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, and 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 allow instruction to 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 market as the PLATO Learning EnvironmentTM, or PLE TM. As of July 31, 2009, approximately 1,350 school districts, community colleges and other educational institutions across 50 states subscribed to our instructional solutions delivered on PLETM, and over 1.4 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 as they involve, subjective or complex judgments:

· Revenue recognition

· Capitalized software development costs

· Valuation of deferred income taxes

· Valuation 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. As a result of our application of SOP 98-1 in fiscal year 2009, we are capitalizing software development costs upon completion of the preliminary project stage rather than when technological feasibility is achieved, which we did for prior years pursuant to SFAS No. 86, "Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed" ("SFAS 86"). Application of SOP 98-1 also allows us to capitalize only direct costs of software development, rather than both direct costs and an allocation of indirect costs, which was allowed under SFAS 86.

There have been no other significant new accounting principles applied during the first nine months 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.

Cost of Revenue and 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 a number of factors including 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 8% 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. 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 table summarizes 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:

Revenue by Category (in thousands):

                                   Three Months Ended                          Nine Months Ended
                                        July 31,                                    July 31,
                           2009          2008         % Change         2009          2008         % Change
 Subscriptions           $  10,774     $   9,247           16.5 %    $  30,368     $  25,691           18.2 %
 License fees                1,328         3,353          (60.4 %)       3,338         7,113          (53.1 %)
 Services:
 Professional services       1,787         2,259          (20.9 %)       5,536         6,579          (15.9 %)
 Software maintenance        2,142         3,032          (29.4 %)       6,838         9,393          (27.2 %)
 Other                         708           747           (5.2 %)       2,203         2,242           (1.7 %)
 Total Services              4,637         6,038          (23.2 %)      14,577        18,214          (20.0 %)
 Total revenues          $  16,739     $  18,638          (10.2 %)   $  48,283     $  51,018           (5.4 %)

Total revenues for the third quarter of 2009 declined 10.2% to $16.7 million, from $18.6 million for the same period in 2008.

Subscription revenues grew $1.6 million, or 16.5%, from $9.2 million in the third quarter of 2008 to $10.8 million for the same period this year. The increase in subscription revenue reflects continued growth in our base of subscription customers. As of July 31, 2009, approximately 1,350 educational institutions were subscribed to our PLE platform, up from approximately 1,100 institutions as of July 31, 2008.

Revenues from license fees on the sale of legacy perpetual license products and related software maintenance revenue totaled $3.5 million, a decline of 45.7%. The decline in license fees and software maintenance revenue reflects our declining emphasis on sales of non-strategic products licensed on a perpetual basis.

Professional services revenues declined $500,000 due to a reduction in the number of training days delivered resulting from lower training order levels in the fourth quarter of fiscal 2008 when a large portion of training orders for delivery in the upcoming school year are placed by customers..

Total revenues for the first nine months of 2009 declined 5.4% to $48.3 million from $51.0 million for the same period in 2008. Subscription revenues grew $4.7 million or 18.2%, but less than the $6.3 million decline in non-strategic license fees and software maintenance revenue on perpetual products. Professional services revenue declined $1.0 million to $5.5 million. The changes in revenue for the first nine months of the year are due largely to the same reasons as those affecting the third quarter as discussed above.

Cost of Revenue

Cost of Revenue by Category (in thousands):

                                   Three Months Ended                          Nine Months Ended
                                        July 31,                                    July 31,
                           2009          2008         % Change         2009          2008         % Change
 Subscriptions           $   4,095     $   4,593          (10.8 %)   $  12,165     $  14,058          (13.5 %)
 License fees                  611         1,540          (60.3 %)       1,467         4,060          (63.9 %)
 Services                    2,418         3,172          (23.8 %)       7,182         9,082          (20.9 %)
 Total cost of revenue   $   7,124     $   9,305          (23.4 %)   $  20,814     $  27,200          (23.5 %)

Total cost of revenue for the third quarter decreased $2.2 million to $7.1 million, or 23.4%, from the same period in 2008. Subscription cost of revenue declined $500,000 or 10.8%, on declines in software development amortization and royalty costs. The decline in amortization is due to asset impairments and reduced levels of capitalized software development spending in fiscal 2008. The decline in royalty costs relates to a royalty arrangement with a third party provider of curriculum content that was renegotiated in late fiscal 2008.

License fee cost of revenue in the third quarter declined $900,000 compared to the third quarter of 2008 due to lower product amortization, and to cost reduction initiatives undertaken in fiscal 2008. The services cost of revenue decreased 23.8% to $2.4 million from $3.2 million for the same period last year due to the lower professional services costs on lower revenue levels, and lower support costs due to our declining base of customers using our legacy perpetual products.

The total cost of revenue for the nine months ended July 31, 2009 decreased 23.5% to $20.8 million primarily due to the same reasons as those affecting the third quarter.

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.

                           Three Months Ended           Percent            Nine Months Ended           Percent
                                July 31,                Increase                July 31,               Increase
                           2009           2008         (Decrease)          2009          2008         (Decrease)
Sales and marketing     $    5,969      $   6,657            (10.3 %)   $   17,460     $  21,182            (17.6 %)
General and
administrative               2,209          2,258             (2.2 %)        6,504         7,909            (17.8 %)
Software maintenance
and development                976          1,128            (13.5 %)        2,251         3,306            (31.9 %)
Amortization of
intangibles                    214            388            (44.8 %)          640         1,163            (45.0 %)
Restructuring                    -            800           (100.0 %)            -         2,435           (100.0 %)
Total operating
expenses                $    9,368      $  11,231            (16.6 %)   $   26,855     $  35,995            (25.4 %)

Total operating expenses were $9.4 million for the third quarter of 2009, a decrease of 16.6%, or $1.9 million, from the same period in 2008. Total operating expenses for the first nine months of fiscal 2009 were $26.9 million, down $9.1 million, or 25.4%, from the same period last year. The fiscal 2008 periods include restructuring charges of $0.8 million in the third quarter and $2.4 million in the year-to date period. The absence of these charges in fiscal 2009 accounted for declines in total operating expenses of 6.4% and 5.4%, respectively. As discussed further below, the balance of the declines in both periods generally reflects the actions taken last year to streamline our cost structure and complete our transition to a software-as-a-service business model.

Sales and marketing expenses declined $700,000 for the third quarter of 2009, and $3.7 million for the first nine months, on reduced indirect sales, travel and marketing costs from the same periods in 2008. None of these declines were due to a reduction in our field direct sales force, which has remained at about the same level throughout fiscal 2008 and 2009.

General and administrative costs declined 2.2% to $2.2 million for the third quarter of 2009 from the same period in 2008 due primarily to reductions in headcount, compliance and other professional services costs. These factors combined with improved collections experience in the second quarter of 2009 that resulted in a reduction in bad debt expense were the primary contributors to the 17.8% decline in general and administrative expenses for the first nine months of the year.

Software maintenance and development expenses in the third quarter and first nine months of 2009 declined $150,000 and $1.1 million, respectively, compared to the same periods in 2008, reflecting increasing stability of our PLE platform, the quality of new product releases and reduced maintenance on legacy products. Third quarter 2009 software maintenance and development expenses also include a charge of approximately $300,000 related to the departure of our former Chief Technology Officer in the quarter.

Other (Expense) Income, Net

Other (expense) 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. The deterioration in other (expense) income from the fiscal 2008 to fiscal 2009 third quarter and year-to-date periods is primarily due to lower interest income from declining interest rates and generally lower cash balances.

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
("deferred revenue backlog"). On this basis, deferred revenue backlog was $62.7
million and $50.6 million at July 31, 2009 and 2008, respectively, as follows
(in thousands):

                                                      As of July 31,
                                             2009         2008        % Change

 Total Deferred Revenue                    $ 48,570     $ 43,324           12.1 %

 Add: Unbilled amounts due under
 non-cancelable subscription agreements      14,170        7,324           93.5 %

 Deferred Revenue Backlog                  $ 62,740     $ 50,648           23.9 %

 Components of Deferred Revenue Backlog:
 Subscriptions                             $ 51,771     $ 38,413           34.8 %

 License fees                                    99          349          (71.6 %)

 Services                                    10,870       11,886           (8.5 %)

 Deferred Revenue Backlog                  $ 62,740     $ 50,648           23.9 %

At July 31, 2009, we expect approximately $49.3 million of our deferred revenue backlog to be recognized as revenue subsequent to fiscal year 2009.

Liquidity and Capital Resources

Cash and Cash Equivalents

At July 31, 2009, cash and cash equivalents were $14.2 million, a decrease of $5.8 million from October 31, 2008. This decrease primarily represents net cash used in operations in 2009 of $2.0 million, and investments in capitalized software development of $3.4 million. Included in the $2.0 million in net cash used in operations were approximately $2.4 million in severance paid to terminated employees and a one-time payment of $1.3 million pursuant to a renegotiated royalty arrangement.

Working Capital and Liquidity

At July 31, 2009, our principal sources of liquidity included cash and cash equivalents totaling $14.2 million, net billed accounts receivable of $17.8 million, and unbilled commitments under non-cancelable subscription contracts totaling $14.2 million, of which $2.8 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 July 31, 2009 and October 31, 2008, availability under the line was $20 million and there were no borrowings outstanding.

Cash used by operations in the first nine months decreased to $2.0 million in 2009, from $3.5 million in the first nine months of 2008, due to reductions in overall spending partially offset by the $3.7 million in cash payments discussed under the caption "Cash and Cash Equivalents" above. Cash used in investing activities declined to $3.9 million for the first nine months of 2009, from $9.1 million for the same period last year reflecting a reduction in our software investment requirements.

Our future liquidity needs will depend on, among other factors, the timing and extent of software development expenditures, order volume, the timing and collection of receivables, and expenditures in connection with possible acquisitions or stock repurchases. From time to time, we may 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 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.

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 nine months ended July 31, 2009.

At July 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 July 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 July 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.