Varsity (VSTY) 10-Q 2007 Q2 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 June 30, 2007

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	54-1876848
(State of Incorporation)	IRS Employer (Identification Number)
1300 19th Street NW 8th Floor Washington, D.C.	20036
(Address of Principal Executive Offices)	(Zip Code)

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

(Formerly of 1850 M Street NW, Suite 1150, Washington D.C.)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See the definitions of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Act. (Check one):

Large accelerated filer  ¨    Accelerated filer  ¨    Non-accelerated filer  x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).    Yes  ¨    No  x

As of August 7, 2007, the registrant had 20,176,052 shares of common stock outstanding.

VARSITY GROUP INC.

QUARTERLY REPORT ON FORM 10-Q

For the quarter ended June 30, 2007

INDEX

		Page Number
	PART I. FINANCIAL INFORMATION
Item 1.	Financial Statements
	Condensed consolidated balance sheets as of June 30, 2007 and December 31, 2006	3
	Condensed consolidated statements of operations for the three and six months ended June 30, 2007 and 2006	4
	Condensed consolidated statements of cash flows for the six months ended June 30, 2007 and 2006	5
	Notes to condensed consolidated financial statements	6
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	12
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	18
Item 4.	Controls and Procedures	19
	PART II. OTHER INFORMATION
Item 1.	Legal Proceedings	19
Item 1A.	Risk Factors	19
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	19
Item 3.	Defaults Upon Senior Securities	19
Item 4.	Submission of Matters to a vote of Security Holders	19
Item 5.	Other Information	20
Item 6.	Exhibits	20
	Signatures	21

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PART I.

FINANCIAL INFORMATION

Item 1: Financial Statements

VARSITY GROUP INC.

CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)

(in thousands)

	June 30, 2007			December 31, 2006
ASSETS
Current Assets:
Cash and cash equivalents	$	69		$	436
Restricted cash		2,027			—
Short-term investments		—			2,498
Accounts receivable, net of allowance for doubtful accounts of $215 at June 30, 2007 and $203 at December 31, 2006, respectively		594			1,673
Inventory		12,044			8,636
Other		827			2,532
Total current assets		15,561			15,775
Property, plant and equipment, net of depreciation		786			1,156
Software developed for internal use, net of amortization		2,259			2,090
Intangible assets, net of amortization		6			8
Goodwill		511			511
Long-term investments		—			3,949
Other assets		161			159
Total assets		19,284		$	23,648
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current Liabilities:
Accounts payable	$	5,040		$	2,384
Line of Credit		4,734			—
Margin Loan		—			4,205
Other accrued expenses and other current liabilities		926			2,654
Taxes payable		54			56
Total current liabilities		10,754			9,299
Long-term liabilities:
Other non-current liabilities		152			157
Total liabilities		10,906			9,456
Commitments and contingencies
Stockholders’ equity:
Preferred stock: $.0001 par value, 20,000 shares authorized; 0 shares issued and outstanding at June 30, 2007 and December 31, 2006, respectively		—			—
Common stock, $.0001 par value, 60,000 shares authorized, 20,176 and 19,575 shares issued and 18,961 and 18,360 shares outstanding at June 30, 2007 and December 31, 2006, respectively		2			2
Additional paid-in capital		91,037			90,721
Accumulated unrealized loss on securities		—			(2	)
Accumulated deficit		(80,928	)		(74,796	)
Treasury stock, $.0001 par value, 1,215 shares at June 30, 2007 and December 31, 2006, respectively		(1,733	)		(1,733	)
Total stockholders’ equity		8,378			14,192
Total liabilities and stockholders’ equity	$	19,284		$	23,648

See accompanying notes to condensed consolidated financial statements.

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VARSITY GROUP INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)

(in thousands, except per share data)

	Three Months Ended June 30,						Six Months Ended June 30,
	2007			2006			2007			2006
Net sales:
Textbooks	$	667		$	688		$	1,884		$	2,155
Uniforms		714			1,089			1,222			1,610
Solutions		—			91			—			91
Shipping		73			83			263			315
Total net sales		1,454			1,951			3,369			4,171
Operating expenses:
Cost of textbooks		291			394			1,096			1,507
Cost of uniforms		435			508			680			732
Cost of solutions		—			36			—			36
Cost of shipping		94			130			347			381
Sales and marketing		1,987			2,313			3,520			3,554
General and administrative		1,964			2,586			3,759			4,090
Amortization of acquired intangibles		—			58			—			97
Total operating expenses		4,771			6,025			9,402			10,397
Loss from operations		(3,317	)		(4,074	)		(6,033	)		(6,226	)
Other (expense) income, net:
Interest (expense) income, net		(59	)		100			(46	)		218
Other income (expense), net		17			(1	)		(39	)		—
Other (expense) income, net		(42	)		99			(85	)		218
Loss before income taxes		(3,359	)		(3,975	)		(6,118	)		(6,008	)
Income tax (expense) benefit		(13	)		1,584			(15	)		2,457
Net loss	$	(3,372	)	$	(2,391	)	$	(6,133	)	$	(3,551	)
Net loss per share:
Basic and Diluted	$	(0.18	)	$	(0.14	)	$	(0.33	)	$	(0.20	)
Weighted average shares:
Basic and diluted		18,657			17,526			18,541			17,337

See accompanying notes to condensed consolidated financial statements.

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VARSITY GROUP INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

(in thousands)

	Six Months Ended June 30,
	2007			2006
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss	$	(6,133	)	$	(3,551	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization		543			519
Provision for bad debt		(12	)		23
Deferred income tax benefit		—			(2,503	)
Non-cash stock compensation		192			197
Changes in operating assets and liabilities:
Accounts receivable		1,091			1,646
Inventory		(3,409	)		(6,810	)
Other current and non-current assets		1,748			4,701
Accounts payable		2,656			3,968
Other accrued expenses and other current liabilities		(1,886	)		(966	)
Net cash (used in) operating activities		(5,210	)		(2,776	)
CASH FLOWS FROM INVESTING ACTIVITIES:
Payments for acquisitions and intangible asset		—			(1,307	)
Purchases of property, equipment and software developed for internal use		(433	)		(2003	)
Proceeds from sales of equipment		92			—
Increase in restricted cash		2,027			—
Sales of investments		2,352			3,350
Net cash provided by investing activities		4,038			40
CASH FLOWS FROM FINANCING ACTIVITIES:
Payments against margin loan		(4,205	)		—
Net borrowings under line of credit		4,734			—
Bank overdraft		159			—
Payments for capital lease obligations		(7	)		(7	)
Proceeds from exercise of stock options		124			745
Net cash provided by financing activities		805			738
Net decrease in cash and cash equivalents		(367	)		(1,998	)
Cash and cash equivalents at beginning of period		436			2,733
Cash and cash equivalents at end of period	$	69		$	735
Supplemental disclosure of cash flow information:
Cash paid for income taxes	$	32			108
Cash paid for interest		71			—
Non-cash investing activities
Reduction in goodwill recorded in the acquisition of Campus Outfitters		—			23
Acquisitions of IQ Digital (May 2006)
Fair value fixed assets and other assets acquired		—			(444	)
Identified intangible assets		—			(136	)
Goodwill		—			(706	)
Fair value of liabilities assumed		—			34
Cash expended for acquisitions		—			(1,252	)
Cash paid against acquisition accruals and adjustments to goodwill		—			(30	)
Total cash paid for acquisitions		—		$	(1,282	)

See accompanying notes to condensed consolidated financial statements

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VARSITY GROUP INC. AND SUBSIDIARIES

NOTES TO CONDENSED (UNAUDITED) CONSOLIDATED FINANCIAL STATEMENTS

Note 1: Description of Operations

Varsity Group Inc. (the “Company”) was incorporated on December 16, 1997 and launched its website, www.varsitybooks.com, in August 1998, at which time the Company began generating revenues. Varsity Group is an outsourcing solutions provider for the education community. Varsity Group offers schools a comprehensive eCommerce solution for their textbook procurement operations and is a provider of uniform apparel needs for schools and businesses with physical retail locations in Indiana, Maryland, Michigan, North Carolina, New Jersey, New York, Ohio, Texas and Virginia.

Note 2: Basis of Presentation

The condensed consolidated financial statements of Varsity Group Inc. 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, 2006. Our business is seasonal and thus operating results for the interim periods are not necessarily indicative of results for an entire year.

The year-end condensed consolidated balance sheet data was derived from audited financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States of America.

Recent Accounting Standards

In June 2006, the FASB issued Financial Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”) which clarifies the accounting for uncertainty in income taxes recognized in a company’s financial statements in accordance with SFAS No. 109, “Accounting for Income Taxes.” FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The Company adopted FIN 48 as of January 1, 2007 and the adoption did not result in the recording of any adjustments related to tax positions previously taken and did not have an effect on its financial position or results of operations.

Note 3: Stock-Based Compensation

1998 Stock Plan

On October 2, 1998, the Company adopted the 1998 Stock Plan, which was amended and restated in fiscal year 2000 and further amended in 2003, and under which incentive stock options, non-qualified stock options, restricted stock or stock rights, or any combination thereof may be granted to the Company’s employees and directors. There presently are 9.1 million shares authorized under the 1998 Stock Plan, subject to increase annually on the date of our annual meeting of stockholders by (i) three percent of the Company’s outstanding common stock on such date, (ii) 750,000 shares, or (iii) such lesser amount as the Company’s Board may determine. The Company has reserved an additional 2.2 million shares of its common stock for future option grants. The Compensation Committee of the Board of Directors administers the Plan and determines the individuals to whom options will be granted, the number of options granted, the exercise price and vesting schedule. Options are exercisable at prices established at the date of grant and have a term of ten years and vesting periods between one and 60 months. Vested options held at the date of termination may be exercised within three months. Shares issued under the plan upon option exercise or granting of restricted stock are generally issued from authorized but previously unissued shares. The Board of Directors may terminate the Plan at anytime.

Adoption of SFAS No. 123R

On January 1, 2006, the Company adopted the provisions of SFAS 123R, which establishes accounting for stock-based awards made to employees and directors. Accordingly, stock-based compensation expense is measured at grant date, based on the fair value of the award, and is recognized as expense over the remaining requisite service period. The Company previously applied APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations and provided the required pro forma disclosures of SFAS 123. The adoption of SFAS 123R resulted in stock-based compensation expense of approximately $96,000 and $192,000 for the three and six months ended June 30, 2007, respectively, and $148,000 and $197,000 for the three and six months ended June 30, 2006, respectively. This stock-based compensation expense negatively impacted basic and diluted earnings per share by approximately $0.01 per share for both three and six months ended June 30, 2007 and 2006, respectively.

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The weighted-average grant date fair value of options granted during the three and six months ended June 30, 2006 was approximately $2.36 and $2.34, respectively. The fair value of each option is estimated on the date of grant using the Black-Scholes option-pricing model. The application of this valuation model involves assumptions that are highly subjective, judgmental and sensitive in the determination of compensation expense. There were no grants issued during the six months ended June 30, 2007. The following weighted-average assumptions were used for grants during the three and six months ended June 30, 2006:

	Three Months Ended June 30,			Six Months Ended June 30,
	2007	2006		2007	2006
Expected volatility	—	50.45	%	—	51.14	%
Risk-free rate	—	4.91	%	—	4.86	%
Expected term	—	6.11 years		—	6.18 years
Dividend yield	—	0.0	%	—	0.0	%

The Company’s computation of expected volatility for grants during the six months ended June 30, 2006 was based on the historical volatility of the Company’s stock. The Company’s computation of expected term for grants during the six months ended June 30, 2006, represents management’s determination of such term after accessing the available historical experience. The risk-free interest rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the time of grant. The Company currently recognizes stock-based compensation expense for the fair values of these awards on a straight-line basis over the requisite service period of each of these awards.

A summary of activity of all options is as follows (in thousands, except per share data and contractual term):

	Number of Stock Options		Weighted Average Exercise Price	Weighted Average Contractual Term	Aggregate Intrinsic Value
Outstanding, December 31, 2006	3,513		4.73	7.00	$	392
Granted	—		—
Exercised	(98	)	1.27
Forfeited	(327	)	5.08
Outstanding, June 30, 2007	3,088		4.80	6.47	$	27
Exercisable, June 30, 2007	2,547		5.20	5.89	$	27

The aggregate intrinsic value in the above table reflects the total pre-tax intrinsic value (the difference between the Company’s closing stock price on the last trading day of the period and the exercise price of the options, multiplied by the number of in-the-money stock options) that would have been received by the option holders had all option holders exercised their options on the last day of the period. The intrinsic value of the Company’s stock options changes based on the closing price of the Company’s stock. The closing price per share of the Company’s common stock on June 30, 2007 was $0.88. The total intrinsic value of options exercised during the six months ended June 30, 2007 was approximately $0.1 million. The intrinsic value is calculated as the difference between the market value as of the date of exercise and the exercise price of the shares.

As of June 30, 2007, unrecognized stock-based compensation expense related to stock options of approximately $0.8 million is expected to be recognized over a weighted-average period of 2.7 years.

Because of the Company’s net operating losses, the Company did not realize any tax benefits from the tax deductions from share-based payment arrangements during the six months ended June 30, 2007.

Restricted Stock

As of June 30, 2007, there were no shares of restricted stock outstanding.

Note 4: Net Loss Per Share

Basic loss per share is computed using the weighted average number of shares of common stock outstanding for the period. Diluted loss per share is computed using the weighted average number of shares of common stock and, when dilutive, potential

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common shares from stock options, warrants and restricted stock to purchase common stock using the treasury stock method. The effect of stock options, warrants and restricted stock for the three and six month periods ended June 30, 2007 and June 30, 2006 were excluded from the calculation of diluted net loss per share because including these shares would be anti-dilutive due to the Company’s reported net loss.

Note 5: Other Comprehensive Loss

Other comprehensive loss relates to unrealized losses on short-term and long-term investments. The following table sets forth the comprehensive loss for the three and six months ended June 30, 2007 and 2006 (amounts in thousands):

	Three Months Ended June 30,						Six Months Ended June 30,
	2007			2006			2007			2006
Net loss as reported	$	(3,372	)	$	(2,391	)	$	(6,133	)	$	(3,551	)
Other comprehensive loss		—			—			—			—
Unrealized gain (loss) on investments, net of reclassification adjustment		—			(3	)		2			(16	)
Total comprehensive loss	$	(3,372	)	$	(2,394	)	$	(6,131	)	$	(3,567	)

Note 6: Other Current Assets

The following is a summary of other current assets as of June 30, 2007 and December 31, 2006 (in thousands):

	June 30,		December 31,
	2007		2006
Other Current Assets
Rebates due from B&T	$	454	$	1,357
Returns-in-transit		—		605
Other		373		570
	$	827	$	2,532

• Amounts due from B&T, net, result from Company owned textbooks that B&T has returned to publishers for credit net of amounts payable that the Company owes to B&T;

• Returns-in-transit consists of new textbooks that the Company returned to publishers for credit during the fourth quarter of fiscal 2006 that had not yet been processed by the publishers as of December 31, 2006; and

• Other consists of prepaids and other assets.

Note 7: Intangible Assets and Goodwill

An intangible asset as of June 30, 2007, consisting of the IQ Digital trademark resulting from the purchase price allocation of the May 2006 IQ-Digital acquisition, is as follows (in thousands):

	Life	Gross Assets		Accumulated Amortization		Net Assets
June 30, 2007
IQ Digital trademark	3 yrs		10		4		6
Total		$	10	$	4	$	6

There were no changes in the amount of carrying value of goodwill in the six months ended June 30, 2007.

Amortization expense related to the Company’s acquired intangible assets was $1,000 and $2,000 during the three and six months ended June 30, 2007, respectively. Estimated aggregate future amortization expense for intangible assets remaining as of June 30, 2007 is as follows: (amounts in thousands):

	2007		2008		2009		Thereafter		Total
Amortization expense	$	2	$	3	$	1	$	—	$	6

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Note 8: Acquisitions and Purchase of Assets

On May 1, 2006, the Company acquired substantially all the assets of IQ Digital Studios (“IQ Digital”) from White Hat Ventures, LLC for approximately $1.3 million cash plus the assumption of certain liabilities. IQ Digital was based in Akron, Ohio and was an advertising agency focused on educational branding, communications and marketing. The purchase price allocation was as follows: $706,000 to goodwill, $444,000 to fixed assets and other assets, $136,000 to other acquired intangibles and $34,000 to assumed liabilities. The goodwill and most of the acquired intangible assets associated with the purchase were fully impaired during the Company’s fourth quarter of fiscal 2006.

On March 29, 2006, the Company purchased the assets of Lydia Learn (www.lydialearn.com) from White Hat On Campus, LLC, for cash of approximately $0.4 million. Approximately $350,000 was allocated to acquired software and $25,000 was allocated to a non-compete agreement, and the remaining balance of the purchase price was allocated to various fixed or current assets. In late November 2006, efforts to launch service offerings outside the book and uniform areas were terminated or suspended and accordingly, the Lydia Learn asset was fully impaired.

On May 26, 2005, the Company acquired substantially all of the assets of privately held Campus Outfitters, LLC, for cash of approximately $3.1 million and 123,967 shares of common stock valued at approximately $0.7 million, for an aggregate purchase price of approximately $3.8 million, plus the assumption of certain liabilities. The Company may be required to make additional contingent payments if the common stock recipients do not sell, pledge, or in any way transfer the common stock before the two year anniversary of the acquisition close date and the value of the Company’s common stock is not equal to or greater than the per share purchase price on the two year anniversary date. The additional contingent payments, if any, would be payable in cash or shares of the Company’s common stock. Accordingly, on June 1, 2007, the Company made an additional payment, in shares of the Company’s stock, of 502,776 shares.

Note 9: Income Taxes

The Company accounts for income taxes in accordance with Statement of Financial Accounting Standards No. 109 (“SFAS 109,”) “Accounting for Income Taxes.” Under SFAS No. 109, deferred tax assets and liabilities are determined based on differences between the financial reporting and tax basis of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. A valuation allowance is established when necessary to reduce deferred tax assets to the amount expected to be realized. In determining the need for a valuation allowance, our management reviews both positive and negative evidence pursuant to the requirements of SFAS No. 109, including current and historical results of operations, the annual limitation on utilization of net operating loss carry forwards pursuant to Internal Revenue Code section 382, future income projections and the overall prospects of our business. Based upon management’s assessment of all current available evidence, including the current year operating loss, we have concluded that none of the deferred tax benefits should be recognized at this time. Consequently, we have reserved all deferred tax assets. We will continue to monitor all available evidence and reassess the potential realization of our deferred tax assets. Approximately $1.9 million of the valuation allowance relates to net operating losses resulting from stock option windfall benefits, e.g. disqualifying dispositions. Reductions in the valuation allowance for those assets will result in an increase to additional paid-in capital after the valuation allowance related to all other deferred tax assets amounts have been reduced.

The Company files a U.S. federal income tax return and returns in various state jurisdictions. The Company is subject to U.S. federal tax and state tax examinations for the tax years 2003 to 2006. The Company is subject to certain state tax examinations for the tax years 2002 – 2006 for those states with longer statutes of limitation than the Federal three-year statute. The Company does not believe there will be any material changes in its unrecognized tax positions over the next 12 months.

During the three months and six months ended June 30, 2006, the Company recorded income tax benefits of $1.6 million and $2.5 million, respectively. In the third quarter of 2006, we determined that deferred tax assets would not be realized and we ceased recording income tax benefits. For the three months and six months ended June 30, 2007, no income tax benefits were recorded.

Note 10: Inventories

Inventories, consisting of products available for sale, are valued at the lower of cost or market value and are accounted for principally using the FIFO method. The Company’s inventory balance as of June 30, 2007 and December 31, 2006 consists of (in thousands):

	June 30,		December 31,
	2007		2006
Inventory
New textbooks	$	3,390	$	3,739
Used textbooks		4,090		1,724
Uniforms and apparel		4,564		3,173
	$	12,044	$	8,636

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The components of inventory are as follows:

• New textbooks consist of new book inventory held at Baker & Taylor (“B&T”), our fulfillment partner, acquired by B&T in support of our Varsity Partners textbook program for which they generally do not enjoy standard return privileges with the publisher. New textbooks also include inventory held at Campus Outfitters retail locations and new textbooks held at other locations;

• Used textbooks consist of used textbooks held at B&T, Campus Outfitters retail locations, or other locations; and

• Uniforms and apparel consists of school uniform related inventory held at our Campus Outfitters warehouses or retail locations.

Under the Company’s agreement with B&T in which B&T provides most of the Company’s order fulfillment and drop shipment services, B&T generally only assumes ownership of new textbooks that they are able to return to publishers for credit, which historically has approximated 90% of all new textbook inventories. B&T does not assume ownership of the used products it processes for the Company, and consistent with the agreement with B&T, the Company purchases from B&T at cost new textbooks that B&T procured in support of our textbook program and cannot return for publisher credit at the conclusion of each selling season. This inventory has typically been held by B&T for fulfillment in subsequent periods. On a quarterly basis, the Company assesses its inventory for potential write-down for estimated excess and obsolete or unmarketable inventory and records write-downs equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions.

Note 11: Business Segments.

Prior to its acquisition of Campus Outfitters in May 2005, the Company was primarily an Internet retailer of textbooks and educational materials targeting private middle and high schools, small colleges and distance and continuing education markets. The Company’s chief operating decision maker reviewed financial information presented on a consolidated basis. Accordingly, the Company considered itself to be in a single industry segment. In May 2005, the Company added a second product line with its acquisition of Campus Outfitters, a leading provider of uniform apparel needs to schools and businesses. Accordingly, the Company’s operations are aggregated into two reportable business segments: textbook trade and uniform trade.

The business segments reported below are the segments of the Company for which discrete financial information was available and for which the Company’s chief operating decision maker evaluated gross margins in its first and second quarters of fiscal 2007 (amounts in thousands):

	Three months ended June 30, 2007
	Textbooks						Uniforms						Corporate				Total
	2007			2006			2007			2006			2007		2006		2007			2006
Sales	$	667		$	688		$	714		$	1,089		$	—	$	91	$	1,381		$	1,868
Product gross margin	$	376		$	294		$	279		$	581		$	—	$	55	$	655		$	930
Shipping revenue	$	69		$	83		$	4		$	—		$	—	$	—	$	73		$	83
Shipping gross margin	$	(11	)	$	(15	)	$	(10	)	$	(34	)	$	—	$	—	$	(21	)	$	(49	)
Total sales	$	736		$	771		$	718		$	1,089		$	—	$	91	$	1,454		$	1,951
Blended gross margin	$	65		$	279		$	269		$	547		$	—	$	55	$	634		$	881
Goodwill	$	511		$	511		$	—		$	1,893		$	—	$	706	$	511		$	3,110
Total assets	$	10,647		$	10,923		$	6,208		$	6,970		$	2,429	$	27,239	$	19,284		$	45,132
	Six months ended June 30, 2007
	Textbooks						Uniforms						Corporate				Total
	2007			2006			2007			2006			2007		2006		2007			2006
Sales	$	1,884		$	2,156		$	1,222		$	1,610		$	—	$	91	$	3,106		$	3,857
Product gross margin	$	788		$	649		$	542		$	878		$	—	$	55	$	1,330		$	1,582
Shipping revenue	$	251		$	304		$	11		$	11		$	—	$	—	$	262		$	315
Shipping gross margin	$	(56	)	$	(14	)	$	(28	)	$	(64	)	$	—	$	—	$	(84	)	$	(78	)
Total sales	$	2,135		$	2,460		$	1,233		$	1,620		$	—	$	91	$	3,368		$	4,171
Blended gross margin	$	732		$	635		$	514		$	814		$	—	$	55	$	1,246		$	1,504
Goodwill	$	511		$	511		$	—		$	1,893		$	—	$	706	$	511		$	3,110
Total assets	$	10,647		$	10,923		$	6,208		$	6,970		$	2,429	$	27,239	$	19,284		$	45,132

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Note 12: Related Party Transaction.

Connected with the acquisition of Campus Outfitters, the Company assumed the lease to the Campus Outfitters 16,800 square foot corporate headquarters building in College Park, MD which is owned by 5112 Berwyn LLC, a Maryland limited liability company whose controlling shareholders are Adam Hanin, the founder of Campus Outfitters and Executive Vice President of Sales of the Company until June 15, 2006. Under terms of the lease, the Company is obligated to pay 5112 Berwyn LLC $18,000 a month through May 2015. In July 2006, 5112 Berwyn LLC sold the Campus Outfitters headquarters building to an unrelated party. The Company’s total related party payments in fiscal 2006 until the time of sale was $126,000.

Note 13: Financing Arrangements – Line of Credit

On March 8, 2007, the Company entered into a Revolving Line of Credit Loan Agreement and Security Agreement with Bank of America, N.A. (“BOA”) in which BOA will lend up to a maximum amount of $5 million to assist in funding the Company’s seasonal cash requirements. Under the facility, the Company may use up to $1 million of the $5 million borrowing ceiling to issue letters of credit.

Interest on outstanding balances is calculated and paid monthly in arrears based on the 30 day LIBOR rate then in effect plus 2.25%. The interest rate at June 30, 2007 was 7.57%. A daily commitment fee of 0.25% per annum is paid monthly in arrears on the unused portion of the facility.

Borrowing ceiling levels are established monthly by establishing a Borrowing Base calculated as the sum of the following percentages of asset groupings: 100% of eligible restricted cash investments; 80% of eligible commercial accounts receivable; 50% of the eligible value of new book inventory; 25% of the eligible value of used book inventory and 50% of the eligible value of apparel inventory. The Borrowing Base on June 30, 2007 exceeded the borrowing ceiling therefore the borrowing ceiling on June 30, 2007 was limited to the maximum $5 million. The amount of borrowings under the facility on June 30, 2007 was $4,734,000, with $266,000 remaining available under the facility on June 30, 2007.

A $2 million restricted cash investment is required to be maintained at all times with BOA as the investment collateral portion of the borrowing base. The facility is secured by substantially all of the Company’s assets. The agreement terminates on April 30, 2008.

The agreement is subject to various restrictive covenants, which include restrictions on; the use of loan proceeds, the sale or transfer of assets, incurring additional indebtedness, acquisitions of assets and other business, investments of assets, loans made by the Company, repurchases of Company securities and change of control. The agreement is subject to Company compliance with a minimum tangible net worth covenant.

Note 14: Subsequent Events

On July 25, 2007, Varsity Group Inc. granted 1.2 million stock options to employees with an exercise price of $1.20 per share. The options will vest monthly over four years from the grant date, however, vesting will accelerate and all unvested options will vest on the July 25, 2009 provided Varsity Group Inc. meets certain operating financial targets for fiscal year 2008 as approved by the Board of Directors.

On July 25, 2007 Varsity Group Inc. entered into a sub-sublease for its entire headquarters facility located at 1300 19^th Street, NW, Washington D.C. for the entire remaining term of its existing sublease. Under the terms of the lease, the sub lessee is obligated to pay the Company monthly base rent of approximately $49,000 in the first year of the lease, with rents escalating thereafter.

On August 1, 2007 Varsity Group Inc. entered into a sublease for its new headquarters facility located at 2677 Prosperity Avenue, Fairfax, Virginia. Under the terms of the lease, the Company is obligated to pay monthly base rent of approximately $25,800 in the first year of the lease, with rents escalating thereafter.

On August 9, 2007 the Company. amended an existing Services and Management Agreement with SchoolOne.com LLC (“SchoolOne”) under which SchoolOne develops all of the Company’s new technology and provides services and support for all the Company’s processes and systems. Under the terms of the amendment, the term of the agreement is extended through December 31, 2007 and for the six-month period July 1, 2007 through December 31, 2007 Varsity Group Inc. is obligated to pay SchoolOne $1.2 million.

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

Forward Looking Statements

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2006. This discussion contains forward-looking statements that involve risks and uncertainties that could cause our actual results to differ materially. These statements relate to future events or our future financial performance and are based on information available to us as of the date hereof, and we assume no obligation to update any forward-looking statement. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “except,” “plan,” “anticipate,” “intend,” “seek,” “expect,” “believe,” “estimate,” “predict,” “potential” or “continue,” the negative of such terms or other comparable terminology. These statements are only predictions. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including but not limited to, those discussed in “Risk Factors” included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2006 and other reports and filings made with the Securities and Exchange Commission.

The following discussion provides additional information to the accompanying consolidated financial statements and notes to help provide an understanding of our financial condition, changes in financial condition and results of operations. This discussion is organized as follows:

• Overview. This section provides a general description of our business, economic and industry-wide factors relevant to us and material opportunities, challenges and risks in our business.

• Critical Accounting Policies. This section discusses those accounting policies that contain uncertainties and require significant judgment in their application.

• Results of Operations. This section provides an analysis of our results of operations for all periods presented in the accompanying consolidated statements of operations.

• Liquidity and Capital Resources. This section provides an analysis of our sources and uses of cash, capital expenditures and the amount of financial capacity available to fund our future commitments.

Overview

We are an outsourcing solutions provider for the education community. Under the “VarsityBooks” and “Campus Outfitters” brands, we provide textbooks, uniforms and school supplies to private K-12 schools, colleges, and distance and continuing education markets. Through our textbook and uniform outsource solutions, schools are released from the operational and financial challenges associated with managing highly seasonal retail operations and are free to focus on their core educational mission. Parents and students benefit from the increased convenience and value associated with our comprehensive textbook and uniform programs.

We were incorporated in December 1997 and began offering books for sale on our website on August 10, 1998. Prior to 2005, our revenues consisted primarily of sales of new textbooks. In May 2005, we acquired Campus Outfitters, a retailer of school uniforms to the private K-12 school marketplace, and introduced school uniforms as a second revenue stream into our business. To date, the primary channel for textbook sales has been through online eCommerce transactions, while the majority of uniform sales have been recognized through retail stores and on-campus sales events.

Our original sales model focused on building a broad consumer brand offering promotions and deeply discounted textbook prices to entice college students to visit our website and purchase their textbooks from us. However, during 2000 we began to focus resources on the growth and development of our eduPartners program, whereby we became a provider of new textbooks and learning materials to private middle and high school, college, distance, and continuing education markets. This model represents the overwhelming majority of our textbook business today.

Within our textbook solution, we create a customized virtual bookstore for each partner school which is hosted on our website, www.varsitybooks.com. This site contains the required and optional educational materials and supplies selected by the school organized by grade, academic discipline and course name. Students and parents from each of our partner schools access their customized bookstore to place their orders via a direct link from their school’s homepage or by searching for their school bookstore by region and state on our homepage. Once an order has been submitted, it is typically picked, packed and shipped within one business day from one of three distribution centers nationwide.

Member schools leverage our textbook solution to lower their operating overhead by outsourcing their bookstore operation while delivering a more efficient and flexible bookstore solution to their community. In addition, our partner schools have access to our unique program administration website that provides them with sales and inventory reports, among other valuable features. Student and parent customers value the convenience of our online shopping experience and take comfort in the knowledge that

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our posted booklists have been reviewed for content and accuracy and approved by their school. As a further convenience to parents, students and school officials, to the extent any of our partner schools adopt textbooks to be used in the next school term, we will typically offer parents and students several options to sell back their textbooks to us at the end of the school year, helping to lower their total cost of textbook ownership. These used textbooks are offered for sale the following school year providing our student and parent customers lower cost pricing alternatives.

In May 2005, as part of our strategy to expand the number of services and products we offer our customers, we acquired Campus Outfitters. Through the Campus Outfitters brand, Varsity Group owns and operates eight retail locations serving private K-12 school communities as their official school uniform provider. Parents and students are also able to purchase uniforms and related items via on-campus sales events which are held at eligible schools as well as online through customized virtual stores which are created onwww.campusoutfitters.com for each partner school containing all required uniform components. We believe with the Campus Outfitters acquisition, we now have the opportunity to begin cross-selling our textbook and uniform model between our combined network of existing customers.

Beginning in the second quarter of 2006, we moved aggressively to launch service offerings outside our core book and uniform offerings. Significant costs were incurred in this effort. In November 2006, due to the financial impact of cost increases together with limited new revenue generation from non-book/uniform service offerings, efforts to launch service offerings outside the book and uniform areas were terminated or suspended. Significant cost reductions have been implemented, and our current strategy includes only the book, uniform and school supplies businesses. Our August 2006 partnership with Office Depot enables us to provide School Supplies solutions to parents and students and Office Supplies solutions to schools.

During our second quarter of fiscal 2007, we again focused on increasing our used textbook inventory through our on-campus textbook buyback program. Through these buyback events, we provide our partner school parents and students the option of selling back to us at the end of the current school year textbooks that our partner schools are adopting for use during the approaching school year. This increases the overall number of used textbooks available to our partner schools throughout the school year, lowers the total cost of textbook ownership for parents and students and provides customers more purchasing options. During fiscal 2006, used book unit sales increased 20% as compared to fiscal 2005 and used books were approximately 16% of our textbook sales for fiscal 2006. Used book unit sales have increased 25% for the six months ended June 30, 2007 compared to the prior year period.

Our overall success and ability to maintain and increase profitability from operations will depend, in part, upon our ability to retain our current customers, attract additional schools to our programs, provide a compelling and satisfying shopping experience to our retail customers, and manage our relationship with our primary fulfillment partner, Baker and Taylor, Inc. (“B&T”), a leading distributor of books, videos and music products.

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.

Pursuant to guidance published by the SEC regarding disclosure about critical accounting policies, we have identified the following accounting policies as critical to the understanding of our financial statements.

CRITICAL ACCOUNTING POLICIES

Our consolidated financial statements are prepared in conformity with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, sales, and expenses, and related disclosure of contingent assets and liabilities. We re-evaluate our estimates on an on-going basis. Our estimates and judgments are based on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Actual results may differ from these estimates or judgments under different assumptions or conditions.

We believe the following are the critical accounting policies which affect our more significant judgments and estimates used in the preparation of our unaudited condensed consolidated financial statements:

• Revenue Recognition;

• Deferred Income Taxes;

• Stock-Based Compensation Plans;

• Valuation of Inventories;

• Business Acquisition and Valuation and Impairment Review of Long-Lived Assets

A complete discussion of these policies is contained in our Form 10-K filed with the Securities and Exchange Commission for the period ending December 31, 2006. There were no significant changes to the critical accounting policies discussed in the Company’s 10-K filed for December 31, 2006, except for the adoption of FIN 48 which is discussed in Note 1 to the consolidated financial statements.

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Results of Operations:

The following table includes the condensed consolidated statements of operations data for the three and six months ended June 30, 2007 and June 30, 2006, expressed as a percentage of total net sales:

	Three Months Ended June 30,				Six Months Ended June 30,
	2007		2006		2007		2006
Net sales:
Textbooks	45.8	%	35.3	%	55.9	%	51.7	%
Uniforms	49.1	%	55.7	%	36.3	%	38.6	%
Solutions	—		4.7	%	—		2.2	%
Shipping	5.1	%	4.3	%	7.8	%	7.5	%
Total net sales	100.0	%	100.0	%	100.0	%	100.0	%
Operating Expenses:
Cost of textbooks	20.0	%	20.2	%	32.5	%	36.1	%
Cost of uniforms	29.9	%	26.0	%	20.2	%	17.6	%
Cost of solutions	—		1.9	%	—		0.9	%
Cost of shipping	6.5	%	6.7	%	10.3	%	9.1	%
Sales and marketing	136.7	%	118.6	%	104.5	%	85.2	%
General and administrative	135.0	%	132.6	%	111.6	%	98.1	%
Amortization of acquired intangibles	—		3.0	%	—		2.3	%
Total operating expenses	328.1	%	308.8	%	279.1	%	249.2	%
Loss from operations	(228.1	)%	(208.8	)%	(179.1	)%	(149.2	)%
Other income, net	(2.8	)%	5.1	%	(2.5	)%	5.2	%
Loss before income taxes	(230.9	)%	(203.7	)%	(181.6	)%	(144.0	)%
Income tax (expense) benefit	(0.9	)%	81.2	%	(0.5	)%	58.9	%
Net loss	(231.8	)%	(122.6	)%	(182.1	)%	(85.1	)%

Seasonality:

We experience significant seasonality in our results of operations. Consistent with our focus on the expansion of eduPartners and introduction of Campus Outfitters uniform model and their current concentration of private middle and high school institutions, since the year ended December 31, 2000, our peak selling period is the July/August/September back-to-school season. During fiscal 2006 and 2005, approximately 88% and 86% of our revenues, respectively, were recognized in this period. We expect this trend to continue during fiscal 2007. While many private middle and high school institutions have an active book-buying season in December/January, the volume of purchases are typically significantly lower than the initial back-to-school season. Historically, Campus Outfitters has experienced the same seasonality in its results of operations. Consistent with its current concentration of private elementary, middle and high schools, Campus Outfitters peak selling season has been July/August/September back-to-school season. Part of our strategy is to extend our textbook program more deeply into the college and distance learning markets, expand our uniform model to more broadly incorporate branded apparel and identify profitable new products or services to market to our existing customer base. This could result in more balanced revenues throughout the year. However, based upon our current program, product and school mix, we will continue to experience significant fluctuations in quarterly operating results. Please see “Forward-Looking Statements.”

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Net Sales:

Net sales decreased 25.4%, or $0.5 million, to $1.5 million, and decreased 19.2%, or $0.8 million, to $3.4 million for the three and six-month periods ended June 30, 2007, respectively, compared to the same periods in 2006.

Although the total number of textbooks sold online during the six month period ended June 30, 2007 increased by 6%, textbook revenue decreased by approximately $0.3 million for the six month period ended June 30, 2007. This resulted from a sales allowance adjustment related to 2006 revenue of $0.2 million along with an increase in the number of used textbooks sold during first two quarters of 2007 compared to the prior year period.

Uniform revenue decreased 34.5% and 24.1%, or $0.4 million for the three and six-month periods ended June 30, 2007 compared to the same periods in 2006. This resulted from a comparable decline in the number of schools and customers served for 2007.

Net sales consist of sales of textbooks and uniforms and charges to customers for outbound shipping and are net of allowances for returns, promotional discounts and coupons. Revenues from sales are recognized at the time products are received by the customer. Over time, expansion of used book revenue as a percentage of total revenues may serve to lower textbook revenue growth since used books are typically priced at a 25% discount to comparable new textbooks. However, the related decrease in revenue growth is typically offset by higher gross margins associated with the sale of used books. See “Forward Looking Statements.”

Operating Expenses:

Cost of Textbooks -Cost of textbooks consists of the cost of textbooks and related education material sold to customers. Cost of textbooks decreased 26.1%, or approximately $0.1 million, to approximately $0.3 million, and decreased 27.3%, or approximately $0.4 million, to approximately $1.1 million for the three and six months ended June 30, 2007, respectively. Expressed as a percentage of related revenue, cost of textbooks was 43.6% and 57.2% for the three months ended June 30, 2007 and 2006, respectively, and 58.2% and 69.9% for the six months ended June 30, 2007 and 2006, respectively. This decrease in the three and six month periods ended June 30, 2007 was attributable to a 23% and 25% increase in online sales of used books during the three and six months ended June 30, 2007, respectively, as compared to the prior year periods, and an overall shift in textbook revenue mix during a seasonally insignificant fiscal period from a revenue perspective. We expect that textbook costs for the full fiscal year will be consistent with, or lower than, historical levels. Cost of textbooks varies with textbook revenue and we expect these costs to increase in absolute dollars as our customer base and number of partner schools served expands. Please see “Forward-Looking Statements.”

Cost of Uniforms - Cost of uniforms consists of the cost of uniforms and apparel sold to customers. Cost of uniforms decreased approximately $0.1 million, or 14.4%, to approximately $0.4 million, and decreased approximately $0.1 million, or 7.1%, to approximately $0.7 million for the three and six months ended June 30, 2007, respectively. Expressed as a percentage of related revenue, cost of uniforms was 60.9% and 46.6% for the three months ended June 30, 2007 and 2006, respectively, and 55.7% and 45.5% for the six months ended June 30, 2007 and 2006, respectively. The decrease in margins in the three and six-month periods ended June 30, 2007 was largely attributable to year over year price increases in product, which were not passed on to our customers. Margins for the three-month period ended June 30, 2007 was also negatively impacted by approximately 5% to 7% due to an increase in uniforms sold at wholesale prices. Cost of uniforms varies with uniform revenue and we expect these costs to increase in absolute dollars as our customer base expands. Please see “Forward-Looking Statements.”

Cost of Shipping. Cost of shipping consists of outbound shipping to our customers. Cost of shipping decreased $36,000, or 27.7%, to $94,000, and decreased approximately $35,000, or 9.1%, to approximately $0.3 million for the three and six months ended June 30, 2007, respectively. Expressed as a percentage of related revenue, cost of shipping was 128.77% and 156.63% for the three months ended June 30, 2007 and 2006, respectively, and 132.1% and 121.3% for the six months ended June 30, 2007 and 2006, respectively.

Sales and Marketing.Sales and marketing expense consists primarily of promotional expenditures, credit card processing fees, travel expense, expenses associated with contracting with our eduPartners schools, expenses associated with our Campus Outfitters retail locations and road shows, seasonal overhead associated with performing inventory purchases at eduPartner schools, and payroll and related expenses for personnel engaged in sales and marketing, account management, eduPartners operations and Campus Outfitters operations. Sales and marketing expense decreased approximately 13.8%, or $0.3 million, and remained flat for the three and six months ended June 30, 2007, respectively compared to the same period in 2006. The following table sets forth sales and marketing expense for the three and six months ended June 30, 2007 and 2006 (in thousands):

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	Three months ended June 30						Six months ended June 30
	2007			2006			2007			2006
Variable sales and marketing expense	$	201		$	279		$	389		$	443
Percentage of total revenue		13.8	%		14.3	%		11.5	%		10.6	%
Other sales and marketing expense	$	1,786		$	2,034		$	3,131		$	3,111
Percentage of total revenue		122.8	%		104.3	%		92.9	%		74.6	%
Sales and marketing expense, as reported	$	1,987		$	2,313		$	3,520		$	3,554
Percentage of total revenue		136.7	%		118.6	%		104.5	%		85.2	%

Variable sales and marketing expense consists of credit card expenses, certain expenses associated with contracting with our textbook and apparel program schools, and sales expenses associated with our agreement with B&T. We expect that variable sales and marketing expense will increase during our peak selling period in the July/August/September back-to-school season. Please see “Forward-Looking Statements.”

Other sales and marketing expense consists of primarily payroll and related expenses for personnel engaged in sales and marketing, account management, textbook, uniform and solutions operations, travel expense, expenses associated with our Campus Outfitters retail locations and road shows and seasonal overhead associated with performing inventory purchases at textbook program schools. Other sales and marketing expense decreased 12.2%, or approximately $0.2 million, to approximately $1.8 million, and remained flat for the three and six months ended June 30, 2007, respectively. The decrease in the three months ended June 30, 2007 was largely attributable to the termination or suspension of all non-textbook / uniforms / school supply service offerings in our fourth quarter of fiscal 2006. Please see “Forward-Looking Statements.”

General and administrative. General and administrative expense consists of payroll and related expenses for executive, administrative, and our development and systems personnel, facilities expenses, costs associated with our agreement with SchoolOne which is developing our new technology and providing services and support for our processes and systems, costs associated with the upgrade and maintenance of our website, outside consultant and professional services expenses, travel, and other general corporate expenses. General and administrative expense, reported net of $0.2 million and $0.5 million of costs capitalized for software developed or purchased for internal use during the three months ended June 30, 2007 and 2006, respectively, decreased 21.3% or approximately $0.5 million, to approximately $2.0 million. General and administrative expense, reported net of $0.4 million and $1.1 million of costs capitalized for software developed or purchased for internal use during the six months ended June 30, 2007 and 2006, respectively, decreased 5% or approximately $0.2 million, to approximately $3.8 million for the six months ended June 30, 2007. These decreases were primarily attributable to the termination or suspension of all non-textbook / uniforms / school supply service offerings in our fourth quarter of fiscal 2006. Please see “Forward-Looking Statements.”

We are capitalizing development costs in accordance with American Institute of Certified Public Accountants (“AICPA”) Statement of Position No. 98-1 (“SOP 98-1”), “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use.” Please see “Forward-Looking Statements.”

Amortization of Acquired Intangibles.

Our acquisitions of Campus Outfitters in May 2005 and IQ Digital in May 2006 were accounted for under the purchase method of accounting. As a result, we recorded intangible assets at their applicable fair values of the net tangible assets acquired. Amortization of acquired intangibles was approximately $58,000 and $97,000 during the three and six-months ended June 30, 2006, respectively. During our fourth quarter 2006, we recorded impairment charges against all of our acquired intangibles except for the IQ Digital trademark. As a result, future amortization for acquired intangibles is immaterial. Please see “Forward-Looking Statements.”

Other (expense) income, net

Other (expense) income, net consists primarily of interest income on our cash and cash equivalents and investments, and interest expense related to our outstanding margin loan and line of credit. Other expense was approximately $42,000 and $0.1 million for the three and six months ended June 30, 2007, respectively, compared to other income of $0.1 million and $0.2 million for the three and six months ended June 30, 2006, respectively. The decrease was due to lower average invested cash and increasing borrowings under the revolving line of credit during the three and six months ended June 30, 2007 as compared to the prior year period and a recognized loss of approximately $41,000 due to the sale of a long-term security before its maturity date.

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Income Taxes

During the three months and six months ended June 30, 2006, the Company recorded income tax benefits of $1.6 million and $2.5 million, respectively. In the third quarter of 2006, we determined that deferred tax assets would not be realized and we ceased recording income tax benefits. For the three months and six months ended June 30, 2007, no income tax benefits were recorded.

In July 2006, the FASB issued FIN 48, which clarifies the accounting for uncertainty in income taxes by prescribing the minimum recognition threshold a tax position is required to meet before being recognized in the financial statements. FIN 48 also provides guidance on de-recognition, measurement, classification, interest and penalties, accounting for interim periods and disclosures for uncertain tax positions. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company’s adoption of FIN 48 on January 1, 2007, did not result in the recording of any previously unrecognized tax positions and did not have an effect on its financial position or results of operations.

The Company files a U.S. federal income tax return and returns in various state jurisdictions. The Company is subject to U.S. federal tax and state tax examinations for the tax years 2003 to 2006. The Company is subject to certain state tax examinations for the tax years 2002 – 2006 for those states with longer statutes of limitation than the Federal three-year statute. The Company does not believe there will be any material changes in its unrecognized tax positions over the next 12 months.

The Company’s policy is to recognize interest and penalties accrued on any unrecognized tax positions as a component of income tax expense. As of the date of adoption of FIN 48, the Company did not have any accrued interest or penalties associated with any unrecognized tax positions, and there was no related interest or penalties recognized during the three months and six months ended June 30, 2007.

Liquidity and Capital Resources

As of June 30, 2007, we had approximately $2.1 million of cash, cash equivalents, and restricted cash and our net working capital was approximately $4.8 million compared to approximately $2.6 million of cash, cash equivalents and short-term investments and net working capital of approximately $6.5 million at December 31, 2006. As of June 30, 2007, we did not have any cash invested in long-term investments compared to approximately $3.9 million at December 31, 2006. The decrease in cash, cash equivalents, restricted cash and short-term investments during the six months ended June 30, 2007 was primarily attributable to cash payments for our school partner incentive accruals and cash used to fund operating losses. This decrease was partially offset by the collection of certain receivables due from B&T.

As of June 30, 2007, our principal commitments consisted of borrowings under our line of credit agreement with Bank of America, obligations outstanding under operating leases, our service agreement with SchoolOne, and accounts payable. Beginning in the second quarter of 2006, we moved aggressively to launch service offerings outside our core book and uniform offerings. Significant costs and cash expenditures were incurred in this effort. In November 2006, due to the financial impact of cost increases together with limited new revenue generation from non-book/uniform service offerings, efforts to launch service offerings outside the book and uniform areas were terminated or suspended. Significant cost reductions have been implemented, and our current strategy includes only the book, uniform and school supplies businesses. As a result, we anticipate a reduction in cash used in operating activities in fiscal 2007. However, the seasonal nature of our business requires that we manage our liquidity carefully in advance of the fall selling season. Please see “Forward-Looking Statements.”

Net cash used in operating activities was approximately $5.2 million for the six months ended June 30, 2007 compared to net cash used in operating activities of approximately $2.8 million for the six months ended June 30, 2006. The change was primarily due to an increased net loss in the six months ended June 30, 2007 and a smaller decrease in other current assets related to year-end rebates we had with B&T compared to the prior year period, as well as an increase in accrued expenses, offset by a decrease in cash expended for inventory.

Investing activities consist of acquisitions of businesses, capitalization of software developed for internal use, purchases of property, plant and equipment, purchases of software, purchases and sales of short-term and long-term investments, and proceeds from sales of property plant and equipment. Net cash provided by investing activities was approximately $4.0 million for the six months ended June 30, 2007 compared to net cash used in investing activities of approximately $40,000 for the six months ended June 30, 2006. During the six months ended June 30, 2007 we had sales of short-term and long-term investments of approximately $4.4 million, which we used to payoff our margin loan outstanding as of December 31, 2006, compared to net sales of short-term and long-term investments of $3.4 million during the comparable reporting period. Total purchases of property, equipment and software, including capitalization of software, was approximately $0.4 million during the six months ended June 30, 2007, a decrease of approximately $1.6 million over the comparable period in 2006. During fiscal 2006, we made significant investments in our people, processes and systems to accelerate the growth of our business. As a result, we expect our total fiscal 2007 expenditures for property, equipment and software, including capitalization of software, to be significantly lower in fiscal 2007. Also during the six months ended June 30, 2007, we received cash proceeds of approximately $0.1 million resulting from sales of fixed assets no longer in service due to the closure of our IQ Digital Studios office in Akron, Ohio.

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Net cash provided by financing activities was approximately $0.8 million for the six months ended June 30, 2007 compared to net cash provided by financing activities of approximately $0.7 for the six months ended June 30, 2006. During the six months ended June 30, 2007, we made a full payment of approximately $4.2 million against our margin loan outstanding as of December 31, 2006. This was offset by actual cash borrowings of approximately $4.7 million under our line of credit agreement with Bank of America as well as prospective cash borrowings of approximately $0.2 million to cover outstanding checks at June 30, 2007.

The following table provides an overview or our aggregate contractual obligations as of June 30, 2007, and the effect these obligations are expected to have on our liquidity and cash flows for the remainder of fiscal 2007 and in future periods are as follows (in thousands):

Contractual Obligations	2007		2008		2009		2010		2011		Thereafter		Total
Capital lease obligations & other	$	4	$	2	$	—	$	—	$	—	$	—	$	6
Line of credit obligations	$	—	$	4,734	$	—	$	—	$	—	$	—	$	4,734
SchoolOne (1)	$	1,179	$	—	$	—	$	—	$	—	$	—	$	1,179
Operating lease obligations	$	775	$	1,370	$	1,213	$	802	$	398	$	738	$	5,296
Total	$	1,958	$	6,106	$	1,213	$	802	$	398	$	738	$	11,215

(1) Second amended agreement signed in August 2007 for services from July 2007 through December 2007.

As of the date of this filing, we currently lease approximately 92,000 square feet pursuant to leases that are month-to-month or are scheduled to expire between August 2007 and May 2015.

Our business is presently highly seasonal, with the vast bulk of our revenues from the sale of books and apparel being earned during the back to school season in the third quarter of each year. In addition, beginning in the second quarter of 2006, we moved aggressively to launch service offerings outside our core book and uniform offerings. We experienced significant cash expenditures in this effort. In November 2006, due to the financial impact of cost increases and cash expenditures together with limited new revenue generation from non-book/uniform service offerings, efforts to launch service offerings outside the book and uniform areas were terminated or suspended. Significant cost reductions have been implemented, and our current strategy includes only the book and uniform businesses, however, as a result of this, our net cash and investments position was approximately $9.8 million lower as of December 31, 2006 compared to December 31, 2005. In March 2007, we entered into a Revolving Line of Credit Loan Agreement and Security Agreement with Bank of America, N.A. (“BOA”) in which BOA will lend up to a maximum amount of $5 million to assist in funding the Company’s seasonal cash requirements. The Company may also issue letters of credit under the facility. Borrowing ceiling levels are established monthly utilizing a borrowing base formula based on percentages of month-end inventory, receivable and investment collateral values. A $2 million restricted cash investment is required to be maintained at all times as the investment collateral portion of the borrowing base. The facility is secured by substantially all of our assets. The agreement terminates on April 30, 2008. With the BOA agreement in place, we presently believe that our cash, cash equivalents and investments are sufficient to fund our operating needs until the 2007 back to school season and that cash generated from our sales during the back to school season will fund our cash needs for the remainder of the fiscal 2007 year. We are still considering spending reductions and additional external financings to meet our liquidity needs. Please see “Forward-Looking Statements.”

Item 3. Quantitative and Qualitative Disclosures About Market Risk

We are exposed to market risk for the effect of interest rate changes and changes in the market values of our investments and for our balances outstanding under our line of credit agreement with BOA.

Interest Rate Risk. Our cash equivalents, restricted cash, short-term and long-term investments, and our balances outstanding under our line of credit agreement with BOA are subject to interest rate risk. We manage this risk by maintaining an investment portfolio of instruments with high credit quality and relatively short average maturities. These instruments are designated as available-for-sale and, accordingly, are presented at fair value on our balance sheets and include, but are not limited to, commercial paper, money-market instruments, bank time deposits and variable rate and fixed rate obligations of corporations and national, state and local governments and agencies. These instruments are denominated in U.S. dollars. The fair market value of cash equivalents, short-term and long-term investments subject to interest rate risk was $2.0 million and $6.4 million at June 30, 2007 and December 31, 2006, respectively. We also hold cash balances in accounts with commercial banks in the United States. These cash balances represent operating balances only and are invested in short-term deposits of the local bank and are not included in the amounts above.

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The weighted average yield on interest-bearing investments held as of June 30, 2007 was approximately 4.4% per annum. A 100 basis point increase in the 30-day LIBOR rate would have increased our annual interest expense by approximately $0.1 million.

Item 4. Controls and Procedures

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms and that such information is accumulated and communicated to our management, including our Chief Executive Officer/Chief Financial Officer and Chief Accounting Officer, as appropriate, to allow for timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

As of the end of the period covered by this report, as required by SEC Rule 13a-15(b), we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer/Chief Financial Officer and Chief Accounting Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on and as of the date of such evaluation, our Chief Executive Officer/Chief Financial Officer and Chief Accounting Officers have concluded that, as of the end of the period covered by this report, our disclosure controls and procedures were effective with the exception of the material weakness that management identified in our Annual Report on Form 10-K for the fiscal year ended December 31, 2006 (see below).

In our Annual Report on Form 10-K for the fiscal year ended December 31, 2006, management identified a material weakness in internal control over financial reporting. Specifically, we did not maintain effective controls over the accuracy of the calculation of diluted shares outstanding used in our earnings per share calculation. The source of the error was an error in the functioning of a spreadsheet used to make the underlying computations. Accordingly, management concluded that our internal control over financial reporting was not effective as of December 31, 2006.

Changes in Internal Control over Financial Reporting

Management has evaluated, with the participation of our Chief Executive Officer/Chief Financial Officer and Chief Accounting Officer, whether any changes in our internal control over financial reporting that occurred during our last fiscal quarter have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. No such changes occurred during our last fiscal quarter.

PART II.

OTHER INFORMATION

Item 1: Legal Proceedings

Not Applicable

Item 1A: Risk Factors

For a comprehensive discussion of our risk factors, please refer to the audited financial statements and notes included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2006.

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

On June 14, 2007, we held our 2007 Annual Meeting of Stockholders. At the meeting, our stockholders voted on the following:

• The election of two directors: John Kernan (with 13,325,276 affirmative votes, 0 votes against and 1,026,240 votes withheld) and Allen Morgan (with 13,334,951 affirmative votes, 0 votes against and 1,016,565 votes withheld) both with terms expiring in 2010.

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Item 5: Other Information

Not Applicable

Item 6: Exhibits

(a) Exhibits

31.1 Certification of the Company’s Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2 Certification of the Company’s Chief Accounting Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1 Certification of the Company’s Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2 Certification of the Company’s Chief Accounting Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

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SIGNATURES

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

Date: August 14, 2007

Varsity Group Inc.
By:	/s/ JAMES CRAIG
	James Craig
	Chief Executive Officer

Varsity Group Inc.
By:	/s/ JOHN GRIFFIN
	John Griffin
	Chief Accounting Officer

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