Varsity (VSTY) 10-Q 2002 Q1 Quarterly report

UNITED
STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

(MARK ONE)

[X]	QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
	For the quarterly period ended March 31, 2002
	OR
[  ]	TRANSITION REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
	For the transition period from                         to                        .

Commission file number 0-28977

VARSITY GROUP INC.
(Exact Name of Registrant as Specified in Its Charter)

Delaware
(State of Incorporation)

1130 Connecticut Ave., Suite 350
Washington, D.C.
(Address of Principal Executive
Offices) 54-1876848
IRS Employer

(Identification Number)
20036
(Zip Code)

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

(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  [X]     No          

APPLICABLE ONLY TO ISSUERS INVOLVED IN BANKRUPTCY PROCEEDINGS
DURING THE PRECEDING FIVE YEARS:

     Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Sections 12, 13 or 15 (d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court.  Yes           No          

     As of May 1, 2002, the registrant had 16,114,416 shares of common stock outstanding.

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VARSITY GROUP INC. AND SUBSIDIARIES

QUARTERLY REPORT ON FORM 10-Q
For the quarter ended March 31, 2002

INDEX

		Page Number
	PART I. FINANCIAL INFORMATION
Item 1.	Financial Statements
	Condensed consolidated statements of operations for the		3
	three months ended March 31, 2001 and 2002
	Condensed consolidated balance sheets as of December 31,		4
	2001 and March 31, 2002
	Condensed consolidated statements of cash flows for the		5
	three months ended March 31, 2001 and 2002
	Notes to condensed consolidated financial statements		6
Item 2	Management's Discussion and Analysis of Financial		6
	Condition and Results of Operations
Item 3	Quantitative and Qualitative Disclosures About Market Risk		10
	PART II. OTHER INFORMATION
Item 1	Legal Proceedings		10
Item 2	Changes in Securities		10
Item 3	Defaults Upon Senior Securities		10
Item 4	Submission of Matters to a Vote of Security Holders		10
Item 5	Other Information		10
Item 6	Exhibits and Reports on Form 8-K		10

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PART I.
FINANCIAL INFORMATION

Item 1: Financial Statements

VARSITY GROUP INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except share and per share data)
(unaudited)

			Three Months Ended
			March 31,
			2001			2002
Net sales:
	Product		$	1,135		$	703
	Shipping			139			82
	Marketing services			247			14
		Total net sales		1,521			799
Operating expenses				1,011			501
	Cost of books – related party Cost of shipping – related party			98			46
	Cost of marketing services			25			—
	Marketing and sales (including $63 and $38 with related party for three months ended March 31, 2001 and 2002, respectively)			340			301
	Product development			136			35
	General and administrative			1,212			338
	Non-cash compensation			275			100
		Total operating expenses		3,097			1,321
Loss from operations				(1,576	)		(522	)
Other income, net:
	Interest income			188			57
	Other income			58			—
	Other income, net			246			57
Net loss			$	(1,330	)	$	(465	)
Net loss per share:
	Basic and diluted		$	(0.08	)	$	(0.03	)
Weighted average shares:
	Basic and diluted			16,154,996			15,973,703

See accompanying notes to condensed consolidated financial statements.

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VARSITY GROUP INC.

CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except share and per share data)

ASSETS

				December 31, 2001			March 31, 2002
							(unaudited)
Current assets:
	Cash and cash equivalents			$	16,811		$	13,543
	Short-term investments				—			3,000
	Accounts receivable, net of allowance of doubtful accounts of $48 at December 31, 2001 and $34 at March 31, 2002				71			81
	Other current assets				432			373
	Total current assets				17,314			16,997
	Fixed assets, net				204			154
	Other assets				79			45
		Total assets		$	17,597		$	17,196
			LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
	Accounts payable			$	222		$	208
	Other accrued expenses and other current liabilities				196			157
	Sales taxes payable				1,281			1,288
		Total current liabilities			1,699			1,653
Long-term liabilities					—			—
		Total liabilities			1,699			1,653
Stockholders’ equity:
	Preferred stock: $.0001 par value, 20,000,000 shares authorized; 0 shares issued and outstanding at December 31, 2001 and March 31, 2002				—			—
	Common stock: $.0001 par value, 60,000,000 shares authorized, 16,871,062 and 17,071,479 shares issued and outstanding at December 31, 2001 and March 31, 2002, respectively				2			2
	Additional paid-in capital				87,458			87,600
	Deferred compensation				(527	)		(559	)
	Accumulated deficit				(70,461	)		(70,926	)
	Treasury Stock, $.0001 par value, 957,063 shares at December 31, 2001 and March 31, 2002				(574	)		(574	)
		Total stockholders’ equity			15,898			15,543
		Total liabilities and stockholders’ equity		$	17,597		$	17,196

See accompanying notes to condensed consolidated financial statements.

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VARSITY GROUP INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)

					Three Months Ended
					March 31,
					2001			2002
Operating activities:
	Net loss				$	(1,330	)	$	(465	)
Adjustments to reconcile net loss to net cash used in operating activities:
	Depreciation and amortization					285			60
	Bad debt expense					(74	)		(11	)
	Loss on disposal of fixed assets and write off of underutilized assets					(58	)		—
	Non-cash compensation					336			100
	Changes in operating assets and liabilities:
			Accounts receivable, net			893			1
			Prepaid marketing			5			—
			Other current assets			242			59
			Accounts payable			(488	)		(14	)
			Lease liability			(368	)		—
			Deferred revenue			50			—
			Other accrued expenses and other current liabilities			(290	)		(41	)
			Taxes payable			2			7
			Other non-current liabilities			(131	)		—
			Other non-current assets			53			34
				Net cash used in operating activities		(873	)		(270	)
Investing activities:
	Additions to fixed assets					—			(10	)
	Increase in short-term investments					—			(3,000	)
		Proceeds from sale of fixed assets				58			—
				Net cash provided by / (used in) investing activities		58			(3,010	)
Financing activities:
	Proceeds from exercise of stock options					7			12
	Proceeds from warrant subscription receivable					707			—
				Net cash provided by financing activities		714			12
Net decrease in cash and cash equivalents						(101	)		(3,268	)
Cash and cash equivalents at beginning of period						15,710			16,811
Cash and cash equivalents at end of period					$	15,609		$	13,543
Supplemental disclosure of cash flow information:
	Cash paid for income taxes and interest				$	16		$	—

See accompanying notes to consolidated financial statements

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VARSITY GROUP INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Note 1: Description of Operations

Varsity Group Inc. (the “Company”) is an Internet retailer of new textbooks and educational materials targeting private middle and high schools, small colleges and distance and continuing education markets. Varsity Group Inc. was incorporated on December 16, 1997 and launched its website in August 1998, at which time the Company began generating revenues. In August 1999, the Company established two wholly-owned subsidiaries, CollegeImpact.com, Inc. and VarsityBooks.com, LLC to assist in the overall management of its marketing and retailing activities, respectively.

The Company is an online retailer of new textbooks and educational materials, targeting private middle and high schools, small colleges and distance and continuing education markets through its eduPartner program. As an Internet-based retailer of textbooks, the Company uses its website, www.VarsityBooks.com, to sell textbooks and other learning materials to students nationwide.

In February 2000, the Company completed an initial public offering. Net proceeds to the Company from the initial public offering totaled $36.0 million. Effective upon the closing of the offering, all shares of the Company’s preferred stock converted into 8,966,879 shares of the Company’s common stock.

Note 2: Basis of Presentation

The condensed consolidated financial statements of Varsity Group Inc. and subsidiaries included herein have been prepared by the Company without audit, pursuant to the rules and regulations of the Securities and Exchange Commission and reflect all adjustments which are, in the opinion of management, necessary for a fair presentation of the results for the interim period in conformity with generally accepted accounting principles.

Certain information and footnote disclosure normally included in the financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted. The interim financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2001. Operating results for the interim periods are not necessarily indicative of results for an entire year.

Certain reclassifications of prior year amounts have been made to conform with the current year presentation.

Item 2:Management’s Discussion and Analysis of Financial Condition and Results of Operations

Forward Looking Statements

This document contains forward-looking statements. These statements relate to future events or our future financial performance. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “except,” “plan,” “anticipate,” “expect,” “believe,” “estimate,” “predict,” “potential” or “continue,” the negative of such terms or other comparable terminology. These statements are only predictions. Actual events or results may differ materially.

Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. Moreover, neither we nor any other person assumes responsibility for the accuracy and completeness of the forward-looking statements. We are under no duty to update any of the forward-looking statements after the date of this report to conform such statements to actual results or to changes in our expectations.

Readers are also urged to carefully review and consider the various disclosures made by us that attempt to advise interested parties of the factors which affect our business, including without limitation the disclosures made under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included herein and under the captions “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Risk Factors” included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2001 and other reports and filings made with the Securities and Exchange Commission.

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Overview

We are a leading online retailer of new textbooks and educational materials targeting private middle and high schools, colleges and distance and continuing education markets. Through eduPartners, our program serving schools and organizations directly, we provide an opportunity for educational institutions to maximize their resources and offer increased convenience and value to their students by outsourcing to us the sale of new textbooks and other learning materials.

We were incorporated in December 1997 and began offering books for sale on our website on August 10, 1998. To date, our revenues have consisted primarily of sales of new textbooks. In January 1999 we created eduPartners, whereby we became the exclusive provider of new books and learning materials to a variety of learning institutions. This program is a cost-effective model that enables us to increase the number of customers to our website and generate book sales that does not require the significant marketing and brand building expenses associated with our earlier model.

During 2000, we began to focus resources on the growth and development of our eduPartner program and we extended that focus throughout 2001. In quarter ending September 30, 2001, revenues from eduPartners accounted for approximately 97% of our overall sales of books, an increase from the 69% share of total book revenues eduPartners represented during the quarter ending September 30, 2000. We expect eduPartners to remain the primary source of textbook revenues moving forward. Net sales consist of sales of books and charges to customers for outbound shipping and are net of allowances for returns, promotional discounts and coupons. Revenues from sales of textbooks are recognized at the time products are received by the customer.

Presently, we are the exclusive new textbook supplier for approximately 120 educational institutions in our eduPartners program. At these institutions we are endorsed as the school’s official bookstore and gain direct access and exposure to their students. Benefits of this business model include significantly lower marketing and customer acquisition costs than our historical college-focused retail book business, greater sales visibility, higher margins and attractive sell-through or penetration per school account. We are able to reduce the overhead associated with textbook sales because we do not maintain individual on-site stores and we outsource our ordering, inventory, warehousing and fulfillment needs with Baker & Taylor, a leading distributor of books, videos and music products. In addition to providing new textbooks at competitive prices, we are committed to providing top quality customer service and account management support.

The Company has also provided marketing services for other businesses seeking to reach the college and private middle and high school demographics by marketing to students online through its website and on college campuses utilizing a nationwide network of student marketing representatives. During 2001, we made a strategic decision to focus resources on the growth and development of the eduPartners program. We determined that the eduPartners model presented the greatest prospects for long-term growth and shareholder value creation and elected to concentrate the resources and energy of the entire organization on maximizing this opportunity. We completed all outstanding on-campus marketing services contracts during 2001 and ceased new development of on-campus marketing services programs. We anticipate future marketing services revenue will likely represent a relatively small percentage of textbook revenues and will be focused on delivering online solutions compatible with our target eduPartners market. Revenues from our marketing programs are recognized straight-line over the contract term, provided that no significant performance obligations remain and the collection of the related receivable is probable. Costs associated with our marketing programs are recognized as incurred.

Throughout 2001, our business priorities, focus and resources adapted to meet the changing market dynamics and economic realities. We successfully lowered overall expenses and increased the margins of our retail book business to accelerate our path to profitability. In addition, we made significant reductions in the marketing and sales overhead expenses associated with our business. As a result, during the three months ending September 30, 2001, we recorded the first profitable fiscal period in our history, posting over $1 million in net operating profits. We also recognized positive cash flows from operations of $0.4 million for the year ended December 31, 2001.

Although our margins have increased and our overall expenses have been lowered significantly, our ability to reach annual operating profitability depends on our ability to generate and sustain higher net revenues. We base our current and future expense levels on our operating plans and estimates of future revenues. In view of the rapidly evolving nature of our business and our limited operating history, we have limited experience forecasting our revenues. Therefore we believe that period-to-period comparisons of our financial results might not necessarily be meaningful and you should not rely on them as an indication of future performance. If we cannot achieve and sustain profitability or positive cash flow from operations, we may be unable to meet our working capital requirements or to obtain additional financing, which would adversely affect our business and my cause us to discontinue operations.

We have incurred substantial losses in every fiscal year since inception. For the year ended December 31, 2001, we incurred a loss from operations of approximately $2.8 million and positive cash flows from operations of $0.4 million. For the year ended December 31, 2000, we incurred a loss from operations of approximately $34.8 million and negative cash flows from operations of $27.5 million. For the year ended December 31, 1999, we incurred a loss from operations of approximately $31.9

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million and negative cash flows from operations of $29.4 million. As of December 31, 2000 and 2001 we had accumulated deficits of approximately $68.2 million and $70.5 million, respectively.

However, during the three months ending September 30, 2001, the Company recorded the first profitable fiscal period in its history with a net profit of approximately $1.0 million in the critical back-to-school textbook buying season. We were also able to record positive cash flows from operations of $0.4 million for the year ended December 31, 2001. Yet, the operating profits from this quarter were not sufficient to reverse the losses recorded in the other three fiscal quarters of 2001, resulting in a net loss of approximately $2.2 million for the year ended December 31, 2001.

During the three months ending March 31, 2002 the Company reported a net loss of approximately $0.5 million, down from a net loss of $1.3 million for the same period in 2001. Cash used in operating activities during the three months ending March 31, 2002 was approximately $0.3 million, down from $0.9 million for the three months ending March 31, 2001.

We expect that operating losses and negative cash flows from operations will likely continue until our seasonally critical back-to-school buying season in the third quarter of 2002. Based upon our current cost structure and recent growth levels within the eduPartners program, we believe we are positioned to improve upon the financial performance of 2001. As part of the increased emphasis on eduPartners and lower overhead cost structure, we expect the costs and expenses related to brand development, marketing and other promotional activities associated with our traditional retail book business will continue to decrease from recent levels. Although this is more likely to result in decreased revenues from the sales of new textbooks than would be the case if we continued to spend at or above our previous levels, we believe, in the aggregate, that this will reduce the historical losses and negative cash flows from our sales of textbooks. We intend to increase spending on the development of eduPartners and relationships with other related businesses. Failure to generate sufficient revenues, raise additional capital or, if necessary, reduce discretionary spending could harm our results of operations and financial condition.

Three Months Ended March 31, 2002
compared to
Three Months Ended March 31, 2001

Net Sales

Net sales decreased to $0.8 million for the three months ended March 31, 2002 from $1.5 million for the three months ended March 31, 2001. This decrease was primarily attributable to the Company’s focus on building core revenues within the eduPartners program. Consistent with this eduPartner focus, the Company significantly reduced marketing expenditures for non-eduPartner sales, resulting in a decrease in traditional retail textbook sales and marketing services revenues. Revenues from our core eduPartners program increased to over $0.6 million for the three months ending March 31, 2002 from approximately $0.4 million for the same period in 2001. Marketing services revenue totaled $14,000 for the three months ended March 31, 2002, a decrease from the $247,000 recognized in the same period in 2001. This decrease was attributable to our decision to close our on-campus marketing services business. No new significant marketing services contracts were signed during the three months ending March 31, 2002.

Operating Expenses

Cost of Books — Related Party (Baker & Taylor).Cost of books — related party consists of the cost of books sold to customers. Cost of books-related party decreased to approximately $0.5 million for the three months ended March 31, 2002 from $1.0 million for the three months ended March 31, 2001. This decrease was primarily attributable to our decreased sales volume.

Cost of Shipping — Related Party (Baker & Taylor).Cost of shipping — related party consists of outbound shipping to the customer. Cost of shipping decreased to approximately $46,000 for the three months ended March 31, 2002 from approximately $0.1 million for the three months ended March 31, 2001. This decrease was primarily attributable to our decreased sales volume.

Cost of Marketing Services—Cost of marketing services includes personnel costs associated with the implementation of our on campus marketing programs and other directly identifiable costs associated with our online advertising and on campus promotions. We did not incur any marketing services costs during the three months ended March 31, 2002. This decrease from approximately $25,000 for the three months ended March 31, 2001 was attributable to lack of any on-campus marketing programs .

Marketing and Sale —Marketing and sales expense consists primarily of advertising and promotional expenditures and payroll and related expenses such as the amortization of deferred compensation for personnel engaged in marketing and expansion of eduPartners. Marketing and sales expense was $0.3 million for the three months ended March 31, 2002 , consistent with expenses of $0.3 million for the three months ended March 31, 2001.

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Product Development— Product development expense consists of payroll and related expenses such as the amortization of deferred compensation for development and systems personnel and consultants. Product development expense decreased to approximately $35,000 for the three months ended March 31, 2002 from $0.1 million for the three months ended March 31, 2001. This decrease was primarily attributable to decreased web development, consulting and personnel costs between periods.

General and Administrative— General and administrative expense consists of payroll and related expenses for executive and administrative personnel such as the amortization of deferred compensation, facilities expenses, professional services expenses, travel and other general corporate expenses. General and administrative expense decreased to $0.3 million for the three months ended March 31, 2002 from $1.2 million for the three months ended March 31, 2001. This decrease was primarily attributable to decreased personnel and professional services expenses between years.

Non-Cash Compensation —Non-cash compensation expense consists of expenses related to the granting of employee options and restricted stock grants measured based on the intrinsic value of the stock option or grant. Non-cash compensation expense decreased to $0.1 million for the three months ended March 31, 2002 from $0.3 million for the three months ended March 31, 2001. This decrease was primarily attributable to lower amortized compensation expense for options issued before the Company’s initial public offering. Non-cash compensation expense is amortized based upon an accelerated expense schedule, resulting in higher than average expenses in the early years and lower than average expenses in the later years.

Other income, net

Other income, net consists primarily of interest income on our cash and cash equivalents and investments and gains or losses associated with the disposal of fixed assets. Other income was $57,000 for the three months ended March 31, 2002 compared to $0.2 million for the three months ended March 31, 2001. Interest income decreased largely due to lower rates of return compared to the previous period.

Income Taxes

As of March 31, 2002, we had net operating loss carryforwards for federal income tax purposes of approximately $60 million, which expire beginning in 2018. We have provided a full valuation allowance on the resulting deferred tax asset because of uncertainty regarding its realizability. For the three months ended March 31, 2002, no income tax expense was recognized because the reduction in the deferred tax asset related to net operating losses was offset by a related reduction in the valuation allowance.

Liquidity and Capital Resources

As of March 31, 2002, we had $16.5 million of cash, cash equivalents and short term investments. As of that date, our principal commitments consisted of obligations outstanding, accounts payable and accrued liabilities. Although we have no material commitments for capital expenditures, we may experience increases in our capital expenditures and lease commitments consistent with anticipated growth in operations, infrastructure and personnel.

Net cash used in operating activities was $0.3 million for the three months ended March 31, 2002 compared to $0.9 million net cash used in operations for the three months ended March 31, 2001. This decrease was largely attributable to reduced operating losses adjusted for changes in accounts receivable, accounts payable and accrued expenses.

Net cash used in investing activities was $3.0 million for the three months ended March 31, 2002 compared to net cash provided by investing activities of $58,000 for the three months ended March 31, 2001. This increase was largely to purchase of high-grade short-term investments.

Net cash provided by financing activities was $12,000 for the three months ended March 31, 2002 and $0.7 million the three months ended March 31, 2001. Net cash provided by financing activities during the three months ending March 31, 2001, consisted primarily of net proceeds from the exercise of employee stock options. Net cash provided by financing activities during the three months ending March 31, 2002, consisted primarily of net proceeds from warrant subscription receivables.

As part of the increased emphasis on eduPartners, we anticipate that costs and expenses related to brand development, marketing and other promotional activities associated with our traditional retail book business will continue to decrease from previous levels associated with our original national college-focused retail book business. Although this may result in decreased revenues from the sales of new textbooks than would be the case if we continued to spend at or above our historical levels, we believe, in the aggregate, that this will reduce the losses and negative cash flows historically associated with our sales of new textbooks. We intend to increase spending on the development of eduPartners and relationships with other

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businesses. Our failure to generate sufficient revenues, raise additional capital or, if necessary, reduce discretionary spending could harm our results of operations and financial condition.

We currently anticipate that our available funds will be sufficient to meet our anticipated needs for working capital and capital expenditures until such time as we achieve annual operating profitability. We may need to raise additional funds prior to the expiration of such period if, for example, we pursue new business, technology or intellectual property acquisitions or experience net losses that exceed our current expectations. Any required additional financing may be unavailable on terms favorable to us, or at all.

Item 3.Quantitative and Qualitative Disclosures About Market Risk

The Company is subject to interest rate risk on its cash and cash equivalents, short-term investments and credit facility. If market rates were to increase immediately and uniformly by 10% from the level at March 31, 2002, the change to the Company’s interest sensitive assets and liabilities would have an immaterial effect on the Company’s financial position, results of operations and cash flows over the next fiscal year.

PART II.
OTHER INFORMATION

Item 1:Legal Proceedings

              Not Applicable

Item 2:Changes in 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

               Not Applicable

Item 6:Exhibits and Reports on Form 8-K

(a)   Exhibits

         None

(b)   Reports on Form 8-K None

         None

SIGNATURES

     Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

Date: May 2, 2002	Varsity Group Inc.
	By:                    /s/   Jack M. Benson
	Jack M. Benson
	Chief Financial Officer

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