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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington, DC 20549
 FORM 10-Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d)
OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended January 31, 2005 Commission File Number 0-20842 PLATO LEARNING, INC. (Exact name of Registrant as specified in its charter)
 Delaware
    
    36-3660532(State or other jurisdiction of incorporation or organization)
    
    (IRS Employer Identification Number)
 10801 Nesbitt Avenue South, Bloomington, MN 55437(Address of principal executive offices) (952) 832-1000(Registrants telephone number, including area code) Not Applicable(Former name, former address and former fiscal year, if changed since last report) Indicate by check mark whether the Registrant (1) has filed all reports required to be filed
by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or
for such shorter period that the registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days. Yes
þ       No o Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of
the Exchange Act. Yes þ
      No o Indicate the number of shares outstanding of each of the Registrants classes of common stock, as
of the latest practicable date. 23,346,150 shares of common stock, $.01 par value, outstanding as
of February 28, 2005.   1




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PLATO LEARNING, INC. Form 10-Q
 Quarter Ended January 31, 2005
 TABLE OF CONTENTS PagePART I. FINANCIAL INFORMATIONItem 1.    Consolidated Financial Statements (Unaudited):Consolidated Statements of Operations for the
Three Months Ended January 31, 2005 and 2004
    
    
    4Consolidated Balance Sheets as of
January 31, 2005 and October 31, 2004
    
    
    5Consolidated Statements of Cash Flows for the
Three Months Ended January 31, 2005 and 2004
    
    
    6Notes to Consolidated Financial Statements
    
    
    7Item 2.     Managements Discussion and Analysis of Financial
Condition and Results of Operations
    
    
    14Item 3.    Quantitative and Qualitative Disclosures About Market Risk
    
    
    29Item 4.
     Controls and Procedures
    
    
    29PART II. OTHER INFORMATIONItem 1.     Legal Proceedings
    
    
    30Item 2.     Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    30Item 3.     Defaults Upon Senior Securities
    
    
    30Item 4.     Submission of Matters to a Vote of Security Holders
    
    
    30Item 5.
     Other Information
    
    
    30Item 6.
     Exhibits
    
    
    31SIGNATURES
    
    
    32Certification of CEO Pursuant to Section 302Certification of CFO Pursuant to Section 302Certification of CEO Pursuant to Section 906Certification of CFO Pursuant to Section 906
  2




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




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PLATO Learning, Inc. and Subsidiaries 
 Consolidated Statements of Operations
(Unaudited, in thousands, except per share amounts)
 
 Three Months EndedJanuary 31,2005
    
    
    2004Revenues:License fees
    
    $
    11,095
    
    
    $
    13,059Subscriptions
    
    
    4,533
    
    
    
    4,508Services
    
    
    8,196
    
    
    
    6,337Other
    
    
    1,631
    
    
    
    2,544Total revenues
    
    
    25,455
    
    
    
    26,448Cost of revenues:License fees
    
    
    3,432
    
    
    
    3,341Subscriptions
    
    
    2,313
    
    
    
    1,679Services
    
    
    6,126
    
    
    
    3,764Other
    
    
    1,700
    
    
    
    2,199Total cost of revenues
    
    
    13,571
    
    
    
    10,983Gross profit
    
    
    11,884
    
    
    
    15,465Operating expenses:Sales and marketing
    
    
    13,326
    
    
    
    15,185General and administrative
    
    
    4,210
    
    
    
    4,492Product development
    
    
    1,471
    
    
    
    2,203Amortization of intangibles
    
    
    1,092
    
    
    
    983Restructuring and other charges
    
    
    2,289
    
    
    
    Total operating expenses
    
    
    22,388
    
    
    
    22,863Operating loss
    
    
    (10,504
    )
    
    
    (7,398
    )Interest income
    
    
    212
    
    
    
    119Interest expense
    
    
    (15
    )
    
    
    (35
    )Other expense, net
    
    
    (70
    )
    
    
    (71
    )Loss before income taxes
    
    
    (10,377
    )
    
    
    (7,385
    )Income tax expense
    
    
    150
    
    
    
    150Net loss
    
    $
    (10,527
    )
    
    $
    (7,535
    )Loss per share:Basic and diluted
    
    $
    (0.46
    )
    
    $
    (0.35
    )Weighted average common shares outstanding:Basic and diluted
    
    
    23,110
    
    
    
    21,500
 See Notes to Consolidated Financial Statements 4




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PLATO Learning, Inc. and Subsidiaries 
 Consolidated Balance Sheets
(In thousands, except per share amounts)
 
 January 31,
    
    
    October 31,2005
    
    
    2004(Unaudited)
    
    
    (See Note)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    38,859
    
    
    $
    29,235Marketable securities
    
    
    2,999
    
    
    
    12,615Accounts receivable, net
    
    
    28,672
    
    
    
    41,852Prepaid expenses and other current assets
    
    
    10,434
    
    
    
    9,460Total current assets
    
    
    80,964
    
    
    
    93,162Long-term marketable securities
    
    
    
    
    
    
    3,608Equipment and leasehold improvements, net of accumulated
depreciation and amortization of $11,152 and $10,361, respectively
    
    
    7,839
    
    
    
    7,946Product development costs, net of accumulated amortization of
$20,731 and $18,835, respectively
    
    
    17,821
    
    
    
    17,116Goodwill
    
    
    71,404
    
    
    
    71,267Identified intangible assets, net
    
    
    37,232
    
    
    
    39,432Other assets
    
    
    178
    
    
    
    213Total assets
    
    $
    215,438
    
    
    $
    232,744LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    2,999
    
    
    $
    5,196Accrued employee salaries and benefits
    
    
    6,907
    
    
    
    8,772Accrued liabilities
    
    
    6,793
    
    
    
    6,383Deferred revenue
    
    
    40,732
    
    
    
    43,042Total current liabilities
    
    
    57,431
    
    
    
    63,393Long-term deferred revenue
    
    
    5,927
    
    
    
    8,533Deferred income taxes
    
    
    1,472
    
    
    
    1,322Other liabilities
    
    
    26
    
    
    
    46Total liabilities
    
    
    64,856
    
    
    
    73,294Stockholders equity:Common stock, $.01 par value, 50,000 shares authorized;
23,340 shares issued and 23,320 outstanding at January 31,
2005; 23,095 shares issued and 23,075 shares outstanding
at October 31, 2004
    
    
    233
    
    
    
    231Additional paid in capital
    
    
    164,354
    
    
    
    162,956Treasury stock at cost, 20 shares
    
    
    (205
    )
    
    
    (205
    )Accumulated deficit
    
    
    (13,377
    )
    
    
    (2,850
    )Accumulated other comprehensive loss
    
    
    (423
    )
    
    
    (682
    )Total stockholders equity
    
    
    150,582
    
    
    
    159,450Total liabilities and stockholders equity
    
    $
    215,438
    
    
    $
    232,744
 Note: The balance sheet at
October 31, 2004 has been derived from our audited financial
statements at that date. See Notes to Consolidated Financial Statements. 5




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PLATO Learning, Inc. and Subsidiaries 
 Consolidated Statements of Cash Flows
(Unaudited, in thousands)
 
 Three Months EndedJanuary 31,2005
    
    
    2004Operating activities:Net loss
    
    $
    (10,527
    )
    
    $
    (7,535
    )Adjustments to reconcile net loss to net cash
used in operating activities:Deferred income taxes
    
    
    150
    
    
    
    150Amortization of capitalized product development costs
    
    
    1,868
    
    
    
    1,764Amortization of identified intangible assets
    
    
    2,243
    
    
    
    1,780Depreciation and amortization of equipment and
leasehold improvements
    
    
    873
    
    
    
    911Restructuring and other charges
    
    
    2,289
    
    
    
    Provision for doubtful accounts
    
    
    305
    
    
    
    346Loss on disposal of equipment
    
    
    14
    
    
    
    1Changes in assets and liabilities, net of effects of acquisitions:Accounts receivable
    
    
    12,875
    
    
    
    5,741Prepaid expenses and other current and noncurrent assets
    
    
    (939
    )
    
    
    (1,296
    )Accounts payable
    
    
    (2,197
    )
    
    
    (1,314
    )Accrued liabilities, accrued employee salaries and
benefits and other liabilities
    
    
    (3,738
    )
    
    
    (3,586
    )Deferred revenue
    
    
    (4,916
    )
    
    
    1,786Total adjustments
    
    
    8,827
    
    
    
    6,283Net cash used in operating activities
    
    
    (1,700
    )
    
    
    (1,252
    )Investing activities:Acquisitions, net of cash acquired
    
    
    
    
    
    
    2,324Capital expenditures
    
    
    (748
    )
    
    
    (572
    )Capitalization of product development costs
    
    
    (2,876
    )
    
    
    (1,664
    )Purchases of marketable securities
    
    
    (2,985
    )
    
    
    Sales and maturities of marketable securities
    
    
    16,251
    
    
    
    116Net cash provided by investing activities
    
    
    9,642
    
    
    
    204Financing activities:Net proceeds from issuance of common stock
    
    
    1,400
    
    
    
    1,311Repayments of capital lease obligations
    
    
    (26
    )
    
    
    (60
    )Net cash provided by financing activities
    
    
    1,374
    
    
    
    1,251Effect of foreign currency on cash
    
    
    308
    
    
    
    159Net increase in cash and cash equivalents
    
    
    9,624
    
    
    
    362Cash and cash equivalents at beginning of period
    
    
    29,235
    
    
    
    23,834Cash and cash equivalents at end of period
    
    $
    38,859
    
    
    $
    24,196
 See Notes to Consolidated Financial Statements 6




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PLATO Learning, Inc. and Subsidiaries 
 Notes to Consolidated Financial Statements
 1. Business We provide computer-based and e-learning instruction software and related services for
kindergarten through adult learners, offering curricula in reading, writing, math, science, social
studies, and life and job skills. We also offer online assessment and accountability solutions and
standards-based professional development services. With over 6,000 hours of objective-based,
problem-solving courseware, plus assessment, alignment, and curriculum management tools, we create
standards-based curricula that facilitate learning and school improvement. PLATO educational software is delivered via networks, CD-ROM, the Internet, and private
intranets. We market our software products and related services primarily to K-12 schools and
colleges. We also sell to job training programs, correctional institutions, military education
programs, corporations, and individuals. We are subject to risks and uncertainties including, but not limited to, dependence on
information technology spending by our customers, well-established competitors, customers dependent
on government funding, fluctuations of our quarterly results, a lengthy and variable sales cycle,
dependence on key personnel, dependence on our intellectual property rights, and rapid
technological change. 2. Basis of Presentation The accompanying unaudited consolidated financial statements have been prepared in accordance
with accounting principles generally accepted in the United States of America for interim financial
information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly,
they do not include all of the information and footnotes required by accounting principles
generally accepted in the United States of America for complete financial statements. We have
included all normal recurring and other adjustments considered necessary to give a fair
presentation of our operating results for the interim periods shown. Operating results for these
interim periods are not necessarily indicative of the results to be expected for the full fiscal
year. For further information, refer to the consolidated financial statements and accompanying
notes included in our Annual Report on Form 10-K for the fiscal year ended October 31, 2004. The accompanying unaudited consolidated financial statements include the accounts of PLATO
Learning, Inc. and its wholly owned subsidiaries. All significant intercompany accounts and
transactions have been eliminated. 3. Summary of Significant Accounting Policies For more information on our significant accounting policies, refer to Note 2 to Consolidated
Financial Statements in our Annual Report on Form 10-K for the year ended October 31, 2004. Stock-Based Compensation We account for our stock-based employee compensation arrangements in accordance with the
provisions of Accounting Principles Board Opinion No. 25 Accounting for Stock Issued to Employees 7




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and comply with the disclosure provisions of Statement of Financial Accounting Standards (SFAS)
No. 123, Accounting for StockBased Compensation and SFAS No. 148 Accounting for Stock-Based
Compensation  Transition and Disclosure, an amendment of Financial Accounting Standards Board
Statement No. 123. For purposes of the pro forma disclosures 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 EndedJanuary 31,2005
    
    
    2004Net loss, as reported
    
    $
    (10,527
    )
    
    $
    (7,535
    )Add: stock-based compensation expense included
in reported net loss
    
    
    
    
    
    
    Deduct: stock-based compensation expense determined
using the fair value based method for all awards
    
    
    (1,030
    )
    
    
    (1,626
    )Pro forma net loss
    
    $
    (11,557
    )
    
    $
    (9,161
    )Basic and diluted loss per share:As reported
    
    $
    (0.46
    )
    
    $
    (0.35
    )Pro forma
    
    $
    (0.50
    )
    
    $
    (0.43
    )
 In
December 2004, the Financial Accounting Standards Board issued
SFAS No. 123(R),
Share-Based Payment (SFAS 123(R)). SFAS 123(R) establishes standards for accounting for
transactions in which an entity exchanges its equity instruments for goods or services. SFAS
123(R) focuses primarily on accounting for transactions in which an entity obtains employee
services in share-based payment transactions. SFAS 123(R) requires that the fair value of such
equity instruments be recognized as expense in the financial statements as services are performed.
Prior to SFAS 123(R), only the pro forma disclosures of fair value presented above were required.
SFAS 123(R) is effective for our fourth quarter of 2005. The adoption of this new accounting
pronouncement is expected to have a material impact on our consolidated financial statements. 8




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4. Acquisitions In November 2003, we acquired Lightspan, Inc. (Lightspan). In December 2003, we acquired
New Media (Holdings) Limited (New Media). For more information on these acquisitions, refer to
Note 3 to Consolidated Financial Statements in our Annual Report on Form 10-K for the year ended
October 31, 2004. Our unaudited pro forma consolidated results of operations, as if the Lightspan
acquisition had occurred at the beginning of the period presented, were as follows: Three MonthsEndedJanuary 31, 2004(Unaudited)Revenues
    
    $
    27,417Net loss
    
    
    (9,116
    )Basic and diluted loss per share
    
    
    (0.40
    )
 The unaudited pro forma data gives effect to actual operating results prior to the
acquisition and adjustments to reflect increased identified intangible asset amortization and the
current accounting treatment of income taxes. No effect has been given to cost reductions or
operating synergies in this presentation. The unaudited pro forma consolidated results of
operations are for comparative purposes only and do not necessarily reflect the results that would
have occurred had the acquisition occurred at the beginning of the period presented or the results
which may occur in the future. The pro forma data does not include New Media, as the effects of
this acquisition were not material on a pro forma basis. 5. Accounts Receivable The components of accounts receivable were as follows: January 31,
    
    
    October 31,2005
    
    
    2004Trade accounts receivable
    
    $
    20,969
    
    
    $
    28,396Installment accounts receivable
    
    
    10,004
    
    
    
    16,168Allowance for doubtful accounts
    
    
    (2,301
    )
    
    
    (2,712
    )$
    28,672
    
    
    $
    41,852
 The provision for doubtful accounts, included in general and administrative expense on
the consolidated statements of operations, was $305 and $346 for the three months ended January 31,
2005 and 2004, respectively. 6. Goodwill and Identified Intangible Assets Goodwill The changes in goodwill from October 31, 2004 were as follows: Balance, October 31, 2004
    
    $
    71,267Foreign currency translation
    
    
    137Balance, January 31, 2005
    
    $
    71,404
 9




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Identified Intangible Assets Identified intangible assets subject to amortization were as follows: January 31, 2005
    
    
    October 31, 2004Gross
    
    
    
    
    
    
    
    
    
    
    GrossCarrying
    
    
    Accumulated
    
    
    Net Carrying
    
    
    Carrying
    
    
    Accumulated
    
    
    Net CarryingValue
    
    
    Amortzation
    
    
    Value
    
    
    Value
    
    
    Amortzation
    
    
    ValueAcquired technology
    
    $
    24,906
    
    
    $
    (7,046
    )
    
    $
    17,860
    
    
    $
    24,856
    
    
    $
    (5,882
    )
    
    $
    18,974Trademarks and
tradenames
    
    
    3,680
    
    
    
    (1,505
    )
    
    
    2,175
    
    
    
    3,680
    
    
    
    (1,328
    )
    
    
    2,352Customer relationships
and lists
    
    
    21,242
    
    
    
    (4,441
    )
    
    
    16,801
    
    
    
    21,238
    
    
    
    (3,653
    )
    
    
    17,585Employment agreement
    
    
    413
    
    
    
    (413
    )
    
    
    
    
    
    
    413
    
    
    
    (413
    )
    
    
    Noncompete agreements
    
    
    1,090
    
    
    
    (694
    )
    
    
    396
    
    
    
    1,090
    
    
    
    (569
    )
    
    
    521$
    51,331
    
    
    $
    (41,099
    )
    
    $
    37,232
    
    
    $
    51,277
    
    
    $
    (11,845
    )
    
    $
    39,432
 Amortization expense for identified intangible assets was $2,243 and $1,780 for the three
months ended January 31, 2005 and 2004, respectively, of which $1,151 and $797 was included in cost
of revenues related to license fees and subscriptions for each period, respectively. The estimated future annual amortization expense for identified intangible assets is as
follows: Remainder of 2005
    
    
    6,1412006
    
    
    7,1592007
    
    
    6,9362008
    
    
    6,3392009
    
    
    5,055Thereafter
    
    
    5,602$
    37,232
 7. Debt Revolving Loan Our revolving loan agreement with Wells Fargo Bank, N.A. provides for a maximum $12,500 line
of credit through July 1, 2005. Substantially all of our assets are pledged as collateral under
the agreement. There were no borrowings outstanding at January 31, 2005 or October 31, 2004. The agreement contains restrictive financial covenants (including Minimum Tangible Net Worth,
Minimum Debt Service Coverage, Maximum Leverage, Maximum Cash Flow Leverage and Maximum Annual
Capital Expenditures) and restrictions on additional borrowings, asset sales and dividends, as
defined. All applicable covenants were satisfied as of and for the twelve-month period ended
January 31, 2005. 10




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8. Deferred Revenue The components of deferred revenue were as follows: January 31,
    
    
    October 31,2005
    
    
    2004License fees
    
    $
    5,474
    
    
    $
    5,490Subscriptions
    
    
    11,249
    
    
    
    13,473Services
    
    
    29,467
    
    
    
    32,079Other
    
    
    469
    
    
    
    53346,659
    
    
    
    51,575Less: long-term amounts
    
    
    (5,927
    )
    
    
    (8,533
    )$
    40,732
    
    
    $
    43,042
 9. Restructuring and Other Charges Restructuring and other charges include severance costs for headcount reductions and costs
paid to, or claimed by, terminated executive officers under employment agreements: Three MonthsEndedJanuary 31, 2005Executive officer changes
    
    $
    1,586U.K. headcount reduction
    
    
    430U.S. headcount reduction
    
    
    273$
    2,289
 In January 2005, we initiated plans to reduce headcount by approximately 30 positions and
close certain facilities in the United Kingdom (U.K.). This restructuring is part of an ongoing
evaluation of our U.K. operations and we are continuing to explore alternatives as necessary to
improve the U.K.s impact on our profitability. Severance costs of $430 for these planned employee
terminations were recorded during the three months ended January 31, 2005. The majority of these
costs are expected to be paid during our second quarter of 2005 as employees are terminated.
Additional charges are expected in 2005 for costs associated with the planned facility closings.
These charges will be recorded as the facilities are closed and no longer being used. Also in January 2005, we reduced headcount in the United States to more closely align our cost
structure with expected revenues in 2005. Six positions were eliminated and severance charges of
$273 were recorded during the three months ended January 31, 2005. All of these costs had been
paid as of January 31, 2005. In November 2004, we announced the resignations of John Murray, our Chairman, President and
Chief Executive Officer, and three other executive officers. The severance provisions of Mr.
Murrays employment agreement, dated January 1, 2001, provide for him to (a) be paid his current
base salary of
$350 per year through December 31, 2007, (b) be paid bonus earned for the fiscal year ended
October 31, 2004 and a pro rata portion of bonus, if earned, for the fiscal year ending October 31,
2005, and (c) be granted options to purchase 260,000 shares of common stock, with an exercise price
equal to fair market value as of the date of grant, which will vest over a three-year period. In
addition, certain options previously granted to Mr. Murray will accelerate and be immediately
exercisable. Mr. Murrays right to 11




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receive these benefits is subject to his complying with his
continuing obligations under the employment agreement related to a transition period and the
confidentiality, non-competition and non-solicitation provisions of the employment agreement, and
executing a release of claims. We recorded charges of $1,586 related to these executive
terminations during the three months ended January 31, 2005, of which $274 had been paid as of
January 31, 2005. We are currently negotiating the terms of Mr. Murrays severance arrangement and
the amount and timing of charges related to it have not yet been
finalized. 10. Income Taxes At January 31, 2005 and October 31, 2004, our deferred tax assets were fully reserved. At
October 31, 2004, approximately $28,980 of the gross deferred tax asset relates to our net
operating loss carryforwards in the United States (U.S.) of approximately $72,451, which expire
in varying amounts between 2005 and 2023. Also included in our gross deferred tax asset was $2,117
for our net operating loss carryforwards of approximately $5,293 related to our foreign
subsidiaries. We have provided a full valuation allowance related to these foreign deferred income
tax assets due to the uncertainty in realization of future taxable income in these foreign
jurisdictions. Realization of our U.S. deferred tax asset is dependent on generating sufficient taxable
income in the U. S. prior to expiration of these loss carryforwards. Our merger with Lightspan in
the first quarter of fiscal 2004 impacted our assessment of the realization of deferred tax assets
because the merged company is considered one consolidated taxable entity. As a result of the merger, we acquired approximately $290,000 of Lightspans net operating
loss carryforwards. Based on a preliminary Section 382 limitation analysis, the usage of these net
operating loss carryforwards is limited to approximately $3,200 per year and, therefore,
approximately $45,000 of the acquired net operating loss carryforwards are available to the
combined entity. These amounts are preliminary and may change as the Section 382 limitation
analysis is completed and analysis of recent announcements by the Internal Revenue Service is taken
into account. The combined net operating loss carryforwards at the acquisition date, which represent the majority
of the merged companys deferred tax assets at that date, have been reviewed for realization
primarily based upon historical results and secondarily upon projected results. Although we expect
taxable income in 2005, this expectation is highly dependent on the improvement of market
conditions and operational performance. Lightspan has historically incurred
significant operating losses, which carry more weight than the projected results. Consequently our
historical combined operating results were insufficient to support the combined post-merger
deferred tax assets. As a result, net deferred tax assets, excluding the deferred tax liability
relating to tax deductible goodwill, which cannot be used to support realization of the other net
deferred tax assets, were fully reserved in the purchase accounting for the Lightspan
acquisition in the first quarter of 2004 thereby increasing goodwill. Any subsequent reversal of
the valuation allowance recorded on the combined entitys pre-acquisition deferred tax assets will
be recorded as a reduction of goodwill, as opposed to recording an income tax benefit in the
consolidated statement of operations. A similar analysis and judgment has resulted in a full
valuation allowance being placed on the deferred tax assets generated subsequent to the acquisition
of Lightspan. 12




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11. Per Share Data The calculation of basic and diluted loss per share was as follows: Three Months EndedJanuary 31,2005
    
    
    2004Net loss
    
    $
    (10,527
    )
    
    $
    (7,535
    )Basic and diluted:Weighted average common shares outstanding
    
    
    23,110
    
    
    
    21,500Basic and diluted loss per share
    
    $
    (0.46
    )
    
    $
    (0.35
    )
 The calculation of diluted loss per share for the three months ended January 31, 2005 and
2004 excluded the effect of approximately 3,591,000 and 3,676,000 potential common shares from the
conversion of outstanding options and warrants and common shares held in escrow, respectively, as
they were antidilutive. 12. Comprehensive Loss Total comprehensive loss was as follows: Three Months EndedJanuary 31,2005
    
    
    2004Net loss
    
    $
    (10,527
    )
    
    $
    (7,535
    )Unrealized gains on available for sale securities
    
    
    42
    
    
    
    Foreign currency translation adjustments
    
    
    217
    
    
    
    237Total comprehensive loss
    
    $
    (10,268
    )
    
    $
    (7,298
    )
 13. Segment and Geographic Information We operate and manage our business as one industry segment, which is the development and
marketing of educational software and related services. We have foreign subsidiaries in Canada and
the U.K. Our foreign operations are not significant to our consolidated business. At January 31,
2005, approximately 7% of our long-term assets are located in foreign countries, and for the three
months ended January 31, 2005, approximately 4% of our revenues are from foreign countries. 14. Subsequent Event In February 2005, we announced the appointment of Michael A. Morache, as President and Chief
Executive Officer of PLATO Learning, Inc. This appointment became effective on February 28, 2005,
at which time we entered into an employment agreement with Mr. Morache which provides for, among
other things, annual salary, benefits, and cash bonus payments and restricted stock and stock
option grants as determined by our Board of Directors. The agreement also provides for potential
future cash payments of up to $1,600 subject to certain conditions and events. 13




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Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations Overview We provide computer-based and e-learning instruction software and related services for
kindergarten through adult learners, offering curricula in reading, writing, math, science, social
studies, and life and job skills. We also offer online assessment and accountability solutions and
standards-based professional development services. With over 6,000 hours of objective-based,
problem-solving courseware, plus assessment, alignment, and curriculum management tools, we create
standards-based curricula that facilitate learning and school improvement. PLATO educational software is delivered via networks, CD-ROM, the Internet, and private
intranets. We market our software products and related services primarily to K-12 schools and
colleges. We also sell to job training programs, correctional institutions, military education
programs, corporations, and individuals. We are subject to risks and uncertainties including, but not limited to, dependence on
information technology spending by our customers, well-established competitors, customers dependent
on government funding, fluctuations of our quarterly results, a lengthy and variable sales cycle,
dependence on key personnel, dependence on our intellectual property rights, and rapid
technological change. As provided for in the Private Securities Litigation Reform Act of 1995, we
caution investors that these factors could cause our future results of operations to vary from
those anticipated in previously made forward-looking statements and any other forward-looking
statements made in this document and elsewhere by or on behalf of us. Critical Accounting Policies and Estimates Our discussion and analysis of financial condition and results of operations is based upon our
consolidated financial statements, which have been prepared in accordance with accounting
principles generally accepted in the United States of America. The preparation of these financial
statements requires us to make estimates and judgments that affect the reported amounts of assets,
liabilities, revenues, and expenses. We continually evaluate our critical accounting policies and
estimates, and have identified revenue recognition, the allowance for doubtful accounts,
capitalized product development costs, the valuation of our deferred income taxes, and the
valuation and impairment analysis of goodwill and identified intangible assets as the critical
accounting policies and estimates that are significant to the financial statement presentation and
that require difficult, subjective, and complex judgments. See Note 2 to Consolidated Financial Statements in our Annual Report on Form 10-K for the
fiscal year ended October 31, 2004 for additional discussion on these and other accounting policies
and disclosures required by accounting principles generally accepted in the United States of
America. Revenue Recognition Revenue recognition rules for software companies are very complex. We follow specific and
detailed guidelines in determining the proper amount of revenue to be recorded; however, certain
judgments affect the application of our revenue recognition policy. Revenue results are difficult
to predict, and any shortfall in revenue or delay in recognizing revenue could cause our operating
results to vary significantly from quarter to quarter. 14




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The significant judgments for revenue recognition typically involve whether collectibility can
be considered probable and whether fees are fixed or determinable. In addition, our transactions
often consist of multiple element arrangements, which must be analyzed to determine the relative
fair value of each element, the amount of revenue to be recognized upon shipment, if any, and the
period and conditions under which deferred revenue should be recognized. We recognize revenue in accordance with the provisions of Statement of Position No. 97-2,
Software Revenue Recognition, as amended and modified, as well as Technical Practice Aids issued
from time to time by the American Institute of Certified Public Accountants, and Staff Accounting
Bulletin No. 104, Revenue Recognition. We license software under non-cancelable license and
subscription agreements. We also provide related professional services, including consulting,
training, tutoring, and implementation services, as well as ongoing customer support and
maintenance. Consulting, training, and implementation services are not essential to the
functionality of our software products. Accordingly, revenues from these services are recognized
separately. Revenue from the sale of courseware licenses is recognized upon meeting the following
criteria: (i) a written customer order has been executed, (ii) courseware has been delivered, (iii)
the license fee is fixed or determinable, and (iv) collectibility of the fee is probable. For software arrangements that include more than one element, we allocate the total
arrangement fee among each deliverable based on vendor-specific objective evidence (VSOE) of the
relative fair value of each deliverable. VSOE is determined using the price charged when that
element is sold separately. For software arrangements in which we do not have VSOE for undelivered
elements, revenue is deferred until the earlier of when VSOE is determined for the undelivered
elements or when all elements for which we do not have VSOE have been delivered. If collectibility of the fee is not probable, revenue is recognized as payments are received
from the customer provided all other revenue recognition criteria have been met. If the fee due
from the customer is not fixed or determinable, revenue is recognized as the payments become due
provided all other revenue recognition criteria have been met. Subscription revenue, primarily fees charged for our PLATO Web Learning Network, eduTest and
PLATO Orion products, is recognized on a ratable basis as the products are delivered over the
subscription period. Services revenue consists of software support and maintenance, which is deferred and
recognized ratably over the support period, and consulting, training, tutoring, and implementation
services, which are recognized as the services are performed. Other revenue, primarily from hardware and third-party software products, is recognized as the
products are delivered and all other revenue recognition criteria are met. Allowance for Doubtful Accounts We determine an allowance for doubtful accounts based upon an analysis of the collectibility
of specific accounts, historical experience, and the aging of the trade and installment accounts
receivable. Bad debt expense is included in general and administrative expense in our consolidated
statements of operations. The assumptions and estimates used to determine the allowance are
subject to constant revision and involve significant judgment. The primary factors that impact
these assumptions include the efficiency
and effectiveness of our billing and collection functions, our historical experience, and our 15




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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 $2,301, or 7.4%
of gross accounts receivable, at January 31, 2005, as compared to $2,712, or 6.1%, at October 31,
2004. Capitalized Product Development Costs Our product development costs relate to the research, development, enhancement, and
maintenance of our courseware products. The amortization of capitalized product development costs
is included in cost of revenues related to license fees and subscriptions. Research and
development costs, relating principally to the design and development of new products and the
routine enhancement and maintenance of existing products, are expensed as incurred. We capitalize
product development costs when the projects under development reach technological feasibility. A
significant portion of our product development costs qualify for capitalization due to the
concentration of our development efforts on the content of our courseware. Capitalization ends
when a product is available for general release to our customers, at which time amortization of the
capitalized costs begins. We amortize these costs using the greater of: (a) the amount determined
by the ratio of the products current revenue to total expected future revenue, or (b) the
straight-line method over the estimated useful life of the product, which is generally three years.
During all periods presented, we used the straight-line method to amortize the capitalized costs
as this method resulted in greater amortization. The significant judgment regarding capitalization of product development costs involves the
recoverability of capitalized costs. We evaluate our capitalized costs at least annually, or more
frequently if events or changes in circumstances indicate that the asset might be impaired, to
determine if the unamortized balance related to any given product exceeds the estimated net
realizable value of that product. Estimating net realizable value requires us to estimate future
revenues and cash flows to be generated by the product and to use judgment in quantifying the
amount, if any, to be written off. Actual cash flows and amounts realized from the courseware
products could differ materially from those estimated. In addition, any future changes to our
courseware product offerings could result in write-offs of previously capitalized costs and have a
significant impact on our consolidated results of operations. Valuation of Deferred Income Taxes We account for deferred income taxes based upon differences between the financial reporting
and income tax bases of our assets and liabilities. The measurement of deferred taxes is adjusted
by a valuation allowance, if necessary, to recognize the extent to which the future tax benefits
will be recognized. At January 31, 2005 and October 31, 2004, our deferred tax assets were fully reserved. At
October 31, 2004, approximately $28,980 of the gross deferred tax asset relates to our net
operating loss carryforwards in the United States (U.S.) of approximately $72,451, which expire
in varying amounts between 2005 and 2023. Also included in our gross deferred tax asset was $2,117
for our net operating loss carryforwards of approximately $5,293 related to our foreign
subsidiaries. We have provided a full
valuation allowance related to these foreign deferred income tax assets due to the uncertainty
in realization of future taxable income in these foreign jurisdictions. 16




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Realization of our U.S. deferred tax asset is dependent on generating sufficient taxable
income in the U. S. prior to expiration of these loss carryforwards. Our merger with Lightspan in
the first quarter of fiscal 2004 impacted our assessment of the realization of deferred tax assets
because the merged company is considered one consolidated taxable entity. As a result of the merger, we acquired approximately $290,000 of Lightspans net operating
loss carryforwards. Based on a preliminary Section 382 limitation analysis, the usage of these net
operating loss carryforwards is limited to approximately $3,200 per year and, therefore,
approximately $45,000 of the acquired net operating loss carryforwards are available to the
combined entity. These amounts are preliminary and may change as the Section 382 limitation
analysis is completed and analysis of recent announcements by the Internal Revenue Service is taken
into account. The combined net operating loss carryforwards at the acquisition date, which represent the
majority of the merged companys deferred tax assets at that date, have been reviewed for
realization primarily based upon historical results and secondarily upon projected results.
Although we expect taxable income in 2005, this expectation is highly dependent on the improvement
of market conditions and operational performance. Lightspan has historically
incurred significant operating losses, which carry more weight than the projected results.
Consequently our historical combined operating results were insufficient to support the combined
post-merger deferred tax assets. As a result, net deferred tax assets, excluding the deferred tax
liability relating to tax deductible goodwill, which cannot be used to support realization of the
other net deferred tax assets, were fully reserved for in the purchase accounting for the Lightspan
acquisition in the first quarter of 2004 thereby increasing goodwill. Any subsequent reversal of
the valuation allowance recorded on the combined entitys pre-acquisition deferred tax assets will
be recorded as a reduction of goodwill, as opposed to recording an income tax benefit in the
consolidated statement of operations. A similar analysis and judgment has resulted in a full
valuation allowance being placed on the deferred tax assets generated subsequent to the acquisition
of Lightspan. Goodwill and Identified Intangible Assets We record our acquisitions in accordance with Statement of Financial Accounting Standards
(SFAS) No. 141, Business Combinations. We allocate the cost of acquired companies to the
tangible and identified intangible assets and liabilities acquired, with the remaining amount being
recorded as goodwill. Certain intangible assets, such as acquired technology, are amortized to
expense over their estimated useful lives, while in-process research and development, if any, is
recorded as a one-time charge at the acquisition date. Most of the companies we have acquired have not had significant tangible assets and, as a
result, the majority of the purchase price has typically been allocated to identified intangible
assets and/or goodwill, which increases future amortization expense of identified intangible assets
and the potential for impairment charges that we may incur. Accordingly, the allocation of the
purchase price to intangible assets may have a significant impact on our future operating results.
In addition, the allocation of the purchase price requires that we make significant assumptions and
estimates, including estimates of future cash flows expected to be generated by the acquired
assets. Should different conditions prevail, we may have to record impairment charges, which may
have a significant impact on our consolidated financial statements. 17




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##### Table of Contents



We account for goodwill and other intangible assets in accordance with the provisions of SFAS
No. 142, Goodwill and Other Intangible Assets. Under SFAS No. 142, goodwill and intangible
assets with indefinite lives are not amortized to expense and must be reviewed for impairment
annually or more frequently if events or changes in circumstances indicate that the asset might be
impaired. The first step of the impairment test, used to identify potential impairment, compares
the fair value of a reporting unit with its carrying amount, including goodwill and intangible
assets with indefinite lives. We operate as one reporting unit and therefore compare our book
value to market value (market capitalization plus a control premium). If our fair value exceeds
our book value, our goodwill is considered not impaired, and the second step of the impairment test
is unnecessary. If our book value exceeds our market value, the second step of the impairment test
is performed to measure the amount of impairment loss, if any. For this step the implied fair
value of the goodwill is compared with the book value of the goodwill. If the carrying amount of
the goodwill exceeds the implied fair value of the goodwill, an impairment loss would be recognized
in an amount equal to that excess. Any loss recognized cannot exceed the carrying amount of
goodwill. After an impairment loss is recognized, the adjusted carrying amount of goodwill is its
new accounting basis. Subsequent reversal of a previously recognized impairment loss is prohibited
once the measurement of that loss is completed. We completed our annual goodwill impairment
assessment as of October 31, 2004. Goodwill was not impaired and no impairment charge was
recorded. Acquisitions Our acquisition strategy is to acquire complementary products or businesses that will enable
us to achieve our strategic goals, including market leadership, growth rates that exceed the
market, and providing innovative, leading, and distinct products and services. During the three
months ended January 31, 2004, we acquired Lightspan, Inc. and New Media (Holdings) Limited. See
Note 3 to Consolidated Financial Statements in our Annual Report on Form 10-K for the fiscal year
ended October 31, 2004 for more information on these strategic acquisitions. 18




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##### Table of Contents



RESULTS OF OPERATIONS Operating Results as a Percentage of Revenue Three Months EndedJanuary 31,2005
    
    
    2004Revenues:License fees
    
    
    43.6
    %
    
    
    49.4
    %Subscriptions
    
    
    17.8
    
    
    
    17.0Services
    
    
    32.2
    
    
    
    24.0Other
    
    
    6.4
    
    
    
    9.6Total revenues
    
    
    100.0
    
    
    
    100.0Cost of revenues:License fees
    
    
    13.4
    
    
    
    12.6Subscriptions
    
    
    9.1
    
    
    
    6.4Services
    
    
    24.1
    
    
    
    14.2Other
    
    
    6.7
    
    
    
    8.3Total cost of revenues
    
    
    53.3
    
    
    
    41.5Gross profit
    
    
    46.7
    
    
    
    58.5Operating expenses:Sales and marketing
    
    
    52.4
    
    
    
    57.4General and administrative
    
    
    16.5
    
    
    
    17.0Product development
    
    
    5.8
    
    
    
    8.3Amortization of intangibles
    
    
    4.3
    
    
    
    3.7Restructuring and other charges
    
    
    9.0
    
    
    
    Total operating expenses
    
    
    88.0
    
    
    
    86.4Operating loss
    
    
    (41.3
    )
    
    
    (27.9
    )Interest income and expense and
other expense, net
    
    
    0.5
    
    
    
    Loss before income taxes
    
    
    (40.8
    )
    
    
    (27.9
    )Income tax expense
    
    
    0.6
    
    
    
    0.6Net loss
    
    
    (41.4
    )%
    
    
    (28.5
    )%
 The following discussion of the results of operations for the three months ended January
31, 2005 compared to the same period in 2004 includes non-GAAP financial measures that present the
combined revenues and operating expenses on a pro forma basis as if Lightspan had been acquired as
of November 1, 2003. Non-GAAP financial measures should not be considered as a substitute for, or
superior to, measures of financial performance prepared in accordance with GAAP. Our management
views these non-GAAP financial measures to be helpful in assessing our progress in integrating the
operations of Lightspan. In addition, these non-GAAP financial measures facilitate internal
comparisons to our historical operating results and comparisons to competitors operating results.
We include these non-GAAP financial measures because we believe they are useful to investors in
allowing for greater transparency related to supplemental information used by our management in its
financial and operational analysis. Investors are encouraged to review the reconciliation of the
non-GAAP financial measures used herein to their most directly comparable GAAP financial measures
as provided with our consolidated financial statements. 19




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##### Table of Contents



Revenues Total Revenues Total reported revenues decreased 3.8% to $25,455 for the three months ended January 31, 2005
from $26,448 for the same period in 2004. Total pro forma revenues decreased 7.2% for the same
period. Our first quarter 2005 revenues were impacted by several initiatives implemented in the
quarter and by management changes. Initiatives included realignment of the sales and service
organizations to better serve the elementary market and implementation of new systems and
procedures aimed at improving the efficiencies of our sales process in the future. When comparing
quarters, we were also impacted by the timing of Lightspans year-end at the acquisition date.
Lightspans fourth quarter aligned with our first quarter in 2004, and their sales force continued
to be compensated under Lightspans annual plan until the end of that quarter. As a result, our
first quarter 2004 benefited from increased sales activity, as the Lightspan sales force drove to
reach their annual performance objectives. These
initiatives are expected to have some impact on second quarter 2005 as
well, resulting in an anticipated reduction in revenues from second
quarter 2004 amounts. We expect to recover from the impact on the
first two quarters of 2005 in the second half of the year and achieve
growth in revenues for the full fiscal year 2005 over fiscal year
2004. The following table presents 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 January 31,2005
    
    
    2004Total Revenues
    
    $
    
    
    % of revenue
    
    
    $
    
    
    % of revenue
    
    
    % ChangePLATO (as reported)
    
    $
    25,455
    
    
    
    100.0
    %
    
    $
    26,448
    
    
    
    100.0
    %
    
    
    -3.8
    %Lightspan (pre-acquisition)
    
    
    
    
    
    
    
    
    
    
    969Pro forma
    
    $
    25,455
    
    
    
    100.0
    %
    
    $
    27,417
    
    
    
    100.0
    %
    
    
    -7.2
    %
 On a pro forma basis, assuming Lightspan had been included for all periods presented, we
executed 29 orders of $100 or greater during the three months ended January 31, 2005, as compared
to 44 for the same period in 2004. This decrease can be attributed to the factors affecting
revenue mentioned above, resulting in low order volume. The average size of orders between $100
and $249 decreased from $144 to $141, while the average size of orders of $250 and greater
decreased from $651 to $448. The number and magnitude of these larger orders can have a
significant impact on our operating results. Information regarding these orders was as follows: Three Months Ended January 31,2005
    
    
    2004 (Pro Forma)
    
    
    % ChangeOrder Size
    
    Number
    
    
    Value
    
    
    Number
    
    
    Value
    
    
    Number
    
    
    Value$100 to $249
    
    
    18
    
    
    $
    2,529
    
    
    
    30
    
    
    $
    4,309
    
    
    
    -40.0
    %
    
    
    -41.3
    %$250 or greater
    
    
    11
    
    
    
    4,924
    
    
    
    14
    
    
    
    9,118
    
    
    
    -21.4
    %
    
    
    -46.0
    %29
    
    
    $
    7,453
    
    
    
    44
    
    
    $
    13,427
    
    
    
    -34.1
    %
    
    
    -44.5
    %
 License Fees License fees revenues were $11,095 for the three months ended January 31, 2005, a decrease of
15.0% from the $13,059 reported for the same period in 2004. As reported and pro forma license
fees revenues were the same for the three months ended January 31, 2004, as there were no Lightspan
license fees revenues prior to the acquisition date during that period. 20




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##### Table of Contents



The decrease in license fees revenues for the three months ended January 31, 2005, as compared
to the same period in 2004, can be attributed to the factors affecting revenue mentioned above.
While there has been some improvement in the flow of funds to education, timing of federal funding
and economic uncertainties, particularly state budget difficulties, are expected to continue to
impact our revenues during 2005. In addition, an expected change in our revenue mix towards increased
subscriptions revenues in the future could also impact our perpetual license fees revenues. As a
percentage of total revenues, license fees revenues were 43.6% for the three months ended January
31, 2005, as compared to 47.6% of total pro forma revenues for the same period in 2004. This
decrease was primarily due to the factors affecting revenue mentioned
above and the increase in services revenues as discussed below. 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 January 31,2005
    
    
    2004Subscriptions Revenues
    
    $
    
    
    % of revenue
    
    
    $
    
    
    % of revenue
    
    
    % ChangePLATO (as reported)
    
    $
    4,533
    
    
    
    17.8
    %
    
    $
    4,508
    
    
    
    17.0
    %
    
    
    0.6
    %Lightspan (pre-acquisition)
    
    
    
    
    
    
    
    
    
    
    531Pro forma
    
    $
    4,533
    
    
    
    17.8
    %
    
    $
    5,039
    
    
    
    18.4
    %
    
    
    -10.0
    %
 Reported revenues from subscriptions were comparable for the three months ended January
31, 2005 and 2004. Pro forma subscriptions revenues decreased 10.0% for the three months ended
January 31, 2005, from the same period in 2004. Subscriptions revenues were impacted by the low
order volume mentioned above and in part by stronger sales of our client hosted web courseware
during the three months ended January 31, 2005. We do not believe this is a trend, but that we
will see a gradual shift away from perpetual licenses to our subscription-based products in the
future. Services 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 January 31,2005
    
    
    2004Services Revenues
    
    $
    
    
    % of revenue
    
    
    $
    
    
    % of revenue
    
    
    % ChangePLATO (as reported)
    
    $
    8,196
    
    
    
    32.2
    %
    
    $
    6,337
    
    
    
    24.0
    %
    
    
    29.3
    %Lightspan (pre-acquisition)
    
    
    
    
    
    
    
    
    
    
    438Pro forma
    
    $
    8,196
    
    
    
    32.2
    %
    
    $
    6,775
    
    
    
    24.7
    %
    
    
    21.0
    %
 Services revenues, both as reported and pro forma, increased for the three months ended
January 31, 2005, as compared to the same period in 2004. This increase was driven by our new
Supplemental Educational Services offering and also by substantial growth in our software support
and educational consulting services revenues, increasing 18% and 36%, respectively. As a
percentage of total revenues, both as reported and pro forma services revenues increased for the
three months ended January 31, 2005, compared to the same period in 2004, due to the factors
discussed above. 21




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Other Other revenues were $1,631 for the three months ended January 31, 2005, a decrease of 35.9%
from the $2,544 reported for the same period in 2004. As reported and pro forma other revenues
were the same for the three months ended January 31, 2004 as there were no Lightspan other revenues
prior to the acquisition date during that period. Other revenues consist primarily of hardware and third-party courseware products. The
elementary grade products acquired from Lightspan run on PlayStationÒ game consoles, which,
along with the sale of related accessories, are a component of other revenues. The decrease in
other revenues for the three months ended January 31, 2005, compared to the same period in 2004,
was primarily due to a decrease in hardware sales, which tends to fluctuate quarter to quarter. Backlog Our deferred revenue was $46,659 and $51,575 at January 31, 2005 and October 31, 2004,
respectively. Deferred revenue excludes amounts that we expect to earn in the future from the U.S.
Department of the Navy contract (approximately $12,897) and the Idaho Department of Education
contract (approximately $15,261). Ultimate realization of these contracts is dependent on delivery
of services, accomplishment of milestones, and customer acceptance. In a recent development, the
Albertson Foundation issued a press release stating that the Idaho Student Information Management
System project is under review due to the increasing costs of that project. It is unknown what
impact this will have on our portion of the project. In addition, at January 31, 2005, we have orders for approximately $5,740 of products and
services from multiple customers that have not met various revenue recognition criteria and for
which we are not yet able to bill customers. No assurances exist regarding when or if revenue will
be recorded or customers will be billed for these products or services. All contracts and
agreements are subject to the delivery of products and services, collection and other conditions. Cost of Revenues 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 January 31,2005
    
    
    2004Total Cost of Revenues
    
    $
    
    
    % of revenue
    
    
    $
    
    
    % of revenue
    
    
    % ChangePLATO (as reported)
    
    $
    13,571
    
    
    
    53.3
    %
    
    $
    10,983
    
    
    
    41.5
    %
    
    
    23.6
    %Lightspan (pre-acquisition)
    
    
    
    
    
    
    
    
    
    
    242Pro forma
    
    $
    13,571
    
    
    
    53.3
    %
    
    $
    11,225
    
    
    
    40.9
    %
    
    
    20.9
    %
 Total cost of revenues and total cost of revenues as a percentage of total revenues, both as
reported and pro forma, increased for the three months ended January 31, 2005, as compared to the
same period in 2004, due a number of factors, including decreased license fees revenues (which have
lower costs), increased services revenues (which have higher costs), a decline in educational
consulting service revenues from year-end 2004 run rates (for which much of the costs are fixed),
and increased investments in the service organization and realignment of those resources to focus
on service revenue growth initiatives (which shifted some costs from selling expense to cost of
revenues). 22




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Amortization of capitalized product development costs, a component of cost of revenues related
to license fees and subscriptions, was $1,868 and $1,764 for the three months ended January 31,
2005 and 2004, respectively. Amortization has increased as projects completed during prior periods
are now being amortized to expense. We expect this amortization to increase in 2005 as additional
products are completed. Capitalized development costs were $2,876 and $1,664 for the three months
ended January 31, 2005 and 2004, 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 January 31,2005
    
    
    2004Revenue category
    
    As Reported
    
    
    As Reported
    
    
    Pro FormaLicense fees
    
    
    69.1
    %
    
    
    74.4
    %
    
    
    74.4
    %Subscriptions
    
    
    49.0
    %
    
    
    62.8
    %
    
    
    64.8
    %Services
    
    
    25.3
    %
    
    
    40.6
    %
    
    
    42.3
    %Other
    
    
    -4.2
    %
    
    
    13.6
    %
    
    
    13.6
    %Total
    
    
    46.7
    %
    
    
    58.5
    %
    
    
    59.1
    %
 The decrease in gross profit margin, both as reported and pro forma, for the three months
ended January 31, 2005 from the same period in 2004 resulted primarily from the higher proportion
of services revenues included in our product sales mix in 2005, which carry lower margins, and the
cost of revenues factors discussed above. Future gross profit margin will be dependent primarily
on the amount of revenue, our revenue mix, the amount of professional development expenses required
to provide our services, and the amortization of capitalized product development costs and acquired
technology included in cost of revenues. Gross profit margin is
expected to be lower for fiscal year 2005, compared to fiscal year
2004, as a result of these factors and the required implementation of
SFAS No. 123(R) in our fourth quarter 2005. 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 January 31,2005
    
    
    2004Sales and Marketing
    
    $
    
    
    % of revenue
    
    
    $
    
    
    % of revenue
    
    
    % ChangePLATO (as reported)
    
    $
    13,326
    
    
    
    52.4
    %
    
    $
    15,185
    
    
    
    57.4
    %
    
    
    -12.2
    %Lightspan (pre-acquisition)
    
    
    
    
    
    
    
    
    
    
    1,282Pro forma
    
    $
    13,326
    
    
    
    52.4
    %
    
    $
    16,467
    
    
    
    60.1
    %
    
    
    -19.1
    %
 Sales and marketing expenses, both as reported and pro forma, decreased for the three
months ended January 31, 2005, as compared to 2004, due primarily to the achievement of cost
synergies from combining the PLATO and Lightspan sales and marketing
activities, realignment of our service resources to focus on service
revenue growth initiatives (which shifted some costs from selling
expense to cost of revenues),
and decreased commissions
resulting from the decrease in revenues. Our ability to continue to leverage our cost structure
and improve profitability is primarily dependent on our ability to generate higher revenues,
integrate our acquisitions and realize sales and marketing
productivity improvements. For the full fiscal year 2005, sales and
marketing expenses are expected to be below fiscal year 2004 amounts,
excluding the impact from the implementation of SFAS No. 123(R),
required in our fourth quarter 2005. 23




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##### Table of Contents



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 January 31,2005
    
    
    2004General and Administrative
    
    $
    
    
    % of revenue
    
    
    $
    
    
    % of revenue
    
    
    % ChangePLATO (as reported)
    
    $
    4,210
    
    
    
    16.5
    %
    
    $
    4,492
    
    
    
    17.0
    %
    
    
    -6.3
    %Lightspan (pre-acquisition)
    
    
    
    
    
    
    
    
    
    
    310Pro forma
    
    $
    4,210
    
    
    
    16.5
    %
    
    $
    4,802
    
    
    
    17.5
    %
    
    
    -12.3
    %
 General and administrative expenses, both as reported and pro forma, decreased for the
three months ended January 31, 2005, as compared to the same period in 2004, due primarily to the
achievement of cost synergies from combining the PLATO and Lightspan general and administrative
activities. For the full fiscal year 2005, general and administrative
expenses are expected to be below fiscal year 2004 amounts, excluding
the impact from the implementation of SFAS No. 123(R), required
in our fourth quarter 2005. Product Development The majority of our product development costs are required to be capitalized. Product
development expense does not reflect these capitalized costs, as they are amortized through cost of
revenues. Accordingly, our product development expense, as a percentage of revenue, does not
demonstrate our total level of development activity. 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 January 31,2005
    
    
    2004Product Development
    
    $
    
    
    % of revenue
    
    
    $
    
    
    % of revenue
    
    
    % ChangePLATO (as reported)
    
    $
    1,471
    
    
    
    5.8
    %
    
    $
    2,203
    
    
    
    8.3
    %
    
    
    -33.2
    %Lightspan (pre-acquisition)
    
    
    
    
    
    
    
    
    
    
    327Pro forma
    
    $
    1,471
    
    
    
    5.8
    %
    
    $
    2,530
    
    
    
    9.2
    %
    
    
    -41.9
    %
 Product development expenses, both as reported and pro forma, decreased for the three
months ended January 31, 2005, as compared to the same period in 2004, due primarily to the
increased capitalization of approximately $1,100 of Lightspan and New Media-related product
development costs, compared to the same period in 2004. Product development spending, before capitalization and amortization, was 17.1% of total
revenues, as reported, for the three months ended January 31, 2005, compared to 14.6% for the same
period in 2004. Our spending percentage and spending dollars increased due to new projects
undertaken in 2005. 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. For the full fiscal year 2005,
product development expenses are expected to be below fiscal year
2004 amounts, excluding the impact from the implementation of SFAS
No. 123(R), required in our fourth quarter 2005. 24




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##### Table of Contents



Amortization of Intangibles Expense for the three months ended January 31, 2005 and 2004 represented the amortization of
identified intangible assets, other than acquired technology, from our acquisitions. Acquired
technology intangible assets are amortized through cost of revenues. See Note 6 to Consolidated
Financial Statements for additional information on goodwill and identified intangible assets. Restructuring and Other Charges Restructuring and other charges of $2,289 for the three months ended January 31, 2005 include
severance costs for headcount reductions and costs paid to, or claimed by, terminated executive
officers under employment agreements. In January 2005, we initiated plans to reduce headcount by approximately 30 positions and
close certain facilities in the United Kingdom (U.K.). This restructuring is part of an ongoing
evaluation of our U.K. operations and we are continuing to explore alternatives as necessary to
improve the U.K.s impact on our profitability. Severance costs of $430 for these planned employee
terminations were recorded during the three months ended January 31, 2005. The majority of these
costs are expected to be paid during our second quarter of 2005 as employees are terminated.
Additional charges are expected in 2005 for costs associated with the planned facility closings.
These charges will be recorded as the facilities are closed and no longer being used. Also in January 2005, we reduced headcount in the United States to more closely align our cost
structure with expected revenues in 2005. Six positions were eliminated and severance charges of
$273 were recorded during the three months ended January 31, 2005. All of these costs had been
paid as of January 31, 2005. In November 2004, we announced the resignations of John Murray, our Chairman, President and
Chief Executive Officer, and three other executive officers. We recorded charges of $1,586 related
to these executive terminations during the three months ended January 31, 2005, of which $274 had
been paid as of January 31, 2005. We are currently negotiating the terms of Mr. Murrays severance
arrangement and the amount and timing of charges related to it have not yet
been finalized. We
are continuing to review our business operations and strategy, and
may implement changes to improve our focus and efficiency in the
future. As a result, additional restructuring and other charges may
be incurred. Income Taxes As discussed under the caption Critical Accounting Policies and Estimates, as a result of
the Lightspan acquisition, the net deferred tax assets as of the acquisition date, excluding the
deferred tax liability relating to tax deductible goodwill (which cannot be used to support
realization of the other net deferred tax assets), were fully reserved for in purchase accounting,
thereby increasing goodwill, in the first quarter of 2004. Any future reductions of the valuation
allowance recorded on the combined entitys pre-acquisition deferred tax assets will be recorded as
a reduction to goodwill, as opposed to recording an income tax benefit in the consolidated statement of operations. Income tax expense for future
periods, however, will be impacted by any reductions in the valuation allowance related to
post-acquisition deferred tax assets, for which we have also recorded a full valuation allowance at
January 31, 2005 and October 31, 2004. 25




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##### Table of Contents



Our historical effective income tax rate has been highly volatile due to the mix between our
U.S. operating results, for which we record income taxes, and our foreign operating results, for
which we do not record an income tax benefit due to the uncertainty of realizing these tax benefits
in future years in our foreign jurisdictions. Our effective income tax rate for future quarters
and fiscal years is dependent on the level of profitability in each of the U.S. and our foreign
subsidiaries. In addition, even if there is a loss in the U.S., we expect income tax expense of
approximately $600 per year, or $150 per quarter, related to
amortization of goodwill that is deductible for tax
purposes but not for book purposes. As goodwill from the NetSchools acquisition is amortized for
tax purposes, the book basis of the goodwill will further exceed the tax basis, resulting in
increases to the related deferred tax liability, which cannot be used to support realization of the
other net deferred tax assets. We currently expect a consolidated income tax rate of about 45% for
the full year 2005. The extent of any variance from this expectation is highly dependent on our
operating results in each of our U.S. and foreign subsidiaries. A larger than expected foreign
loss, or lower than expected U.S. profit, will likely result in a higher consolidated effective tax
rate. Conversely, if our foreign or U.S. subsidiaries are more profitable than planned, our
consolidated effective tax rate could decline. FINANCIAL CONDITION Liquidity and Capital Resources At January 31, 2005, our principal sources of liquidity included cash and cash equivalents of
$38,859, marketable securities of $2,999, net accounts receivable of $28,672, and our unused line
of credit of $12,500. Working capital was $23,533 and $29,769 at January 31, 2005 and October 31,
2004, respectively. The decrease in working capital was primarily due to the decrease in net accounts receivable
of $13,180, offset by the decreases in accounts payable and accrued salaries and benefits of $4,062
and deferred revenue of $2,310. Accounts receivable decreased due to collection of amounts
outstanding at year end and improvements in our collection process. Accounts payable and accrued
salaries and benefits decreased due to payment of amounts accrued at year end, including year end
commissions and bonuses. Deferred revenue, which is satisfied through delivery of products and
services rather than cash, decreased due to more of these products and services being delivered
than were added through new business in the quarter. During the three months ended January 31, 2005, cash and cash equivalents increased $9,624.
Cash used in operations, excluding changes in our asset and liability accounts, of $2,785, was more
than offset by the changes in our asset and liability accounts of $1,085, the cash flow from
investing activities of $9,642, and the cash flow from financing activities of $1,374.
Depreciation and amortization was $4,984 for the three months ended January 31, 2005, an increase
of $529 compared to the same period in 2004, due primarily to increased amortization of identified
intangible assets and capitalized product development costs as
mentioned below. The cash flow
from changes in our asset and liability accounts was primarily due to the factors described above. During the three months ended January 31, 2004, cash and cash equivalents increased $362.
Cash used in operations, excluding changes in our asset and liability accounts, of $2,583 was more
than offset by the changes in our asset and liability accounts of $1,331, and the cash flows from our investing
activities of $204 and our financing activities of $1,251. Changes in
our asset and liability accounts
were primarily due to decreased accounts receivable and increased deferred revenue, partially
offset by increased prepaid expenses and other current assets and decreased accrued liabilities. 26




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##### Table of Contents



Net cash provided by our investing activities was $9,642 and $204 for the three months ended
January 31, 2005 and 2004, respectively. During the three months ended January 31, 2005, as compared to the same period in 2004, we
increased our capitalization of product development costs by $1,212, increased our purchases of
marketable securities by $2,985, and increased our sales and maturities of marketable securities by
$16,135. Capitalization of product development costs increased primarily due to devoting
substantial resources to develop courseware related to the Lightspan and New Media acquisitions.
We also had net cash provided from the Lightspan and New Media acquisitions of $2,324 for the three
months ended January 31, 2004. Net cash provided by our financing activities, principally from the exercise of stock options,
was $1,374 and $1,251 for the three months ended January 31, 2005 and 2004, respectively. Our Board of Directors approved a stock repurchase plan in December 2001, which authorizes us
to repurchase up to $15,000 of our common stock in the open market and in privately negotiated
transactions. The plan has no set termination date and the timing of any repurchases will be
dependent on prevailing market conditions and alternative uses of capital. We did not repurchase
any shares of our common stock during the three months ended January 31, 2005. 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. We have resources available under our revolving loan agreement with Wells Fargo Bank, N.A. to
provide borrowings up to $12,500, through July 1, 2005, as determined by the available borrowing
base. At January 31, 2005, there were no borrowings outstanding and our unused borrowing capacity
was $12,500. The agreement contains restrictive financial covenants (including Minimum Tangible
Net Worth, Minimum Debt Service Coverage, Maximum Leverage, Maximum Cash Flow Leverage and Maximum
Annual Capital Expenditures) and restrictions on additional borrowings, asset sales and dividends,
as defined. All applicable covenants were satisfied as of and for the twelve-month period ended
January 31, 2005. From time to time, we evaluate potential acquisitions of products or businesses that
complement our core business. We may consider and acquire other complementary businesses,
products, or technologies in the future. We anticipate using cash during the first half of 2005 to fund expected losses from operations
and our capital expenditure needs given the historic seasonality of our operations. 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 January 31, 2005. 27




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##### Table of Contents



Disclosures about Contractual Obligations and Commercial Commitments Our contractual obligations and commercial commitments consist primarily of future minimum
payments due under operating leases, royalty agreements, and capital lease obligations. In
addition, any future borrowings under our revolving loan agreement, which provides for a maximum
$12,500 line of credit through July 1, 2005, would require future use of cash. A
table showing our contractual obligations was provided in
Item 7. of our Annual Report on Form 10-K for the year
ended October 31, 2004. There were no significant changes to our
contractual obligations during the three months ended
January 31, 2005. At January 31, 2005, we had no significant commitments for capital expenditures. With the acquisition of New Media in 2004, there is additional guaranteed deferred
consideration of approximately $450 due over the period from the acquisition date through December
2006 based on New Media revenues. As of January 31, 2005, no payments of this additional
consideration have been required. Interest Rate Risk Our borrowing capacity primarily consists of a revolving loan with interest rates that
fluctuate based upon the Prime Rate and LIBOR market indexes. At January 31, 2005, we did not have
any outstanding borrowings under this revolving credit facility. Our only debt consisted of
capital lease obligations at fixed interest rates. As a result, risk relating to interest
fluctuation is considered minimal. Foreign Currency Exchange Rate Risk We market our products and services worldwide and have operations in Canada and the U.K. As a
result, financial results and cash flows could be affected by changes in foreign currency exchange
rates or weak economic conditions in foreign markets. Working funds necessary to facilitate the
short-term operations of our foreign subsidiaries are kept in local currencies in which they do
business. Any gains or losses from foreign currency transactions are included in the consolidated
statements of operations. Approximately 4% and 2% of our total revenues, as reported, were
denominated in currencies other than the U.S. dollar for the three months ended January 31, 2005
and 2004, respectively. Our foreign subsidiaries are not a significant component of our business,
and, as a result, risk relating to foreign currency fluctuation is considered minimal. New Accounting Pronouncements In December 2004, the Financial Accounting Standards Board issued SFAS No. 123(R), Share-Based
Payment (SFAS 123(R)). SFAS 123(R) establishes standards for accounting for transactions in
which an entity exchanges its equity instruments for goods or services. SFAS 123(R) focuses
primarily on accounting for transactions in which an entity obtains employee services in
share-based payment transactions. SFAS 123(R) requires that the fair value of such equity
instruments be recognized as expense in the financial statements as services are performed. Prior
to SFAS 123(R), only the pro forma disclosures of fair value presented above were required. SFAS
123(R) is effective for our fourth quarter of 2005. The adoption of this new accounting
pronouncement is expected to have a material impact on our consolidated financial statements. 28




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##### Table of Contents



Item 3.
    Quantitative and Qualitative Disclosures About Market Risk See the information set forth under the captions, Interest Rate Risk and Foreign Currency
Exchange Rate Risk in Managements Discussion and Analysis of Financial Condition and Results of
Operations. 
  Item 4.
    Controls and Procedures As of January 31, 2005, our Chief Executive Officer and Chief Financial Officer have conducted
an evaluation of the effectiveness of our disclosure controls and procedures (as defined in Rules
13a-15(e) or 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. All internal control systems, no matter how well designed, have inherent limitations.
Therefore, even those systems determined to be effective can provide only reasonable assurance with
respect to financial statement preparation and presentation. 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. There were no changes in our internal controls over financial reporting that occurred during
our most recent fiscal quarter that have materially affected, or are reasonably likely to
materially affect, our internal controls over financial reporting. 29




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##### Table of Contents



PART II. 
  Item 1.
    Legal Proceedings  Credit Suisse First Boston and several of its clients, including
Lightspan, Inc. (which we acquired in November 2003), are
defendants in a securities class action lawsuit captioned Liu, et
al. v. Credit Suisse First Boston Corp., et al. pending in the
United States District Court for the Southern District of New
York. The complaint alleges that Credit Suisse First Boston, its
affiliates, and the securities issuer defendants (including
Lightspan, Inc.) manipulated the price of the issuer defendants
shares in the post-initial public offering market. The securities
issuer defendants (including Lightspan, Inc.) have filed a motion
to dismiss the complaint in September 2004 on the grounds of
multiple pleading deficiencies. The court has not yet ruled on
the motion to dismiss. 
  Item 2.
    Unregistered Sales of Equity Securities and Use of Proceeds  Not Applicable. 
  Item 3.
    Defaults Upon Senior Securities 
  Not Applicable. 
  Item 4.
    Submission of Matters to a Vote of Security Holders  Not Applicable. 
  Item 5.
    Other Information  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. 30




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##### Table of Contents



Item 6.
    Exhibits  (a)
    Exhibits  Exhibit Number and Description  31.01
    Certification of Chief Executive Officer under Rule 13a-14(a) adopted
pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.31.02
    Certification of Chief Financial Officer under Rule 13a-14(a) adopted
pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.32.01
    Certification of Chief Executive Officer under 18 U.S.C. 1350 pursuant
to Section 906 of the Sarbanes-Oxley Act of 2002.32.02
    Certification of Chief Financial Officer under 18 U.S.C. 1350 pursuant
to Section 906 of the Sarbanes-Oxley Act of 2002.(b)
    Reports on Form 8-K:  The following Current Reports on Form 8-K were filed during the quarter ended January
31, 2005:November 10, 2004 announcing the resignation of Greg Melsen as Chief Financial Officer
and the appointment of Larry Betterley as Vice President and Chief
Financial Officer.
November 10, 2004 providing updated financial guidance for our fourth quarter and fiscal
year 2004.November 17, 2004 announcing the resignation of John Murray as Chairman, President and
Chief Executive Officer, the appointment of David W. Smith as interim President and
Chief Executive Officer, and the appointment of Thomas Hudson as Chairman of the Board
of Directors.November 23, 2004 announcing that our fourth quarter and fiscal year 2004 financial
results would be released on December 15, 2004, instead of the previously announced
December 2, 2004, and to reaffirm the updated financial guidance issued on November 10,
2004.December 8, 2004 to file our Amended and Restated By-Laws.December 15, 2004 announcing our fourth quarter and fiscal year 2004 financial results.December 17, 2004 to file employment agreements with certain executive officers. 31




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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. PLATO LEARNING, INC.
    
    By
    
    /s/ MICHAEL A. MORACHEMarch 14, 2005
    
    
    
    Michael A. MorachePresident and Chief Executive Officer(principal executive officer)/s/ LAURENCE L. BETTERLEYLaurence L. BetterleySenior Vice President and Chief FinancialOfficer(principal financial and accounting officer)
 32