##### Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington, DC 20549
 FORM 10-Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d)
OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended April 30, 2005 Commission File Number 0-20842 PLATO LEARNING, INC. (Exact name of Registrant as specified in its charter)
 Delaware
    
    36-3660532(State or other jurisdiction of incorporation or organization)
    
    (IRS Employer Identification Number)
 10801 Nesbitt Avenue South, Bloomington, MN 55437(Address of principal executive offices) (952) 832-1000(Registrants telephone number, including area code) Not Applicable(Former name, former address and former fiscal year, if changed since last report) Indicate by check mark whether the Registrant (1) has filed all reports required to be filed
by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or
for such shorter period that the registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days. Yes þ No o Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of
the Exchange Act. Yes þ No o Indicate the number of shares outstanding of each of the Registrants classes of common stock, as
of the latest practicable date. 23,491,497 shares of common stock, $.01 par value, outstanding as
of May 31, 2005.   1




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PLATO LEARNING, INC.
Form 10-Q
Quarter Ended April 30, 2005 TABLE OF CONTENTS PagePART I. FINANCIAL INFORMATIONItem 1. Consolidated Financial Statements (Unaudited):Consolidated Statements of Operations for the Three and Six Months Ended April 30, 2005 and 2004
    
    
    4Consolidated Balance Sheets as of April 30, 2005 and October 31, 2004
    
    
    5Consolidated Statements of Cash Flows for the Six Months Ended April 30, 2005 and 2004
    
    
    6Notes to Consolidated Financial Statements
    
    
    7Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    17Item 3. Quantitative and Qualitative Disclosures About Market Risk
    
    
    33Item 4. Controls and Procedures
    
    
    33PART II. OTHER INFORMATIONItem 1. Legal Proceedings
    
    
    34Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    34Item 3. Defaults Upon Senior Securities
    
    
    34Item 4. Submission of Matters to a Vote of Security Holders
    
    
    34Item 5. Other Information
    
    
    34Item 6. Exhibits
    
    
    35SIGNATURES
    
    
    36Certification of CEO Pursuant to Section 302Certification of CFO Pursuant to Section 302Certification of CEO Pursuant to Section 906Certification of CFO Pursuant to Section 906
 2




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PART I. FINANCIAL INFORMATION 
 Item 1. Consolidated Financial Statements (Unaudited) 3




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PLATO Learning, Inc. and Subsidiaries 
 Consolidated Statements of Operations
 (Unaudited, in thousands, except per share amounts)
 
 Three Months Ended
    
    
    Six Months EndedApril 30,
    
    
    April 30,2005
    
    
    2004
    
    
    2005
    
    
    2004Revenues:License fees
    
    $
    14,233
    
    
    $
    17,213
    
    
    $
    25,328
    
    
    $
    30,272Subscriptions
    
    
    4,517
    
    
    
    5,325
    
    
    
    9,050
    
    
    
    9,833Services
    
    
    10,908
    
    
    
    7,197
    
    
    
    19,104
    
    
    
    13,534Other
    
    
    1,771
    
    
    
    2,585
    
    
    
    3,402
    
    
    
    5,129Total revenues
    
    
    31,429
    
    
    
    32,320
    
    
    
    56,884
    
    
    
    58,768Cost of revenues:License fees
    
    
    2,869
    
    
    
    3,234
    
    
    
    6,301
    
    
    
    6,575Subscriptions
    
    
    2,142
    
    
    
    2,061
    
    
    
    4,455
    
    
    
    3,740Services
    
    
    6,108
    
    
    
    4,570
    
    
    
    12,234
    
    
    
    8,334Other
    
    
    1,985
    
    
    
    2,342
    
    
    
    3,685
    
    
    
    4,541Total cost of revenues
    
    
    13,104
    
    
    
    12,207
    
    
    
    26,675
    
    
    
    23,190Gross profit
    
    
    18,325
    
    
    
    20,113
    
    
    
    30,209
    
    
    
    35,578Operating expenses:Sales and marketing
    
    
    13,410
    
    
    
    15,793
    
    
    
    26,736
    
    
    
    30,978General and administrative
    
    
    4,842
    
    
    
    5,040
    
    
    
    9,052
    
    
    
    9,532Product development
    
    
    1,222
    
    
    
    1,346
    
    
    
    2,693
    
    
    
    3,549Amortization of intangibles
    
    
    1,080
    
    
    
    1,102
    
    
    
    2,172
    
    
    
    2,085Restructuring and other charges
    
    
    632
    
    
    
    
    
    
    
    2,921
    
    
    
    Total operating expenses
    
    
    21,186
    
    
    
    23,281
    
    
    
    43,574
    
    
    
    46,144Operating loss
    
    
    (2,861
    )
    
    
    (3,168
    )
    
    
    (13,365
    )
    
    
    (10,566
    )Interest income
    
    
    168
    
    
    
    138
    
    
    
    380
    
    
    
    257Interest expense
    
    
    (28
    )
    
    
    (37
    )
    
    
    (43
    )
    
    
    (72
    )Other expense, net
    
    
    (83
    )
    
    
    (13
    )
    
    
    (153
    )
    
    
    (84
    )Loss before income taxes
    
    
    (2,804
    )
    
    
    (3,080
    )
    
    
    (13,181
    )
    
    
    (10,465
    )Income tax expense
    
    
    150
    
    
    
    150
    
    
    
    300
    
    
    
    300Net loss
    
    $
    (2,954
    )
    
    $
    (3,230
    )
    
    $
    (13,481
    )
    
    $
    (10,765
    )Loss per share:Basic and diluted
    
    $
    (0.13
    )
    
    $
    (0.14
    )
    
    $
    (0.58
    )
    
    $
    (0.48
    )Weighted average common shares outstanding:Basic and diluted
    
    
    23,378
    
    
    
    22,989
    
    
    
    23,240
    
    
    
    22,236
 See Notes to Consolidated Financial Statements 4




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PLATO Learning, Inc. and Subsidiaries 
 Consolidated Balance Sheets
 (In thousands, except per share amounts)
 
 April 30,
    
    
    October 31,2005
    
    
    2004(Unaudited)
    
    
    (See Note)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    25,534
    
    
    $
    29,235Marketable securities
    
    
    5,982
    
    
    
    12,615Accounts receivable, net
    
    
    28,589
    
    
    
    41,852Prepaid expenses and other current assets
    
    
    9,672
    
    
    
    9,460Total current assets
    
    
    69,777
    
    
    
    93,162Long-term marketable securities
    
    
    
    
    
    
    3,608Equipment and leasehold improvements, net of accumulated
depreciation and amortization of $11,955 and $10,361, respectively
    
    
    7,499
    
    
    
    7,946Product development costs, net of accumulated amortization of
$22,294 and $18,835, respectively
    
    
    18,628
    
    
    
    17,116Goodwill
    
    
    71,997
    
    
    
    71,267Identified intangible assets, net
    
    
    35,291
    
    
    
    39,432Other assets
    
    
    1,088
    
    
    
    213Total assets
    
    $
    204,280
    
    
    $
    232,744LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    2,104
    
    
    $
    5,196Accrued employee salaries and benefits
    
    
    6,798
    
    
    
    8,772Accrued liabilities
    
    
    5,624
    
    
    
    6,383Deferred revenue
    
    
    33,434
    
    
    
    43,042Total current liabilities
    
    
    47,960
    
    
    
    63,393Long-term deferred revenue
    
    
    5,835
    
    
    
    8,533Deferred income taxes
    
    
    1,622
    
    
    
    1,322Other liabilities
    
    
    39
    
    
    
    46Total liabilities
    
    
    55,456
    
    
    
    73,294Stockholders equity:Common stock, $.01 par value, 50,000 shares authorized;
23,495 shares issued and 23,475 shares outstanding at April 30,
2005; 23,095 shares issued and 23,075 shares outstanding
at October 31, 2004
    
    
    235
    
    
    
    231Additional paid in capital
    
    
    165,457
    
    
    
    162,956Treasury stock at cost, 20 shares
    
    
    (205
    )
    
    
    (205
    )Accumulated deficit
    
    
    (16,331
    )
    
    
    (2,850
    )Accumulated other comprehensive loss
    
    
    (332
    )
    
    
    (682
    )Total stockholders equity
    
    
    148,824
    
    
    
    159,450Total liabilities and stockholders equity
    
    $
    204,280
    
    
    $
    232,744
 Note: The balance sheet at October 31, 2004 has been derived from our audited financial statements at that date. See Notes to Consolidated Financial Statements. 5




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PLATO Learning, Inc. and Subsidiaries 
 Consolidated Statements of Cash Flows
 (Unaudited, in thousands)
 
 Six Months EndedApril 30,2005
    
    
    2004Operating activities:Net loss
    
    $
    (13,481
    )
    
    $
    (10,765
    )Adjustments to reconcile net loss to net cash
used in operating activities:Deferred income taxes
    
    
    300
    
    
    
    300Amortization of capitalized product development costs
    
    
    3,463
    
    
    
    3,478Amortization of identified intangible and other noncurrent assets
    
    
    4,280
    
    
    
    3,763Depreciation and amortization of equipment and
leasehold improvements
    
    
    1,743
    
    
    
    1,837Restructuring and other charges
    
    
    2,921
    
    
    
    Provision for doubtful accounts
    
    
    674
    
    
    
    827Stock-based compensation
    
    
    39
    
    
    
    217Loss on disposal of equipment
    
    
    32
    
    
    
    1Changes in assets and liabilities, net of effects of acquisitions:Accounts receivable
    
    
    12,589
    
    
    
    5,775Prepaid expenses and other current and noncurrent assets
    
    
    (1,170
    )
    
    
    (755
    )Accounts payable
    
    
    (3,092
    )
    
    
    (1,854
    )Accrued liabilities, accrued employee salaries and
benefits and other liabilities
    
    
    (5,588
    )
    
    
    (6,210
    )Deferred revenue
    
    
    (12,306
    )
    
    
    (834
    )Total adjustments
    
    
    3,885
    
    
    
    6,545Net cash used in operating activities
    
    
    (9,596
    )
    
    
    (4,220
    )Investing activities:Acquisitions, net of cash acquired
    
    
    
    
    
    
    2,460Capitalization of product development costs
    
    
    (5,211
    )
    
    
    (4,291
    )Capital expenditures
    
    
    (1,375
    )
    
    
    (1,112
    )Purchases of marketable securities
    
    
    (9,266
    )
    
    
    (287
    )Sales and maturities of marketable securities
    
    
    19,559
    
    
    
    370Net cash provided by (used in) investing activities
    
    
    3,707
    
    
    
    (2,860
    )Financing activities:Net proceeds from issuance of common stock
    
    
    1,925
    
    
    
    1,491Repurchase of common stock
    
    
    
    
    
    
    (205
    )Repayments of capital lease obligations
    
    
    (127
    )
    
    
    (70
    )Net cash provided by financing activities
    
    
    1,798
    
    
    
    1,216Effect of foreign currency on cash
    
    
    390
    
    
    
    (28
    )Net decrease in cash and cash equivalents
    
    
    (3,701
    )
    
    
    (5,892
    )Cash and cash equivalents at beginning of period
    
    
    29,235
    
    
    
    23,834Cash and cash equivalents at end of period
    
    $
    25,534
    
    
    $
    17,942
 See Notes to Consolidated Financial Statements 6




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PLATO Learning, Inc. and Subsidiaries 
 Notes to Consolidated Financial Statements
  1. Business We provide computer-based and e-learning instruction software and related services for
kindergarten through adult learners, offering curricula in reading, writing, math, science, social
studies, and life and job skills. We also offer online assessment and accountability solutions and
standards-based professional development services. With over 6,000 hours of objective-based,
problem-solving courseware, plus assessment, alignment, and curriculum management tools, we create
standards-based curricula that facilitate learning and school improvement. PLATO educational software is delivered via networks, CD-ROM, the Internet, and private
intranets. We market our software products and related services primarily to K-12 schools and
colleges. We also sell to job training programs, correctional institutions, military education
programs, corporations, and individuals. We are subject to risks and uncertainties including, but not limited to, dependence on
information technology spending by our customers, well-established competitors, customers dependent
on government funding, fluctuations of our quarterly results, a lengthy and variable sales cycle,
dependence on key personnel, dependence on our intellectual property rights, and rapid
technological change. 2. Basis of Presentation The accompanying unaudited consolidated financial statements have been prepared in accordance
with accounting principles generally accepted in the United States of America for interim financial
information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly,
they do not include all of the information and footnotes required by accounting principles
generally accepted in the United States of America for complete financial statements. We have
included all normal recurring and other adjustments considered necessary to give a fair
presentation of our operating results for the interim periods shown. Operating results for these
interim periods are not necessarily indicative of the results to be expected for the full fiscal
year. For further information, refer to the consolidated financial statements and accompanying
notes included in our Annual Report on Form 10-K for the fiscal year ended October 31, 2004. The accompanying unaudited consolidated financial statements include the accounts of PLATO
Learning, Inc. and its wholly owned subsidiaries. All significant intercompany accounts and
transactions have been eliminated. 7




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##### Table of Contents



3. Summary of Significant Accounting Policies For more information on our significant accounting policies, refer to Note 2 to Consolidated
Financial Statements in our Annual Report on Form 10-K for the year ended October 31, 2004. Stock-Based Compensation We account for our stock-based employee compensation arrangements in accordance with the
provisions of Accounting Principles Board Opinion No. 25 Accounting for Stock Issued to Employees
and comply with the disclosure provisions of Statement of Financial Accounting Standards (SFAS)
No. 123, Accounting for Stock-Based Compensation and SFAS No. 148 Accounting for Stock-Based
Compensation  Transition and Disclosure, an amendment of Financial Accounting Standards Board
Statement No. 123. For purposes of the pro forma disclosures, the estimated fair value of
stock-based employee compensation is amortized to expense over the vesting period of the related
arrangement. Had compensation expense for the stock-based employee compensation been recognized based on
the fair value at the grant date consistent with the provisions of SFAS No. 123, reported results
for the three and six months ended April 30, 2005 would have been adjusted to the pro forma amounts
presented below: Three Months
    
    
    Six MonthsEnded
    
    
    EndedApril 30,
    
    
    April 30,2005
    
    
    2005Net loss, as reported
    
    $
    (2,954
    )
    
    $
    (13,481
    )Add: stock-based compensation expense included
in reported net loss
    
    
    39
    
    
    
    39Deduct: stock-based compensation expense determined
using the fair value
based method for all
awards
    
    
    (775
    )
    
    
    (1,505
    )Pro forma net loss
    
    $
    (3,690
    )
    
    $
    (14,947
    )Basic and diluted loss per share:As reported
    
    $
    (0.13
    )
    
    $
    (0.58
    )Pro forma
    
    $
    (0.16
    )
    
    $
    (0.64
    )
 We recently discovered that our disclosures of pro forma stock-based compensation expense
deductions, pro forma net losses, and pro forma basic and diluted net loss per share amounts included in
previous filings with the Securities and Exchange Commission
(SEC) have been incorrect,
primarily related to the treatment of stock option forfeitures and
recognition of related tax benefits. The pro forma
disclosures included below have been corrected based on our revised calculations. 8




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Had
compensation expense for the stock-based employee
compensation been recognized based on the fair value at the grant date
consistent with the
provisions of SFAS No. 123, reported results for the three and
six months ended April 30, 2004 and the three months ended
January 31, 2005, would have been
adjusted
to the pro forma amounts
presented below, including the effects of the correction discussed above: Three Months Ended
    
    
    Six Months Ended
    

    Three Months EndedApril 30, 2004
    
    
    April 30, 2004
    

January 31, 2005As Reported
    
    

As
Restated
    
    
    As Reported
    
    

As
Restated
    
    
    As Reported
    
    
    As RestatedNet loss, as reported
    
    $
    (3,230
    )
    
    $
    (3,230
    )
    
    $
    (10,765
    )
    
    $
    (10,765
    )

$
(10,527
)

$
(10,527
)Add: stock-based compensation expense included
in reported net loss
    
    
    217
    
    
    
    217
    
    
    
    217
    
    
    
    217
    






Deduct: stock-based compensation expense determined
using the fair value based method for all awards
    
    
    (2,269
    )
    
    
    (1,545
    )
    
    
    (3,895
    )
    
    
    (2,645
    )


(1,030
)


(730
)Pro forma net loss
    
    $
    (5,282
    )
    
    $
    (4,558
    )
    
    $
    (14,443
    )
    
    $
    (13,193
    )

$
(11,557
)

$
(11,257
)Basic and diluted loss per share:As reported
    
    $
    (0.14
    )
    
    $
    (0.14
    )
    
    $
    (0.48
    )
    
    $
    (0.48
    )

$
(0.46
)

$
(0.46
)Pro forma
    
    $
    (0.23
    )
    
    $
    (0.20
    )
    
    $
    (0.65
    )
    
    $
    (0.59
    )

$
(0.50
)

$
(0.49
)
 In
December 2004, the Financial Accounting Standards Board issued
SFAS No. 123(R),
Share-Based Payment (SFAS 123(R)). SFAS 123(R) establishes standards for accounting for
transactions in which an entity exchanges its equity instruments for goods or services. SFAS
123(R) focuses primarily on accounting for transactions in which an entity obtains employee
services in share-based payment transactions. SFAS 123(R) requires that the fair value of such
equity instruments be recognized as expense in the financial statements as services are performed.
Prior to SFAS 123(R), only the pro forma disclosures of fair value presented above were required.
In March 2005, the SEC issued Staff Accounting Bulletin No. 107, TOPIC 14: Share-Based payment
which addresses the interaction between SFAS 123(R) and certain SEC rules and regulations and
provides views regarding the valuation of share-based payment arrangements for public companies.
SFAS 123(R) is effective for our first quarter of 2006 and
the adoption of this new accounting pronouncement is expected to have a material impact on our
consolidated financial statements. 9




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4. Acquisitions In November 2003, we acquired Lightspan, Inc. (Lightspan). In December 2003, we acquired
New Media (Holdings) Limited (New Media). For more information on these acquisitions, refer to
Note 3 to Consolidated Financial Statements in our Annual Report on Form 10-K for the year ended
October 31, 2004. Our unaudited pro forma consolidated results of operations, as if the Lightspan
acquisition had occurred at the beginning of the period presented, were as follows: Six MonthsEndedApril 30, 2004(Unaudited)Revenues
    
    $
    59,737Net loss
    
    
    (12,496
    )Basic and diluted loss per share
    
    
    (0.55
    )
 The unaudited pro forma data gives effect to actual operating results prior to the
acquisition and adjustments to reflect increased identified intangible asset amortization and the
current accounting treatment of income taxes. No effect has been given to cost reductions or
operating synergies in this presentation. The unaudited pro forma consolidated results of
operations are for comparative purposes only and do not necessarily reflect the results that would
have occurred had the acquisition occurred at the beginning of the period presented or the results
which may occur in the future. The pro forma data does not include New Media, as the effects of
this acquisition were not material on a pro forma basis. 5. Accounts Receivable The components of accounts receivable were as follows: April 30,
    
    
    October 31,2005
    
    
    2004Trade accounts receivable
    
    $
    22,306
    
    
    $
    28,396Installment accounts receivable
    
    
    9,247
    
    
    
    16,168Allowance for doubtful accounts
    
    
    (2,964
    )
    
    
    (2,712
    )$
    28,589
    
    
    $
    41,852
 The provision for doubtful accounts, included in general and administrative expense on
the consolidated statements of operations, was $369 and $481 for the three months, and $674 and
$827 for the six months ended April 30, 2005 and 2004, respectively. 10




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6. Goodwill and Identified Intangible Assets Goodwill The changes in goodwill from October 31, 2004 were as follows: Balance, October 31, 2004
    
    $
    71,267Release of shares from escrow
    
    
    541Foreign currency translation
    
    
    189Balance, April 30, 2005
    
    $
    71,997
 Goodwill was increased by $541 as a result of the release of the remaining escrow shares
relating to the NetSchools acquisition in 2002. Identified Intangible Assets Identified intangible assets subject to amortization were as follows: April 30, 2005
    
    
    October 31, 2004Gross Carrying
    
    
    Accumulated
    
    
    Net Carrying
    
    
    Gross Carrying
    
    
    Accumulated
    
    
    Net CarryingValue
    
    
    Amortzation
    
    
    Value
    
    
    Value
    
    
    Amortzation
    
    
    ValueAcquired technology
    
    $
    24,926
    
    
    $
    (7,932
    )
    
    $
    16,994
    
    
    $
    24,856
    
    
    $
    (5,882
    )
    
    $
    18,974Trademarks and
tradenames
    
    
    3,680
    
    
    
    (1,682
    )
    
    
    1,998
    
    
    
    3,680
    
    
    
    (1,328
    )
    
    
    2,352Customer relationships
and lists
    
    
    21,243
    
    
    
    (5,215
    )
    
    
    16,028
    
    
    
    21,238
    
    
    
    (3,653
    )
    
    
    17,585Noncompete agreements
    
    
    1,090
    
    
    
    (819
    )
    
    
    271
    
    
    
    1,090
    
    
    
    (569
    )
    
    
    521$
    50,939
    
    
    $
    (15,648
    )
    
    $
    35,291
    
    
    $
    50,864
    
    
    $
    (11,432
    )
    
    $
    39,432
 Amortization expense for identified intangible assets was $2,037 and $1,983 for the three
months and $4,280 and $3,763 for the six months ended April 30, 2005 and 2004, respectively, of
which $957 and $881, and $2,108 and $1,678, was included in cost of revenues related to license
fees and subscriptions for each period, respectively. The estimated future annual amortization expense for identified intangible assets is as
follows: Remainder of 2005
    
    
    
    
    
    
    3,9142006
    
    
    
    
    
    
    7,1632007
    
    
    
    
    
    
    6,9402008
    
    
    
    
    
    
    6,3412009
    
    
    
    
    
    
    5,330Thereafter
    
    
    
    
    
    
    5,603$
    35,291
 The amortization amounts presented above are estimates. Actual amortization expense may
be different due to the acquisition, impairment, or accelerated amortization of identified
intangible assets, changes in foreign currency exchange rates, and other factors. 11




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7. Debt Revolving Loan Our revolving loan agreement with Wells Fargo Bank, N.A. provides for a maximum $12,500 line
of credit through July 1, 2005. Substantially all of our assets are pledged as collateral under
the agreement. There were no borrowings outstanding at April 30, 2005 or October 31, 2004. The agreement contains restrictive financial covenants (including Minimum Tangible Net Worth,
Minimum Debt Service Coverage, Maximum Leverage, Maximum Cash Flow Leverage and Maximum Annual
Capital Expenditures) and restrictions on additional borrowings, asset sales and dividends, as
defined. All applicable covenants were satisfied as of and for the twelve-month period ended April
30, 2005, except for the Minimum Tangible Net Worth covenant. We have received a waiver from Wells
Fargo Bank, N.A. covering this noncompliance. We are currently negotiating an extension of our
revolving loan agreement. 8. Deferred Revenue The components of deferred revenue were as follows: April 30,
    
    
    October 31,2005
    
    
    2004License fees
    
    $
    3,860
    
    
    $
    5,490Subscriptions
    
    
    9,722
    
    
    
    13,473Services
    
    
    25,316
    
    
    
    32,079Other
    
    
    371
    
    
    
    533Total
    
    
    39,269
    
    
    
    51,575Less: long-term amounts
    
    
    (5,835
    )
    
    
    (8,533
    )Current portion
    
    $
    33,434
    
    
    $
    43,042
 9. Commitments and Contingencies Employment Agreements In February 2005, Michael A. Morache, was appointed President and Chief Executive Officer of
PLATO Learning, Inc., at which time we entered into an employment agreement with Mr. Morache which
provides for, among other things, annual salary, benefits, and cash bonus payments and restricted
stock and stock option grants as determined by our Board of Directors. The agreement also provides
for potential future cash payments of up to $1,600 subject to certain conditions and events. Legal Proceedings Credit Suisse First Boston and several of its clients, including Lightspan, Inc. (which we
acquired in November 2003), are defendants in a securities class action lawsuit captioned Liu, et
al. v. Credit Suisse First Boston Corp., et al. pending in the United States District Court for the
Southern District of New York. The complaint alleges that Credit Suisse First Boston, its
affiliates, and the securities issuer defendants (including Lightspan, Inc.) manipulated the price
of the issuer defendants shares in the post-initial public offering market. The securities issuer
defendants (including Lightspan, Inc.) filed a motion to dismiss the complaint in September 2004 on the grounds of multiple
pleading 12




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##### Table of Contents



deficiencies. On April 1, 2005, the complaint was dismissed with prejudice. On April 15,
2005, the plaintiff filed a motion for reconsideration. The court has not yet ruled on that
motion. 10. Restructuring and Other Charges Restructuring and other charges include primarily severance costs for headcount reductions,
committed costs of vacated facilities, and costs paid to terminated executive officers under
employment agreements. These charges are summarized as follows: Three Months
    
    
    Six MonthsEnded
    
    
    EndedApril 30, 2005
    
    
    April 30, 2005Restructuring charges:U.K. facility closure liabilities
    
    $
    313
    
    
    $
    313Severance and related benefits for U.K. headcount reduction
    
    
    22
    
    
    
    452Severance and related benefits for U.S. headcount reduction
    
    
    26
    
    
    
    299Other
    
    
    92
    
    
    
    92453
    
    
    
    1,156Other charges:Executive officer changes
    
    
    9
    
    
    
    1,595Other
    
    
    170
    
    
    
    170179
    
    
    
    1,765$
    632
    
    
    $
    2,921
 Restructuring Charges In January 2005, we initiated plans to reduce headcount by approximately 30 positions and
close certain facilities in the United Kingdom (U.K.). This restructuring is part of an ongoing
evaluation of our U.K. operations and we are continuing to explore alternatives as necessary to
improve the U.K.s impact on our profitability. Severance costs of $430 for these planned employee
terminations were recorded during the three months ended January 31, 2005. Additional severance
costs of $22 were recorded during the six months ended April 30, 2005. The majority of these
severance costs had been paid as of April 30, 2005. As part of this U.K. restructuring, facility
closing costs of $313 were recorded during the three months ended April 30, 2005 as the facilities
were vacated. Also in January 2005, we reduced headcount in the United States to reduce management layers
and improve efficiency. Six positions were eliminated and severance charges of $273 were recorded
during the three months ended January 31, 2005. One additional position was eliminated during the
three months ended April 30, 2005 and $26 of additional severance charges was recorded. All of
these costs had been paid as of April 30, 2005. 13




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##### Table of Contents



The restructuring reserve activity was as follows: U.S.
    
    
    U.K.Severance and
    
    
    Severance and
    
    
    Facilityrelated benefits
    
    
    related benefits
    
    
    closingsProvision for restructuring
    
    $
    273
    
    
    $
    430
    
    
    $
    313Adjustment to provision
    
    
    26
    
    
    
    22
    
    
    
    Cash payments
    
    
    (299
    )
    
    
    (399
    )
    
    
    $
    
    
    
    $
    53
    
    
    $
    313
 Other Charges In November 2004, we announced the resignations of John Murray, our Chairman, President and
Chief Executive Officer, and three other executive officers. The severance provisions of Mr.
Murrays employment agreement, dated January 1, 2001, provide for him to (a) be paid his current
base salary of $350 per year through December 31, 2007, (b) be paid bonus earned for the fiscal
year ended October 31, 2004 and a pro rata portion of bonus, if earned, for the fiscal year ending
October 31, 2005, and (c) be granted options to purchase 260,000 shares of common stock, with an
exercise price equal to fair market value as of the date of grant, which will vest over a
three-year period. In addition, certain options previously granted to Mr. Murray will accelerate
and be immediately exercisable under the original terms of the options. Mr. Murrays right to
receive these benefits is subject to his complying with his continuing obligations under the
employment agreement related to a transition period and the confidentiality, non-competition and
non-solicitation provisions of the employment agreement, and executing a release of claims. In
March 2005, we finalized Mr. Murrays severance arrangements and entered into an agreement to pay
him $1,000 in lieu of the stock option grant mentioned above. The $1,000 value of this agreement
was assigned to the non-compete provisions of his employment agreement and is being amortized over
its three-year period. This amortization is included in general and administrative expense on the
consolidated statements of operations. We recorded charges of $1,586 related to these executive terminations during the three months
ended January 31, 2005. Additional charges of approximately $179 were recorded during the three
months ended April 30, 2005, primarily for legal costs related to executive terminations and
contract termination costs. 11. Income Taxes At April 30, 2005 and October 31, 2004, our deferred tax assets were fully reserved. At
October 31, 2004, approximately $28,980 of the gross deferred tax asset relates to our net
operating loss carryforwards in the United States (U.S.) of approximately $72,451, which expire
in varying amounts between 2005 and 2023. Also included in our gross deferred tax asset was $2,117
for our net operating loss carryforwards of approximately $5,293 related to our foreign
subsidiaries. We have provided a full valuation allowance related to these foreign deferred income
tax assets due to the uncertainty in realization of future taxable income in these foreign
jurisdictions. Realization of our U.S. deferred tax asset is dependent on generating sufficient taxable
income in the U. S. prior to expiration of these loss carryforwards. Our merger with Lightspan in
the first quarter of fiscal 2004 impacted our assessment of the realization of deferred tax assets
because the merged company is considered one consolidated taxable entity. 14




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##### Table of Contents



As a result of the merger, we acquired approximately $290,000 of Lightspans net operating
loss carryforwards. Based on a preliminary Section 382 limitation analysis, the usage of these net
operating loss carryforwards is limited to approximately $3,200 per year and, therefore,
approximately $45,000 of the acquired net operating loss carryforwards are available to the
combined entity. These amounts are preliminary and may change as the Section 382 limitation
analysis is completed and analysis of recent announcements by the Internal Revenue Service is taken
into account. The combined net operating loss carryforwards at the acquisition date, which represent the
majority of the merged companys deferred tax assets at that date, have been reviewed for
realization primarily based upon historical results and secondarily upon projected results.
Although we expect taxable income in 2005, this expectation is highly dependent on the improvement
of operational performance. Lightspan has historically incurred significant operating losses,
which carry more weight than the projected results. Consequently our historical combined operating
results were insufficient to support the combined post-merger deferred tax assets. As a result,
net deferred tax assets, excluding the deferred tax liability relating to tax deductible goodwill,
which cannot be used to support realization of the other net deferred tax assets, were fully
reserved in the purchase accounting for the Lightspan acquisition in the first quarter of 2004
thereby increasing goodwill. Any subsequent reversal of the valuation allowance recorded on the
combined entitys pre-acquisition deferred tax assets will be recorded as a reduction of goodwill,
as opposed to recording an income tax benefit in the consolidated statement of operations. A
similar analysis and judgment has resulted in a full valuation allowance being placed on the
deferred tax assets generated subsequent to the acquisition of Lightspan. 12. Per Share Data The calculation of basic and diluted loss per share was as follows: Three Months Ended
    
    
    Six Months EndedApril 30,
    
    
    April 30,2005
    
    
    2004
    
    
    2005
    
    
    2004Net loss
    
    $
    (2,954
    )
    
    $
    (3,230
    )
    
    $
    (13,481
    )
    
    $
    (10,765
    )Basic and diluted:Weighted average common shares outstanding
    
    
    23,378
    
    
    
    22,989
    
    
    
    23,240
    
    
    
    22,236Basic and diluted loss per share
    
    $
    (0.13
    )
    
    $
    (0.14
    )
    
    $
    (0.58
    )
    
    $
    (0.48
    )
 The calculation of diluted loss per share for the three and six months ended April 30,
2005 and 2004 excluded the effect of approximately 3,457,000 and 3,502,000 potential common shares
from the conversion of outstanding options and warrants and common shares held in escrow,
respectively, as they were antidilutive. 15




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13. Comprehensive Loss Total comprehensive loss was as follows: Three Months Ended
    
    
    Six Months EndedApril 30,
    
    
    April 30,2005
    
    
    2004
    
    
    2005
    
    
    2004Net loss
    
    $
    (2,954
    )
    
    $
    (3,230
    )
    
    $
    (13,481
    )
    
    $
    (10,765
    )Unrealized gains on available for sale securities
    
    
    10
    
    
    
    
    
    
    
    52
    
    
    
    Foreign currency translation adjustments
    
    
    81
    
    
    
    (233
    )
    
    
    298
    
    
    
    4Total comprehensive loss
    
    $
    (2,863
    )
    
    $
    (3,463
    )
    
    $
    (13,131
    )
    
    $
    (10,761
    )
 14. Segment and Geographic Information We operate and manage our business as one industry segment, which is the development and
marketing of educational software and related services. We have foreign subsidiaries in Canada and
the U.K. Our foreign operations are not significant to our consolidated business. At April 30,
2005, approximately 7% of our long-term assets were located in foreign countries, and for the three
and six months ended April 30, 2005, approximately 4% of our revenues were from foreign countries. 16




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Item 2.
Managements Discussion and Analysis of Financial Condition and
Results of Operations
              (Dollars in thousands, except per share amounts) Overview We provide computer-based and e-learning instruction software and related services for
kindergarten through adult learners, offering curricula in reading, writing, math, science, social
studies, and life and job skills. We also offer online assessment and accountability solutions and
standards-based professional development services. With over 6,000 hours of objective-based,
problem-solving courseware, plus assessment, alignment, and curriculum management tools, we create
standards-based curricula that facilitate learning and school improvement. PLATO educational software is delivered via networks, CD-ROM, the Internet, and private
intranets. We market our software products and related services primarily to K-12 schools and
colleges. We also sell to job training programs, correctional institutions, military education
programs, corporations, and individuals. We are subject to risks and uncertainties including, but not limited to, dependence on
information technology spending by our customers, well-established competitors, customers dependent
on government funding, fluctuations of our quarterly results, a lengthy and variable sales cycle,
dependence on key personnel, dependence on our intellectual property rights, and rapid
technological change. As provided for in the Private Securities Litigation Reform Act of 1995, we
caution investors that these factors could cause our future results of operations to vary from
those anticipated in previously made forward-looking statements and any other forward-looking
statements made in this document and elsewhere by or on behalf of us. Critical Accounting Policies and Estimates Our discussion and analysis of financial condition and results of operations is based upon our
consolidated financial statements, which have been prepared in accordance with accounting
principles generally accepted in the United States of America. The preparation of these financial
statements requires us to make estimates and judgments that affect the reported amounts of assets,
liabilities, revenues, and expenses. We continually evaluate our critical accounting policies and
estimates, and have identified revenue recognition, the allowance for doubtful accounts,
capitalized product development costs, the valuation of our deferred income taxes, and the
valuation and impairment analysis of goodwill and identified intangible assets as the critical
accounting policies and estimates that are significant to the financial statement presentation and
that require difficult, subjective, and complex judgments. See Note 2 to Consolidated Financial Statements in our Annual Report on Form 10-K for the
fiscal year ended October 31, 2004 for additional discussion on these and other accounting policies
and disclosures required by accounting principles generally accepted in the United States of
America. Revenue Recognition Revenue recognition rules for software companies are very complex. We follow specific and
detailed guidelines in determining the proper amount of revenue to be recorded; however, certain
judgments affect the application of our revenue recognition policy. Revenue results are difficult
to predict, and any shortfall in revenue or delay in recognizing revenue could cause our operating
results to vary significantly from quarter to quarter. 17




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##### Table of Contents



The significant judgments for revenue recognition typically involve whether collectibility can
be considered probable and whether fees are fixed or determinable. In addition, our transactions
often consist of multiple element arrangements, which must be analyzed to determine the relative
fair value of each element, the amount of revenue to be recognized upon shipment, if any, and the
period and conditions under which deferred revenue should be recognized. We recognize revenue in accordance with the provisions of Statement of Position No. 97-2,
Software Revenue Recognition, as amended and modified, as well as Technical Practice Aids issued
from time to time by the American Institute of Certified Public Accountants, and Staff Accounting
Bulletin No. 104, Revenue Recognition. We license software under non-cancelable license and
subscription agreements. We also provide related professional services, including consulting,
training, tutoring, and implementation services, as well as ongoing customer support and
maintenance. Consulting, training, and implementation services are not essential to the
functionality of our software products. Accordingly, revenues from these services are recognized
separately. Revenue from the sale of courseware licenses is recognized upon meeting the following
criteria: (i) a written customer order has been executed, (ii) courseware has been delivered, (iii)
the license fee is fixed or determinable, and (iv) collectibility of the fee is probable. For software arrangements that include more than one element, we allocate the total
arrangement fee among each deliverable based on vendor-specific objective evidence (VSOE) of the
relative fair value of each deliverable. VSOE is determined using the price charged when that
element is sold separately. For software arrangements in which we do not have VSOE for undelivered
elements, revenue is deferred until the earlier of when VSOE is determined for the undelivered
elements or when all elements for which we do not have VSOE have been delivered. If collectibility of the fee is not probable, revenue is recognized as payments are received
from the customer provided all other revenue recognition criteria have been met. If the fee due
from the customer is not fixed or determinable, revenue is recognized as the payments become due
provided all other revenue recognition criteria have been met. Subscription revenue, primarily fees charged for our PLATO Web Learning Network, eduTest and
PLATO Orion products, is recognized on a ratable basis as the products are delivered over the
subscription period. Services revenue consists of software support and maintenance, which is deferred and
recognized ratably over the support period, and consulting, training, tutoring, and implementation
services, which are recognized as the services are performed. Other revenue, primarily from hardware and third-party software products, is recognized as the
products are delivered and all other revenue recognition criteria are met. Allowance for Doubtful Accounts We determine an allowance for doubtful accounts based upon an analysis of the collectibility
of specific accounts, historical experience, and the aging of the trade and installment accounts
receivable. Bad debt expense is included in general and administrative expense in our consolidated
statements of operations. The assumptions and estimates used to determine the allowance are
subject to constant revision and involve significant judgment. The primary factors that impact
these assumptions include the efficiency and effectiveness of our billing and collection functions,
our historical experience, and our 18




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credit assessment process. We believe that the current budget difficulties facing some states
will not have a significant impact on the collection of our accounts receivable. However, a change
in the underlying conditions contributing to our belief could impact our assessment of
collectibility and, therefore, require a change in the allowance for doubtful accounts and the
amount of bad debt expense. Actual collection results could differ materially from those estimated
and have a significant impact on our consolidated results of operations. Our provision for bad
debts is based on our historical experience using a detailed analysis of customer-specific activity
and receivable balances performed on a quarterly basis. Our allowance for doubtful accounts was
$2,964, or 9.4% of gross accounts receivable, at April 30, 2005, as compared to $2,712, or 6.1%, at
October 31, 2004. Capitalized Product Development Costs Our product development costs relate to the research, development, enhancement, and
maintenance of our courseware products. The amortization of capitalized product development costs
is included in cost of revenues related to license fees and subscriptions. Research and
development costs, relating principally to the design and development of new products and the
routine enhancement and maintenance of existing products, are expensed as incurred. We capitalize
product development costs when the projects under development reach technological feasibility.
Many of our new products leverage off of proven delivery platforms and are primarily content, which
has no technological hurdles. As a result, a significant portion of our product development costs
qualify for capitalization due to the concentration of our development efforts on the content of
our courseware. Capitalization ends when a product is available for general release to our
customers, at which time amortization of the capitalized costs begins. We amortize these costs
using the greater of: (a) the amount determined by the ratio of the products current revenue to
total expected future revenue, or (b) the straight-line method over the estimated useful life of
the product, which is generally three years. During all periods presented, we used the
straight-line method to amortize the capitalized costs as this method resulted in greater
amortization. The significant judgment regarding capitalization of product development costs involves the
recoverability of capitalized costs. We evaluate our capitalized costs at least annually, or more
frequently if events or changes in circumstances indicate that the asset might be impaired, to
determine if the unamortized balance related to any given product exceeds the estimated net
realizable value of that product. Estimating net realizable value requires us to estimate future
revenues and cash flows to be generated by the product and to use judgment in quantifying the
amount, if any, to be written off. Actual cash flows and amounts realized from the courseware
products could differ materially from those estimated. In addition, any future changes to our
courseware product offerings could result in write-offs of previously capitalized costs and have a
significant impact on our consolidated results of operations. Valuation of Deferred Income Taxes We account for deferred income taxes based upon differences between the financial reporting
and income tax bases of our assets and liabilities. The measurement of deferred taxes is adjusted
by a valuation allowance, if necessary, to recognize the extent to which the future tax benefits
will be recognized. At April 30, 2005 and October 31, 2004, our deferred tax assets were fully reserved. At
October 31, 2004, approximately $28,980 of the gross deferred tax asset relates to our net
operating loss carryforwards in the United States (U.S.) of approximately $72,451, which expire
in varying amounts between 2005 and 2023. Also included in our gross deferred tax asset was $2,117
for our net operating loss carryforwards of approximately $5,293 related to our foreign
subsidiaries. We have provided a full 19




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valuation allowance related to these foreign deferred income tax assets due to the uncertainty
in realization of future taxable income in these foreign jurisdictions. Realization of our U.S. deferred tax asset is dependent on generating sufficient taxable
income in the U. S. prior to expiration of these loss carryforwards. Our merger with Lightspan in
the first quarter of fiscal 2004 impacted our assessment of the realization of deferred tax assets
because the merged company is considered one consolidated taxable entity. As a result of the merger, we acquired approximately $290,000 of Lightspans net operating
loss carryforwards. Based on a preliminary Section 382 limitation analysis, the usage of these net
operating loss carryforwards is limited to approximately $3,200 per year and, therefore,
approximately $45,000 of the acquired net operating loss carryforwards are available to the
combined entity. These amounts are preliminary and may change as the Section 382 limitation
analysis is completed and analysis of recent announcements by the Internal Revenue Service is taken
into account. The combined net operating loss carryforwards at the acquisition date, which represent the
majority of the merged companys deferred tax assets at that date, have been reviewed for
realization primarily based upon historical results and secondarily upon projected results.
Although we expect taxable income in 2005, this expectation is highly dependent on the improvement
of operational performance. Lightspan has historically incurred significant operating losses,
which carry more weight than the projected results. Consequently our historical combined operating
results were insufficient to support the combined post-merger deferred tax assets. As a result,
net deferred tax assets, excluding the deferred tax liability relating to tax deductible goodwill,
which cannot be used to support realization of the other net deferred tax assets, were fully
reserved for in the purchase accounting for the Lightspan acquisition in the first quarter of 2004
thereby increasing goodwill. Any subsequent reversal of the valuation allowance recorded on the
combined entitys pre-acquisition deferred tax assets will be recorded as a reduction of goodwill,
as opposed to recording an income tax benefit in the consolidated statement of operations. A
similar analysis and judgment has resulted in a full valuation allowance being placed on the
deferred tax assets generated subsequent to the acquisition of Lightspan. Goodwill and Identified Intangible Assets We record our acquisitions in accordance with Statement of Financial Accounting Standards
(SFAS) No. 141, Business Combinations. We allocate the cost of acquired companies to the
tangible and identified intangible assets and liabilities acquired, with the remaining amount being
recorded as goodwill. Certain intangible assets, such as acquired technology, are amortized to
expense over their estimated useful lives, while in-process research and development, if any, is
recorded as a one-time charge at the acquisition date. Most of the companies we have acquired have not had significant tangible assets and, as a
result, the majority of the purchase price has typically been allocated to identified intangible
assets and/or goodwill, which increases future amortization expense of identified intangible assets
and the potential for impairment charges that we may incur. Accordingly, the allocation of the
purchase price to intangible assets may have a significant impact on our future operating results.
In addition, the allocation of the purchase price requires that we make significant assumptions and
estimates, including estimates of future cash flows expected to be generated by the acquired
assets. Should different conditions prevail, we may have to record impairment charges, which may
have a significant impact on our consolidated financial statements. 20




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We account for goodwill and other intangible assets in accordance with the provisions of SFAS
No. 142, Goodwill and Other Intangible Assets. Under SFAS No. 142, goodwill and intangible
assets with indefinite lives are not amortized to expense and must be reviewed for impairment
annually or more frequently if events or changes in circumstances indicate that the asset might be
impaired. The first step of the impairment test, used to identify potential impairment, compares
the fair value of a reporting unit with its carrying amount, including goodwill and intangible
assets with indefinite lives. We operate as one reporting unit and therefore compare our book
value to our fair value (market capitalization plus a control premium). If our fair value exceeds
our book value, our goodwill is considered not impaired, and the second step of the impairment test
is unnecessary. If our book value exceeds our fair value, the second step of the impairment test
is performed to measure the amount of impairment loss, if any. For this step the implied fair
value of the goodwill is compared with the book value of the goodwill. If the carrying amount of
the goodwill exceeds the implied fair value of the goodwill, an impairment loss would be recognized
in an amount equal to that excess. Any loss recognized cannot exceed the carrying amount of
goodwill. After an impairment loss is recognized, the adjusted carrying amount of goodwill is its
new accounting basis. Subsequent reversal of a previously recognized impairment loss is prohibited
once the measurement of that loss is completed. We completed our annual goodwill impairment
assessment as of October 31, 2004. Goodwill was not impaired and no impairment charge was
recorded. Acquisitions Our acquisition strategy is to acquire complementary products or businesses that will enable
us to achieve our strategic goals, including market leadership, growth rates that exceed the
market, and providing innovative, leading, and distinct products and services. During the three
months ended January 31, 2004, we acquired Lightspan, Inc. and New Media (Holdings) Limited. See
Note 3 to Consolidated Financial Statements in our Annual Report on Form 10-K for the fiscal year
ended October 31, 2004 for more information on these strategic acquisitions. 21




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##### Table of Contents



RESULTS OF OPERATIONS Operating Results as a Percentage of Revenue Three Months Ended
    
    
    Six Months EndedApril 30,
    
    
    April 30,2005
    
    
    2004
    
    
    2005
    
    
    2004Revenues:License fees
    
    
    45.3
    %
    
    
    53.2
    %
    
    
    44.5
    %
    
    
    51.5
    %Subscriptions
    
    
    14.4
    
    
    
    16.5
    
    
    
    15.9
    
    
    
    16.8Services
    
    
    34.7
    
    
    
    22.3
    
    
    
    33.6
    
    
    
    23.0Other
    
    
    5.6
    
    
    
    8.0
    
    
    
    6.0
    
    
    
    8.7Total revenues
    
    
    100.0
    
    
    
    100.0
    
    
    
    100.0
    
    
    
    100.0Cost of revenues:License fees
    
    
    9.1
    
    
    
    10.0
    
    
    
    11.1
    
    
    
    11.2Subscriptions
    
    
    6.8
    
    
    
    6.4
    
    
    
    7.8
    
    
    
    6.4Services
    
    
    19.5
    
    
    
    14.1
    
    
    
    21.5
    
    
    
    14.2Other
    
    
    6.3
    
    
    
    7.3
    
    
    
    6.5
    
    
    
    7.7Total cost of revenues
    
    
    41.7
    
    
    
    37.8
    
    
    
    46.9
    
    
    
    39.5Gross profit
    
    
    58.3
    
    
    
    62.2
    
    
    
    53.1
    
    
    
    60.5Operating expenses:Sales and marketing
    
    
    42.7
    
    
    
    48.9
    
    
    
    47.0
    
    
    
    52.7General and administrative
    
    
    15.4
    
    
    
    15.6
    
    
    
    15.9
    
    
    
    16.2Product development
    
    
    3.9
    
    
    
    4.1
    
    
    
    4.7
    
    
    
    6.0Amortization of intangibles
    
    
    3.4
    
    
    
    3.4
    
    
    
    3.8
    
    
    
    3.6Restructuring and other charges
    
    
    2.0
    
    
    
    
    
    
    
    5.2
    
    
    
    Total operating expenses
    
    
    67.4
    
    
    
    72.0
    
    
    
    76.6
    
    
    
    78.5Operating loss
    
    
    (9.1
    )
    
    
    (9.8
    )
    
    
    (23.5
    )
    
    
    (18.0
    )Interest income and expense and
other expense, net
    
    
    0.2
    
    
    
    0.3
    
    
    
    0.3
    
    
    
    0.2Loss before income taxes
    
    
    (8.9
    )
    
    
    (9.5
    )
    
    
    (23.2
    )
    
    
    (17.8
    )Income tax expense
    
    
    0.5
    
    
    
    0.5
    
    
    
    0.5
    
    
    
    0.5Net loss
    
    
    (9.4
    )%
    
    
    (10.0
    )%
    
    
    (23.7
    )%
    
    
    (18.3
    )%
 The following discussion of the results of operations for the six months ended April 30,
2005 compared to the same period in 2004 includes non-GAAP financial measures that present the
combined revenues and operating expenses on a pro forma basis as if Lightspan had been acquired as
of November 1, 2003. Non-GAAP financial measures should not be considered as a substitute for, or
superior to, measures of financial performance prepared in accordance with GAAP. Our management
views these non-GAAP financial measures to be helpful in assessing our progress in integrating the
operations of Lightspan. In addition, these non-GAAP financial measures facilitate internal
comparisons to our historical operating results and comparisons to competitors operating results.
We include these non-GAAP financial measures because we believe they are useful to investors in
allowing for greater transparency related to supplemental information used by our management in its
financial and operational analysis. Investors are encouraged to review the reconciliation of the
non-GAAP financial measures used herein to their most directly comparable GAAP financial measures
as provided with our consolidated financial statements. 22




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##### Table of Contents



Revenues Total Revenues Total revenues for the three months ended April 30, 2005 were $31,429, a decrease of 2.8% from
the $32,320 reported for the same period in 2004. Total revenues for the six months ended April
30, 2005 were $56,884, a decrease of 3.2% from the $58,768 reported for the same period in 2004.
Total revenues on a pro forma basis, as if Lightspan revenues prior to the acquisition had been
included, were $59,737 for the six months ended April 30, 2004. Total revenues for the three and six months ended April 30, 2005 decreased, as compared to the
same periods in 2004, primarily due to the impact of several initiatives implemented in 2005 and to
management changes. Initiatives included realignment of the sales and service organizations to
better serve the elementary market and implementation of new systems and procedures aimed at
improving the efficiencies of our sales process in the future. These changes affected all
non-service revenues, including deferred revenues. While these changes have a short-term negative
impact, we expect that they will have a positive impact in the longer term. Service revenues
continued to grow and nearly offset the decline in non-service revenue categories. We expect to
recover from the negative impact of these initiatives in the second half of the year and achieve
overall growth in total revenues for the full fiscal year 2005 over fiscal year 2004. We executed 29 orders of $100 or greater during the three months ended April 30, 2005, as
compared to 51 for the same period in 2004. This decrease can be attributed to the factors
affecting revenue mentioned above, resulting in low order volume. The average size of orders
between $100 and $249 increased from $149 to $159, while the average size of orders of $250 and
greater decreased from $629 to $506. The number and magnitude of these larger orders can have a
significant impact on our operating results. Information regarding these larger orders was as
follows: Three Months Ended April 30,2005
    
    
    2004
    
    
    % ChangeOrder Size
    
    Number
    
    
    Value
    
    
    Number
    
    
    Value
    
    
    Number
    
    
    Value$100 to $249
    
    
    19
    
    
    $
    3,021
    
    
    
    40
    
    
    $
    5,961
    
    
    
    -52.5
    %
    
    
    -49.3
    %$250 or greater
    
    
    10
    
    
    
    5,060
    
    
    
    11
    
    
    
    6,919
    
    
    
    -9.1
    %
    
    
    -26.9
    %29
    
    
    $
    8,081
    
    
    
    51
    
    
    $
    12,880
    
    
    
    -43.1
    %
    
    
    -37.3
    %
 Six Months Ended April 30,2005
    
    
    2004 (Pro Forma)
    
    
    % ChangeOrder Size
    
    Number
    
    
    Value
    
    
    Number
    
    
    Value
    
    
    Number
    
    
    Value$100 to $249
    
    
    37
    
    
    $
    5,550
    
    
    
    70
    
    
    $
    10,270
    
    
    
    -47.1
    %
    
    
    -46.0
    %$250 or greater
    
    
    21
    
    
    
    9,984
    
    
    
    25
    
    
    
    16,037
    
    
    
    -16.0
    %
    
    
    -37.7
    %58
    
    
    $
    15,534
    
    
    
    95
    
    
    $
    26,307
    
    
    
    -38.9
    %
    
    
    -41.0
    %
 License Fees License fees revenues for the three months ended April 30, 2005 were $14,233, a decrease of
17.3% from the $17,213 reported for the same period in 2004. License fees revenues for the six
months ended April 30, 2005 were $25,328, a decrease of 16.3% from the $30,272 reported for the
same period in 2004. As reported and pro forma license fees revenues were the same for the six months
ended April 30, 2004, as there were no Lightspan license fees revenues prior to
the acquisition
date during that period. 23




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##### Table of Contents



The decrease in license fees revenues for the three and six months ended April 30, 2005, as
compared to the same periods in 2004, can be attributed to the factors affecting revenue mentioned
under the caption Total Revenues above. As a percentage of total revenues, license fees revenues
decreased for the three and six months ended April 30, 2005, compared to the same periods in 2004,
primarily due to the factors affecting revenue discussed earlier. An expected change in our
revenue mix towards increased subscriptions revenues in the future could also impact our perpetual
license fees revenues. Subscriptions Subscriptions revenues for the three months ended April 30, 2005 were $4,517, a decrease of
15.2% from the $5,325 reported for the same period in 2004. Subscriptions revenues for the six
months ended April 30, 2005 were $9,050, a decrease of 8.0% from the $9,833 reported for the same
period in 2004. Subscriptions revenues on a pro forma basis, as if Lightspan revenues prior to the
acquisition had been included, were $10,364 for the six months ended April 30, 2004. The decrease in subscriptions revenues, both in dollars and as a percentage of revenues, can
be attributed to the low order volume mentioned earlier and in part to stronger sales of our client
hosted web courseware during the three and six months ended April 30, 2005. We do not believe this
is a trend, but that we will see a gradual shift away from perpetual licenses to our
subscription-based products in the future. Services Services revenues for the three months ended April 30, 2005 were $10,908, an increase of 51.6%
from the $7,197 reported for the same period in 2004. Services revenues for the six months ended
April 30, 2005 were $19,104, an increase of 41.2% from the $13,534 reported for the same period in
2004. Services revenues on a pro forma basis, as if Lightspan revenues prior to the acquisition
had been included, were $13,972 for the six months ended April 30, 2004. The increase in services revenues, both in dollars and as a percentage of revenues, were
driven by our new Supplemental Educational Services offering, and also by substantial growth in our
software support and educational consulting services revenues. Other Other revenues for the three months ended April 30, 2005 were $1,771, a decrease of 31.5% from
the $2,585 reported for the same period in 2004. Other revenues for the six months ended April 30,
2005 were $3,402, a decrease of 33.7% from the $5,129 reported for the same period in 2004. As
reported and pro forma other revenues were the same for the six months ended April 30, 2004, as
there were no Lightspan other revenues prior to the acquisition date during that period. Other revenues consist primarily of hardware and third-party courseware products. The
elementary grade products acquired from Lightspan run on PlayStationÒ game consoles, which,
along with the sale of related accessories, are a component of other revenues. The decreases in
other revenues were primarily due to a decrease in hardware sales, which tend to fluctuate from
quarter to quarter. 24




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##### Table of Contents



Backlog Our deferred revenue was $39,269 and $51,575 at April 30, 2005 and October 31, 2004,
respectively. Deferred revenue excludes amounts that we expect to earn in the future from the U.S.
Department of the Navy contract (approximately $12,300). Ultimate realization of this contract is
dependent on delivery of services and customer acceptance. In prior filings, we have discussed a
contract with the Idaho Department of Education, which was also excluded from deferred revenue. We
have received notice of that customers intent to terminate that contract. We do not expect that
this will have a significant impact on our business. In addition, at April 30, 2005, we have orders for approximately $2,952 of products and
services from multiple customers that have not met various revenue recognition criteria and for

which we are not yet able to bill customers. No assurances exist regarding when or if revenue will
be recorded or customers will be billed for these products or services. All contracts and
agreements are subject to the delivery of products and services, collection and other conditions. Cost of Revenues Total cost of revenues for the three months ended April 30, 2005 were $13,104, an increase of
7.3% from the $12,207 reported for the same period in 2004. Total cost of revenues for the six
months ended April 30, 2005 were $26,675, an increase of 15.0% from the $23,190 reported for the
same period in 2004. Total cost of revenues on a pro forma basis, as if Lightspan cost of revenues
prior to the acquisition had been included, were $23,432 for the six months ended April 30, 2004. Total cost of revenues, both in dollars and as a percentage of revenues, increased for the
three and six months ended April 30, 2005, as compared to the same periods in 2004, due to a number
of factors, including decreased license fees and subscriptions revenues (which have low variable
costs), increased services revenues (which have higher costs), and increased investments in the
service organization and realignment of those resources from sales support to billable activities
(which shifted some costs from selling expense to cost of revenues). Amortization of capitalized product development costs, a component of cost of revenues related
to license fees and subscriptions, was $1,595 and $1,714 for the three months, and $3,463 and
$3,478 for the six months ended April 30, 2005 and 2004, respectively. Capitalized development
costs were $2,335 and $2,627 for the three months, and $5,211 and $4,291 for the six months ended
April 30, 2005 and 2004, respectively. The decrease in capitalized product development costs for
the three-month period was primarily due to the completion of certain New Media projects. The
increase in capitalized product development costs for the six-month period was primarily due to
costs capitalized for Lightspan and New Media products since acquisition. 25




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##### Table of Contents



A comparison of gross profit margin by revenue category is as follows: Three Months Ended
    
    
    Six Months EndedApril 30,
    
    
    April 30,2005
    
    
    2004
    
    
    2005
    
    
    2004Revenue category
    
    As Reported
    
    
    As Reported
    
    
    As Reported
    
    
    As ReportedLicense fees
    
    
    79.8
    %
    
    
    81.2
    %
    
    
    75.1
    %
    
    
    78.3
    %Subscriptions
    
    
    52.6
    %
    
    
    61.3
    %
    
    
    50.8
    %
    
    
    62.0
    %Services
    
    
    44.0
    %
    
    
    36.5
    %
    
    
    36.0
    %
    
    
    38.4
    %Other
    
    
    -12.1
    %
    
    
    9.4
    %
    
    
    -8.3
    %
    
    
    11.5
    %Total
    
    
    58.3
    %
    
    
    62.2
    %
    
    
    53.1
    %
    
    
    60.5
    %
 The total gross profit margin on a pro forma basis, as if Lightspan gross profit prior to
the acquisition had been included, was 60.8% for the six months ended April 30, 2004. The decreases in total gross profit margin resulted primarily from the higher proportion of
services revenues included in our product sales mix in 2005, which carry lower margins, and the
cost of revenues factors discussed earlier. Future gross profit margin will be dependent primarily
on the amount of revenue, our revenue mix, the amount of professional development expenses required
to provide our services, and the amortization of capitalized product development costs and acquired
technology included in cost of revenues. Gross profit margin is expected to be lower for fiscal
year 2005, compared to fiscal year 2004, as a result of these factors. Operating Expenses Sales and Marketing Total sales and marketing expenses for the three months ended April 30, 2005 were $13,410, a
decrease of 15.1% from the $15,793 reported for the same period in 2004. Total sales and marketing
expenses for the six months ended April 30, 2005 were $26,736, a decrease of 13.7% from the $30,978
reported for the same period in 2004. Total sales and marketing expenses on a pro forma basis, as
if Lightspan expenses prior to the acquisition had been included, were $32,260 for the six months
ended April 30, 2004. Sales and marketing expenses, both in dollars and as a percentage of revenues, decreased for
the three and six months ended April 30, 2005, as compared to the same periods in 2004, due
primarily to cost reduction activities initiated in 2004 and 2005, realignment of our service
resources from sales support to billable activities (which shifted some costs from selling expense
to cost of revenues), and decreased commissions resulting from the decrease in revenues. Our
ability to continue to leverage our cost structure and improve profitability is primarily dependent
on our ability to generate higher revenues and realize sales and marketing productivity
improvements. For the full fiscal year 2005, sales and marketing expenses are expected to be below
fiscal year 2004 amounts. General and Administrative Total general and administrative expenses for the three months ended April 30, 2005 were
$4,842, a decrease of 3.9% from the $5,040 reported for the same period in 2004. Total general and
administrative expenses for the six months ended April 30, 2005 were $9,052, a decrease of 5.0%
from the $9,532 reported for the same period in 2004. Total general and administrative expenses on a
pro forma basis, as if Lightspan expenses prior to the acquisition had been
included, were $9,842
for the six months ended April 30, 2004. 26




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##### Table of Contents



General and administrative expenses, both in dollars and as a percentage of revenues,
decreased for the three and six months ended April 30, 2005, as compared to the same periods in
2004, due primarily to the achievement of cost reduction activities initiated in 2004 and 2005,
somewhat offset by increased professional fees for Sarbanes-Oxley compliance and process
improvements. For the full fiscal year 2005, general and administrative expenses are expected to
be below fiscal year 2004 amounts. Product Development The majority of our product development costs are required to be capitalized. Product
development expense does not reflect these capitalized costs, as they are amortized through cost of
revenues. Accordingly, our product development expense, as a percentage of revenue, does not
reflect our total level of development activity. Total product development expenses for the three months ended April 30, 2005 were $1,222, a
decrease of 9.2% from the $1,346 reported for the same period in 2004. Total product development
expenses for the six months ended April 30, 2005 were $2,693, a decrease of 24.1% from the $3,549
reported for the same period in 2004. Total product development expenses on a pro forma basis, as
if Lightspan expenses prior to the acquisition had been included, were $3,876 for the six months
ended April 30, 2004. Product development expenses, both in dollars and as a percentage of revenues, decreased for
the three and six months ended April 30, 2005, as compared to the same periods in 2004, due
primarily to a shift in spending toward more capitalized projects compared to the same periods in
2004. Product development spending, before capitalization and amortization, was 11.3% and 12.3% of
total revenues for the three months, and 13.9% and 13.3% for the six months ended April 30, 2005
and 2004, respectively. As part of our growth strategy, we intend to continually introduce new
products and product improvements. For the full fiscal year 2005, product development spending is
expected to be above fiscal year 2004 amounts, while product development expenses are expected to
be below fiscal year 2004 amounts. Amortization of Intangibles Expense for the three and six months ended April 30, 2005 and 2004 represented the
amortization of identified intangible assets, other than acquired technology, from our
acquisitions. Acquired technology intangible assets are amortized through cost of revenues. See
Note 6 to Consolidated Financial Statements for additional information on goodwill and identified
intangible assets. Restructuring and Other Charges Restructuring and other charges include primarily severance costs for headcount reductions,
committed costs of vacated facilities, and costs paid to terminated executive officers under
employment agreements. These charges are summarized as follows: 27




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##### Table of Contents



Three Months
    
    
    Six MonthsEnded
    
    
    EndedApril 30, 2005
    
    
    April 30, 2005Restructuring charges:U.K. facility closure liabilities
    
    $
    313
    
    
    $
    313Severance and related benefits
for U.K. headcount reduction
    
    
    22
    
    
    
    452Severance and related benefits
for U.S. headcount reduction
    
    
    26
    
    
    
    299Other
    
    
    92
    
    
    
    92453
    
    
    
    1,156Other charges:Executive officer changes
    
    
    9
    
    
    
    1,595Other
    
    
    170
    
    
    
    170179
    
    
    
    1,765$
    632
    
    
    $
    2,921
 In January 2005, we initiated plans to reduce headcount by approximately 30 positions and
close certain facilities in the United Kingdom (U.K.). This restructuring is part of an ongoing
evaluation of our U.K. operations and we are continuing to explore alternatives as necessary to
improve the U.K.s impact on our profitability. Severance costs of $430 for these planned employee
terminations were recorded during the three months ended January 31, 2005. Additional severance
costs of $22 were recorded during the six months ended April 30, 2005. The majority of these
severance costs had been paid as of April 30, 2005. As part of this U.K. restructuring, facility
closing costs of $313 were recorded during the three months ended April 30, 2005 as the facilities
were vacated. Also in January 2005, we reduced headcount in the United States to reduce management layers
and improve efficiency. Six positions were eliminated and severance charges of $273 were recorded
during the three months ended January 31, 2005. One additional position was eliminated during the
three months ended April 30, 2005 and $26 of additional severance charges was recorded. All of
these costs had been paid as of April 30, 2005. The restructuring reserve activity was as follows: U.S.
    
    
    U.K.Severance and
    
    
    Severance and
    
    
    Facilityrelated benefits
    
    
    related benefits
    
    
    closingsProvision for restructuring
    
    $
    273
    
    
    $
    430
    
    
    $
    313Adjustment to provision
    
    
    26
    
    
    
    22
    
    
    
    Cash payments
    
    
    (299
    )
    
    
    (399
    )
    
    
    $
    
    
    
    $
    53
    
    
    $
    313
 In November 2004, we announced the resignations of John Murray, our Chairman, President
and Chief Executive Officer, and three other executive officers. The severance provisions of Mr.
Murrays employment agreement, dated January 1, 2001, provide for him to (a) be paid his current
base salary of $350 per year through December 31, 2007, (b) be paid bonus earned for the fiscal
year ended October 31, 2004 and a pro rata portion of bonus, if earned, for the fiscal year ending October 31, 2005,
and (c) be granted options to purchase 260,000 shares of common stock, with an exercise price equal
to fair market value as of the date of grant, which will vest over a three-year period. In
addition, certain options previously granted to Mr. Murray will accelerate and be immediately
exercisable under the original terms 28




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##### Table of Contents



of the options. Mr. Murrays right to receive these benefits
is subject to his complying with his continuing obligations under the employment agreement related
to a transition period and the confidentiality, non-competition and non-solicitation provisions of
the employment agreement, and executing a release of claims. In March 2005, we finalized Mr.
Murrays severance arrangements and entered into an agreement to pay him $1,000 in lieu of the
stock option grant mentioned above. The $1,000 value of this agreement was assigned to the
non-compete provisions of his employment agreement and is being amortized over its three-year
period. This amortization is included in general and administrative expense on the consolidated
statements of operations. We recorded charges of $1,586 related to these executive terminations during the three months
ended January 31, 2005. Additional charges of approximately $179 were recorded during the three
months ended April 30, 2005, primarily for legal costs related to executive terminations and
contract termination costs. We are continuing to review our business operations and strategy, and may implement changes to
improve our focus and efficiency in the future. As a result, additional restructuring and other
charges may be incurred. Income Taxes As discussed under the caption Critical Accounting Policies and Estimates, as a result of
the Lightspan acquisition, the net deferred tax assets as of the acquisition date, excluding the
deferred tax liability relating to tax deductible goodwill (which cannot be used to support
realization of the other net deferred tax assets), were fully reserved for in purchase accounting,
thereby increasing goodwill, in the first quarter of 2004. Any future reductions of the valuation
allowance recorded on the combined entitys pre-acquisition deferred tax assets will be recorded as
a reduction to goodwill, as opposed to recording an income tax benefit in the consolidated
statement of operations. Income tax expense for future periods, however, will be impacted by any
reductions in the valuation allowance related to post-acquisition deferred tax assets, for which we
have also recorded a full valuation allowance at April 30, 2005 and October 31, 2004. Our historical effective income tax rate has been highly volatile due to the mix between our
U.S. operating results, for which we record income taxes, and our foreign operating results, for
which we do not record an income tax benefit due to the uncertainty of realizing these tax benefits
in future years in our foreign jurisdictions. Our effective income tax rate for future quarters
and fiscal years is dependent on the level of profitability in each of the U.S. and our foreign
subsidiaries. In addition, even if there is a loss in the U.S., we expect income tax expense of
approximately $600 per year, or $150 per quarter, related to amortization of goodwill that is
deductible for tax purposes but not for book purposes. As goodwill from the NetSchools acquisition
is amortized for tax purposes, the book basis of the goodwill will further exceed the tax basis,
resulting in increases to the related deferred tax liability, which cannot be used to support
realization of the other net deferred tax assets. We currently expect a consolidated income tax
rate of about 45% for the full year 2005. The extent of any variance from this expectation is
highly dependent on our operating results in each of our U.S. and foreign subsidiaries. A larger
than expected foreign loss, or lower than expected U.S. profit, will likely result in a higher
consolidated effective tax rate. Conversely, if our foreign or U.S. subsidiaries are more
profitable than planned, our consolidated effective tax rate could decline. 29




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##### Table of Contents



FINANCIAL CONDITION Liquidity and Capital Resources At April 30, 2005, our principal sources of liquidity included cash and cash equivalents of
$25,534, marketable securities of $5,982, net accounts receivable of $28,589, and our unused line
of credit of $12,500. Working capital was $21,817 and $29,769 at April 30, 2005 and October 31,
2004, respectively. The decrease in working capital was primarily due to the decrease in cash, cash equivalents,
and marketable securities of $10,334 and the decrease in net accounts receivable of $13,263, offset
by the decreases in accounts payable, accrued salaries and benefits, and accrued liabilities of
$5,825, and deferred revenue of $9,608. Accounts receivable decreased due to low order volume in
the first half of 2005, collection of amounts outstanding at year end, and improvements in our
collection process. Accounts payable and accrued salaries and benefits decreased due to payment of
amounts accrued at year end, including year end commissions and bonuses. Deferred revenue, which
is satisfied through delivery of products and services rather than cash, decreased as more of these
products and services were delivered than were added through new business, due to lower order
volume, which was partially the result of the seasonality of orders. During the six months ended April 30, 2005, cash and cash equivalents decreased $3,701. Cash
used in operations, excluding changes in our asset and liability accounts, was $29. The cash used
by changes in our asset and liability accounts of $9,567, was partially offset by the cash provided
by investing activities of $3,707, and the cash provided by financing activities of $1,798.
Depreciation and amortization was $9,486 for the six months ended April 30, 2005, an increase of
$408 compared to the same period in 2004, due primarily to increased amortization of identified
intangible assets. During the six months ended April 30, 2004, cash and cash equivalents decreased $5,892. Cash
used in operations, excluding changes in our asset and liability accounts, of $342, the cash used
by changes in our asset and liability accounts of $3,878, and the cash used in our investing
activities of $2,860, was slightly offset by the cash provided by our financing activities of
$1,216. Net cash provided by our investing activities was $3,707 for the six months ended April 30,
2005, as compared to net cash used of $2,860 for the same period in 2004. During the six months
ended April 30, 2005, as compared to the same period in 2004, we increased our capitalization of
product development costs by $920, increased our purchases of marketable securities by $8,979, and
increased our sales and maturities of marketable securities by $19,189. Capitalization of product
development costs increased primarily due to devoting substantial resources to develop courseware
related to the Lightspan and New Media acquisitions. We also had net cash provided from the
Lightspan and New Media acquisitions of $2,460 for the six months ended April 30, 2004. Net cash provided by our financing activities, principally from the exercise of stock options,
was $1,798 and $1,216 for the six months ended April 30, 2005 and 2004, respectively. Our Board of Directors approved a stock repurchase plan in December 2001, which authorizes us
to repurchase up to $15,000 of our common stock in the open market and in privately negotiated
transactions. The plan has no set termination date and the timing of any repurchases will be
dependent on prevailing market conditions and alternative uses of capital. We did not repurchase
any shares of our common stock during the six months ended April 30, 2005. Cumulatively, we have
repurchased 30




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##### Table of Contents



approximately 1,465,000 shares for an aggregate cost of approximately $13,700 under the
repurchase plan and approximately $1,300 remains available for future repurchases, if any. We have resources available under our revolving loan agreement with Wells Fargo Bank, N.A. to
provide borrowings up to $12,500, through July 1, 2005, as determined by the available borrowing
base. At April 30, 2005, there were no borrowings outstanding and our unused borrowing capacity
was $12,500. The agreement contains restrictive financial covenants (including Minimum Tangible
Net Worth, Minimum Debt Service Coverage, Maximum Leverage, Maximum Cash Flow Leverage and Maximum
Annual Capital Expenditures) and restrictions on additional borrowings, asset sales and dividends,
as defined. All applicable covenants were satisfied as of and for the twelve-month period ended
April 30, 2005, except for the Minimum Tangible Net Worth covenant. We have received a waiver from
Wells Fargo Bank, N.A. covering this noncompliance. We are currently negotiating an extension of
our revolving loan agreement. From time to time, we evaluate potential acquisitions of products or businesses that
complement our core business. We may consider and acquire other complementary businesses,
products, or technologies in the future. We maintain adequate cash balances and credit facilities to meet our anticipated working
capital, capital expenditure, and business investment requirements for at least the next twelve
months. Disclosures about Off-Balance Sheet Arrangements We do not have any off-balance sheet arrangements as of April 30, 2005. Disclosures about Contractual Obligations and Commercial Commitments Our contractual obligations and commercial commitments consist primarily of future minimum
payments due under operating leases, royalty agreements, and capital lease obligations. In
addition, any future borrowings under our revolving loan agreement would require future use of
cash. A table showing our contractual obligations was provided in Item 7 of our Annual Report on
Form 10-K for the year ended October 31, 2004. There were no significant changes to our
contractual obligations during the three months ended April 30, 2005. At April 30, 2005, we had no significant commitments for capital expenditures. With the acquisition of New Media in 2004, there is additional guaranteed deferred
consideration of approximately $450 due over the period from the acquisition date through December
2006 based on New Media revenues. As of April 30, 2005, no payments of this additional
consideration have been required. Interest Rate Risk Our borrowing capacity primarily consists of a revolving loan with interest rates that
fluctuate based upon the Prime Rate and LIBOR market indexes. At April 30, 2005, we did not have
any outstanding borrowings under this revolving credit facility. Our only debt consisted of
capital lease obligations at fixed interest rates. As a result, risk relating to interest
fluctuation is considered minimal. 31




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Foreign Currency Exchange Rate Risk We market our products and services worldwide and have operations in Canada and the U.K. As a
result, financial results and cash flows could be affected by changes in foreign currency exchange
rates or weak economic conditions in foreign markets. Working funds necessary to facilitate the
short-term operations of our foreign subsidiaries are kept in local currencies in which they do
business. Any gains or losses from foreign currency transactions are included in the consolidated
statements of operations. Our foreign subsidiaries are not a significant component of our
business, and, as a result, risk relating to foreign currency fluctuation is considered minimal. New Accounting Pronouncements In December 2004, the Financial Accounting Standards Board issued SFAS No. 123(R),
Share-Based Payment (SFAS 123(R)). SFAS 123(R) establishes standards for accounting for
transactions in which an entity exchanges its equity instruments for goods or services. SFAS
123(R) focuses primarily on accounting for transactions in which an entity obtains employee
services in share-based payment transactions. SFAS 123(R) requires that the fair value of such
equity instruments be recognized as expense in the financial statements as services are performed.
Prior to SFAS 123(R), only the pro forma disclosures of fair value presented above were required.
In March 2005, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin No.
107, TOPIC 14: Share-Based payment which addresses the interaction between SFAS 123(R) and
certain SEC rules and regulations and provides views regarding the valuation of share-based payment
arrangements for public companies. SFAS 123(R) is
effective for our first quarter of 2006 and the adoption of this new accounting pronouncement is
expected to have a material impact on our consolidated financial statements. 32




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Item 3. Quantitative and Qualitative Disclosures About Market Risk See the information set forth under the captions, Interest Rate Risk and Foreign Currency
Exchange Rate Risk in Managements Discussion and Analysis of Financial Condition and Results of
Operations. 
 Item 4. Controls and Procedures Evaluation of Disclosure Controls and Procedures.As of April 30, 2005, our Chief Executive
Officer and Chief Financial Officer have conducted an evaluation of the effectiveness of our
disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange
Act) as of the end of the period covered by this report. Based on that evaluation, our Chief
Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures
are ineffective at a reasonable assurance level as of April 30, 2005 to make known to them in a
timely fashion material information related to the Company required to be filed in this report due
to the material weakness described below. A material weakness is a control deficiency, or combination of control deficiencies, that
results in a more than remote likelihood that a material misstatement of the annual or interim
financial statements will not be prevented or detected. As of April 30, 2005, the Company did not
maintain effective controls over the accounting for pro forma stock-based compensation expense
required to be disclosed under SFAS No. 123. Specifically, the Company did not maintain effective
controls to ensure the appropriate pro forma accounting treatment of stock option forfeitures and
recognition of related tax benefits. This control deficiency will result in the restatement of the
Companys annual consolidated financial statements for each of the three years in the period ended
October 31, 2004, and the interim consolidated financial statements during fiscal years 2003 and
2004, and for the quarter ended January 31, 2005. Additionally, this control deficiency could
result in a material misstatement to disclosures in annual or interim financial statements that
would not be prevented or detected. Accordingly, management determined that this control
deficiency constitutes a material weakness. Because of this material weakness, we have concluded
that the Company did not maintain effective internal control over financial reporting as of April
30, 2005, based on criteria in Internal Control-Integrated Framework. Subsequent to April 30, 2005, the Company has implemented additional processing and review
procedures to ensure the proper accounting for pro forma stock-based compensation expense. The
Company also plans to implement a software package that will assist them with more effective
tracking of employee stock option activity and the calculations of stock-based compensation. By
implementing these internal control improvements, the Company expects to remediate this material
weakness before October 31, 2005, which is the Companys required compliance date under the Act. All internal control systems, no matter how well designed, have inherent limitations.
Therefore, even those systems determined to be effective can provide only reasonable assurance with
respect to financial statement preparation and presentation. We will continue to improve the
design and effectiveness of our disclosure controls and procedures to the extent necessary in the
future to provide our senior management with timely access to such material information, and to
correct any deficiencies that we may discover in the future. Changes in Internal Control Over Financial Reporting.There were no changes in our internal
control over financial reporting that occurred during our most recent fiscal quarter that have
materially affected, or are reasonably likely to materially affect, our internal controls over
financial reporting. 33




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PART II. 
 Item 1.Legal Proceedings Credit Suisse First Boston and several of its clients, including
Lightspan, Inc. (which we acquired in November 2003), are
defendants in a securities class action lawsuit captioned Liu, et
al. v. Credit Suisse First Boston Corp., et al. pending in the
United States District Court for the Southern District of New
York. The complaint alleges that Credit Suisse First Boston, its
affiliates, and the securities issuer defendants (including
Lightspan, Inc.) manipulated the price of the issuer defendants
 shares in the post-initial public offering market. The securities
issuer defendants (including Lightspan, Inc.) filed a motion to
dismiss the complaint in September 2004 on the grounds of multiple
pleading deficiencies. On April 1, 2005, the complaint was
dismissed with prejudice. On April 15, 2005, the plaintiff filed
a motion for reconsideration. The court has not yet ruled on that
motion. 
 Item 2.Unregistered Sales of Equity Securities and Use of Proceeds Not Applicable. 
 Item 3.Defaults Upon Senior Securities Not Applicable. 
 Item 4.Submission of Matters to a Vote of Security Holders Our Annual Meeting of Stockholders was held on March 3, 2005. There were 23,145,986
shares of our common stock entitled to vote at the meeting and a total of 22,016,272
shares (95.1%) were represented. Voting was as follows:  1.
    Election of Director Joseph E. Duffy: For 21,747,445 and Withhold
268,827.2.
    Election of Director Thomas G. Hudson: For 18,345,154 and Withhold
2,671,118.3.
    Ratification of appointment of PricewaterhouseCoopers LLP as our
independent registered public accounting firm for the fiscal year ending October
31, 2005: For 21,667,551, Against 284,533, Abstain 64,188, and Broker Non-Vote 0. 
 Item 5.Other Information On June 30, 2004, we were notified by PricewaterhouseCoopers LLP (PwC) that its global
captive insurer made an investment in our common stock in mid-October 2003. PwC became
aware of the investment in June 2004, at which time its investment position was
liquidated. As a result, PwC was not independent when it issued its opinion with
respect to our consolidated financial statements as of, and for the year ended, October
31, 2003. The Audit Committee of the Company has reviewed this matter in detail. The Audit
Committee has considered the circumstances and effect of the loss of independence with
respect to the audit of the fiscal year 2003 financial statements, the costs and other
effects of engaging new independent auditors to re-audit the fiscal 2003 financial
statements, and the fact that the Company is not aware of any impact on its fiscal 2003
financial statements from this lack of independence. The Audit Committee consulted with
the outside legal counsel of the Company and the staff of the Securities and Exchange
Commission in reaching its decision to not re-audit the fiscal 2003 financial
statements and to continue the
engagement of PwC as its independent auditors. 34




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Item 6.Exhibits Exhibit Number and Description  31.01
    Certification of Chief Executive Officer under Rule 13a-14(a) adopted
pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.31.02
    Certification of Chief Financial Officer under Rule 13a-14(a) adopted
pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.32.01
    Certification of Chief Executive Officer under 18 U.S.C. 1350 pursuant
to Section 906 of the Sarbanes-Oxley Act of 2002.32.02
    Certification of Chief Financial Officer under 18 U.S.C. 1350 pursuant
to Section 906 of the Sarbanes-Oxley Act of 2002. 35




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SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused
this report to be signed on its behalf by the undersigned thereunto duly authorized. PLATO LEARNING, INC.
    By
    /s/     MICHAEL A. MORACHEJune 9, 2005
    
    Michael A. MorachePresident and Chief Executive Officer
(principal executive officer) /s/     LAURENCE L. BETTERLEYLaurence L. BetterleySenior Vice President and Chief Financial Officer
(principal financial and accounting officer) 36