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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 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 July 31, 2004 Commission File Number 0-20842 PLATO LEARNING, INC. 
  Delaware
    
    36-3660532(State or other jurisdiction
    
    (I.R.S. Employerof incorporation or organization)
    
    Identification Number)
 10801 Nesbitt Avenue South, Bloomington, MN
    
    55437(Address of principal executive offices)
    
    (Zip Code)
 Registrants telephone number, including area code: (952)832-1000 Not Applicable 
   Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days:  Yes [X]  No [  ] Indicate by check mark whether the Registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act:  Yes [X]  No [  ] Indicate the number of shares outstanding of each of the issuers classes of
common stock, as of the latest practicable date. Common stock, $.01 par value
    
    23,044,846 sharesClass
    
    Outstanding as of August 31, 2004
 1




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PLATO Learning, Inc.
Form 10-Q INDEX PageNumberPART I. FINANCIAL INFORMATIONItem 1. Consolidated Financial Statements (Unaudited):Consolidated Statements of Operations for the
Three and Nine Months Ended July 31, 2004 and 2003
    
    
    3Consolidated Balance Sheets as of
July 31, 2004 and October 31, 2003
    
    
    4Consolidated Statements of Cash Flows for the
Nine Months Ended July 31, 2004 and 2003
    
    
    5Notes to Consolidated Financial Statements
    
    
    6Item 2. Managements Discussion and Analysis of
Results of Operations and Financial Condition
    
    
    17Item 3. Quantitative and Qualitative Disclosures About Market Risk
    
    
    38Item 4. Controls and Procedures
    
    
    38PART II. OTHER INFORMATIONItem 1. Legal Proceedings
    
    
    39Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of
Equity Securities
    
    
    39Item 3. Defaults Upon Senior Securities
    
    
    39Item 4. Submission of Matters to a Vote of Security Holders
    
    
    39Item 5. Other Information
    
    
    39Item 6. Exhibits and Reports on Form 8-K
    
    
    40SIGNATURES
    
    
    41Form of Stock Option AgreementsCertification 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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PLATO Learning, Inc. and Subsidiaries 
 Consolidated Statements of Operations
 (Unaudited, in thousands, except per share amounts)
 Three Months Ended
    
    Nine Months EndedJuly 31,
    
    July 31,2004
    
    2003
    
    2004
    
    2003Revenues:License fees
    
    $
    25,421
    
    
    $
    16,300
    
    
    $
    55,693
    
    
    $
    33,497Subscriptions
    
    
    5,812
    
    
    
    1,806
    
    
    
    15,645
    
    
    
    5,197Services
    
    
    7,403
    
    
    
    3,918
    
    
    
    20,937
    
    
    
    11,597Other
    
    
    1,977
    
    
    
    1,769
    
    
    
    7,106
    
    
    
    4,426Total revenues
    
    
    40,613
    
    
    
    23,793
    
    
    
    99,381
    
    
    
    54,717Cost of revenues:License fees
    
    
    3,378
    
    
    
    2,124
    
    
    
    9,953
    
    
    
    5,798Subscriptions
    
    
    1,782
    
    
    
    1,204
    
    
    
    5,522
    
    
    
    2,559Services
    
    
    4,193
    
    
    
    2,646
    
    
    
    12,527
    
    
    
    8,024Other
    
    
    2,157
    
    
    
    1,649
    
    
    
    6,698
    
    
    
    3,951Total cost of revenues
    
    
    11,510
    
    
    
    7,623
    
    
    
    34,700
    
    
    
    20,332Gross profit
    
    
    29,103
    
    
    
    16,170
    
    
    
    64,681
    
    
    
    34,385Operating expenses:Sales and marketing
    
    
    14,897
    
    
    
    10,079
    
    
    
    45,875
    
    
    
    29,263General and administrative
    
    
    4,915
    
    
    
    3,200
    
    
    
    14,447
    
    
    
    9,511Product development
    
    
    1,293
    
    
    
    472
    
    
    
    4,842
    
    
    
    1,660Amortization of intangibles
    
    
    1,112
    
    
    
    147
    
    
    
    3,197
    
    
    
    441Restructuring charges
    
    
    
    
    
    
    422
    
    
    
    
    
    
    
    802Total operating expenses
    
    
    22,217
    
    
    
    14,320
    
    
    
    68,361
    
    
    
    41,677Operating income (loss)
    
    
    6,886
    
    
    
    1,850
    
    
    
    (3,680
    )
    
    
    (7,292
    )Interest income
    
    
    41
    
    
    
    83
    
    
    
    298
    
    
    
    295Interest expense
    
    
    (28
    )
    
    
    (34
    )
    
    
    (100
    )
    
    
    (88
    )Other expense, net
    
    
    (25
    )
    
    
    (14
    )
    
    
    (109
    )
    
    
    (43
    )Earnings (loss) before income taxes
    
    
    6,874
    
    
    
    1,885
    
    
    
    (3,591
    )
    
    
    (7,128
    )Income tax expense (benefit)
    
    
    150
    
    
    
    1,600
    
    
    
    450
    
    
    
    (2,185
    )Net earnings (loss)
    
    $
    6,724
    
    
    $
    285
    
    
    $
    (4,041
    )
    
    $
    (4,943
    )Earnings (loss) per share:Basic and diluted
    
    $
    0.29
    
    
    $
    0.02
    
    
    $
    (0.18
    )
    
    $
    (0.30
    )Weighted average common shares outstanding:Basic
    
    
    23,012
    
    
    
    16,363
    
    
    
    22,497
    
    
    
    16,558Diluted
    
    
    23,556
    
    
    
    16,420
    
    
    
    22,497
    
    
    
    16,558
 See Notes to Consolidated Financial Statements 3




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PLATO Learning, Inc. and Subsidiaries 
 Consolidated Balance Sheets
 (In thousands, except per share amounts)
 July 31,
    
    October 31,2004
    
    2003(Unaudited)
    
    (See Note)AssetsCurrent assets:Cash and cash equivalents
    
    $
    27,011
    
    
    $
    23,834Accounts receivable, net
    
    
    46,831
    
    
    
    39,176Prepaid expenses and other current assets
    
    
    9,389
    
    
    
    4,819Deferred income taxes
    
    
    
    
    
    
    2,218Total current assets
    
    
    83,231
    
    
    
    70,047Long-term marketable securities
    
    
    3,993
    
    
    
    3,862Equipment and leasehold improvements, net of accumulated
depreciation and amortization of $9,542 and $7,536, respectively
    
    
    6,899
    
    
    
    5,024Product development costs, net of accumulated
amortization of $17,045 and $11,838, respectively
    
    
    16,481
    
    
    
    14,738Goodwill
    
    
    67,743
    
    
    
    39,609Identified intangible assets, net
    
    
    41,369
    
    
    
    14,707Other assets
    
    
    1,617
    
    
    
    1,975Total assets
    
    $
    221,333
    
    
    $
    149,962Liabilities and Stockholders EquityCurrent liabilities:Accounts payable
    
    $
    3,794
    
    
    $
    2,876Accrued employee salaries and benefits
    
    
    9,934
    
    
    
    6,678Accrued liabilities
    
    
    6,173
    
    
    
    3,600Deferred revenue
    
    
    35,607
    
    
    
    22,192Total current liabilities
    
    
    55,508
    
    
    
    35,346Deferred revenue
    
    
    7,337
    
    
    
    4,372Deferred income taxes
    
    
    1,163
    
    
    
    Other liabilities
    
    
    141
    
    
    
    312Total liabilities
    
    
    64,149
    
    
    
    40,030Stockholders equity:Common stock, $.01 par value, 50,000 shares authorized;
23,065 shares issued and 23,045 outstanding at July 31,
2004; 17,671 shares issued and 16,370 shares outstanding
at October 31, 2003
    
    
    230
    
    
    
    164Additional paid in capital
    
    
    162,828
    
    
    
    123,135Treasury stock at cost, 20 and 1,301 shares, respectively
    
    
    (205
    )
    
    
    (11,652
    )Accumulated deficit
    
    
    (5,063
    )
    
    
    (1,022
    )Accumulated other comprehensive loss
    
    
    (606
    )
    
    
    (693
    )Total stockholders equity
    
    
    157,184
    
    
    
    109,932Total liabilities and stockholders equity
    
    $
    221,333
    
    
    $
    149,962
 Note: The balance sheet at October 31, 2003 has been derived from our audited
financial statements at that date. See Notes to Consolidated Financial Statements. 4




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PLATO Learning, Inc. and Subsidiaries 
 Consolidated Statements of Cash Flows
 (Unaudited, in thousands)
 Nine Months EndedJuly 31,2004
    
    2003Operating activities:Net loss
    
    $
    (4,041
    )
    
    $
    (4,943
    )Adjustments to reconcile net loss to net cash
provided by operating activities:Deferred income taxes
    
    
    450
    
    
    
    (2,185
    )Amortization of capitalized product development costs
    
    
    5,160
    
    
    
    4,202Amortization of identified intangible assets
    
    
    5,706
    
    
    
    1,495Depreciation and amortization of equipment and
leasehold improvements
    
    
    2,600
    
    
    
    1,635Provision for doubtful accounts
    
    
    1,522
    
    
    
    1,607Stock-based compensation
    
    
    217
    
    
    
    Loss on disposal of equipment
    
    
    79
    
    
    
    59Changes in assets and liabilities, net of effects of acquisitions:Accounts receivable
    
    
    (357
    )
    
    
    (2,220
    )Prepaid expenses and other current and noncurrent assets
    
    
    (2,184
    )
    
    
    395Accounts payable
    
    
    (1,566
    )
    
    
    1,339Accrued liabilities, accrued employee salaries and
benefits and other liabilities
    
    
    (3,210
    )
    
    
    (1,484
    )Deferred revenue
    
    
    3,789
    
    
    
    5,350Total adjustments
    
    
    12,206
    
    
    
    10,193Net cash provided by operating activities
    
    
    8,165
    
    
    
    5,250Investing activities:Acquisitions, net of cash acquired
    
    
    2,460
    
    
    
    Capitalization of product development costs
    
    
    (6,830
    )
    
    
    (4,893
    )Capital expenditures
    
    
    (1,880
    )
    
    
    (1,542
    )Purchases of marketable securities
    
    
    (387
    )
    
    
    Sales of marketable securities
    
    
    256
    
    
    
    Net cash used in investing activities
    
    
    (6,381
    )
    
    
    (6,435
    )Financing activities:Repurchase of common stock
    
    
    (205
    )
    
    
    (2,161
    )Net proceeds from issuance of common stock
    
    
    1,812
    
    
    
    51Repayments of capital lease obligations
    
    
    (54
    )
    
    
    (196
    )Net cash provided by (used in) financing activities
    
    
    1,553
    
    
    
    (2,306
    )Effect of foreign currency on cash
    
    
    (160
    )
    
    
    17Net increase (decrease) in cash and cash equivalents
    
    
    3,177
    
    
    
    (3,474
    )Cash and cash equivalents at beginning of period
    
    
    23,834
    
    
    
    30,390Cash and cash equivalents at end of period
    
    $
    27,011
    
    
    $
    26,916
 See Notes to Consolidated Financial Statements 5




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PLATO Learning, Inc. and Subsidiaries 
 Notes to Consolidated Financial Statements
   1.
    
    Business We enhance the learning process by providing computer-based and e-learning
instruction software for kindergarten through adult learners, offering
curricula in reading, writing, mathematics, science, social studies and life
and job skills. We also offer innovative 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 courseware is delivered
via networks, CD-ROM, private intranets and the Internet. In addition, single
topic PLATO courseware is available through our e-commerce web site and
distributors. We market our courseware products and 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, rapid technological change and our ability to integrate
acquisitions.  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 adjustments, and other
adjustments specifically relating to goodwill as discussed in Note 6,
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, 2003. 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. Certain reclassifications of previously reported amounts have been made to
conform to the current period presentation in the consolidated statements of
operations. These reclassifications did not change previously reported
revenues, operating loss or net loss and related per share amounts. For more
information on these reclassifications, refer to Note 3 to Consolidated
Financial Statements in our Annual Report on Form 10-K for the year ended
October 31, 2003. 6




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PLATO Learning, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands, except per share amounts)  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, 2003. 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 (FASB) Statement No. 123. We have adopted the disclosure-only provisions of SFAS No. 123. For purposes
of the pro forma disclosures below, 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 would have
been adjusted to the pro forma amounts presented below: Three Months Ended
    
    Nine Months EndedJuly 31,
    
    July 31,2004
    
    2003
    
    2004
    
    2003Net earnings (loss), as reported
    
    $
    6,724
    
    
    $
    285
    
    
    $
    (4,041
    )
    
    $
    (4,943
    )Add: stock-based compensation expense included
in reported net earnings (loss)
    
    
    
    
    
    
    
    
    
    
    217
    
    
    
    Deduct: stock-based compensation expense determined
using the fair value based method for all awards,
net of related tax effects in 2003
    
    
    (1,419
    )
    
    
    (983
    )
    
    
    (5,314
    )
    
    
    (3,085
    )Pro forma net earnings (loss)
    
    $
    5,305
    
    
    $
    (698
    )
    
    $
    (9,138
    )
    
    $
    (8,028
    )Basic and diluted earnings (loss) per share:As reported
    
    $
    0.29
    
    
    $
    0.02
    
    
    $
    (0.18
    )
    
    $
    (0.30
    )Pro forma
    
    $
    0.23
    
    
    $
    (0.04
    )
    
    $
    (0.41
    )
    
    $
    (0.48
    )
 New Accounting Pronouncements In January 2003, the FASB issued FASB Interpretation No. (FIN) 46,
Consolidation of Variable Interest Entities. In December 2003, the FASB
issued a revised version of this Interpretation, FIN 46®. FIN 46®
addresses the requirements for business enterprises to consolidate related
entities, in which they do not have controlling interests through voting or
other rights, if they are determined to be the primary beneficiary of these
entities as a result of variable economic interests. FIN 46 or FIN 46® must
be applied to Special Purpose Entities (SPEs) created prior to February 1,
2003 and all entities, including SPEs, created subsequent to 7




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PLATO Learning, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands, except per share amounts) January 31, 2003 in our first quarter of fiscal year 2004. FIN 46® also must
be applied for all entities created prior to February 1, 2003 in our second
quarter of fiscal year 2004. We adopted FIN 46® beginning in our first quarter of fiscal year 2004, and no
variable interests with SPEs or entities created prior to February 1, 2003 or
subsequent to January 31, 2003 have been identified; therefore, there was no
impact on our consolidated financial statements, and no disclosures were
required. While we currently have no arrangements of this nature, if we enter
into any such arrangements in the future, our consolidated financial statements
may be adversely affected.  4.
    
    Acquisitions We account for business combinations in accordance with SFAS No. 141, Business
Combinations. All of our acquisitions, including those prior to the adoption
of SFAS No. 141, were accounted for using the purchase method of accounting.
The assets and liabilities acquired were recorded at their estimated fair
values on the dates of acquisition. Operating results of the acquired
companies were included in our consolidated financial statements from the dates
of acquisition. Acquisition-related goodwill and identified intangible assets
are subject to the provisions of SFAS No. 142, Goodwill and Other Intangible
Assets, which require goodwill to be tested periodically for impairment, but
not be amortized. Identified intangible assets are amortized over their
estimated lives. See Note 6 for additional information regarding goodwill and
identified intangible assets. Lightspan, Inc. On November 17, 2003, we acquired Lightspan, Inc. (Lightspan), a
publicly-held corporation and provider of curriculum-based educational software
and online assessment products used in schools, at home and in community
colleges. This acquisition is expected to strengthen our product offerings in
the K-8 and post-secondary markets and enhance our ability to provide
comprehensive solutions to K-12 and adult learning institutions. We acquired all of the outstanding shares of Lightspan for 6,576,129 shares of
our common stock valued at $52,082 for accounting purposes, $23,361 for
estimated assumed liabilities, $2,700 for estimated severance payments, $900
for estimated lease termination costs, and direct acquisition fees of $1,931.
Of the 6,576,129 shares issued, 1,301,692 were from our treasury stock. Direct
acquisition fees consisted primarily of investment banking, legal and
professional fees. The number of shares issued included shares issued for
Lightspans in-the-money stock options. The fair value of the Lightspan
options and warrants assumed in connection with the merger and converted to
PLATO options and warrants was not significant. 8




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PLATO Learning, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands, except per share amounts) The purchase price consisted of the following components: Fair value of common stock issued
    
    $
    52,082Direct acquisition fees
    
    
    1,931Estimated severance payments
    
    
    2,700Estimated lease termination costs
    
    
    900Estimated liabilities assumed
    
    
    23,361$
    80,974
 The allocation of the total purchase price, including acquisition fees, was as
follows: Estimated fair value of tangible assets acquired
    
    $
    27,194Fair value of identified intangible assets
    
    
    30,400Estimated goodwill
    
    
    26,506Deferred income taxes
    
    
    (3,126
    )$
    80,974
 An appraisal firm assisted us with the valuation of identified intangible
assets, consisting of $19,800 for customer relationships, $7,300 for developed
content and technology, $2,300 for trademarks and trade names and $1,000 for a
non-compete agreement. These identified intangible assets are being amortized
over periods of seven years for customer relationships, nine years for
developed content and technology, four and one-half years for trademarks and
trade names and two years for the non-compete agreement. In connection with this acquisition, we developed plans for workforce and
facility reductions. The aggregate estimated costs of these plans is $3,700,
which consisted of $2,700 related to the elimination of 144 positions in the
United States and $900 related to lease termination, which ends October 31,
2004 and has a minimum monthly lease payment of $106. As of July 31, 2004,
approximately $2,390 of the estimated $2,700 of severance costs have been paid.
We expect to complete these activities within one year from the acquisition
date. Until the lesser of one year or when these activities are completed, the
allocation of the purchase price is preliminary and subject to adjustment. See Note 6 for discussion of purchase price adjustments made subsequent to the
acquisition date. New Media (Holdings) Limited On December 17, 2003, we acquired New Media (Holdings) Limited (New Media), a
United Kingdom (U.K.) based publisher of curriculum-focused software
primarily for teaching secondary school science and math, for approximately
$6,800 in cash. This acquisition enhances our science offering, provides a
science simulation development capability that we did not previously have and
will allow us to introduce New Medias products to markets in the United States
for the first time. Additionally, this acquisition is expected to provide
critical mass and
revenue diversification in the U.K. and strengthen our relationships with the
U.K. Education Department. 9




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PLATO Learning, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands, except per share amounts) The purchase price consisted of the following components: Cash paid
    
    $
    6,750Direct acquisition fees
    
    
    429Liabilities assumed
    
    
    864$
    8,043
 The allocation of the total purchase price, including acquisition fees, was as
follows: Fair value of tangible assets acquired
    
    $
    1,664Estimated fair value of identified intangible assets
    
    
    1,939Estimated goodwill
    
    
    4,440$
    8,043
 An appraisal firm assisted us with the valuation of identified intangible
assets, consisting of $1,804 for developed content and technology and $135 for
customer relationships. These identified intangible assets are being amortized
over periods of four to seven years for developed content and technology and
one to five years for customer relationships. Unaudited Pro Forma Data Our unaudited pro forma consolidated results of operations, as if the Lightspan
acquisition had occurred at the beginning of the periods presented, were as
follows: Nine Months EndedJuly 31,2004
    
    2003(Unaudited)
    
    (Unaudited)Revenues
    
    $
    100,350
    
    
    $
    92,088Net loss
    
    
    (5,472
    )
    
    
    (21,534
    )Basic and diluted loss per share
    
    
    (0.24
    )
    
    
    (0.93
    )
 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
periods 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. 10




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PLATO Learning, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands, except per share amounts)  5.
    
    Accounts Receivable The components of accounts receivable were as follows: July 31,
    
    October 31,2004
    
    2003Trade accounts receivable
    
    $
    28,596
    
    
    $
    21,415Installment accounts receivable
    
    
    22,617
    
    
    
    22,015Allowance for doubtful accounts
    
    
    (4,382
    )
    
    
    (4,254
    )$
    46,831
    
    
    $
    39,176
 The provision for doubtful accounts, included in general and administrative
expense on the consolidated statements of operations, was $695 and $555 for the
three months and $1,522 and $1,607 for the nine months ended July 31, 2004 and
2003, respectively.  6.
    
    Goodwill and Identified Intangible Assets We account for goodwill and identified 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 no longer
amortized to expense and must be periodically reviewed for impairment. If such
review indicates that the carrying amount of an intangible asset exceeds its
fair value, an impairment loss would be recognized equal to that excess amount. Goodwill The changes in goodwill from October 31, 2003 were as follows: Balance, October 31, 2003
    
    $
    39,609Acquisition of Lightspan
    
    
    26,506Acquisition of New Media
    
    
    4,440Release of shares from escrow
    
    
    (2,895
    )Foreign currency translation
    
    
    83Balance, July 31, 2004
    
    $
    67,743
 Goodwill was decreased by $2,895 during the three months ended January 31, 2004
as a result of the release of escrow shares relating to the NetSchools
acquisition in 2002. As of July 31, 2004, 100,000 shares remained in escrow
relating to this acquisition. Goodwill was decreased by $1,943 during the three months ended July 31, 2004 as
a result of adjustments to the purchase price allocation for the Lightspan
acquisition. Estimated lease termination costs were reduced by $100,
liabilities assumed relating to commissions and bonuses were reduced by $2,670
and the fair value of tangible assets acquired relating to pre-acquisition 11




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PLATO Learning, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands, except per share amounts) directors and officers insurance was reduced by $827. Additional adjustments
to the purchase price allocation may be necessary as we finalize the purchase
accounting for this acquisition. Identified Intangible Assets Identified intangible assets subject to amortization were as follows: July 31, 2004
    
    October 31, 2003Gross Carrying
    
    Accumulated
    
    Net Carrying
    
    Gross Carrying
    
    Accumulated
    
    Net CarryingValue
    
    Amortzation
    
    Value
    
    Value
    
    Amortzation
    
    ValueAcquired technology
    
    $
    24,853
    
    
    $
    (4,976
    )
    
    $
    19,877
    
    
    $
    15,717
    
    
    $
    (2,589
    )
    
    $
    13,128Trademark
    
    
    3,680
    
    
    
    (1,149
    )
    
    
    2,531
    
    
    
    1,380
    
    
    
    (640
    )
    
    
    740Customer relationships
    
    
    21,237
    
    
    
    (2,954
    )
    
    
    18,283
    
    
    
    1,300
    
    
    
    (595
    )
    
    
    705Employment agreement
    
    
    413
    
    
    
    (381
    )
    
    
    32
    
    
    
    413
    
    
    
    (279
    )
    
    
    134Noncompete agreements
    
    
    1,090
    
    
    
    (444
    )
    
    
    646
    
    
    
    90
    
    
    
    (90
    )
    
    
    $
    51,273
    
    
    $
    (9,904
    )
    
    $
    41,369
    
    
    $
    18,900
    
    
    $
    (4,193
    )
    
    $
    14,707
 Amortization expense for identified intangible assets was $1,943 and $525 for
the three months ended July 31, 2004 and 2003, respectively, of which $831 and
$378 was included in cost of revenues for each period. Amortization expense
was $5,706 and $1,495 for the nine months ended July 31, 2004 and 2003,
respectively, of which $2,509 and $1,054 was included in cost of revenues for
each period. The estimated future annual amortization expense for identified intangible
assets is as follows: Remainder of 2004
    
    
    1,9772005
    
    
    7,5892006
    
    
    6,9132007
    
    
    6,6892008
    
    
    6,104Thereafter
    
    
    12,097$
    41,369
  7.
    
    Debt Revolving Loan On June 10, 2004, we extended our revolving loan agreement with Wells Fargo
Bank, N.A. through July 1, 2005. The revolving loan agreement provides for a
maximum $12,500 line of credit. Substantially all of our assets are pledged as
collateral under the agreement. There were no borrowings outstanding at July
31, 2004 or October 31, 2003. The agreement contains restrictive financial covenants (including Minimum
Tangible Net Worth, Minimum Debt Service Coverage, Maximum Leverage, Maximum
Cash Flow Leverage and 12




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PLATO Learning, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands, except per share amounts) 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 July 31,
2004.  8.
    
    Deferred Revenue The components of deferred revenue were as follows: July 31,
    
    October 31,2004
    
    2003License fees
    
    $
    8,583
    
    
    $
    4,762Subscriptions
    
    
    9,141
    
    
    
    4,134Services
    
    
    24,668
    
    
    
    17,360Other
    
    
    552
    
    
    
    30842,944
    
    
    
    26,564Less: long-term amounts
    
    
    (7,337
    )
    
    
    (4,372
    )$
    35,607
    
    
    $
    22,192
  9.
    
    Restructuring Charges In May 2003, we replaced our Managing Director of operations in the United
Kingdom, and severed relationships with two senior executives (our Chief
Operating Officer and a co-founder of NetSchools) and three other employees in
connection with a restructuring plan to align our cost structure with future
expectations. The consolidated statement of operations for 2003 included a
restructuring charge of $422 recorded in the third quarter for severance costs
related to this action. As of October 31, 2003, approximately $252 of these
severance costs had been paid and as of July 31, 2004 substantially all of
these severance costs had been paid. In December 2002, we reduced the size of our workforce by approximately 30
positions and closed approximately 30 open job requisitions, all in the United
States, which together represented about 10% of our planned workforce, in
connection with a restructuring plan to align our cost structure with future
expectations. The consolidated statement of operations for 2003 included a
restructuring charge of $380 recorded in the first quarter for severance costs
related to this reduction. All of these severance costs were paid as of
October 31, 2003. 13




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PLATO Learning, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands, except per share amounts)  10.
    
    Income Taxes At October 31, 2003, we had a net deferred income tax asset of $2,218.
Approximately $7,377 of the deferred tax asset related to our net operating
loss carryforwards in the United States of approximately $18,500, which expire
in varying amounts between 2004 and 2023. We also had net operating loss
carryforwards of approximately $3,000 related to our foreign subsidiaries. We
provided a full valuation allowance related to these foreign deferred tax
assets due to the uncertainty in realization of future taxable income in these
foreign jurisdictions. Realization of our deferred tax asset is dependent on generating sufficient
taxable income in the United States prior to expiration of these loss
carryforwards. Although realization was not assured at October 31, 2003, we
believed it was more likely than not that all of the deferred tax asset would
be realized. We based this belief upon the levels of taxable income generated
historically, as well as projections of future taxable income. However, 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
$2,500 per year and, therefore, approximately $35,000 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 finalized. Our combined net operating loss carryforwards as of the acquisition date were
approximately $57,000. The combined net operating loss carryforwards, which
represent the majority of the merged companys deferred tax assets, must be
reviewed for realization primarily based upon historical results and
secondarily upon projected results. Although we expect taxable income in 2004,
this expectation is highly dependent on the integration of the Lightspan
acquisition. Lightspan has historically incurred significant operating losses
which carry more weight than the projected results. Consequently, it is our
current view that, while we had cumulative taxable income for the last three
fiscal years, our combined historical 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 our 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
income tax expense and a reduction of goodwill. 14




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PLATO Learning, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands, except per share amounts)  11.
    
    Per Share Data Basic loss per share is calculated by dividing net loss by the weighted average
number of common shares outstanding during the period. Diluted loss per share
is calculated by dividing net loss by the weighted average number of common
and, where dilutive, potential common shares outstanding during the period.
Potential common shares include options and warrants. The calculation of basic and diluted earnings (loss) per share was as follows: Three Months Ended
    
    Nine Months EndedJuly 31,
    
    July 31,2004
    
    2003
    
    2004
    
    2003Net earnings (loss)
    
    $
    6,724
    
    
    $
    285
    
    
    $
    (4,041
    )
    
    $
    (4,943
    )Basic:Weighted average common shares outstanding
    
    
    23,012,000
    
    
    
    16,363,000
    
    
    
    22,497,000
    
    
    
    16,558,000Basic earnings (loss) per share
    
    $
    0.29
    
    
    $
    0.02
    
    
    $
    (0.18
    )
    
    $
    (0.30
    )Diluted:Weighted average common shares outstanding
    
    
    23,012,000
    
    
    
    16,363,000
    
    
    
    22,497,000
    
    
    
    16,558,000Potential common shares:Stock options and warrants
    
    
    444,000
    
    
    
    57,000
    
    
    
    
    
    
    
    Common shares held in escrow
    
    
    100,000
    
    
    
    
    
    
    
    
    
    
    
    Restricted common shares
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Weighted average common and potential common
shares outstanding for diluted earnings
(loss) per share
    
    
    23,556,000
    
    
    
    16,420,000
    
    
    
    22,497,000
    
    
    
    16,558,000Diluted earnings (loss) per share
    
    $
    0.29
    
    
    $
    0.02
    
    
    $
    (0.18
    )
    
    $
    (0.30
    )
 The calculation of diluted loss per share for the three and nine months ended
July 31, 2004 and 2003 excluded the effect of approximately 3,472,000 and
3,050,000 potential common shares from the conversion of outstanding options
and warrants and common shares held in escrow, respectively, as they were
antidilutive.  12.
    
    Comprehensive Earnings (Loss) Total comprehensive earnings (loss) was as follows: Three Months Ended
    
    Nine Months EndedJuly 31,
    
    July 31,2004
    
    2003
    
    2004
    
    2003Net earnings (loss)
    
    $
    6,724
    
    
    $
    285
    
    
    $
    (4,041
    )
    
    $
    (4,943
    )Foreign currency translation adjustments
    
    
    83
    
    
    
    9
    
    
    
    87
    
    
    
    43Total comprehensive earnings (loss)
    
    $
    6,807
    
    
    $
    294
    
    
    $
    (3,954
    )
    
    $
    (4,900
    )
 15




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PLATO Learning, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands, except per share amounts)  13.
    
    Segment and Geographic Information We operate and manage our business as one segment, the development and
marketing of educational software and related services. We have foreign subsidiaries in Canada and the United Kingdom. Our foreign
operations are not significant to our consolidated business. At July 31, 2004,
less than 1% of our long-term assets are located in foreign countries, and for
the nine months ended July 31, 2004, approximately 3% of our revenues are from
foreign countries. 16




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PLATO Learning, Inc. and Subsidiaries 
 Managements Discussion and Analysis of Results of
 Operations and Financial Condition
  OVERVIEW We enhance the learning process by providing computer-based and e-learning
instruction software for kindergarten through adult learners, offering
curricula in reading, writing, mathematics, science, social studies and life
and job skills. We also offer innovative 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 courseware is delivered
via networks, CD-ROM, private intranets and the Internet. We market our
courseware products and services primarily to K-12 schools and colleges. We
also sell to job training programs, correctional institutions, military
education programs, corporations and individuals. In November 2003, we acquired Lightspan, Inc. (Lightspan), a provider of
curriculum-based educational software and on-line assessment products and
services that increase student achievement and enhance teacher professional
development. These products are used in schools and homes and align all key
federal reform initiatives, offering school districts a comprehensive
achievement and accountability system to assess, align, instruct and evaluate.
This acquisition is expected to strengthen our product offerings, with two
strong and complimentary brands, in the K-8 and post secondary markets. We
also expect this acquisition to enhance our ability to provide comprehensive
solutions to K-12 and adult learning institutions. The combination of Lightspan and PLATO also unites Lightspans Academic Systems
products with our community college products to establish the largest provider
of on-line content for under-prepared college students. In addition, the
merger of sales forces will provide critical mass for servicing elementary,
secondary, district level, and colleges across all product lines and services.
We believe these advantages, plus the elimination of significant duplicate
costs, will provide greater earnings and cash flow potential for the combined
company, and ultimately a greater valuation. Lightspan generated revenues of approximately $50,000 in its fiscal year ended
January 31, 2003. We expect to achieve approximately $17,500 of cost
reductions in 2004 and annualized cost reductions of between $20,000 and
$25,000 thereafter, primarily through workforce reductions and the elimination
of duplicate costs. The acquisition is expected to be modestly dilutive to our
earnings per share for fiscal year 2004. Earnings per share will be impacted
by non-cash charges for the amortization of identified intangible assets
acquired with this transaction. In December 2003, we acquired New Media (Holdings) Limited (New Media), a
United Kingdom (U.K.) based publisher of curriculum-focused software
primarily for teaching secondary school science and math. This acquisition
enhances our science offering, provides a science simulation development
capability that we did not previously have and will allow us to introduce New
Medias products to markets in the United States for the first time.
Additionally, 17




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PLATO Learning, Inc. and Subsidiaries
Managements Discussion and Analysis of Results of
Operations and Financial Condition
(Dollars in thousands) this acquisition is expected to provide critical mass and revenue
diversification in the U.K. and strengthen our relationships with the U.K.
Education Department. 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, rapid technological change and our ability to integrate
acquisitions. 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 results of operations and financial condition 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, 2003 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. 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 18




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PLATO Learning, Inc. and Subsidiaries
Managements Discussion and Analysis of Results of
Operations and Financial Condition
(Dollars in thousands) 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 in Financial Statements. We license software under non-cancelable
license and subscription agreements. We also provide related professional
services, including consulting, training 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. We do not generally provide
acceptance clauses to our customers. In situations where we do provide
acceptance clauses, revenue is deferred until the clause expires or acceptance
criteria are met. 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 on-line subscription
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 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. 19




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PLATO Learning, Inc. and Subsidiaries
Managements Discussion and Analysis of Results of
Operations and Financial Condition
(Dollars in thousands) 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 statement of operations.
The assumptions and estimates used to determine the allowance are subject to
constant revision and involve significant assumptions and judgment. The
primary factors that impact these assumptions include the efficiency and
effectiveness of our billing and collection functions, our historical
experience and our credit assessment process. We believe that the current
budget difficulties facing many 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 $4,382, or 8.6% of gross accounts receivable, at July
31, 2004, as compared to $4,254, or 9.8%, at October 31, 2003. 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. 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. 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 20




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PLATO Learning, Inc. and Subsidiaries
Managements Discussion and Analysis of Results of
Operations and Financial Condition
(Dollars in thousands) 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 October 31, 2003, we had a net deferred tax asset of $2,218. Approximately
$7,377 of the deferred tax asset relates to our net operating loss
carryforwards in the United States of approximately $18,500, which expire in
varying amounts between 2004 and 2023. We also had net operating loss
carryforwards of approximately $3,000 related to our foreign subsidiaries. We
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 deferred tax asset is dependent on generating sufficient
taxable income in the United States prior to expiration of these loss
carryforwards. Although realization was not assured at October 31, 2003, we
believed it was more likely than not that all of the deferred tax asset would
be realized. We based this belief upon the levels of taxable income generated
historically, as well as projections of future taxable income. However, 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 $2,500 per year and, therefore, approximately $35,000
of the acquired net operating loss carryforwards are available to the combined
entity. Our combined net operating loss carryforwards as of the acquisition date were
approximately $57,000 at April 30, 2004. The combined net operating loss
carryforwards, which represent the majority of the merged companys deferred
tax assets, must be reviewed for realization primarily based upon historical
results and secondarily upon projected results. Although we expect taxable
income in 2004, this expectation is highly dependent on the integration of the
Lightspan acquisition. Lightspan has historically incurred significant
operating losses which carry more weight than the projected results.
Consequently, it is our current view that, while we had cumulative taxable
income for the last three fiscal years, our historical 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 21




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PLATO Learning, Inc. and Subsidiaries
Managements Discussion and Analysis of Results of
Operations and Financial Condition
(Dollars in thousands) purchase
accounting for the Lightspan acquisition in our 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 income tax expense and
a reduction of goodwill. 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 acquire do not have significant tangible assets and,
as a result, the majority of the purchase price is typically 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. 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 goodwill impairment test, used to identify potential
impairment, compares the fair value of a reporting unit with its carrying
amount, including goodwill. We operate as one reporting unit and therefore
compare our book value to market value (market capitalization plus a control
premium). If our fair value exceeds our book value, goodwill is considered not
impaired, thus the second step of the impairment test is unnecessary. If our
book value exceeds our market value, the second step of the goodwill impairment
test shall be performed to measure the amount of impairment loss, if any. The
second step of the goodwill impairment test, used to measure the amount of
impairment loss, compares the implied fair value of the goodwill 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 a goodwill impairment loss is recognized, the
adjusted carrying amount of goodwill is its new accounting basis. Subsequent
reversal of a previously recognized goodwill impairment loss is prohibited once
the measurement of that loss is completed. We completed our annual 22




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##### Table of Contents



PLATO Learning, Inc. and Subsidiaries
Managements Discussion and Analysis of Results of
Operations and Financial Condition
(Dollars in thousands) goodwill
impairment assessment as of October 31, 2003, upon which 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.
Lightspan was acquired in a stock transaction where we issued approximately
6.6 million shares of our common stock, valued at approximately $52,000 for
accounting purposes, for all of Lightspans outstanding stock. We acquired New
Media for approximately $6,800 in cash. See Note 4 to Consolidated Financial
Statements for more information on these strategic acquisitions. 23




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##### Table of Contents



PLATO Learning, Inc. and Subsidiaries
Managements Discussion and Analysis of Results of
Operations and Financial Condition
(Dollars in thousands) RESULTS OF OPERATIONS Operating Results as a Percentage of Revenue Three Months Ended
    
    Nine Months EndedJuly 31,
    
    July 31,2004
    
    2003
    
    2004
    
    2003Revenues:License fees
    
    
    62.6
    %
    
    
    68.5
    %
    
    
    56.0
    %
    
    
    61.2
    %Subscriptions
    
    
    14.3
    
    
    
    7.6
    
    
    
    15.7
    
    
    
    9.5Services
    
    
    18.2
    
    
    
    16.5
    
    
    
    21.1
    
    
    
    21.2Other
    
    
    4.9
    
    
    
    7.4
    
    
    
    7.2
    
    
    
    8.1Total revenues
    
    
    100.0
    
    
    
    100.0
    
    
    
    100.0
    
    
    
    100.0Cost of revenues:License fees
    
    
    8.3
    
    
    
    8.9
    
    
    
    10.0
    
    
    
    10.6Subscriptions
    
    
    4.4
    
    
    
    5.1
    
    
    
    5.6
    
    
    
    4.7Services
    
    
    10.3
    
    
    
    11.1
    
    
    
    12.6
    
    
    
    14.7Other
    
    
    5.3
    
    
    
    6.9
    
    
    
    6.7
    
    
    
    7.2Total cost of revenues
    
    
    28.3
    
    
    
    32.0
    
    
    
    34.9
    
    
    
    37.2Gross profit
    
    
    71.7
    
    
    
    68.0
    
    
    
    65.1
    
    
    
    62.8Operating expenses:Sales and marketing
    
    
    36.7
    
    
    
    42.4
    
    
    
    46.2
    
    
    
    53.5General and administrative
    
    
    12.1
    
    
    
    13.4
    
    
    
    14.5
    
    
    
    17.4Product development
    
    
    3.2
    
    
    
    2.0
    
    
    
    4.9
    
    
    
    3.0Amortization of intangibles
    
    
    2.7
    
    
    
    0.6
    
    
    
    3.2
    
    
    
    0.8Restructuring charge
    
    
    
    
    
    
    1.8
    
    
    
    
    
    
    
    1.4Total operating expenses
    
    
    54.7
    
    
    
    60.2
    
    
    
    68.8
    
    
    
    76.1Operating income (loss)
    
    
    17.0
    
    
    
    7.8
    
    
    
    (3.7
    )
    
    
    (13.3
    )Interest income and expense and
other expense, net
    
    
    (0.1
    )
    
    
    0.1
    
    
    
    0.1
    
    
    
    0.3Earnings (loss) before income taxes
    
    
    16.9
    
    
    
    7.9
    
    
    
    (3.6
    )
    
    
    (13.0
    )Income tax expense (benefit)
    
    
    0.4
    
    
    
    6.7
    
    
    
    0.5
    
    
    
    (4.0
    )Net earnings (loss)
    
    
    16.5
    %
    
    
    1.2
    %
    
    
    (4.1)
    %
    
    
    (9.0)
    %
 Certain reclassifications of previously reported amounts have been made to
conform to the current period presentation in the consolidated statements of
operations. These reclassifications did not change previously reported
revenues, operating loss or net loss and related per share amounts. For more
information on these reclassifications, refer to Note 3 to Consolidated
Financial Statements in our Annual Report on Form 10-K for the year ended
October 31, 2003. 24




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##### Table of Contents



PLATO Learning, Inc. and Subsidiaries
Managements Discussion and Analysis of Results of
Operations and Financial Condition
(Dollars in thousands) Revenues Total Revenues.Total reported revenues increased 70.7% to $40,613 for the
three months ended July 31, 2004 from $23,793 for the same period in 2003.
Total reported revenues increased 81.6% to $99,381 for the nine months ended
July 31, 2004 from $54,717 for the same period in 2003. Our significant
revenue growth in 2004 reflected the acquisition of Lightspan, and, while
impacted by the economic conditions discussed below, also reflected the impact
of large orders and our increased focus on subscriptions revenue, and
correlation and professional development services. We currently expect our
total revenues for fiscal year 2004 to be in the range of $143,000 to $147,000.
The mid point of this range would produce pro forma revenue growth of about
10.5%. The following tables present total revenues, as reported and on a pro forma
basis, as if Lightspan revenues prior to the acquisition had been included for
all periods presented: Three Months Ended July 31,2004
    
    2003Total Revenues
    
    $
    
    % of revenue
    
    $
    
    % of revenue
    
    % ChangePLATO (as reported)
    
    $
    40,613
    
    
    
    100.0
    %
    
    $
    23,793
    
    
    
    100.0
    %
    
    
    70.7
    %Lightspan (pre-acquisition)
    
    
    
    
    
    
    
    
    
    
    14,479Pro forma
    
    $
    40,613
    
    
    
    100.0
    %
    
    $
    38,272
    
    
    
    100.0
    %
    
    
    6.1
    %
 Nine Months Ended July 31,2004
    
    2003Total Revenues
    
    $
    
    % of revenue
    
    $
    
    % of revenue
    
    % ChangePLATO (as reported)
    
    $
    99,381
    
    
    
    100.0
    %
    
    $
    54,717
    
    
    
    100.0
    %
    
    
    81.6
    %Lightspan (pre-acquisition)
    
    
    969
    
    
    
    
    
    
    
    37,371Pro forma
    
    $
    100,350
    
    
    
    100.0
    %
    
    $
    92,088
    
    
    
    100.0
    %
    
    
    9.0
    %
 On a pro forma basis, assuming Lightspan had been included for all periods
presented, we executed 70 orders of $100 or greater during the three months
ended July 31, 2004, as compared to 81 for the same period in 2003. The
average size of orders between $100 and $249 decreased from $157 to $148, while
the average size of orders of $250 and greater increased 47.8% from $508 to
$750. The number and magnitude of these larger orders can have a significant
impact on our operating results. Information regarding these orders was as
follows: Pro FormaThree Months Ended July 31,2004 (1)
    
    2003 (2)
    
    % ChangeOrder Size
    
    Number
    
    Value
    
    Number
    
    Value
    
    Number
    
    Value$100 to $249
    
    
    52
    
    
    $
    7,699
    
    
    
    56
    
    
    $
    8,772
    
    
    
    -7.1
    %
    
    
    -12.2
    %$250 or greater
    
    
    18
    
    
    
    13,506
    
    
    
    25
    
    
    
    12,689
    
    
    
    -28.0
    %
    
    
    6.4
    %70
    
    
    $
    21,205
    
    
    
    81
    
    
    $
    21,461
    
    
    
    -13.6
    %
    
    
    -1.2
    %
 25




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##### Table of Contents



PLATO Learning, Inc. and Subsidiaries
Managements Discussion and Analysis of Results of
Operations and Financial Condition
(Dollars in thousands) Pro FormaNine Months Ended July 31,2004 (1)
    
    2003 (2)
    
    % ChangeOrder Size
    
    Number
    
    Value
    
    Number
    
    Value
    
    Number
    
    Value$100 to $249
    
    
    122
    
    
    $
    17,969
    
    
    
    101
    
    
    $
    15,678
    
    
    
    20.8
    %
    
    
    14.6
    %$250 or greater
    
    
    43
    
    
    
    29,543
    
    
    
    48
    
    
    
    23,509
    
    
    
    -10.4
    %
    
    
    25.7
    %165
    
    
    $
    47,512
    
    
    
    149
    
    
    $
    39,187
    
    
    
    10.7
    %
    
    
    21.2
    %
  (1)
    
    2004 excludes amounts related to the Idaho Department of Education contract signed in Q2-2004.  (2)
    
    2003 include both PLATO Learning and Lightspan. License Fees.The following table presents license fees revenues, as reported
and on a pro forma basis, as if Lightspan revenues prior to the acquisition had
been included for all periods presented: Three Months Ended July 31,2004
    
    2003License Fees Revenues
    
    $
    
    % of revenue
    
    $
    
    % of revenue
    
    % ChangePLATO (as reported)
    
    $
    25,421
    
    
    
    62.6
    %
    
    $
    16,300
    
    
    
    68.5
    %
    
    
    56.0
    %Lightspan (pre-acquisition)
    
    
    
    
    
    
    
    
    
    
    7,976Pro forma
    
    $
    25,421
    
    
    
    62.6
    %
    
    $
    24,276
    
    
    
    63.4
    %
    
    
    4.7
    %
 Nine Months Ended July 31,2004
    
    2003License Fees Revenues
    
    $
    
    % of revenue
    
    $
    
    % of revenue
    
    % ChangePLATO (as reported)
    
    $
    55,693
    
    
    
    56.0
    %
    
    $
    33,497
    
    
    
    61.2
    %
    
    
    66.3
    %Lightspan (pre-acquisition)
    
    
    
    
    
    
    
    
    
    
    18,880Pro forma
    
    $
    55,693
    
    
    
    55.5
    %
    
    $
    52,377
    
    
    
    56.9
    %
    
    
    6.3
    %
 The increase in reported license fees revenues for the three and nine months
ended July 31, 2004, as compared to the same periods in 2003, was primarily due
to the Lightspan acquisition. We continue to feel the effects of federal
funding delays and economic uncertainties, particularly state budget
difficulties, which significantly impacted the level of purchasing done by our
customers. While there continues to be some improvement in the flow of federal
funds to education, as evidenced by the increases in pro forma license fees
revenue for the three and nine months ended July 31, 2004 and 2004, these
conditions are expected to continue to impact our revenues during the remainder
of 2004. As a percentage of total revenues, pro forma license fees revenues
decreased slightly for the three and nine months ended July 31, 2004 from the
same periods in 2003, reflecting the increase in subscriptions and services
revenues as discussed below. 26




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##### Table of Contents



PLATO Learning, Inc. and Subsidiaries
Managements Discussion and Analysis of Results of
Operations and Financial Condition
(Dollars in thousands) Subscriptions.The following table presents subscriptions revenues, as
reported and on a pro forma basis, as if Lightspan revenues prior to the
acquisition had been included for all periods presented: Three Months Ended July 31,2004
    
    2003Subscriptions Revenues
    
    $
    
    % of revenue
    
    $
    
    % of revenue
    
    % ChangePLATO (as reported)
    
    $
    5,812
    
    
    
    14.3
    %
    
    $
    1,806
    
    
    
    7.6
    %
    
    
    221.8
    %Lightspan (pre-acquisition)
    
    
    
    
    
    
    
    
    
    
    2,957Pro forma
    
    $
    5,812
    
    
    
    14.3
    %
    
    $
    4,763
    
    
    
    12.4
    %
    
    
    22.0
    %
 Nine Months Ended July 31,2004
    
    2003Subscriptions Revenues
    
    $
    
    % of revenue
    
    $
    
    % of revenue
    
    % ChangePLATO (as reported)
    
    $
    15,645
    
    
    
    15.7
    %
    
    $
    5,197
    
    
    
    9.5
    %
    
    
    201.0
    %Lightspan (pre-acquisition)
    
    
    531
    
    
    
    
    
    
    
    8,799Pro forma
    
    $
    16,176
    
    
    
    16.1
    %
    
    $
    13,996
    
    
    
    15.2
    %
    
    
    15.6
    %
 Reported revenues from subscriptions increased for the three and nine months
ended July 31, 2004, as compared to the same periods in 2003, primarily due to
the Lightspan acquisition and secondarily due to the growth in PLATO
subscriptions revenue. This also contributed to the growth in pro forma
subscriptions revenues, which comprised 49% and 27% of total pro forma revenue growth for
 the three and nine months ended July 31, 2004, respectively, from the same periods in 2003. We are experiencing an increasing shift away from
perpetual license sales and a growing customer desire to license our products
on a subscription basis. Orders for our subscription-based products continue
to grow, and, while this has a negative impact on revenues in the short-term,
it has positive implications for the longer term, including greater
predictability of future revenues. This growth trend is further demonstrated by an increase
in subscriptions revenues as a percentage of total revenues to 14.4% and 15.8% for the three and nine months
ended July 31, 2004, respectively, compared to 12.4% and 15.2% for the same periods in 2003. Services.The following table presents services revenues, as reported and on a
pro forma basis, as if Lightspan revenues prior to the acquisition had been
included for all periods presented: Three Months Ended July 31,2004
    
    2003Services Revenues
    
    $
    
    % of revenue
    
    $
    
    % of revenue
    
    % ChangePLATO (as reported)
    
    $
    7,403
    
    
    
    18.2
    %
    
    $
    3,918
    
    
    
    16.5
    %
    
    
    88.9
    %Lightspan (pre-acquisition)
    
    
    
    
    
    
    
    
    
    
    2,411Pro forma
    
    $
    7,403
    
    
    
    18.2
    %
    
    $
    6,329
    
    
    
    16.5
    %
    
    
    17.0
    %
 27




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##### Table of Contents



PLATO Learning, Inc. and Subsidiaries
Managements Discussion and Analysis of Results of
Operations and Financial Condition
(Dollars in thousands) Nine Months Ended July 31,2004
    
    2003Services Revenues
    
    $
    
    % of revenue
    
    $
    
    % of revenue
    
    % ChangePLATO (as reported)
    
    $
    20,937
    
    
    
    21.1
    %
    
    $
    11,597
    
    
    
    21.2
    %
    
    
    80.5
    %Lightspan (pre-acquisition)
    
    
    438
    
    
    
    
    
    
    
    7,025Pro forma
    
    $
    21,375
    
    
    
    21.3
    %
    
    $
    18,622
    
    
    
    20.2
    %
    
    
    14.8
    %
 Reported revenues from services increased for the three and nine months ended
July 31, 2004, as compared to the same periods in 2003, due primarily to the
Lightspan acquisition and secondarily due to the increase in PLATO services
revenues, resulting from increased correlation and professional development
services and the continued growth in customer demand for our training and
technical support services. This also contributed to the growth in pro forma
services
revenue. As a percentage of total revenues, pro forma services revenues
increased slightly for the three and nine months ended July 31, 2004 compared
to the same periods in 2003. Other.The following table presents other revenues, as reported and on a pro
forma basis, as if Lightspan revenues prior to the acquisition had been
included for all periods presented: Three Months Ended July 31,2004
    
    2003Other Revenues
    
    $
    
    % of revenue
    
    $
    
    % of revenue
    
    % ChangePLATO (as reported)
    
    $
    1,977
    
    
    
    4.9
    %
    
    $
    1,769
    
    
    
    7.4
    %
    
    
    11.8
    %Lightspan (pre-acquisition)
    
    
    
    
    
    
    
    
    
    
    1,135Pro forma
    
    $
    1,977
    
    
    
    4.9
    %
    
    $
    2,904
    
    
    
    7.6
    %
    
    
    -31.9
    %
 Nine Months Ended July 31,2004
    
    2003Other Revenues
    
    $
    
    % of revenue
    
    $
    
    % of revenue
    
    % ChangePLATO (as reported)
    
    $
    7,106
    
    
    
    7.2
    %
    
    $
    4,426
    
    
    
    8.1
    %
    
    
    60.6
    %Lightspan (pre-acquisition)
    
    
    
    
    
    
    
    
    
    
    2,667Pro forma
    
    $
    7,106
    
    
    
    7.1
    %
    
    $
    7,093
    
    
    
    7.7
    %
    
    
    0.2
    %
 Other revenues, consisting primarily of hardware and third-party courseware
products, increased principally due to the Lightspan acquisition. The
elementary grade products acquired from Lightspan run on PlayStation® game
consoles, which, along with the sale of related accessories, are a component of
other revenues. Backlog.Our deferred revenue was $42,944 and $26,564 at July 31, 2004 and
October 31, 2003, respectively. In addition, we have orders for approximately
$15,400 related to an Idaho Department of Education contract and approximately
$14,000 from a contract with the U.S. Department of the Navy. Ultimate
realization of these contracts is dependent on delivery of services,
accomplishment of milestones and customer acceptance. We also have orders for 28




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##### Table of Contents



PLATO Learning, Inc. and Subsidiaries
Managements Discussion and Analysis of Results of
Operations and Financial Condition
(Dollars in thousands) approximately $6,600 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 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 The following table presents our total cost of revenues, as reported and on a
pro forma basis, as if Lightspan cost of revenues prior to the acquisition had
been included for all periods presented: Three Months Ended July 31,2004
    
    2003Total Cost of Revenues
    
    $
    
    % of revenue
    
    $
    
    % of revenue
    
    % ChangePLATO (as reported)
    
    $
    11,510
    
    
    
    28.3
    %
    
    $
    7,623
    
    
    
    32.0
    %
    
    
    51.0
    %Lightspan (pre-acquisition)
    
    
    
    
    
    
    
    
    
    
    3,967Pro forma
    
    $
    11,510
    
    
    
    28.3
    %
    
    $
    11,590
    
    
    
    30.3
    %
    
    
    -0.7
    %
 Nine Months Ended July 31,2004
    
    2003Total Cost of Revenues
    
    $
    
    % of revenue
    
    $
    
    % of revenue
    
    % ChangePLATO (as reported)
    
    $
    34,700
    
    
    
    34.9
    %
    
    $
    20,332
    
    
    
    37.2
    %
    
    
    70.7
    %Lightspan (pre-acquisition)
    
    
    242
    
    
    
    
    
    
    
    10,715Pro forma
    
    $
    34,942
    
    
    
    34.8
    %
    
    $
    31,047
    
    
    
    33.7
    %
    
    
    12.5
    %
 Total cost of revenues decreased slightly for the three months ended July 31,
2004, as compared to the pro forma amounts for the same period in 2003. A
number of factors contributed to this decrease, including increased license
fees revenues, which have lower costs, and decreased other revenues, which have
higher costs. Partially offsetting the decreased costs from these revenue
changes were increased professional development expenses of $1,228, increased
amortization of capitalized product development costs of $115, increased
amortization of acquired technology of $453 and increased customer support
costs of $471. Total pro forma cost of revenues increased for the nine months ended July 31,
2004, as compared to the same period in 2003, primarily due to increased
professional development expenses of $3,332, increased amortization of
capitalized product development costs of $969, increased amortization of
acquired technology of $1,455 and increased customer support costs of $1,203.
These increases were partially offset by the changes in revenue mix discussed
earlier. Amortization of capitalized product development costs, a component of cost of
sales, was $1,682 and $1,578 for the three months and $5,160 and $4,202 for the
nine months ended July 31, 2004 and 2003, respectively. Amortization has
increased as projects completed during prior periods 29




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##### Table of Contents



PLATO Learning, Inc. and Subsidiaries
Managements Discussion and Analysis of Results of
Operations and Financial Condition
(Dollars in thousands) are now being amortized to
expense. We expect this amortization to increase during the remainder of 2004
as additional products are completed. Capitalized development costs were
$2,539 and $1,725 for the three months and $6,830 and $4,893 for the nine
months ended July 31, 2004 and 2003, respectively. The increase in capitalized
product development costs was primarily due to costs capitalized for Lightspan
and New Media products since acquisition. A comparison of gross profit margin by revenue category as reported and on a
pro forma basis, as if Lightspan revenues and cost of revenues prior to the
acquisition had been included for all periods presented, is as follows: Three Months Ended July 31,2004
    
    2003Revenue category
    
    As Reported
    
    As Reported
    
    Pro FormaLicense fees
    
    
    86.7
    %
    
    
    87.0
    %
    
    
    85.8
    %Subscriptions
    
    
    69.3
    %
    
    
    33.3
    %
    
    
    64.6
    %Services
    
    
    43.4
    %
    
    
    32.5
    %
    
    
    39.5
    %Other
    
    
    -9.1
    %
    
    
    6.8
    %
    
    
    10.0
    %Total
    
    
    71.7
    %
    
    
    68.0
    %
    
    
    69.7
    %
 Nine Months Ended July 31,2004
    
    2003Revenue category
    
    As Reported
    
    Pro Forma
    
    As Reported
    
    Pro FormaLicense fees
    
    
    82.1
    %
    
    
    82.1
    %
    
    
    82.7
    %
    
    
    81.5
    %Subscriptions
    
    
    64.7
    %
    
    
    65.3
    %
    
    
    50.8
    %
    
    
    73.1
    %Services
    
    
    40.2
    %
    
    
    40.7
    %
    
    
    30.8
    %
    
    
    38.2
    %Other
    
    
    5.7
    %
    
    
    5.7
    %
    
    
    10.7
    %
    
    
    14.2
    %Total
    
    
    65.1
    %
    
    
    65.2
    %
    
    
    62.8
    %
    
    
    66.3
    %
 The decrease in pro forma gross profit margin from 2003 to 2004 resulted
primarily from the higher proportion of subscriptions, services and other
revenues included in our product sales mix in 2004, which carry lower margins,
and the increased professional development expenses, amortization of
capitalized product development costs and amortization of acquired technology
as discussed above. Future gross profit margin will be dependent primarily on
our revenue mix, the amount of professional development expenses and
amortization of capitalized product development costs and acquired technology.
The total gross profit margin in the fourth quarter of 2004 is expected to
increase slightly from the third quarter 2004 percentage, due to higher
expected revenues and the fixed nature of amortization costs that are included
in cost of revenues. 30




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PLATO Learning, Inc. and Subsidiaries
Managements Discussion and Analysis of Results of
Operations and Financial Condition
(Dollars in thousands) Operating Expenses Sales and Marketing.The following table presents sales and marketing
expenses, as reported and on a pro forma basis, as if Lightspan expenses prior
to the acquisition had been included for all periods presented: Three Months Ended July 31,2004
    
    2003Sales and Marketing
    
    $
    
    % of revenue
    
    $
    
    % of revenue
    
    % ChangePLATO (as reported)
    
    $
    14,897
    
    
    
    36.7
    %
    
    $
    10,079
    
    
    
    42.4
    %
    
    
    47.8
    %Lightspan (pre-acquisition)
    
    
    
    
    
    
    
    
    
    
    8,614Pro forma
    
    $
    14,897
    
    
    
    36.7
    %
    
    $
    18,693
    
    
    
    48.8
    %
    
    
    -20.3
    %
 Nine Months Ended July 31,2004
    
    2003Sales and Marketing
    
    $
    
    % of revenue
    
    $
    
    % of revenue
    
    % ChangePLATO (as reported)
    
    $
    45,875
    
    
    
    46.2
    %
    
    $
    29,263
    
    
    
    53.5
    %
    
    
    56.8
    %Lightspan (pre-acquisition)
    
    
    1,282
    
    
    
    
    
    
    
    23,935Pro forma
    
    $
    47,157
    
    
    
    47.0
    %
    
    $
    53,198
    
    
    
    57.8
    %
    
    
    -11.4
    %
 Sales and marketing expenses, as reported, increased for the three and nine
months ended July 31, 2004, as compared to the same periods in 2003, due
primarily to the Lightspan acquisition. As a percentage of total revenues,
however, both reported and pro forma sales and marketing expenses decreased,
reflecting the cost reduction plan implemented and recorded in purchase
accounting as well as the synergistic benefits received from combining the
PLATO and Lightspan sales and marketing activities. We expect pro forma sales
and marketing expenses for our fourth quarter and fiscal year 2004 to decrease
as well when compared to the same periods in 2003. Fourth quarter 2004
expenses are expected to be slightly more than those of third quarter 2004
because of additional marketing and commission costs resulting from higher
expected revenues. Our ability to continue to leverage our cost structure and
improve profitability is primarily dependent on our ability to generate higher
revenues, integrate our acquisitions and realize sales force productivity
improvements. 31




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PLATO Learning, Inc. and Subsidiaries
Managements Discussion and Analysis of Results of
Operations and Financial Condition
(Dollars in thousands) General and Administrative. The following table presents general and
administrative expenses, as reported and on a pro forma basis, as if Lightspan
expenses prior to the acquisition had been included for all periods presented: Three Months Ended July 31,2004
    
    2003General and Administrative
    
    $
    
    % of revenue
    
    $
    
    % of revenue
    
    % ChangePLATO (as reported)
    
    $
    4,915
    
    
    
    12.1
    %
    
    $
    3,200
    
    
    
    13.4
    %
    
    
    53.6
    %Lightspan (pre-acquisition)
    
    
    
    
    
    
    
    
    
    
    1,343Pro forma
    
    $
    4,915
    
    
    
    12.1
    %
    
    $
    4,543
    
    
    
    11.9
    %
    
    
    8.2
    %
 Nine Months Ended July 31,2004
    
    2003General and Administrative
    
    $
    
    % of revenue
    
    $
    
    % of revenue
    
    % ChangePLATO (as reported)
    
    $
    14,447
    
    
    
    14.5
    %
    
    $
    9,511
    
    
    
    17.4
    %
    
    
    51.9
    %Lightspan (pre-acquisition)
    
    
    310
    
    
    
    
    
    
    
    5,848Pro forma
    
    $
    14,757
    
    
    
    14.7
    %
    
    $
    15,359
    
    
    
    16.7
    %
    
    
    -3.9
    %
 General and administrative expenses, as reported, increased for the three and
nine months ended July 31, 2004, as compared to the same periods in 2003, due
primarily to the Lightspan acquisition. Pro forma general and administrative
expense increased for the three months ended July 31, 2004, from the same
period in 2003, as the Lightspan synergies were less significant than they were
in sales and marketing and product development expenses, and were offset by
increased infrastructure costs associated with our growing business. The
decrease in pro forma general and administrative expense for the nine months
ended July 31, 2004, as compared to the same period in 2003, reflects the cost
reduction plan implemented and recorded in purchase accounting as well as the
synergistic benefits received from combining the PLATO and Lightspan general
and administrative activities. We expect pro forma general and administrative
expenses for our fourth quarter and fiscal year 2004 to decrease as well when
compared to the same periods in 2003. Fourth quarter 2004 expenses are
expected to increase slightly from third quarter 2004, due to increases in bad
debt expense and bonuses resulting from higher expected revenues. 32




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PLATO Learning, Inc. and Subsidiaries
Managements Discussion and Analysis of Results of
Operations and Financial Condition
(Dollars in thousands) Product Development. The following table presents product development
expenses, as reported and on a pro forma basis, as if Lightspan expenses prior
to the acquisition had been included for all periods presented: Three Months Ended July 31,2004
    
    2003Product Development
    
    $
    
    % of revenue
    
    $
    
    % of revenue
    
    % ChangePLATO (as reported)
    
    $
    1,293
    
    
    
    3.2
    %
    
    $
    472
    
    
    
    2.0
    %
    
    
    173.9
    %Lightspan (pre-acquisition)
    
    
    
    
    
    
    
    
    
    
    2,153Pro forma
    
    $
    1,293
    
    
    
    3.2
    %
    
    $
    2,625
    
    
    
    6.9
    %
    
    
    -50.7
    %
 Nine Months Ended July 31,2004
    
    2003Product Development
    
    $
    
    % of revenue
    
    $
    
    % of revenue
    
    % ChangePLATO (as reported)
    
    $
    4,842
    
    
    
    4.9
    %
    
    $
    1,660
    
    
    
    3.0
    %
    
    
    191.7
    %Lightspan (pre-acquisition)
    
    
    327
    
    
    
    
    
    
    
    7,553Pro forma
    
    $
    5,169
    
    
    
    5.2
    %
    
    $
    9,213
    
    
    
    10.0
    %
    
    
    -43.9
    %
 Product development expenses, as reported, increased for the three and nine
months ended July 31, 2004, as compared to the same periods in 2003, due
primarily to the Lightspan and New Media acquisitions. The decrease in pro
forma product development expense reflects the cost reduction plan implemented
and recorded in purchase accounting as well as the synergistic benefits
received from combining the PLATO and Lightspan product development activities.
We expect pro forma product development expenses for our fourth quarter and
fiscal year 2004 to decrease as well when compared to the same periods in 2003.
Fourth quarter 2004 expenses are expected to be similar to third quarter 2004.
A significant portion of PLATOs product development costs qualify for
capitalization. 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 demonstrate
our total level of development activity. Product development spending, before capitalization, was 9.4% of total revenues
for the three months ended July 31, 2004, compared to 9.2% for the same period
in 2003. Product development spending, before capitalization, was 11.7% of
total revenues for the nine months ended July 31, 2004, compared to 12.0% for
the same period in 2003. Our acquisitions of developed technologies and
curriculum content and the completion of several significant projects in prior
years contributed to the decrease in product development spending in 2004. As
part of our growth strategy, we intend to continually introduce new products
and product improvements. The extent of our future product development
spending and the amount of our future capitalized product development costs are
dependent on our ability to develop and introduce new products and product
improvements on a cost-effective and timely basis. 33




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PLATO Learning, Inc. and Subsidiaries
Managements Discussion and Analysis of Results of
Operations and Financial Condition
(Dollars in thousands) Amortization of Intangibles. Expenses for the three and nine months ended July
31, 2004 and 2003 represented the amortization of identified intangible assets,
other than goodwill and acquired technology, from our previous acquisitions.
The increase from 2003 to 2004 was due primarily to the Lightspan acquisition.
With the adoption of SFAS No. 142 in 2002, goodwill is no longer amortized to
expense. 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 Charge.In May 2003, we replaced our Managing Director of
operations in the United Kingdom, and severed relationships with two senior
executives (our Chief Operating Officer and a co-founder of NetSchools) and
three other employees in connection with a restructuring plan to align our cost
structure with future expectations. The consolidated statement of operations
for the nine months ended July 31, 2003 included a restructuring charge of $422
for severance costs related to this action. As of October 31, 2003,
approximately $252 of these severance costs had been paid and as of July 31,
2004 substantially all of these severance costs had been paid. In December
2002, we reduced the size of our workforce by approximately 30 positions and
closed approximately 30 open job requisitions, all in the United States, which
together represented about 10% of our planned workforce, in connection with a
restructuring plan to align our cost structure with future expectations. The
consolidated statement of operations for the nine months ended July 31, 2003
included a restructuring charge of $380 for severance costs related to this
reduction. All of these severance costs were paid as of October 31, 2003. Income Taxes As discussed earlier in the Critical Accounting Policies and Estimates
section of this Managements Discussion and Analysis, as a result of the
Lightspan acquisition, 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
purchase accounting, thereby increasing goodwill, in the first quarter of 2004.
Any subsequent reversal of the valuation allowance recorded on the combined
entitys pre-acquisition deferred tax assets will be recorded as income tax
expense and a reduction to goodwill. We recorded an income tax provision of $150 for the three months, and $450 for
the nine months ended July 31, 2004, related to the tax amortization of tax
deductible goodwill. No income tax provision (benefit) has been recorded in
2004 for our pre-tax earnings (losses) consistent with the income tax
accounting resulting from the Lightspan acquisition. We recorded an income tax
provision of $1,600 for the three months ended July 31, 2003 on pre-tax
earnings of $1,885. We recorded an income tax benefit of $2,185 for the nine
months ended July 31, 2003 on a pre-tax loss of $7,128. This tax benefit was
recorded as it was more likely than not at that time that the tax benefit would
be realized. Our effective income tax rate for this fiscal year, and future quarters and
fiscal years, is dependent on the level of profitability in each of the United
States, Canada and the U.K. We 34




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PLATO Learning, Inc. and Subsidiaries
Managements Discussion and Analysis of Results of
Operations and Financial Condition
(Dollars in thousands) currently expect a consolidated income tax rate
of about 60% for the full year 2004. The extent of any effective rate variance
from this expectation is highly dependent on our operating results in the
United States and the U.K. A larger than expected loss in the U.K., or lower
than expected
profit in the U.S., will likely result in a higher consolidated effective tax
rate. Conversely, if our U.K. subsidiary or U.S. operations are more
profitable than planned, our consolidated effective tax rate could decline. FINANCIAL CONDITION Liquidity and Capital Resources At July 31, 2004, our principal sources of liquidity included cash and cash
equivalents of $27,011, net accounts receivable of $46,831, long-term
marketable securities of $3,993 and our unused line of credit. Working capital
was $27,723 and $34,701 at July 31, 2004 and October 31, 2003, respectively.
The decrease in working capital was primarily due to the decrease in deferred
income taxes of $2,218, and the increases in accounts payable, accrued salaries
and benefits and accrued liabilities of $6,747 and deferred revenue of $13,415,
offset by the increases in net accounts receivable of $7,655 and prepaid
expenses and other current assets of $4,570. Deferred income taxes decreased
due to our deferred income tax assets being fully reserved through purchase
accounting for the Lightspan acquisition. Accrued liabilities and deferred
revenue increased as a result of the Lightspan acquisition. Deferred revenue,
which is satisfied through delivery of products and services rather than cash,
also increased due to increased sales of our services and subscription-based
products. Accounts receivable increased due to the Lightspan acquisition along
with the increase in revenues, offset by improvements in collection of
outstanding balances. Prepaid expenses and other current assets increased due
to the Lightspan acquisition. Cash provided by operations, excluding changes in our working capital accounts,
was $11,693 and $1,870 for the nine months ended July 31, 2004 and 2003,
respectively. During the nine months ended July 31, 2004, the cash provided by operations,
excluding changes in our working capital accounts, of $11,693 and the net cash
flow provided by financing activities of $1,553 increased our cash and cash
equivalents and was used to fund the changes in our working capital accounts of
$3,528 and the net cash used in our investing activities of $6,381. Changes in
our working capital accounts were primarily due to increased prepaid expenses
and other current assets, decreased accounts payable and accrued liabilities,
partially offset by the increase in deferred revenue. During the nine months ended July 31, 2003, the decrease in cash and cash
equivalents of $3,474, the cash provided by operations, excluding changes in
our working capital accounts, of $1,870 and the changes in our working capital
accounts of $3,380 was used to fund the net cash used in our investing
activities of $6,435 and financing activities of $2,306. Changes in our
working capital accounts were primarily due to increased deferred revenue and
accounts payable, 35




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PLATO Learning, Inc. and Subsidiaries
Managements Discussion and Analysis of Results of
Operations and Financial Condition
(Dollars in thousands) and decreased prepaid expenses and other current assets,
partially offset by increased accounts receivable and decreased accrued
liabilities. Net cash used in our investing activities was $6,381 for the nine months ended
July 31, 2004 and $6,435 for the same period in 2003. In 2004, as compared to
2003, we had net cash provided
from acquisitions of $2,460, we increased our capitalization of product
development costs by $1,937 and we increased our capital expenditures by $338.
Net cash provided from the Lightspan acquisition was $8,696 and net cash used
for the New Media acquisition was $6,236.
Net cash provided by our financing activities was $1,553 for the nine months
ended July 31, 2004, as compared to net cash used of $2,306 for the same period
in 2003. In 2004, we received $1,812 from the exercise of outstanding stock
options and warrants and common stock issued under our employee stock purchase
plan. We also repurchased shares of our common stock for $205. In 2003, we
repurchased shares of our common stock for an aggregate cost of $2,161. 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. Cumulatively, we
have repurchased 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. On June 10, 2004, we extended our revolving loan agreement with Wells Fargo
Bank, N.A. through July 1, 2005. We have resources available under this
revolving loan agreement to provide borrowings up to $12,500, as determined by
the available borrowing base. At July 31, 2004, 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 July 31, 2004. 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. As
discussed earlier, we acquired Lightspan, in a stock transaction, and New
Media, in a cash transaction, during the three months ended January 31, 2004. 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 July 31, 2004. 36




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PLATO Learning, Inc. and Subsidiaries
Managements Discussion and Analysis of Results of
Operations and Financial Condition
(Dollars in thousands) Disclosures about Contractual Obligations and Commercial Commitments Our contractual obligations and commercial commitments consist of future
payments due under capital lease obligations and operating leases. In
addition, any future borrowings under our revolving loan agreement, which
provides for a maximum $12,500 line of credit through July 1, 2005, would
require future use of cash. Payments Due by PeriodLess than
    
    1 to 3
    
    4 to 5
    
    After 5Contractual Obligations
    
    Total
    
    1 year
    
    Years
    
    Years
    
    YearsCapital lease obligations
    
    $
    645
    
    
    $
    337
    
    
    $
    308
    
    
    $
    
    
    
    $
    Operating leases
    
    
    8,922
    
    
    
    2,764
    
    
    
    2,547
    
    
    
    2,062
    
    
    
    1,549Total
    
    $
    9,567
    
    
    $
    3,101
    
    
    $
    2,855
    
    
    $
    2,062
    
    
    $
    1,549
 At July 31, 2004, we had no significant commitments for capital expenditures.
With the NetSchools acquisition in 2002, additional cash consideration may be
due of up to approximately $6,000, contingent on the NetSchools product and
services revenues generated through October 2004. If earned, any additional
consideration will be recorded as additional goodwill. As of July 31, 2004, no
additional consideration has been earned. 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
July 31, 2004, 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. Foreign Currency Exchange Rate Risk We market our products and services worldwide and have operations in Canada and
the United Kingdom. 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.
Approximately 3% of our total revenues were denominated in currencies other
than the U.S. dollar for the nine months ended July 31, 2004. Our foreign
subsidiaries are not a significant component of our business, and, as a result,
risk relating to foreign currency fluctuation is considered minimal. 37




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##### Table of Contents



PART I 
 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 Results of Operations and Financial Condition. 
 Item 4. CONTROLS AND PROCEDURES As of July 31, 2004, 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 effective to make known to them
in a timely fashion material information related to the Company required to be
filed in this report. There have been no significant changes in our internal
controls over financial reporting, or in other factors that could significantly
affect internal controls, subsequent to the date of their evaluation during the
most recent fiscal quarter. While we believe the present design of our disclosure controls and procedures
is effective to make known to our senior management in a timely fashion all
material information concerning our business, 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. 38




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##### Table of Contents



PART II. OTHER INFORMATION 
 Item 1. Legal Proceedings We are not a party to any litigation that is expected to have a
material adverse effect on our business or our consolidated
financial statements. 
 Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of
Equity Securities Not Applicable. 
 Item 3. Defaults Upon Senior Securities Not Applicable. 
 Item 4. Submission of Matters to a Vote of Security Holders Not Applicable. 
 Item 5. Other Information 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 for fiscal
2004. 39




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##### Table of Contents



Item 6. Exhibits and Reports on Form 8-K (a) Exhibits Exhibit Number and Description  10.46
    
    Form of Stock Option Agreements.31.01
    
    Certification of Chief Executive Officer pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.31.02
    
    Certification of Chief Financial Officer pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.32.01
    
    Certification of Chief Executive Officer pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.32.02
    
    Certification of Chief Financial Officer pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002. (b) Reports on Form 8-K: On May 27, 2004 we filed a Current Report on Form 8-K to announce our
second quarter 2004 financial results. 40




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##### Table of Contents



SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized on September 14, 2004. PLATO LEARNING, INC.By
    /s/John MurrayChairman, President andChief Executive Officer
(principal executive officer) /s/Gregory J. MelsenVice President, Finance andChief Financial Officer
(principal financial officer) /s/Laurence L. BetterleyVice President, Finance andChief Accounting Officer
(principal accounting officer) 41