Business Description

PLATO Learning, Inc. is a Delaware corporation that was incorporated in 1989 and is headquartered in Bloomington, Minnesota. We are a leading provider of on-line instruction, curriculum management, assessment, and related professional development services to K-12 schools, community colleges and other educational institutions across the country. Our products are used by customers principally to provide alternative instruction to students performing below their grade level in order to help those students return to the classroom, recover course credits, pass high school exit exams or prepare for college and other post-secondary studies. In addition to the value provided to students, our solutions allow school districts to retain state and federal funding tied to student enrollment. Our courseware and assessment products are designed primarily to help educators meet the demands of state and federal student achievement initiatives for intervention, dropout prevention and college readiness. We also offer online and onsite staff professional development services to ensure optimal use of our products and to help schools meet their accountability requirements and school improvement plans.

Our research-based courseware library includes thousands of hours of mastery-based instruction covering discrete learning objectives in the subject areas of reading, writing, language arts, mathematics, science, and social studies. Our web-based assessment and alignment tools ensure that instruction can be personalized to each student's unique needs and the curriculum is aligned to local, state, and national standards. Using our web-based products, educators are able to identify each student's instructional needs and prescribe an individual learning program of PLATO Learning courseware, educational web sites, the school's textbooks and other core and supplemental instructional materials. A variety of reports are available to help educators identify gaps in student understanding, monitor student progress and ensure that standard learning objectives are being addressed.

Beginning in late fiscal year 2005, we implemented a strategy to deliver our products and solutions on a subscription basis using a new internet-based learning management platform we call the PLATO Learning EnvironmentTM, or PLE TM. The majority of our subscription periods range from one to three years with a dollar value weighted average subscription period of approximately two years in fiscal 2008. As of January 31, 2009, over 1,240 school districts, community colleges and other educational institutions across 50 states subscribed to our instructional solutions delivered on PLETM , and nearly 1.3 million students, teachers and administrators at these institutions were registered to use PLE TM .

We operate our principal business in one industry segment, which is the development and marketing of online curriculum solutions and related services.

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 the policies relating to the following areas as those that are significant to our financial statement presentation, and require difficult, subjective, or complex judgments:

· Revenue recognition

· Capitalized software development costs

· Valuation of deferred income taxes

· Valuation and impairment analysis of identified intangible assets

At the end of fiscal year 2008, we completed our transition to a software-as-a-service business model in which substantially all of our products are now delivered on a hosted, subscription service basis. Based on the completion of this transition, and in accordance with EITF 00-03, Application of SOP 97-2, "Software Revenue Recognition", to Arrangements That Include the Right to Use Software Stored on Another Entity's Hardware, we have applied SOP 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use." effective for the first quarter of fiscal year 2009. Under EITF 00-03, hosting arrangements in which customers do not have a contractual right to take possession of the software are service arrangements, and such software, subject to certain exceptions, is considered internal-use software subject to SOP 98-1. We will continue to use FAS 86, Accounting for the Costs of Computer Software to Be Sold or Otherwise Leased for software sold under contracts in which the customer has a right to take possession of the software.

There have been no other significant new accounting principles applied during the first quarter of 2009. For a more complete discussion of our accounting policies refer to Note 2 to Consolidated Financial Statements in our Annual Report on Form 10-K for the year ended October 31, 2008.

General Factors Affecting our Financial Results

There are a number of general factors that affect our results from period to period. These factors are discussed below.

Revenue. In 2008, we completed a transition of our business model from one that sells one-time perpetual licenses to software, for which revenue is generally recognized up-front upon delivery, to one that sells subscription-based products, for which revenue is recognized over the subscription period. The transition began in 2006 when we introduced many of our new subscription-based products and affects the comparability of our revenues over this period. As subscription revenues grow as a percentage of total revenues, we expect our period to period revenues to become more comparable and predictable.

Gross Profit. A large portion of our costs of revenue are fixed in nature. These costs include amortization of capitalized software development and purchased technology, depreciation and other infrastructure costs to support our hosted subscription services, customer support operations, and full-time professional services personnel who deliver our training services. Accordingly, increases in revenues allow us to leverage these costs resulting in higher gross profit, while decreases in revenues have the opposite effect.

Operating Expenses. General and administrative expenses are substantially fixed in nature. However, certain components such as professional fees and similar expenses can vary based on business results, individual events, or initiatives we may be pursuing at various times throughout the year.

Incentive compensation is a significant variable component of our sales and marketing expenses, approximating 9% to 10% of total revenues in any given period. Sales and marketing expenses also include costs such as travel, tradeshows, and conferences that can vary with revenue activity or individual events that occur during the period.

Software maintenance and development expense in our consolidated statement of operations does not reflect our total level of spending on our products and services. Costs to maintain existing products and preliminary project development costs are charged to software maintenance and development expense as incurred. Costs incurred to develop or enhance new products after preliminary project development costs are incurred, which represent the majority of our total software development spending, are capitalized and amortized to cost of revenues. Accordingly, software maintenance and development expense in our consolidated statement of operations can fluctuate from period to period, in terms of both total dollars and as a percentage of revenue, based on the nature and timing of activities occurring during the period.

Amortization of intangibles represents the amortization of certain identified intangible assets acquired through various acquisitions. While these expenses are generally predictable from period to period because they are fixed over the course of their individual useful lives, they can be affected by events and other factors that result in impairment of these assets and a corresponding reduction in future amortization.

Cash Balances and Cash Flow. Our business is seasonal, with the largest portion of orders coming in our third and fourth fiscal quarters. These periods are when our customers' budget spending typically peaks as they end their current budget period, begin a new budget period, and begin to plan their needs for the upcoming school year. In addition, our costs are largely fixed, and with some exceptions, do not vary significantly with the level of order activity. As a result, cash balances generally decline during the first half of the fiscal year, and increase from those levels as order activity increases in the third and fourth quarter.

Results of Operations

Revenues

The following tables summarize certain key information to aid in the understanding of our discussion and analysis of revenues and should be read in conjunction with Note 2 to the Consolidated Financial Statements in our Annual Report on Form 10-K for the year ended October 31, 2008, which discusses our accounting policies regarding revenue recognition:

Sales Order Information (in thousands):

                                                  Three Months Ended
                                                      January 31,
                                  2009         2008        Percent Increase (Decrease)
Order Value:
Subscriptions                      6,674        5,639                              18.4 %
License fees                       1,031        1,483                             (30.5 %)
Services                           3,134        3,480                              (9.9 %)
Total Order Value               $ 10,839     $ 10,602                               2.2 %

Percent of Total Order Value:
Subscriptions                       61.6 %       53.2 %
License fees                         9.5 %       14.0 %
Services                            28.9 %       32.8 %
Total                              100.0 %      100.0 %

Revenue by Category (in thousands):

                          Three Months Ended
                             January 31,
                   2009         2008        % Change
Subscriptions    $  9,868     $  7,969           23.8 %
License fees        1,004        2,251          (55.4 %)
Services            5,165        5,915          (12.7 %)
Total revenues   $ 16,037     $ 16,135           (0.6 %)

Percentage of Total Revenue

                     Three Months Ended
                         January 31,
Revenue Category      2009          2008
Subscription             61.5 %       49.4 %
License fee               6.3 %       13.9 %
Services                 32.2 %       36.7 %
Total                   100.0 %      100.0 %

Total revenues for the first quarter of 2009 declined slightly to $16.0 million, from $16.1 million for the same period in 2008. Subscription revenues grew $1.9 million, or 23.8%, exceeding the $1.2 million decline in license fees on perpetual products. The increase in subscription revenue reflects our growing base of subscription customers. The decline in license fees revenue reflects our declining emphasis on sales of products licensed on a perpetual basis. Services revenues declined $750,000 on lower software maintenance revenues related to our legacy perpetual products.

Gross Margin

Gross Margin Percentage

                               Three Months Ended January 31,
Revenue Category      2009             2008          Increase (Decrease)
Subscriptions            60.6 %           41.7 %                     18.9 %
License fees             56.3 %           36.8 %                     19.5 %
Services                 53.0 %           56.1 %                     (3.1 %)
Total                    57.9 %           46.3 %                     11.6 %

Total gross margin rate increased to 57.9% for the first quarter of 2009, from 46.3% for the same period in 2008. The 18.9% increase in subscription gross margin had the most significant effect on total gross margin.

Subscription gross margin rate improved to 60.6% in the first quarter of 2009 from 41.7% for the same period in 2008. This improvement reflects the $1.9 million growth in subscription revenues as discussed above, and a $760,000 reduction in subscription costs. The decrease in subscription costs is due to a decline in amortization of capitalized subscription software development costs, and asset impairments, in fiscal 2008.

Services gross margin declined in the first quarter of 2009 to 53.0% from 56.1% for the same period last year. The margin decline was due to a decrease in the mix of higher margin software support services revenues due to our declining base of perpetual license customers.

Operating Expenses

The following table summarizes the amounts and percentage change in amounts from
the corresponding period during the previous year for certain operating expense
line items.

                                                                     Percent
                                         Three Months Ended          Increase
                                             January 31,            (Decrease)
                                         2009           2008        in Amount
Sales and marketing                    $   5,887      $  7,005            (16.0 %)
General and administrative                 2,424         2,950            (17.8 %)
Software maintenance and development         567         1,076            (47.3 %)
Amortization of intangibles                  213           388            (45.1 %)
Total operating expenses               $   9,091      $ 11,419            (20.4 %)

Total operating expenses were $9.1 million for the first quarter of 2009, a decrease of 20.4%, or $2.3 million, from $11.4 million for the same period in 2008. In general, this decline reflects the benefit of restructuring activities in the second half of fiscal 2008, and the continued efficiencies of our software-as-a-service business model.

Sales and marketing expenses declined $1.1 million on reduced indirect sales, travel and marketing costs. None of the decline was due to a reduction in our field sales force, which remained about the same relative to the first quarter of 2008. General and administrative costs declined 17.8% to $2.4 million on lower headcount and a decline in legal and other professional services costs. Software maintenance and development declined $0.5 million reflecting increasing stability of our PLE platform and the quality of new product releases.

Other Income, Net

Other income consists primarily of interest income on our cash and cash equivalent balances, net of the costs of maintaining availability on our line of credit. Other income declined $124,000 for the first quarter of 2009 due to the decrease in our average cash and cash equivalent balances over the prior year, as well as a decline in interest rates.

Backlog

We consider backlog to be the total of deferred revenue reported on our balance
sheet plus unbilled amounts due under non-cancelable subscription agreements. On
this basis, backlog was $48.5 million and $44.4 million at January 31, 2009 and
January 31, 2008, respectively, as follows:

                                                          As of January 31,
                                                          2009          2008
Gross deferred revenue including unbilled amounts
under non-cancelable subscription agreements:
Subscriptions                                          $   38,360     $  30,661
License fees                                                  488           600
Services                                                    9,696        13,121
Total backlog                                          $   48,544     $  44,382

At January 31, 2009, we expect approximately $16.8 million of our backlog to be recognized subsequent to fiscal year 2009.

Liquidity and Capital Resources

Cash and Cash Equivalents

At January 31, 2009, cash and cash equivalents were $12.3 million, a decrease of $7.7 million from October 31, 2008. This decrease primarily represents net cash used in operations in 2009 of $6.1 million, and investments in capitalized software development of $1.6 million. Included in the $6.1 million in net cash used in operations were approximately $3.0 million of non-recurring cash payments, including $1.7 million in severance paid to terminated employees and $1.3 million in non-recurring royalty payments. As discussed above under "General Factors Affecting Our Financial Results", cash flow from operations is typically lower in the first and second quarter of our fiscal year due to the seasonal nature of our business.

Working Capital and Liquidity

At January 31, 2009, our principal sources of liquidity included cash and cash equivalents totaling $12.3 million, net billed accounts receivable of $4.7 million, and unbilled commitments under non-cancelable subscription contracts totaling $9.3 million, of which $3.9 million is expected to be billed in 2009. We also have a three-year senior secured credit facility that provides us with a revolving line of credit up to the lesser of $20 million or the amount of our trailing twelve months subscription and software maintenance revenues. Under this agreement we have the option of selecting an interest rate for any drawdown under the facility equal to the applicable Prime or LIBOR Rate plus a sliding margin that is based on the amount of borrowings outstanding. Borrowings under the agreement are secured by all of our assets. Financial covenants apply only when the unused portion of the line of credit, plus cash and cash equivalents on hand, is less than $12.5 million, and are limited to minimum quarterly thresholds of earnings before interest, taxes, depreciation and amortization (EBITDA). At January 31, 2009 and 2008, availability under the line was $20 million and there were no borrowings outstanding.

Cash used by operations in the first quarter increased to $6.1 million in 2009, from $2.0 million in 2008, due to the non-recurring cash payments discussed above, reduced receivable collections resulting from lower total orders in the fourth quarter of 2008 compared to 2007, partially offset by reductions in overall spending. Cash used in investing activities declined to $1.7 million for the first quarter of 2009, from $3.3 million for the same period last year reflecting a reduction in our software investment requirements.

We believe our existing cash, cash equivalents, anticipated cash provided by operating activities, and availability under our line of credit will be sufficient to meet our working capital and capital expenditure needs over the next 12 months. Our future capital requirements will depend on many factors, including the timing and extent of software development expenditures, order volume, and the timing and collection of receivables.

Contractual Obligations and Commercial Commitments

Our contractual obligations and commercial commitments consist primarily of future minimum payments due under operating leases and royalty and software license agreements. Refer to "Management's Discussion and Analysis of Financial Condition and Results of Operations" in our Annual Report on Form 10-K for the year ended October 31, 2008 for a table showing our contractual obligations. There were no significant changes to our contractual obligations during the three months ended January 31, 2009.

At January 31, 2009, we had no significant commitments for capital expenditures.

Recent Accounting Pronouncements

See Note 2 of the Condensed Consolidated Financial Statements for a summary of the new accounting pronouncements.

Disclosures about Off-Balance Sheet Arrangements

We did not have any off-balance sheet arrangements as of January 31, 2009.

Forward-Looking Statements

In addition to historical information, this Form 10-Q contains forward-looking statements. These forward-looking statements are made in reliance upon the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 ("the Act"). The words "believe," "expect," "anticipate," "intend," "estimate," "forecast," "project," "should" and similar expressions are intended to identify "forward-looking statements" within the meaning of the Act. Forward-looking statements include, among others, statements about our future performance, the sufficiency of our sources of capital for future needs, and the expected impact of recently issued accounting pronouncements. These forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those reflected in the forward-looking statements. Factors that might cause such a difference include, but are not limited to, those discussed in Part II Item 1A of this Form 10-Q and Part I Item 1A of our Annual Report on Form 10-K for the fiscal year ended October 31, 2008. Readers are cautioned not to place undue reliance on these forward-looking statements, which reflect management's opinions only as of the date hereof. We undertake no obligation to revise or publicly release any revision to these forward-looking statements based on circumstances or events, which occur in the future. Readers should carefully review the risk factors described in this report on Form 10-Q and in other documents we file from time to time with the Securities and Exchange Commission.

Interest Rate Risk

Our borrowing capacity primarily consists of a revolving line of credit with interest rates that fluctuate based upon the Prime Rate and LIBOR market indexes. At January 31, 2009, we did not have any outstanding borrowings under this revolving credit facility. As a result, risk relating to interest fluctuation is considered minimal.

Foreign Currency Exchange Rate Risk

Our foreign operations are not a significant component of our business, and as a result, risks relating to foreign currency fluctuation are considered minimal.