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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d)
OF THE SECURITIES EXCHANGE ACT OF 1934
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended July 31, 2005
Commission File Number 0-20842
PLATO LEARNING, INC.
(Exact name of Registrant as specified in its charter)
Delaware (State or other jurisdiction of incorporation or organization) | 36-3660532 (IRS Employer Identification Number) |
10801 Nesbitt Avenue South, Bloomington, MN 55437
(Address of principal executive offices)
(Address of principal executive offices)
(952) 832-1000
(Registrant’s telephone number, including area code)
(Registrant’s telephone number, including area code)
Not Applicable
(Former name, former address and former fiscal year, if changed since last report)
(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. Yesþ Noo
Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yesþ Noo
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yeso Noþ
Indicate the number of shares outstanding of each of the Registrant’s classes of common stock, as of the latest practicable date. 23,550,474 shares of common stock, $.01 par value, outstanding as of August 31, 2005.
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PLATO LEARNING, INC.
Form 10-Q
Quarter Ended July 31, 2005
Form 10-Q
Quarter Ended July 31, 2005
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PLATO Learning, Inc. and Subsidiaries
Condensed Consolidated Statements of Operations (Unaudited)
(In thousands, except per share amounts)
Three Months Ended | Nine Months Ended | |||||||||||||||
July 31, | July 31, | |||||||||||||||
2005 | 2004 | 2005 | 2004 | |||||||||||||
Revenues: | ||||||||||||||||
License fees | $ | 16,747 | $ | 25,421 | $ | 42,075 | $ | 55,693 | ||||||||
Subscriptions | 4,400 | 5,812 | 13,450 | 15,645 | ||||||||||||
Services | 7,440 | 7,403 | 26,544 | 20,937 | ||||||||||||
Other | 2,652 | 1,977 | 6,054 | 7,106 | ||||||||||||
Total revenues | 31,239 | 40,613 | 88,123 | 99,381 | ||||||||||||
Cost of revenues: | ||||||||||||||||
License fees | 3,001 | 3,378 | 9,302 | 9,953 | ||||||||||||
Subscriptions | 1,780 | 1,782 | 6,235 | 5,522 | ||||||||||||
Services | 4,892 | 4,193 | 17,126 | 12,527 | ||||||||||||
Other | 2,560 | 2,157 | 6,245 | 6,698 | ||||||||||||
Total cost of revenues | 12,233 | 11,510 | 38,908 | 34,700 | ||||||||||||
Gross profit | 19,006 | 29,103 | 49,215 | 64,681 | ||||||||||||
Operating expenses: | ||||||||||||||||
Sales and marketing | 11,520 | 14,897 | 38,256 | 45,875 | ||||||||||||
General and administrative | 5,141 | 4,915 | 14,193 | 14,447 | ||||||||||||
Product development | 1,227 | 1,293 | 3,920 | 4,842 | ||||||||||||
Amortization of intangibles | 1,075 | 1,112 | 3,247 | 3,197 | ||||||||||||
Restructuring and other charges | 200 | — | 3,121 | — | ||||||||||||
Total operating expenses | 19,163 | 22,217 | 62,737 | 68,361 | ||||||||||||
Operating income (loss) | (157 | ) | 6,886 | (13,522 | ) | (3,680 | ) | |||||||||
Interest income | 251 | 41 | 631 | 298 | ||||||||||||
Interest expense | (46 | ) | (28 | ) | (89 | ) | (100 | ) | ||||||||
Other expense, net | (209 | ) | (25 | ) | (362 | ) | (109 | ) | ||||||||
Earnings (loss) before income taxes | (161 | ) | 6,874 | (13,342 | ) | (3,591 | ) | |||||||||
Income tax expense | 150 | 150 | 450 | 450 | ||||||||||||
Net earnings (loss) | $ | (311 | ) | $ | 6,724 | $ | (13,792 | ) | $ | (4,041 | ) | |||||
Earnings (loss) per share: | ||||||||||||||||
Basic and diluted | $ | (0.01 | ) | $ | 0.29 | $ | (0.59 | ) | $ | (0.18 | ) | |||||
Weighted average common shares outstanding: | ||||||||||||||||
Basic | 23,490 | 23,012 | 23,325 | 22,497 | ||||||||||||
Diluted | 23,490 | 23,556 | 23,325 | 22,497 | ||||||||||||
See Notes to Condensed Consolidated Financial Statements.
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PLATO Learning, Inc. and Subsidiaries
Condensed Consolidated Balance Sheets (Unaudited)
(In thousands, except per share amounts)
July 31, | October 31, | |||||||
2005 | 2004 | |||||||
ASSETS | ||||||||
Current assets: | ||||||||
Cash and cash equivalents | $ | 38,926 | $ | 29,235 | ||||
Marketable securities | — | 12,615 | ||||||
Accounts receivable, net | 28,468 | 41,852 | ||||||
Prepaid expenses and other current assets | 11,510 | 9,460 | ||||||
Total current assets | 78,904 | 93,162 | ||||||
Long-term marketable securities | — | 3,608 | ||||||
Equipment and leasehold improvements, net of accumulated depreciation and amortization of $12,665 and $10,361, respectively | 6,717 | 7,946 | ||||||
Product development costs, net of accumulated amortization of $24,166 and $18,835, respectively | 18,810 | 17,116 | ||||||
Goodwill | 71,589 | 71,267 | ||||||
Identified intangible assets, net | 33,228 | 39,432 | ||||||
Other assets | 920 | 213 | ||||||
Total assets | $ | 210,168 | $ | 232,744 | ||||
LIABILITIES AND STOCKHOLDERS’ EQUITY | ||||||||
Current liabilities: | ||||||||
Accounts payable | $ | 3,294 | $ | 5,196 | ||||
Accrued employee salaries and benefits | 8,918 | 8,772 | ||||||
Accrued liabilities | 5,996 | 6,383 | ||||||
Deferred revenue | 36,122 | 43,042 | ||||||
Total current liabilities | 54,330 | 63,393 | ||||||
Long-term deferred revenue | 5,824 | 8,533 | ||||||
Deferred income taxes | 1,772 | 1,322 | ||||||
Other liabilities | 65 | 46 | ||||||
Total liabilities | 61,991 | 73,294 | ||||||
Commitments and contingencies (see Note 9) | ||||||||
Stockholders’ equity: | ||||||||
Common stock, $.01 par value, 50,000 shares authorized; 23,562 shares issued and 23,542 shares outstanding at July 31, 2005; 23,095 shares issued and 23,075 shares outstanding at October 31, 2004 | 235 | 231 | ||||||
Additional paid in capital | 165,803 | 162,956 | ||||||
Treasury stock at cost, 20 shares | (205 | ) | (205 | ) | ||||
Accumulated deficit | (16,642 | ) | (2,850 | ) | ||||
Accumulated other comprehensive loss | (1,014 | ) | (682 | ) | ||||
Total stockholders’ equity | 148,177 | 159,450 | ||||||
Total liabilities and stockholders’ equity | $ | 210,168 | $ | 232,744 | ||||
See Notes to Condensed Consolidated Financial Statements.
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PLATO Learning, Inc. and Subsidiaries
Condensed Consolidated Statements of Cash Flows (Unaudited)
(In thousands)
Nine Months Ended | ||||||||
July 31, | ||||||||
2005 | 2004 | |||||||
Operating activities: | ||||||||
Net loss | $ | (13,792 | ) | $ | (4,041 | ) | ||
Adjustments to reconcile net loss to net cash provided by operating activities: | ||||||||
Deferred income taxes | 450 | 450 | ||||||
Amortization of capitalized product development costs | 5,521 | 5,160 | ||||||
Amortization of identified intangible and other noncurrent assets | 6,318 | 5,706 | ||||||
Depreciation and amortization of equipment and leasehold improvements | 2,637 | 2,600 | ||||||
Provision for doubtful accounts | 1,291 | 1,522 | ||||||
Stock-based compensation | 39 | 217 | ||||||
Loss on disposal of equipment | 65 | 79 | ||||||
Changes in operating assets and liabilities, net of effects of acquisitions: | ||||||||
Accounts receivable | 12,093 | (357 | ) | |||||
Prepaid expenses and other current and noncurrent assets | (2,924 | ) | (2,184 | ) | ||||
Accounts payable | (1,902 | ) | (1,566 | ) | ||||
Accrued liabilities, accrued employee salaries and benefits and other liabilities | (150 | ) | (3,210 | ) | ||||
Deferred revenue | (9,629 | ) | 3,789 | |||||
Total adjustments | 13,809 | 12,206 | ||||||
Net cash provided by operating activities | 17 | 8,165 | ||||||
Investing activities: | ||||||||
Acquisitions, net of cash acquired | — | 2,460 | ||||||
Capitalized product development costs | (7,906 | ) | (6,830 | ) | ||||
Purchases of equipment and leasehold improvements | (1,450 | ) | (1,880 | ) | ||||
Purchases of marketable securities | (9,266 | ) | (387 | ) | ||||
Sales and maturities of marketable securities | 25,544 | 256 | ||||||
Net cash provided by (used in) investing activities | 6,922 | (6,381 | ) | |||||
Financing activities: | ||||||||
Net proceeds from issuance of common stock | 2,271 | 1,812 | ||||||
Repurchase of common stock | — | (205 | ) | |||||
Repayments of capital lease obligations | (185 | ) | (54 | ) | ||||
Net cash provided by financing activities | 2,086 | 1,553 | ||||||
Effect of currency exchange rate changes on cash and cash equivalents | 666 | (160 | ) | |||||
Net increase in cash and cash equivalents | 9,691 | 3,177 | ||||||
Cash and cash equivalents at beginning of period | 29,235 | 23,834 | ||||||
Cash and cash equivalents at end of period | $ | 38,926 | $ | 27,011 | ||||
Supplemental cash flow information: | ||||||||
Non-cash investing activities: | ||||||||
Common stock and warrants issued for acquisitions | — | $ | 52,082 |
See Notes to Condensed Consolidated Financial Statements.
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PLATO Learning, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements (Unaudited)
(Dollars in thousands, except per share amounts)
1. Business
We provide computer-based and e-learning instruction software and related services for kindergarten through adult learners, offering curricula in reading, writing, math, science, social studies, and life and job skills. We also offer online assessment and accountability solutions and standards-based professional development services. With over 6,000 hours of objective-based, problem-solving courseware, plus assessment, alignment, and curriculum management tools, we create standards-based curricula that facilitate learning and school improvement.
PLATO educational software is delivered via networks, CD-ROM, the Internet, and private intranets. We market our software products and related services primarily to K-12 schools and colleges. We also sell to job training programs, correctional institutions, military education programs, corporations, and individuals.
We are subject to risks and uncertainties including, but not limited to, dependence on information technology spending by our customers, well-established competitors, customers dependent on government funding, fluctuations of our quarterly results, a lengthy and variable sales cycle, dependence on key personnel, dependence on our intellectual property rights, and rapid technological change.
2. Basis of Presentation
The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. We have included all normal recurring and other adjustments considered necessary to give a fair statement of our operating results for the interim periods shown. Operating results for these interim periods are not necessarily indicative of the results to be expected for the full fiscal year. For further information, refer to the consolidated financial statements and accompanying notes included in our Annual Report on Form 10-K/A for the fiscal year ended October 31, 2004.
The accompanying unaudited condensed consolidated financial statements include the accounts of PLATO Learning, Inc. and its wholly owned subsidiaries. All significant intercompany accounts and transactions have been eliminated.
3. Summary of Significant Accounting Policies
For more information on our significant accounting policies, refer to “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 2 of this Quarterly Report on Form 10-Q and Note 2 to Consolidated Financial Statements in our Annual Report on Form 10-K/A for the year ended October 31, 2004.
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Stock-Based Compensation
We account for our stock-based employee compensation arrangements in accordance with the provisions of Accounting Principles Board Opinion No. 25 “Accounting for Stock Issued to Employees” and comply with the disclosure provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation” and SFAS No. 148 “Accounting for Stock-Based Compensation — Transition and Disclosure, an amendment of Financial Accounting Standards Board Statement No. 123.” For purposes of the pro forma disclosures, the estimated fair value of stock-based employee compensation is amortized to expense over the vesting period of the related arrangement.
Had compensation expense for the stock-based employee compensation been recognized based on the fair value at the grant date consistent with the provisions of SFAS No. 123, reported results for the three and nine months ended July 31, 2005 and 2004 would have been adjusted to the pro forma amounts presented below:
Three Months Ended | Nine Months Ended | |||||||||||||||
July 31, | July 31, | |||||||||||||||
2005 | 2004 | 2005 | 2004 | |||||||||||||
Net earnings (loss), as reported | $ | (311 | ) | $ | 6,724 | $ | (13,792 | ) | $ | (4,041 | ) | |||||
Stock-based compensation expense included in reported net earnings (loss), net of related tax effects | — | — | 39 | 217 | ||||||||||||
Stock-based compensation expense determined using the fair value based method for all awards, net of related tax effects | (547 | ) | (1,225 | ) | (2,052 | ) | (3,870 | ) | ||||||||
Pro forma net earnings (loss) | $ | (858 | ) | $ | 5,499 | $ | (15,805 | ) | $ | (7,694 | ) | |||||
Basic earnings (loss) per share: | ||||||||||||||||
As reported | $ | (0.01 | ) | $ | 0.29 | $ | (0.59 | ) | $ | (0.18 | ) | |||||
Pro forma | $ | (0.04 | ) | $ | 0.24 | $ | (0.68 | ) | $ | (0.34 | ) | |||||
Diluted earnings (loss) per share: | ||||||||||||||||
As reported | $ | (0.01 | ) | $ | 0.29 | $ | (0.59 | ) | $ | (0.18 | ) | |||||
Pro forma | $ | (0.04 | ) | $ | 0.23 | $ | (0.68 | ) | $ | (0.34 | ) | |||||
The pro forma amounts presented above may not be indicative of the results to be expected for the full fiscal year due to continuing stock option activity and other factors.
In December 2004, the Financial Accounting Standards Board issued SFAS No. 123(R), “Share-Based Payment” (“SFAS 123(R)”). SFAS 123(R) establishes standards for accounting for transactions in which an entity exchanges its equity instruments for goods or services. SFAS 123(R) focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions. SFAS 123(R) requires that the fair value of such equity instruments be recognized as expense in the financial statements as services are performed. Prior to SFAS 123(R), only the pro forma disclosures of fair value presented above were required. In March 2005, the SEC issued Staff Accounting Bulletin No. 107, “TOPIC 14: Share-Based Payment” which addresses the interaction between SFAS 123(R) and certain SEC rules and regulations and provides views regarding the valuation of share-based payment arrangements for public companies. SFAS 123(R) is effective for our first quarter of 2006 and the adoption of this new accounting pronouncement is expected to have a material impact on our consolidated financial statements.
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4. Acquisitions
In November 2003, we acquired Lightspan, Inc. (“Lightspan”). In December 2003, we acquired New Media (Holdings) Limited (“New Media”). For more information on these acquisitions, refer to Note 3 to Consolidated Financial Statements in our Annual Report on Form 10-K/A for the year ended October 31, 2004. Our unaudited pro forma consolidated results of operations, as if the Lightspan acquisition had occurred at the beginning of the period presented, were as follows:
Nine Months | ||||
Ended | ||||
July 31, 2004 | ||||
(Unaudited) | ||||
Revenues | $ | 100,350 | ||
Net loss | (5,472 | ) | ||
Basic and diluted loss per share | (0.24 | ) |
The unaudited pro forma data gives effect to actual operating results prior to the acquisition and adjustments to reflect increased identified intangible asset amortization and the current accounting treatment of income taxes. No effect has been given to cost reductions or operating synergies in this presentation. The unaudited pro forma consolidated results of operations are for comparative purposes only and do not necessarily reflect the results that would have occurred had the acquisition occurred at the beginning of the period presented or the results which may occur in the future. The pro forma data does not include New Media, as the effects of this acquisition were not material on a pro forma basis.
5. Accounts Receivable
The components of accounts receivable were as follows:
July 31, | October 31, | |||||||
2005 | 2004 | |||||||
Trade accounts receivable | $ | 24,747 | $ | 28,396 | ||||
Installment accounts receivable | 7,187 | 16,168 | ||||||
Allowance for doubtful accounts | (3,466 | ) | (2,712 | ) | ||||
$ | 28,468 | $ | 41,852 | |||||
The provision for doubtful accounts, included in general and administrative expenses, was $617 and $695 for the three months, and $1,291 and $1,522 for the nine months ended July 31, 2005 and 2004, respectively.
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6. Goodwill and Identified Intangible Assets
Goodwill
The changes in goodwill from October 31, 2004 were as follows:
Balance, October 31, 2004 | $ | 71,267 | ||
Release of shares from escrow | 541 | |||
Foreign currency translation | (219 | ) | ||
Balance, July 31, 2005 | $ | 71,589 | ||
Goodwill was increased by $541 as a result of the release of the remaining escrow shares relating to the NetSchools acquisition in 2002.
Identified Intangible Assets
Identified intangible assets subject to amortization were as follows:
July 31, 2005 | October 31, 2004 | |||||||||||||||||||||||
Gross | Gross | |||||||||||||||||||||||
Carrying | Accumulated | Net Carrying | Carrying | Accumulated | Net Carrying | |||||||||||||||||||
Value | Amortization | Value | Value | Amortization | Value | |||||||||||||||||||
Acquired technology | $ | 24,776 | $ | (8,768 | ) | $ | 16,008 | $ | 24,856 | $ | (5,882 | ) | $ | 18,974 | ||||||||||
Trademarks and tradenames | 3,680 | (1,859 | ) | 1,821 | 3,680 | (1,328 | ) | 2,352 | ||||||||||||||||
Customer relationships and lists | 21,232 | (5,979 | ) | 15,253 | 21,238 | (3,653 | ) | 17,585 | ||||||||||||||||
Noncompete agreements | 1,090 | (944 | ) | 146 | 1,090 | (569 | ) | 521 | ||||||||||||||||
$ | 50,778 | $ | (17,550 | ) | $ | 33,228 | $ | 50,864 | $ | (11,432 | ) | $ | 39,432 | |||||||||||
Amortization expense for identified intangible assets was $1,871 and $1,943 for the three months and $6,151 and $5,706 for the nine months ended July 31, 2005 and 2004, respectively, of which $796 and $831, and $2,904 and $2,509, was included in cost of revenues related to license fees and subscriptions for each period, respectively.
The estimated future annual amortization expense for identified intangible assets is as follows:
Remainder of 2005 | 1,950 | |||||
2006 | 7,135 | |||||
2007 | 6,912 | |||||
2008 | 6,327 | |||||
2009 | 5,317 | |||||
Thereafter | 5,587 | |||||
$ | 33,228 | |||||
The future annual amortization amounts presented above are estimates. Actual amortization expense may be different due to the acquisition, impairment, or accelerated amortization of identified intangible assets, changes in foreign currency exchange rates, and other factors.
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7. Debt
Revolving Loan
On June 30, 2005, we extended our revolving loan agreement with Wells Fargo Bank, N.A. The revolving loan agreement provides for a maximum $12,500 line of credit through January 31, 2006. Substantially all of our assets are pledged as collateral under the agreement. There were no borrowings outstanding at July 31, 2005 or October 31, 2004.
The agreement contains restrictive financial covenants (including Minimum Tangible Net Worth, Minimum Debt Service Coverage, Maximum Leverage, Maximum Cash Flow Leverage and Maximum Annual Capital Expenditures) and restrictions on additional borrowings, asset sales and dividends, as defined. Certain of the covenant calculations are based on the trailing twelve-month period. All applicable covenants were satisfied as of July 31, 2005.
8. Deferred Revenue
The components of deferred revenue were as follows:
July 31, | October 31, | |||||||
2005 | 2004 | |||||||
License fees | $ | 4,033 | $ | 5,490 | ||||
Subscriptions | 10,482 | 13,473 | ||||||
Services | 27,167 | 32,079 | ||||||
Other | 264 | 533 | ||||||
Total | 41,946 | 51,575 | ||||||
Less: long-term amounts | (5,824 | ) | (8,533 | ) | ||||
Current portion | $ | 36,122 | $ | 43,042 | ||||
9. Commitments and Contingencies
Employment Agreements
In February 2005, Michael A. Morache was appointed President and Chief Executive Officer of PLATO Learning, Inc., at which time we entered into an employment agreement with Mr. Morache which provides for, among other things, annual salary, benefits, and cash bonus payments and restricted stock and stock option grants as determined by our Board of Directors. The agreement also provides for potential future cash payments of up to $1,600 subject to certain conditions and events.
Legal Proceedings
Credit Suisse First Boston and several of its clients, including Lightspan, Inc. (which we acquired in November 2003), are defendants in a securities class action lawsuit captioned Liu, et al. v. Credit Suisse First Boston Corp., et al. pending in the United States District Court for the Southern District of New York. The complaint alleges that Credit Suisse First Boston, its affiliates, and the securities issuer defendants (including Lightspan, Inc.) manipulated the price of the issuer defendants’ shares in the post-initial public offering market. The securities issuer defendants (including Lightspan, Inc.) filed a motion to dismiss the complaint in September 2004 on the grounds of multiple pleading deficiencies. On April 1, 2005, the complaint was dismissed with prejudice. On April 15, 2005, the plaintiff filed a motion for reconsideration. This motion was denied on May 13, 2005. The plaintiff filed
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a second motion for reconsideration on May 16, 2005. The court affirmed the previous ruling, rejecting the plaintiff’s second motion. We continue to believe this lawsuit is without merit; however, we can give no assurance as to its ultimate outcome. An unfavorable outcome could have a material adverse effect on our consolidated financial statements.
10. Restructuring and Other Charges
Restructuring and other charges include primarily severance costs for headcount reductions, committed costs of vacated facilities, and costs paid to terminated executive officers under employment agreements. These charges are summarized as follows:
Three Months | Nine Months | |||||||
Ended | Ended | |||||||
July 31, 2005 | July 31, 2005 | |||||||
Restructuring charges: | ||||||||
U.K. facility closure liabilities | $ | — | $ | 313 | ||||
Severance and related benefits for U.K. headcount reduction | — | 452 | ||||||
Severance and related benefits for U.S. headcount reduction | 118 | 417 | ||||||
Other | 70 | 162 | ||||||
188 | 1,344 | |||||||
Other charges: | ||||||||
Executive officer changes | — | 1,595 | ||||||
Other | 12 | 182 | ||||||
12 | 1,777 | |||||||
$ | 200 | $ | 3,121 | |||||
Restructuring Charges
In January 2005, we initiated plans to reduce headcount by approximately 30 positions and close certain facilities in the United Kingdom (“U.K.”). This restructuring is part of an ongoing evaluation of our U.K. operations and we are continuing to explore alternatives as necessary to improve the U.K.’s impact on our profitability. Severance costs of $430 for these planned employee terminations were recorded during the three months ended January 31, 2005. Additional severance costs of $22 were recorded during the six months ended April 30, 2005. All of these severance costs had been paid as of July 31, 2005. As part of this U.K. restructuring, facility closing costs of $313 were recorded during the three months ended April 30, 2005 as the facilities were vacated.
Also in January 2005, we reduced headcount in the United States to reduce management layers and improve efficiency. Six positions were eliminated and severance charges of $273 were recorded during the three months ended January 31, 2005. One additional position was eliminated during the three months ended April 30, 2005 and $26 of additional severance charges were recorded. One additional position was eliminated during the three months ended July 31, 2005 and $118 of additional severance charges were recorded. All of these costs had been paid as of July 31, 2005.
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The restructuring reserve activity was as follows:
U.S. | U.K. | |||||||||||
Severance and | Severance and | Facility | ||||||||||
related benefits | related benefits | closings | ||||||||||
Provision for restructuring | $ | 273 | $ | 430 | $ | 313 | ||||||
Adjustments to provision | 144 | 22 | — | |||||||||
Cash payments | (417 | ) | (456 | ) | (72 | ) | ||||||
Effect of currency exchange rate changes | — | 4 | (23 | ) | ||||||||
Reserve balance at July 31, 2005 | $ | — | $ | — | $ | 218 | ||||||
See Note 15 for a discussion of additional restructuring activities announced subsequent to July 31, 2005.
Other Charges
In November 2004, we announced the resignations of John Murray, our Chairman, President and Chief Executive Officer, and three other executive officers. The severance provisions of Mr. Murray’s employment agreement, dated January 1, 2001, provide for him to (a) be paid his current base salary of $350 per year through December 31, 2007, (b) be paid bonus earned for the fiscal year ended October 31, 2004 and a pro rata portion of bonus, if earned, for the fiscal year ending October 31, 2005, and (c) be granted options to purchase 260,000 shares of common stock, with an exercise price equal to fair market value as of the date of grant, which will vest over a three-year period. In addition, certain options previously granted to Mr. Murray will accelerate and be immediately exercisable under the original terms of the options. Mr. Murray’s right to receive these benefits is subject to his compliance with the confidentiality, non-competition and non-solicitation obligations under the agreement, and the execution of a release of claims. In March 2005, we finalized Mr. Murray’s severance arrangements and entered into an agreement to pay him $1,000 in lieu of the stock option grant mentioned above. The $1,000 value of this agreement was assigned to the non-compete provisions of his employment agreement and is being amortized over its three-year period. This amortization is included in general and administrative expense on the consolidated statements of operations.
We recorded charges of $1,586 related to these executive terminations during the three months ended January 31, 2005. Additional charges of approximately $179 were recorded during the three months ended April 30, 2005, primarily for legal costs related to executive terminations and contract termination costs. Additional charges of approximately $12 were recorded during the three months ended July 31, 2005, primarily for legal costs related to executive terminations.
11. Income Taxes
At July 31, 2005 and October 31, 2004, our deferred tax assets were fully reserved. At October 31, 2004, approximately $28,980 of the gross deferred tax asset relates to our net operating loss carryforwards in the United States (“U.S.”) of approximately $72,451. These net operating loss carryforwards expire in varying amounts between 2005 and 2023. Also included in our gross deferred tax asset was $2,117 related to foreign subsidiary net operating loss carryforwards of approximately $5,293. We have provided a full valuation allowance related to these foreign deferred income tax assets due to the uncertainty in realization of future taxable income in these foreign jurisdictions.
Realization of our U.S. deferred tax asset is dependent on generating sufficient taxable income in the U. S. prior to expiration of these loss carryforwards. Our merger with Lightspan in the first quarter of
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fiscal 2004 impacted our assessment of the realization of deferred tax assets because the merged company is considered one consolidated taxable entity.
As a result of the merger, we acquired approximately $290,000 of Lightspan’s net operating loss carryforwards. Based on a preliminary Section 382 limitation analysis, the usage of these net operating loss carryforwards is limited to approximately $3,200 per year and, therefore, approximately $45,000 of the acquired net operating loss carryforwards are available to the combined entity. These amounts may change as the Section 382 limitation analysis is finalized and recent announcements by the Internal Revenue Service are taken into account.
The combined net operating loss carryforwards at the acquisition date, which represent the majority of the merged company’s deferred tax assets at that date, were reviewed for realization primarily based upon historical results and secondarily upon projected results. Lightspan historically incurred significant operating losses, which carry more weight than projected results. Consequently our historical combined operating results were insufficient to support the combined post-merger deferred tax assets. As a result, net deferred tax assets, excluding the deferred tax liability relating to tax deductible goodwill, which cannot be used to support realization of the other net deferred tax assets, were fully reserved in the purchase accounting for the Lightspan acquisition in the first quarter of 2004 thereby increasing goodwill. Any subsequent reversal of the valuation allowance recorded on the combined entity’s pre-acquisition deferred tax assets will be recorded as a reduction of goodwill, as opposed to recording an income tax benefit in the consolidated statement of operations. A similar analysis and judgment has resulted in a full valuation allowance being placed on the deferred tax assets generated subsequent to the acquisition of Lightspan.
12. Per Share Data
The calculation of basic and diluted earnings (loss) per share was as follows:
Three Months Ended | Nine Months Ended | |||||||||||||||
July 31, | July 31, | |||||||||||||||
2005 | 2004 | 2005 | 2004 | |||||||||||||
Numerator: | ||||||||||||||||
Net earnings (loss) | $ | (311 | ) | $ | 6,724 | $ | (13,792 | ) | $ | (4,041 | ) | |||||
Denominator: | ||||||||||||||||
Weighted average common shares outstanding: | ||||||||||||||||
Basic | 23,490 | 23,012 | 23,325 | 22,497 | ||||||||||||
Options and warrants | — | 544 | — | — | ||||||||||||
Diluted | 23,490 | 23,556 | 23,325 | 22,497 | ||||||||||||
Earnings (loss) per share: | ||||||||||||||||
Basic and diluted | $ | (0.01 | ) | $ | 0.29 | $ | (0.59 | ) | $ | (0.18 | ) | |||||
The calculations of diluted loss per share for the three and nine months ended July 31, 2005 and for the nine months ended July 31, 2004 exclude the antidilutive effect of approximately 3,109,000 and 3,472,000 common shares, respectively, from the potential conversion of outstanding options and warrants and from common shares held in escrow.
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13. Comprehensive Earnings (Loss)
Total comprehensive earnings (loss) was as follows:
Three Months Ended | Nine Months Ended | |||||||||||||||
July 31, | July 31, | |||||||||||||||
2005 | 2004 | 2005 | 2004 | |||||||||||||
Net earnings (loss) | $ | (311 | ) | $ | 6,724 | $ | (13,792 | ) | $ | (4,041 | ) | |||||
Unrealized gains on available for sale securities | 2 | — | 54 | — | ||||||||||||
Foreign currency translation adjustments | (684 | ) | 83 | (386 | ) | 87 | ||||||||||
Total comprehensive earnings (loss) | $ | (993 | ) | $ | 6,807 | $ | (14,124 | ) | $ | (3,954 | ) | |||||
Income tax effects for the components of other comprehensive earnings (loss) were not significant because our deferred tax assets are fully reserved. Accumulated other comprehensive loss was $1,014 and $682 at July 31, 2005 and 2004, respectively.
14. Segment and Geographic Information
We operate and manage our business as one industry segment, which is the development and marketing of educational software and related services. We have foreign subsidiaries in Canada and the U.K. Our foreign operations are not significant to our consolidated business. At July 31, 2005, approximately 4% of our long-term assets were located in foreign countries, and for the three and nine months ended July 31, 2005, approximately 4% of our revenues were from foreign countries.
15. Subsequent Event
On September 1, 2005, we announced the initiation of several cost reduction actions. These actions include shifting a significant portion of our development activities from the U.S. to an offshore location and a further downsizing of our U.K. operations. These actions are expected to be substantially completed in the fourth quarter of 2005 and result in cash and non-cash restructuring charges of between $4,000 and $6,000.
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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
(Dollars in thousands, except per share amounts)
(Dollars in thousands, except per share amounts)
Overview
We provide computer-based and e-learning instruction software and related services for kindergarten through adult learners, offering curricula in reading, writing, math, science, social studies, and life and job skills. We also offer online assessment and accountability solutions and standards-based professional development services. With over 6,000 hours of objective-based, problem-solving courseware, plus assessment, alignment, and curriculum management tools, we create standards-based curricula that facilitate learning and school improvement.
PLATO educational software is delivered via networks, CD-ROM, the Internet, and private intranets. We market our software products and related services primarily to K-12 schools and colleges. We also sell to job training programs, correctional institutions, military education programs, corporations, and individuals.
We are subject to risks and uncertainties including, but not limited to, dependence on information technology spending by our customers, well-established competitors, customers dependent on government funding, fluctuations of our quarterly results, a lengthy and variable sales cycle, dependence on key personnel, dependence on our intellectual property rights, and rapid technological change. For more information on these risks, refer to our Annual Report on Form 10-K/A for the year ended October 31, 2004. As provided for in the Private Securities Litigation Reform Act of 1995, we caution investors that these factors could cause our future results of operations to vary from those anticipated in previously made forward-looking statements and any other forward-looking statements made in this document and elsewhere by or on behalf of us.
Recent Developments
We have a number of existing and potential customers in the areas of the United States affected by Hurricane Katrina. We are currently reviewing the potential impact of this natural disaster on our revenues from those areas of the country.
Critical Accounting Policies and Estimates
Our discussion and analysis of financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, and expenses. We continually evaluate our critical accounting policies and estimates, and have identified revenue recognition, the allowance for doubtful accounts, capitalized product development costs, the valuation of our deferred income taxes, and the valuation and impairment analysis of goodwill and identified intangible assets as the critical accounting policies and estimates that are significant to the financial statement presentation and that require difficult, subjective, and complex judgments.
See Note 2 to Consolidated Financial Statements in our Annual Report on Form 10-K/A for the fiscal year ended October 31, 2004 for additional discussion on these and other accounting policies and disclosures required by accounting principles generally accepted in the United States of America.
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Revenue Recognition
Revenue recognition rules for software companies are very complex. We follow specific and detailed guidelines in determining the proper amount of revenue to be recorded; however, certain judgments affect the application of our revenue recognition policy. Revenue results are difficult to predict, and any shortfall in revenue or delay in recognizing revenue could cause our operating results to vary significantly from quarter to quarter.
The significant judgments for revenue recognition typically involve whether collectibility can be considered probable and whether fees are fixed or determinable. In addition, our transactions often consist of multiple element arrangements, which must be analyzed to determine the relative fair value of each element, the amount of revenue to be recognized upon shipment, if any, and the period and conditions under which deferred revenue should be recognized.
We recognize revenue in accordance with the provisions of Statement of Position No. 97-2, “Software Revenue Recognition”, as amended and modified, as well as Technical Practice Aids issued from time to time by the American Institute of Certified Public Accountants, and Staff Accounting Bulletin No. 104, “Revenue Recognition.” We license software under non-cancelable license and subscription agreements. We also provide related professional services, including consulting, training, tutoring, and implementation services, as well as ongoing customer support and maintenance. Consulting, training, and implementation services are not essential to the functionality of our software products. Accordingly, revenues from these services are recognized separately.
Revenue from the sale of courseware licenses is recognized upon meeting the following criteria: (i) a written customer order has been executed, (ii) courseware has been delivered, (iii) the license fee is fixed or determinable, and (iv) collectibility of the fee is probable.
For software arrangements that include more than one element, we allocate the total arrangement fee among each deliverable based on vendor-specific objective evidence (“VSOE”) of the relative fair value of each deliverable. VSOE is determined using the price charged when that element is sold separately. For software arrangements in which we do not have VSOE for undelivered elements, revenue is deferred until the earlier of when VSOE is determined for the undelivered elements or when all elements for which we do not have VSOE have been delivered.
If collectibility of the fee is not probable, revenue is recognized as payments are received from the customer provided all other revenue recognition criteria have been met. If the fee due from the customer is not fixed or determinable, revenue is recognized as the payments become due provided all other revenue recognition criteria have been met.
Subscription revenue, primarily fees charged for our PLATO Web Learning Network, eduTest and PLATO Orion products, is recognized on a ratable basis as the products are delivered over the subscription period.
Services revenue consists of software support and maintenance, which is deferred and recognized ratably over the support period, and consulting, training, tutoring, and implementation services, which are recognized as the services are performed.
Other revenue, primarily from hardware and third-party software products, is recognized as the products are delivered and all other revenue recognition criteria are met.
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Allowance for Doubtful Accounts
We determine an allowance for doubtful accounts based upon an analysis of the collectibility of specific accounts, historical experience, and the aging of the trade and installment accounts receivable. Bad debt expense is included in general and administrative expense in our consolidated statements of operations. The assumptions and estimates used to determine the allowance are subject to constant revision and involve significant judgment. The primary factors that impact these assumptions include the efficiency and effectiveness of our billing and collection functions, our historical experience, and our credit assessment process. We believe that the current budget difficulties facing some states will not have a significant impact on the collection of our accounts receivable. However, a change in the underlying conditions contributing to our belief could impact our assessment of collectibility and, therefore, require a change in the allowance for doubtful accounts and the amount of bad debt expense. Actual collection results could differ materially from those estimated and have a significant impact on our consolidated results of operations. In addition, we have a number of existing customers in the areas of the United States affected by Hurricane Katrina. We are currently reviewing the potential impact of this natural disaster on the collection of receivables from our customers in these areas of the country. Our provision for bad debts is based on our historical experience using a detailed analysis of customer-specific activity and receivable balances performed on a quarterly basis. Our provision for bad debts, included in general and administrative expense on the consolidated statements of operations, was equal to 1.5% of revenues for each of the nine-month periods ended July 31, 2005 and 2004. Our allowance for doubtful accounts was $3,466, or 10.9% of gross accounts receivable, at July 31, 2005, as compared to $2,712, or 6.1%, at October 31, 2004.
Capitalized Product Development Costs
Our product development costs relate to the research, development, enhancement, and maintenance of our courseware products. The amortization of capitalized product development costs is included in cost of revenues related to license fees and subscriptions. Research and development costs, relating principally to the design and development of new products and the routine enhancement and maintenance of existing products, are expensed as incurred. We capitalize product development costs when the projects under development reach technological feasibility. Many of our new products leverage off of proven delivery platforms and are primarily content, which has no technological hurdles. As a result, a significant portion of our product development costs qualify for capitalization due to the concentration of our development efforts on the content of our courseware. Capitalization ends when a product is available for general release to our customers, at which time amortization of the capitalized costs begins. We amortize these costs using the greater of: (a) the amount determined by the ratio of the product’s current revenue to total expected future revenue, or (b) the straight-line method over the estimated useful life of the product, which is generally three years. During all periods presented, we used the straight-line method to amortize the capitalized costs as this method resulted in greater amortization.
The significant judgment regarding capitalization of product development costs involves the recoverability of capitalized costs. We evaluate our capitalized costs at least annually, or more frequently if events or changes in circumstances indicate that the asset might be impaired, to determine if the unamortized balance related to any given product exceeds the estimated net realizable value of that product. Estimating net realizable value requires us to estimate future revenues and cash flows to be generated by the product and to use judgment in quantifying the amount, if any, to be written off. Actual cash flows and amounts realized from the courseware products could differ materially from those estimated. In addition, any future changes to our courseware product offerings could result in write-offs of previously capitalized costs and have a significant impact on our consolidated results of operations.
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Valuation of Deferred Income Taxes
We account for deferred income taxes based upon differences between the financial reporting and income tax bases of our assets and liabilities. The measurement of deferred taxes is adjusted by a valuation allowance, if necessary, to recognize the extent to which the future tax benefits will be recognized.
At July 31, 2005 and October 31, 2004, our deferred tax assets were fully reserved. At October 31, 2004, approximately $28,980 of the gross deferred tax asset relates to our net operating loss carryforwards in the United States (“U.S.”) of approximately $72,451. These net operating loss carryforwards expire in varying amounts between 2005 and 2023. Also included in our gross deferred tax asset was $2,117 related to foreign subsidiary net operating loss carryforwards of approximately $5,293. We have provided a full valuation allowance related to these foreign deferred income tax assets due to the uncertainty in realization of future taxable income in these foreign jurisdictions.
Realization of our U.S. deferred tax asset is dependent on generating sufficient taxable income in the U. S. prior to expiration of these loss carryforwards. Our merger with Lightspan in the first quarter of fiscal 2004 impacted our assessment of the realization of deferred tax assets because the merged company is considered one consolidated taxable entity.
As a result of the merger, we acquired approximately $290,000 of Lightspan’s net operating loss carryforwards. Based on a preliminary Section 382 limitation analysis, the usage of these net operating loss carryforwards is limited to approximately $3,200 per year and, therefore, approximately $45,000 of the acquired net operating loss carryforwards are available to the combined entity. These amounts may change as the Section 382 limitation analysis is finalized and recent announcements by the Internal Revenue Service are taken into account.
The combined net operating loss carryforwards at the acquisition date, which represented the majority of the merged company’s deferred tax assets at that date, were reviewed for realization primarily based upon historical results and secondarily upon projected results. Lightspan historically incurred significant operating losses, which carry more weight than projected results. Consequently our historical combined operating results were insufficient to support the combined post-merger deferred tax assets. As a result, net deferred tax assets, excluding the deferred tax liability relating to tax deductible goodwill, which cannot be used to support realization of the other net deferred tax assets, were fully reserved for in the purchase accounting for the Lightspan acquisition in the first quarter of 2004 thereby increasing goodwill. Any subsequent reversal of the valuation allowance recorded on the combined entity’s pre-acquisition deferred tax assets will be recorded as a reduction of goodwill, as opposed to recording an income tax benefit in the consolidated statement of operations. A similar analysis and judgment has resulted in a full valuation allowance being placed on the deferred tax assets generated subsequent to the acquisition of Lightspan.
Goodwill and Identified Intangible Assets
We record our acquisitions in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 141, “Business Combinations.” We allocate the cost of acquired companies to the tangible and identified intangible assets and liabilities acquired, with the remaining amount being recorded as goodwill. Certain intangible assets, such as acquired technology, are amortized to expense over their estimated useful lives, while in-process research and development, if any, is recorded as a one-time charge at the acquisition date.
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Most of the companies we have acquired have not had significant tangible assets and, as a result, the majority of the purchase price has typically been allocated to identified intangible assets and/or goodwill, which increases future amortization expense of identified intangible assets and the potential for impairment charges that we may incur. Accordingly, the allocation of the purchase price to intangible assets may have a significant impact on our future operating results. In addition, the allocation of the purchase price requires that we make significant assumptions and estimates, including estimates of future cash flows expected to be generated by the acquired assets. Should different conditions prevail, we may have to record impairment charges, which may have a significant impact on our consolidated financial statements.
We account for goodwill and other intangible assets in accordance with the provisions of SFAS No. 142, “Goodwill and Other Intangible Assets.” Under SFAS No. 142, goodwill and intangible assets with indefinite lives are not amortized to expense and must be reviewed for impairment annually or more frequently if events or changes in circumstances indicate that the asset might be impaired. The first step of the impairment test, used to identify potential impairment, compares the fair value of a reporting unit with its carrying amount, including goodwill and intangible assets with indefinite lives. We operate as one reporting unit and therefore compare our book value to our fair value (market capitalization plus a control premium). If our fair value exceeds our book value, our goodwill is considered not impaired, and the second step of the impairment test is unnecessary. If our book value exceeds our fair value, the second step of the impairment test is performed to measure the amount of impairment loss, if any. For this step the implied fair value of the goodwill is compared with the book value of the goodwill. If the carrying amount of the goodwill exceeds the implied fair value of the goodwill, an impairment loss would be recognized in an amount equal to that excess. Any loss recognized cannot exceed the carrying amount of goodwill. After an impairment loss is recognized, the adjusted carrying amount of goodwill is its new accounting basis. Subsequent reversal of a previously recognized impairment loss is prohibited once the measurement of that loss is completed. We completed our annual goodwill impairment assessment as of October 31, 2004. Goodwill was not impaired and no impairment charge was recorded.
Acquisitions
Our acquisition strategy is to acquire complementary products or businesses that will enable us to achieve our strategic goals, including market leadership, growth rates that exceed the market, and providing innovative, leading, and distinct products and services. During the three months ended January 31, 2004, we acquired Lightspan, Inc. and New Media (Holdings) Limited. See Note 3 to Consolidated Financial Statements in our Annual Report on Form 10-K/A for the fiscal year ended October 31, 2004 for more information on these strategic acquisitions.
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RESULTS OF OPERATIONS
Operating Results as a Percentage of Revenue
Three Months Ended | Nine Months Ended | |||||||||||||||
July 31, | July 31, | |||||||||||||||
2005 | 2004 | 2005 | 2004 | |||||||||||||
Revenues: | ||||||||||||||||
License fees | 53.6 | % | 62.6 | % | 47.7 | % | 56.0 | % | ||||||||
Subscriptions | 14.1 | 14.3 | 15.3 | 15.7 | ||||||||||||
Services | 23.8 | 18.2 | 30.1 | 21.1 | ||||||||||||
Other | 8.5 | 4.9 | 6.9 | 7.2 | ||||||||||||
Total revenues | 100.0 | 100.0 | 100.0 | 100.0 | ||||||||||||
Cost of revenues: | ||||||||||||||||
License fees | 9.6 | 8.3 | 10.6 | 10.0 | ||||||||||||
Subscriptions | 5.7 | 4.4 | 7.1 | 5.6 | ||||||||||||
Services | 15.7 | 10.3 | 19.4 | 12.6 | ||||||||||||
Other | 8.2 | 5.3 | 7.1 | 6.7 | ||||||||||||
Total cost of revenues | 39.2 | 28.3 | 44.2 | 34.9 | ||||||||||||
Gross profit | 60.8 | 71.7 | 55.8 | 65.1 | ||||||||||||
Operating expenses: | ||||||||||||||||
Sales and marketing | 36.9 | 36.7 | 43.4 | 46.2 | ||||||||||||
General and administrative | 16.5 | 12.1 | 16.1 | 14.5 | ||||||||||||
Product development | 3.9 | 3.2 | 4.4 | 4.9 | ||||||||||||
Amortization of intangibles | 3.4 | 2.7 | 3.7 | 3.2 | ||||||||||||
Restructuring and other charges | 0.6 | — | 3.5 | — | ||||||||||||
Total operating expenses | 61.3 | 54.7 | 71.1 | 68.8 | ||||||||||||
Operating income (loss) | (0.5 | ) | 17.0 | (15.3 | ) | (3.7 | ) | |||||||||
Interest income and expense and other expense, net | — | (0.1 | ) | 0.2 | 0.1 | |||||||||||
Earnings (loss) before income taxes | (0.5 | ) | 16.9 | (15.1 | ) | (3.6 | ) | |||||||||
Income tax expense | 0.5 | 0.4 | 0.5 | 0.5 | ||||||||||||
Net earnings (loss) | (1.0 | )% | 16.5 | % | (15.6 | )% | (4.1 | )% | ||||||||
The following discussion of the results of operations for the nine months ended July 31, 2005 compared to the same period in 2004 includes non-GAAP financial measures that present the combined revenues and operating expenses on a pro forma basis as if Lightspan had been acquired as of November 1, 2003. Non-GAAP financial measures should not be considered as a substitute for, or superior to, measures of financial performance prepared in accordance with GAAP. Our management views these non-GAAP financial measures to be helpful in assessing our progress in integrating the operations of Lightspan. In addition, these non-GAAP financial measures facilitate internal comparisons to our historical operating results and comparisons to competitors’ operating results. We include these non-GAAP financial measures because we believe they are useful to investors in allowing for greater transparency related to supplemental information used by our management in its financial and operational analysis. Investors are encouraged to review the reconciliation of the non-GAAP financial measures used herein to their most directly comparable GAAP financial measures as provided with our consolidated financial statements.
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Revenues
Total Revenues
Total revenues for the three months ended July 31, 2005 were $31,239, a decrease of 23.1% from the $40,613 reported for the same period in 2004. Total revenues for the nine months ended July 31, 2005 were $88,123, a decrease of 11.3% from the $99,381 reported for the same period in 2004.
Total revenues for the three and nine months ended July 31, 2005 decreased, as compared to the same periods in 2004, primarily due to the impact of several initiatives implemented in 2005 and to sales force attrition. Initiatives included the realignment of the sales and service organizations to better serve specific markets and the implementation of new systems and procedures aimed at improving the efficiencies of our sales process in the future. These changes affected all non-service revenues, including deferred revenues. While these changes have a short-term negative impact, we expect that they will have a positive impact in the longer term. The learning process related to implemented changes is ongoing and, while improvements are being made, we anticipate that our sales performance for the fourth quarter of 2005 will also be affected. Funding delays in certain states could continue as well. As a result, we expect our fourth quarter 2005 revenues to be between $33,000 and $36,000, which is lower than 2004.
We executed 50 orders of $100 or greater during the three months ended July 31, 2005, as compared to 70 for the same period in 2004. This decrease can be attributed to the factors affecting revenue mentioned above, resulting in lower order volume. The average size of orders between $100 and $249 increased from $148 to $159, while the average size of orders of $250 and greater decreased from $750 to $470. The number and magnitude of these larger orders has a significant impact on our operating results. Information regarding these larger orders was as follows:
Three Months Ended July 31, | ||||||||||||||||||||||||
2005 | 2004 | % Change | ||||||||||||||||||||||
Order Size | Number | Value | Number | Value | Number | Value | ||||||||||||||||||
$100 to $249 | 40 | $ | 6,370 | 52 | $ | 7,699 | -23.1 | % | -17.3 | % | ||||||||||||||
$250 or greater | 10 | 4,709 | 18 | 13,506 | -44.4 | % | -65.1 | % | ||||||||||||||||
50 | $ | 11,079 | 70 | $ | 21,205 | -28.6 | % | -47.8 | % | |||||||||||||||
Nine Months Ended July 31, | ||||||||||||||||||||||||
2005 | 2004 (Pro Forma) | % Change | ||||||||||||||||||||||
Order Size | Number | Value | Number | Value | Number | Value | ||||||||||||||||||
$100 to $249 | 77 | $ | 11,920 | 122 | $ | 17,969 | -36.9 | % | -33.7 | % | ||||||||||||||
$250 or greater | 31 | 14,693 | 43 | 29,543 | -27.9 | % | -50.3 | % | ||||||||||||||||
108 | $ | 26,613 | 165 | $ | 47,512 | -34.5 | % | -44.0 | % | |||||||||||||||
License Fees
License fees revenues for the three months ended July 31, 2005 were $16,747, a decrease of 34.1% from the $25,421 reported for the same period in 2004. License fees revenues for the nine months ended July 31, 2005 were $42,075, a decrease of 24.5% from the $55,693 reported for the same period in 2004.
The decrease in license fees revenues for the three and nine months ended July 31, 2005, as compared to the same periods in 2004, can be attributed to the factors affecting revenue mentioned under
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the caption “Total Revenues” above. As a percentage of total revenues, license fees revenues decreased for the three and nine months ended July 31, 2005, compared to the same periods in 2004, primarily due to the factors affecting revenue discussed earlier. An expected change in our revenue mix towards increased subscriptions revenues in the future could also impact our perpetual license fees revenues.
Subscriptions
Subscriptions revenues for the three months ended July 31, 2005 were $4,400, a decrease of 24.3% from the $5,812 reported for the same period in 2004. Subscriptions revenues for the nine months ended July 31, 2005 were $13,450, a decrease of 14.0% from the $15,645 reported for the same period in 2004.
The decrease in subscriptions revenues, both in dollars and as a percentage of revenues, can be attributed to the lower order volume mentioned earlier and in part to stronger sales of our client hosted web courseware during the three and nine months ended July 31, 2005. We do not believe this is a trend, but that we will see a gradual shift away from perpetual licenses to our subscription-based products in the future.
Services
Services revenues for the three months ended July 31, 2005 were $7,440, comparable to the $7,403 reported for the same period in 2004. Services revenues for the nine months ended July 31, 2005 were $26,544, an increase of 26.8% from the $20,937 reported for the same period in 2004.
The increase in services revenues for the nine months ended July 31, 2005, both in dollars and as a percentage of revenues, were driven by our new Supplemental Educational Services offering, and also by substantial growth in our software support and educational consulting services revenues.
Other
Other revenues for the three months ended July 31, 2005 were $2,652, an increase of 34.1% from the $1,977 reported for the same period in 2004. Other revenues for the nine months ended July 31, 2005 were $6,054, a decrease of 14.8% from the $7,106 reported for the same period in 2004.
Other revenues consist primarily of hardware sold with certain of our courseware products and third-party courseware products. Revenues from these products tend to fluctuate from quarter to quarter.
Backlog
Our deferred revenue was $41,946 and $51,575 at July 31, 2005 and October 31, 2004, respectively. Deferred revenue excludes amounts that we expect to earn in the future from the U.S. Department of the Navy contract (approximately $11,700). Ultimate realization of this contract is dependent on delivery of services and customer acceptance. In prior filings, we have discussed a contract with the Idaho Department of Education, which was also excluded from deferred revenue. We have received notice of that customer’s intent to terminate that contract. We do not expect that this will have a significant impact on our business.
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Cost of Revenues
Total cost of revenues for the three months ended July 31, 2005 were $12,233, an increase of 6.3% from the $11,510 reported for the same period in 2004. Total cost of revenues for the nine months ended July 31, 2005 were $38,908, an increase of 12.1% from the $34,700 reported for the same period in 2004.
Total cost of revenues, both in dollars and as a percentage of revenues, increased for the three and nine months ended July 31, 2005, as compared to the same periods in 2004, due to a number of factors, including decreased license fees and subscriptions revenues (which have low variable costs), increased services revenues (which have higher costs), and increased investments in the service organization and realignment of those resources from sales support to billable activities (which shifted some costs from selling expense to cost of revenues).
Amortization of capitalized product development costs, a component of cost of revenues related to license fees and subscriptions, was $2,058 and $1,682 for the three months, and $5,521 and $5,160 for the nine months ended July 31, 2005 and 2004, respectively. Capitalized development costs were $2,695 and $2,539 for the three months, and $7,906 and $6,830 for the nine months ended July 31, 2005 and 2004, respectively. The increase in capitalized product development costs for the nine-month period was primarily due to an increase in the number and amount of development projects requiring capitalization and the timing of the completion of those projects.
A comparison of gross profit margin by revenue category is as follows:
Three Months Ended | Nine Months Ended | |||||||||||||||
July 31, | July 31, | |||||||||||||||
Revenue category | 2005 | 2004 | 2005 | 2004 | ||||||||||||
License fees | 82.1 | % | 86.7 | % | 77.9 | % | 82.1 | % | ||||||||
Subscriptions | 59.5 | % | 69.3 | % | 53.6 | % | 64.7 | % | ||||||||
Services | 34.2 | % | 43.4 | % | 35.5 | % | 40.2 | % | ||||||||
Other | 3.5 | % | -9.1 | % | -3.2 | % | 5.7 | % | ||||||||
Total | 60.8 | % | 71.7 | % | 55.8 | % | 65.1 | % |
The decreases in total gross profit margin resulted primarily from lower license fees and subscriptions revenues in 2005, which carry higher margins, and the cost of revenues factors discussed earlier. Future gross profit margin will be dependent primarily on the amount of revenue, our revenue mix, the amount of professional development expenses required to provide our services, and the amortization of capitalized product development costs and acquired technology included in cost of revenues. Gross profit margin is expected to be lower for fiscal year 2005, compared to fiscal year 2004, as a result of these factors.
Operating Expenses
Sales and Marketing
Total sales and marketing expenses for the three months ended July 31, 2005 were $11,520, a decrease of 22.7% from the $14,897 reported for the same period in 2004. Total sales and marketing
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expenses for the nine months ended July 31, 2005 were $38,256, a decrease of 16.6% from the $45,875 reported for the same period in 2004.
Sales and marketing expenses, both in dollars and as a percentage of revenues, decreased for the three and nine months ended July 31, 2005, as compared to the same periods in 2004, due primarily to cost reduction activities initiated in 2004 and 2005, realignment of our service resources from sales support to billable activities (which shifted some costs from selling expense to cost of revenues), sales force attrition, and decreased commissions resulting from the decrease in revenues. Our ability to continue to leverage our cost structure and improve profitability is primarily dependent on our ability to generate higher revenues and realize sales and marketing productivity improvements. For the full fiscal year 2005, sales and marketing expenses are expected to be below fiscal year 2004 amounts.
General and Administrative
Total general and administrative expenses for the three months ended July 31, 2005 were $5,141, an increase of 4.6% from the $4,915 reported for the same period in 2004. Total general and administrative expenses for the nine months ended July 31, 2005 were $14,193, a decrease of 1.8% from the $14,447 reported for the same period in 2004.
General and administrative expenses increased for the three months ended July 31, 2005, as compared to the same period in 2004, due primarily to increased professional fees for Sarbanes-Oxley compliance, senior management changes, and process improvements in the third quarter of 2005. General and administrative expenses, both in dollars and as a percentage of revenues, decreased for the nine months ended July 31, 2005, as compared to the same period in 2004, due primarily to the achievement of cost reduction activities initiated in 2004 and 2005, somewhat offset by the increased professional fees for Sarbanes-Oxley compliance, senior management changes, and process improvements in 2005. For the full fiscal year 2005, general and administrative expenses are expected to be below fiscal year 2004 amounts.
Product Development
The majority of our product development costs are required to be capitalized. Product development expense does not reflect these capitalized costs, as they are amortized through cost of revenues. Accordingly, our product development expense, as a percentage of revenue, does not reflect our total level of development activity.
Total product development expenses for the three months ended July 31, 2005 were $1,227, a decrease of 5.1% from the $1,293 reported for the same period in 2004. Total product development expenses for the nine months ended July 31, 2005 were $3,920, a decrease of 19.0% from the $4,842 reported for the same period in 2004.
Product development expenses, both in dollars and as a percentage of revenues, were comparable for the three months ended July 31, 2005 and 2004. Product development expenses decreased for the nine months ended July 31, 2005, as compared to the same period in 2004, due primarily to a shift in spending toward more capitalized projects compared to the same periods in 2004.
Product development spending, before capitalization and amortization, was 12.6% and 9.4% of total revenues for the three months, and 13.4% and 11.7% for the six months ended July 31, 2005 and 2004, respectively. As part of our growth strategy, we intend to continually introduce new products and product improvements. For the full fiscal year 2005, product development spending is expected to be
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above fiscal year 2004 amounts, while product development expenses are expected to be below fiscal year 2004 amounts.
Amortization of Intangibles
Expense for the three and nine months ended July 31, 2005 and 2004 represented the amortization of identified intangible assets, other than acquired technology, from our acquisitions. Acquired technology intangible assets are amortized through cost of revenues. See Note 6 to Consolidated Financial Statements for additional information on goodwill and identified intangible assets.
Restructuring and Other Charges
Restructuring and other charges include primarily severance costs for headcount reductions in the United States and the United Kingdom (the “U.K.”), committed costs of vacated facilities in the U.K., and costs paid to terminated executive officers under employment agreements. These charges are summarized and discussed in more detail in Note 10 to the Condensed Consolidated Financial Statements in Item 1 of this Quarterly Report on Form 10-Q.
On September 1, 2005, we announced the initiation of several cost reduction actions. These actions include shifting a significant portion of our development activities from the U.S. to an offshore location and a further downsizing of our U.K. operations. These actions are expected to be substantially completed in the fourth quarter of 2005 and result in cash and non-cash restructuring charges of between $4,000 and $6,000.
We are continuing to review our business operations and strategy, and may implement changes to improve our focus and efficiency in the future. As a result, additional restructuring and other charges may be incurred.
Income Taxes
As discussed under the caption “Critical Accounting Policies and Estimates”, as a result of the Lightspan acquisition, the net deferred tax assets as of the acquisition date, excluding the deferred tax liability relating to tax deductible goodwill (which cannot be used to support realization of the other net deferred tax assets), were fully reserved for in purchase accounting, thereby increasing goodwill, in the first quarter of 2004. Any future reductions of the valuation allowance recorded on the combined entity’s pre-acquisition deferred tax assets will be recorded as a reduction to goodwill, as opposed to recording an income tax benefit in the consolidated statement of operations. Income tax expense for future periods, however, will be impacted by any reductions in the valuation allowance related to post-acquisition deferred tax assets, for which we have also recorded a full valuation allowance at July 31, 2005 and October 31, 2004.
Our historical effective income tax rate has been highly volatile due to the mix between our U.S. operating results, for which we record income taxes, and our foreign operating results, for which we do not record an income tax benefit due to the uncertainty of realizing these tax benefits in future years in our foreign jurisdictions. Our effective income tax rate for future quarters and fiscal years is dependent on the level of profitability in each of the U.S. and our foreign subsidiaries. In addition, even if there is a loss in the U.S., we expect income tax expense of approximately $600 per year, or $150 per quarter, related to amortization of goodwill that is deductible for tax purposes but not for book purposes. As goodwill from the NetSchools acquisition is amortized for tax purposes, the book basis of the goodwill
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will further exceed the tax basis, resulting in increases to the related deferred tax liability, which cannot be used to support realization of the other net deferred tax assets. We currently expect to incur a loss for the full year 2005.
FINANCIAL CONDITION
Liquidity and Capital Resources
At July 31, 2005, our principal sources of liquidity included cash and cash equivalents of $38,926, net accounts receivable of $28,468, and our unused line of credit of $12,500. Working capital was $24,574 and $29,769 at July 31, 2005 and October 31, 2004, respectively.
The decrease in working capital was primarily due to the decrease in cash, cash equivalents, and marketable securities of $2,924 and the decrease in net accounts receivable of $13,384, offset by the increase in prepaid expenses and other current assets of $2,050 and the decreases in accounts payable, accrued salaries and benefits, and accrued liabilities of $2,143, and deferred revenue of $6,920. Accounts receivable decreased due to the low order volume in 2005, collection of amounts outstanding at year end, and improvements in our collection process. Prepaid expenses and other current assets increased primarily due to the growth in inventories, resulting from purchases of long lead-time hardware related to our Achieve Now product. Accounts payable and accrued salaries and benefits decreased due to payment of amounts accrued at year end, including year end commissions and bonuses. Deferred revenue, which is satisfied through delivery of products and services rather than cash, decreased as more of these products and services were delivered than were added through new business, due to the lower order volume mentioned earlier.
During the nine months ended July 31, 2005, cash and cash equivalents increased $9,691. Cash provided by operations, excluding changes in our asset and liability accounts, was $2,529. The cash used by changes in our asset and liability accounts of $2,512 was more than offset by the cash provided by investing activities of $6,922, and the cash provided by financing activities of $2,086. Depreciation and amortization was $14,476 for the nine months ended July 31, 2005, an increase of $1,010 compared to the same period in 2004, due primarily to increased amortization of identified intangible assets and capitalized product development costs.
During the nine months ended July 31, 2004, cash and cash equivalents increased $3,177. Cash provided by operations, excluding changes in our asset and liability accounts, of $11,693 and cash provided by financing activities of $1,553 was slightly offset by the cash used in our investing activities of $6,381.
Net cash provided by our investing activities was $6,922 for the nine months ended July 31, 2005, as compared to net cash used of $6,381 for the same period in 2004. During the nine months ended July 31, 2005, as compared to the same period in 2004, we increased our capitalization of product development costs by $1,076, increased our purchases of marketable securities by $8,879, and increased our sales and maturities of marketable securities by $25,288. Capitalization of product development costs increased primarily due to increased courseware development. We also had net cash provided from the Lightspan and New Media acquisitions of $2,460 for the nine months ended July 31, 2004.
Net cash provided by our financing activities, principally from the exercise of stock options, was $2,086 and $1,553 for the nine months ended July 31, 2005 and 2004, respectively.
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Our Board of Directors approved a stock repurchase plan in December 2001, which authorizes us to repurchase up to $15,000 of our common stock in the open market and in privately negotiated transactions. The plan has no set termination date and the timing of any repurchases will be dependent on prevailing market conditions and alternative uses of capital. We did not repurchase any shares of our common stock during the nine months ended July 31, 2005. Cumulatively, we have repurchased approximately 1,465,000 shares for an aggregate cost of approximately $13,700 under the repurchase plan and approximately $1,300 remains available for future repurchases, if any.
On June 30, 2005, we extended our revolving loan agreement with Wells Fargo Bank, N.A. The revolving loan agreement provides for borrowings up to $12,500, through January 31, 2006, as determined by the available borrowing base. At July 31, 2005, there were no borrowings outstanding and our unused borrowing capacity was $12,500. The agreement contains restrictive financial covenants (including Minimum Tangible Net Worth, Minimum Debt Service Coverage, Maximum Leverage, Maximum Cash Flow Leverage and Maximum Annual Capital Expenditures) and restrictions on additional borrowings, asset sales and dividends, as defined. Certain of the covenant calculations are based on the trailing twelve-month period. All applicable covenants were satisfied as of July 31, 2005.
From time to time, we evaluate potential acquisitions of products or businesses that complement our core business. We may consider and acquire other complementary businesses, products, or technologies in the future.
We maintain adequate cash balances and credit facilities to meet our anticipated working capital, capital expenditure, and business investment requirements for at least the next twelve months.
Disclosures about Off-Balance Sheet Arrangements
We do not have any off-balance sheet arrangements as of July 31, 2005.
Disclosures about Contractual Obligations and Commercial Commitments
Our contractual obligations and commercial commitments consist primarily of future minimum payments due under operating leases, royalty agreements, and capital lease obligations. In addition, any future borrowings under our revolving loan agreement would require future use of cash.
A table showing our contractual obligations was provided in Item 7 of our Annual Report on Form 10-K/A for the year ended October 31, 2004. There were no significant changes to our contractual obligations during the nine months ended July 31, 2005.
At July 31, 2005, we had no significant commitments for capital expenditures.
With the acquisition of New Media in 2004, there is additional guaranteed deferred consideration of approximately $450 due over the period from the acquisition date through December 2006 based on New Media revenues. As of July 31, 2005, no payments of this additional consideration have been required.
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Interest Rate Risk
Our borrowing capacity primarily consists of a revolving loan with interest rates that fluctuate based upon the Prime Rate and LIBOR market indexes. At July 31, 2005, we did not have any outstanding borrowings under this revolving credit facility. Our only debt consisted of capital lease obligations at fixed interest rates. As a result, risk relating to interest fluctuation is considered minimal.
Foreign Currency Exchange Rate Risk
We market our products and services worldwide and have operations in Canada and the U.K. As a result, financial results and cash flows could be affected by changes in foreign currency exchange rates or weak economic conditions in foreign markets. Working funds necessary to facilitate the short-term operations of our foreign subsidiaries are kept in local currencies in which they do business. Any gains or losses from foreign currency transactions are included in the consolidated statements of operations. Our foreign subsidiaries are not a significant component of our business, and, as a result, risk relating to foreign currency fluctuation is considered minimal.
New Accounting Pronouncements
In December 2004, the Financial Accounting Standards Board issued SFAS No. 123(R), “Share-Based Payment” (“SFAS 123(R)”). SFAS 123(R) establishes standards for accounting for transactions in which an entity exchanges its equity instruments for goods or services. SFAS 123(R) focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions. SFAS 123(R) requires that the fair value of such equity instruments be recognized as expense in the financial statements as services are performed. Prior to SFAS 123(R), only the pro forma disclosures of fair value presented above were required. In March 2005, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin No. 107, “TOPIC 14: Share-Based payment” which addresses the interaction between SFAS 123(R) and certain SEC rules and regulations and provides views regarding the valuation of share-based payment arrangements for public companies. SFAS 123(R) is effective for our first quarter of 2006 and the adoption of this new accounting pronouncement is expected to have a material impact on our consolidated financial statements.
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Item 3. Quantitative and Qualitative Disclosures About Market Risk
See the information set forth under the captions, “Interest Rate Risk” and “Foreign Currency Exchange Rate Risk” in Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Item 4. Controls and Procedures
(a) Evaluation of Disclosure Controls and Procedures.As of July 31, 2005, our Chief Executive Officer and Chief Financial Officer have conducted an evaluation of the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this report. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, due to the control deficiency described below, our disclosure controls and procedures are ineffective at a reasonable assurance level as of July 31, 2005 to make known to them in a timely fashion material information related to the Company required to be filed in this report.
As of April 30, 2005, the Company concluded that it did not maintain effective controls over the accounting for pro forma stock-based compensation expense required to be disclosed under SFAS No. 123. Specifically, the Company did not maintain effective controls to ensure the appropriate pro forma accounting treatment of stock option forfeitures and recognition of related tax benefits. This control deficiency resulted in the restatement of the Company’s annual consolidated financial statements for each of the three years in the period ended October 31, 2004, and the interim consolidated financial statements during fiscal years 2003 and 2004, and for the quarter ended January 31, 2005.
Subsequent to April 30, 2005, the Company has implemented additional processing and review procedures to ensure the proper accounting for pro forma stock-based compensation expense. The Company is in the process of implementing a software package that will assist them with more effective tracking of employee stock option activity and the calculations of stock-based compensation. By implementing these internal control improvements, the Company expects to remediate this material weakness before October 31, 2005, which is the Company’s required compliance date under the Act.
All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation. We will continue to improve the design and effectiveness of our disclosure controls and procedures to the extent necessary in the future to provide our senior management with timely access to such material information, and to correct any deficiencies that we may discover in the future.
(b) Changes in Internal Control Over Financial Reporting.Other than the control procedures discussed above with respect to ensuring the proper accounting for pro forma stock-based compensation expense, there were no changes in our internal control over financial reporting that occurred during our most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.
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PART II.
Item 1.Legal Proceedings
Credit Suisse First Boston and several of its clients, including Lightspan, Inc. (which we acquired in November 2003), are defendants in a securities class action lawsuit captioned Liu, et al. v. Credit Suisse First Boston Corp., et al. pending in the United States District Court for the Southern District of New York. The complaint alleges that Credit Suisse First Boston, its affiliates, and the securities issuer defendants (including Lightspan, Inc.) manipulated the price of the issuer defendants’ shares in the post-initial public offering market. The securities issuer defendants (including Lightspan, Inc.) filed a motion to dismiss the complaint in September 2004 on the grounds of multiple pleading deficiencies. On April 1, 2005, the complaint was dismissed with prejudice. On April 15, 2005, the plaintiff filed a motion for reconsideration. This motion was denied on May 13, 2005. The plaintiff filed a second motion for reconsideration on May 16, 2005. The court affirmed the previous ruling, rejecting the plaintiff’s second motion.
Item 5.Other Information
On June 30, 2004, we were notified by PricewaterhouseCoopers LLP (“PwC”) that its global captive insurer made an investment in our common stock in mid-October 2003. PwC became aware of the investment in June 2004, at which time its investment position was liquidated. As a result, PwC was not independent when it issued its opinion with respect to our consolidated financial statements as of, and for the year ended, October 31, 2003.
The Audit Committee of the Company has reviewed this matter in detail. The Audit Committee has considered the circumstances and effect of the loss of independence with respect to the audit of the fiscal year 2003 financial statements, the costs and other effects of engaging new independent auditors to re-audit the fiscal 2003 financial statements, and the fact that the Company is not aware of any impact on its fiscal 2003 financial statements from this lack of independence. The Audit Committee consulted with the outside legal counsel of the Company and the staff of the Securities and Exchange Commission in reaching its decision to not re-audit the fiscal 2003 financial statements and to continue the engagement of PwC as its independent auditors.
Item 6.Exhibits
Exhibit Number and Description
10.02 | Fifth Amendment to Credit Agreement. | |||||
10.53 | Employment Agreement with Robert J. Rueckl. | |||||
31.01 | Certification of Chief Executive Officer under Rule 13a-14(a) adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. | |||||
31.02 | Certification of Chief Financial Officer under Rule 13a-14(a) adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. | |||||
32.01 | Certification of Chief Executive Officer under 18 U.S.C. 1350 pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. | |||||
32.02 | Certification of Chief Financial Officer under 18 U.S.C. 1350 pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
PLATO LEARNING, INC. | By: | /s/ MICHAEL A. MORACHE | ||
September 9, 2005 | Michael A. Morache | |||
President and Chief Executive Officer (principal executive officer) |
/s/ LAURENCE L. BETTERLEY | ||||
Laurence L. Betterley | ||||
Senior Vice President and Chief Financial Officer (principal financial officer) | ||||
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