                                             |
|--------------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------|
|         |   |                                                                                                                                              |
| May 14, 2003 |   | /s/John D. Atherly                                                                                                                                |
| Date         |   | John D. Atherly  Vice President, Finance and Administration  and Chief Financial Officer  (Duly Authorized Officer and Chief Accounting  Officer) |

 

30

----

 

**Certification of Chief Executive Officer**

 

I, Kevin M. Oakes, certifythat:

 

1.                   I have reviewedthis quarterly report on Form 10-Q of Click2learn, Inc.;

 

2.                   Based on myknowledge, this quarterly report does not contain any untrue statement of amaterial fact or omit to state a material fact necessary to make the statementsmade, in light of the circumstances under which such statements were made, notmisleading with respect to the period covered by this quarterly report;

 

3.                   Based on myknowledge, the financial statements, and other financial information includedin this quarterly report, fairly present in all material respects the financialcondition, results of operations and cash flows of the registrant as of, andfor, the periods presented in this quarterly report;

 

4.                   Theregistrant’s other certifying officer and I are responsible for establishingand maintaining disclosure controls and procedures (as defined in Exchange ActRules 13a-14 and 15d-14) for the registrant and we have:

 

a)        Designed such disclosurecontrols and procedures to ensure that material information relating to theregistrant, including its consolidated subsidiaries, is made known to us byothers within those entities, particularly during the period in which thisquarterly report is being prepared;

 

b)       Evaluated the effectivenessof the registrant’s disclosure controls and procedures as of a date within 90days prior to the filing date of this quarterly report (the “Evaluation Date”);and

 

c)        Presented in thisquarterly report our conclusions about the effectiveness of the disclosurecontrols and procedures based on our evaluation as of the Evaluation Date;

 

5.                   Theregistrant’s other certifying officer and I have disclosed, based on our mostrecent evaluation, to the registrant’s auditors and the Audit Committee ofregistrant’s Board of Directors (or persons performing the equivalentfunction):

 

a)        All significantdeficiencies in the design or operation of internal controls which couldadversely affect registrant’s ability to record, process, summarize and reportfinancial data and have identified for the registrant’s auditors any materialweaknesses in internal controls; and

 

b)       Any fraud, whether or notmaterial, that involves management or other employees who have a significantrole in the registrant’s internal controls; and

 

6.                   Theregistrant’s other certifying officer and I have indicated in this quarterlyreport whether or not there were significant changes in internal controls or inother factors that could significantly affect internal controls subsequent tothe date of our most recent evaluation, including any corrective actions withregard to significant deficiencies and material weaknesses.

 

 
| /s/ Kevin M.  Oakes      |   |
|--------------------------|--------|
| Kevin M.  Oakes          |
| Chief  Executive Officer |

 

31

----

 

**Certification of Chief Financial Officer**

 

I, John D. Atherly, certifythat:

 

1.                   I have reviewedthis quarterly report on Form 10-Q of Click2learn, Inc.;

 

2.                   Based on myknowledge, this quarterly report does not contain any untrue statement of amaterial fact or omit to state a material fact necessary to make the statementsmade, in light of the circumstances under which such statements were made, notmisleading with respect to the period covered by this quarterly report;

 

3.                   Based on myknowledge, the financial statements, and other financial information includedin this quarterly report, fairly present in all material respects the financialcondition, results of operations and cash flows of the registrant as of, andfor, the periods presented in this quarterly report;

 

4.                   Theregistrant’s other certifying officer and I are responsible for establishingand maintaining disclosure controls and procedures (as defined in Exchange ActRules 13a-14 and 15d-14) for the registrant and we have:

 

a)        Designed such disclosurecontrols and procedures to ensure that material information relating to theregistrant, including its consolidated subsidiaries, is made known to us by otherswithin those entities, particularly during the period in which this quarterlyreport is being prepared;

 

b)       Evaluated the effectivenessof the registrant’s disclosure controls and procedures as of a date within 90days prior to the filing date of this quarterly report (the “Evaluation Date”);and

 

c)        Presented in thisquarterly report our conclusions about the effectiveness of the disclosurecontrols and procedures based on our evaluation as of the Evaluation Date;

 

5.                   Theregistrant’s other certifying officer and I have disclosed, based on our mostrecent evaluation, to the registrant’s auditors and the Audit Committee ofregistrant’s Board of Directors (or persons performing the equivalentfunction):

 

a)        All significantdeficiencies in the design or operation of internal controls which couldadversely affect registrant’s ability to record, process, summarize and reportfinancial data and have identified for the registrant’s auditors any materialweaknesses in internal controls; and

 

b)       Any fraud, whether or notmaterial, that involves management or other employees who have a significantrole in the registrant’s internal controls; and

 

6.                   Theregistrant’s other certifying officer and I have indicated in this quarterlyreport whether or not there were significant changes in internal controls or inother factors that could significantly affect internal controls subsequent tothe date of our most recent evaluation, including any corrective actions withregard to significant deficiencies and material weaknesses.

 

 
| /s/ John D.  Atherly     |   |
|--------------------------|--------|
| John D.  Atherly         |
| Chief  Financial Officer |

 

32

----

 

**ExhibitList**

 
| 10.01  |   | Tenth Amendment to Lease Agreement dated as of March  3, 2003 by and between Click2learn and EOP-110 Atrium Place, L.L.C.                          |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                               |
| 99.01  |   | Certification of Chief Executive Officer pursuant to 18 U.S.C.  Section 1350, as adopted pursuant to Section 906 of the Sarbane-Oxley Act of  2002 |
|   |   |                                                                                                                                               |
| 99.02  |   | Certification of Chief Financial Officer pursuant to 18 U.S.C.  Section 1350, as adopted pursuant to Section 906 of the Sarbane-Oxley Act of  2002 |

 

33

----