Forward-Looking Statements

This Report contains statements that constitute "forward-looking statements" within the meaning of Section 21E of the Securities Exchange Act of 1934. The words "expect," "estimate," "anticipate," "predict," "believe," and similar expressions and variations thereof are intended to identify forward-looking statements. Such statements appear in a number of places in this filing and include statements regarding the intent, belief, or current expectations of Peoples Educational Holdings, Inc. (the "Company"), its directors or officers with respect to, among other things, (a) trends affecting the financial condition or results of operations of the Company and (b) the business and growth strategies of the Company. These forward-looking statements involve a number of risks and uncertainties, including (1) demand from major customers,
(2) effects of competition, (3) changes in product or customer mix or revenues and in the level of operating expenses, (4) rapidly changing technologies and our ability to respond thereto, (5) the impact of competitive products and pricing, (6) local and state levels of educational spending, (7) ability to retain qualified personnel, (8) ability to retain our distribution agreements with our major college publishers in the College Preparation market, (9) the sufficiency of our copyright protection, and (10) ability to continue to rely on the services of third party warehouses, and other factors as discussed elsewhere in this report or in our other filings with the SEC. The potential investors and shareholders of the Company are cautioned not to put undue reliance on such forward-looking statements. Such forward-looking statements are not guarantees of future performance and involve risks and uncertainties, and actual results may differ materially from those projected in this Annual Report, for the reasons, among others, discussed in the Section "Management's Discussion and Analysis of Financial Condition and Results of Operations." The Company undertakes no obligation to publicly revise these forward-looking statements to reflect events or circumstances that arise after the date hereof.

Critical Accounting Estimates

Our critical accounting estimates are summarized in the footnotes to our consolidated financial statements. Some of our accounting estimates require management to exercise significant judgment in selecting the appropriate assumptions for calculating financial estimates. These judgments are subject to an inherent degree of uncertainty. These judgments are based on our historical experience, known trends in our industry, terms of existing contracts, and other information from outside sources, as appropriate. Actual results may differ from these estimates under different assumptions and conditions. The most critical accounting estimates that require significant judgment are as follows:

Revenue Recognition and Allowance for Returns

Revenue is recognized when products are shipped, the customer takes title and assumes risk of loss, and collection of the related receivable is probable. The allowances for returns as of May 31, 2012 and 2011 were approximately $33,000 and $174,000, respectively. These allowances are recorded at the time of revenue recognition, if the right of return exists, and are recorded as a reduction of accounts receivable. This allowance is estimated by management based on our historical rate of returns. We recognize shipping and handling revenues as part of revenue, and shipping and handling expenses as part of cost of revenue on the consolidated statements of operations. Subscription based revenue on our digital products is recognized prorata over the life of the subscription agreement.

Deferred Prepublication Costs

Deferred prepublication costs are recorded at their original cost and amortized over a three or five-year period, based on the estimated lives of the related publications. The net carrying value of the deferred prepublication costs is periodically reviewed and compared to an estimate of future net undiscounted cash flows. As of May 31, 2012, the valuation allowance as compared to last year remained unchanged at $137,000. If future net undiscounted cash flows are not sufficient to realize the net carrying value of the asset, an impairment charge will be recognized.

Allowance for Doubtful Accounts

Credit to our customers is determined on a customer-by-customer basis. Trade receivables are carried at original invoice amount less an estimate made for the doubtful receivables based on a review of all outstanding amounts on a monthly basis. We determine the allowance for doubtful accounts after reviewing individual customer accounts as well as considering both historical and expected credit loss experience. Trade receivables are written off when deemed uncollectible. Recoveries of trade receivables previously written off are recorded when received. The allowance for doubtful accounts was $10,000 at both May 31, 2012 and 2011 and is believed to be adequate for any exposure to loss.

Allowance for Excess and Slow-Moving Inventory

We continuously monitor our inventory on hand for salability. This monitoring includes review of historical sales experience, projected sales activity by title, and any planned changes to a title that are known by us. Any inventory identified as slow-moving or non-salable is reserved or written down at that time. The reserves of approximately $2,365,000 and $896,000 at May 31, 2012 and 2011, respectively, are believed to be adequate to cover inventory loss exposure.

Income Taxes

We evaluate deferred tax assets for impairment on a quarterly basis. During the fourth quarter, we increased our deferred tax assets reserve by $4.2 million, resulting in a total reserve of $5.2 million or 100% of the gross deferred tax assets. This was based on a variety of factors, including our fourth quarter and full fiscal 2012, prior year's performance and our expected future performance. We considered all evidence currently available, both positive and negative, in determining, based on the weight of that evidence, the likelihood that the deferred tax asset would be realized. During that review, we determined that the level of our recent historical losses outweighed our forecasted taxable earnings levels for the near and long term. As such, we established a 100% deferred tax valuation allowance. Future profitability would enable us to reduce the valuation allowance and thereby offset income tax expense that would otherwise be recognized.

Stock-Based Compensation Expense

We recognize compensation expense based on the grant-date fair value of the awards. Compensation expense for stock options is recognized over the vesting period of the award. The grant-date fair value of the stock options is determined using the Black-Scholes option-pricing model, using assumptions determined by management to be appropriate. For stock options granted during fiscal year 2012, we used a term of 5 years, volatility of 45% to 46%, and a risk free rate of 0.8% to 1.1%, resulting in a grant-date fair value of $0.28 to $0.37 per share. For the fiscal year ended May 31, 2012, stock-based compensation expense was approximately $206,000.

Year Ended May 31, 2012 vs. Year Ended May 31, 2011



NET REVENUE



(In Thousands)                                       Year Ended May 31,
                                                      2012          2011       Variance       Variance %
Test Preparation, Assessment and Instruction       $   13,661     $ 17,421     $  (3,760 )          -21.6 %
College Preparation                                    11,082       11,612          (530 )           -4.6 %
Literacy                                                  906        2,237        (1,331 )          -59.5 %
               Total Net Revenue                   $   25,649     $ 31,270     $  (5,621 )          -18.0 %

Test Preparation, Assessment, and Instruction

Revenue for this product group for the year was $13.7 million, compared to $17.4 million during the same period in the prior year. Test Preparation and Assessment revenue was $12.2 million, a decrease of $3.3 million from the prior year, while Instruction revenue was $1.5 million, a decline of $430,000 compared to the prior year. The revenue shortfall is primarily due to a decline in one of the states in which we publish state-specific materials. This state is in the process of transitioning to new standards and new tests and during such transitions, schools and districts have reduced their expenditures from historical levels until the transition is complete. Although this change has had a short-term impact on our revenue, it creates future opportunities as educators are in need of products supporting these new standards and test. We recently released materials for the End of Course (EOC) exit exams in this state. This is the first year these EOC tests will count toward graduation, and there is a significant amount of attention from educators to prepare students for these tests. The initial feedback from the market on our EOC products has been favorable.

College Preparation

College Preparation revenue for the current year was $11.1 million, a decline of $530,000 from the prior year. Revenue decline is primarily due to the effects of decreased school spending as a result of school budget cuts. However, we are optimistic about the opportunities for future growth in this market niche and will continue to invest in new proprietary product development for this segment.

Literacy

Revenue for this group was $906,000, compared to $2.2 million in the prior year. Revenue from this product group was affected significantly due to a decrease in federally funded literacy initiatives, specifically ARRA funding (American Recovery and Reinvestment Act of 2009) which was a funding source utilized by customers.

COST OF REVENUE

Cost of Revenue for fiscal 2012 was $20.6 million (80.4% of revenue), compared to $18.5 million (59.2% of revenue) in the prior year.

Cost of revenue consists of two components: direct costs and amortization of prepublication costs. Direct costs consist of (1) product cost, which includes paper, printing, and binding for proprietary print products and product purchases for nonproprietary products, (2) web-hosting fees for our digital products, (3) royalties on proprietary products, and (4) warehousing and shipping costs for all non-digital products.

· Direct costs as a percentage of revenue for fiscal 2012 were 51.8%, an increase from 42.0% in the prior year. The percentage decrease is due to two factors, a shift in product revenue mix and an increase in inventory reserves. During the current year College Preparation revenue, which consists primarily of non-proprietary product represented 43% of revenue, an increase from 37% in the prior year. In addition, due to the beginning of shift in most states from state-specific standards to the common core standards, and the trends in the literacy market, we increased our inventory reserve and recognized $1.5 million of additional expense during the current year compared to the prior year.

· Prepublication costs include one-time expenses associated with developing and producing new or revised proprietary products. It includes all development expenses, including but not limited to writing, design, art, permissions, software development and any other costs incurred up to the release date of the product in print and/or digital format. Prepublication costs are capitalized and expensed on a straight-line basis over a three- or five-year period, based upon the product. We believe our amortization policy is in line with industry practice. For fiscal 2012, amortization expense was $7.4 million and included $2.4 million of accelerated amortization, primarily related to our digital products. Amortization expense in the prior year was $5.4 million. The $2.4 million of accelerated amortization was primarily due to the write-down of underperforming older versions of digital assets.

SELLING, GENERAL AND ADMINISTRATIVE EXPENSES



(In Thousands)                                         Year Ended May 31,
                                                        2012          2011       Variance       Variance %
Selling and Marketing Expense                        $    7,675     $  8,871     $  (1,196 )          -13.5 %
General and Administrative Expenses                       4,648        4,392           256              5.8 %
Total Selling, General and Administrative Expenses   $   12,323     $ 13,263     $    (940 )           -7.1 %

Selling, general, and administrative (SG&A) expenses for fiscal 2012 were $12.3 million, which was a decline of 7.1% from the prior year. As a percentage of revenue, SG&A expenses for fiscal 2012 were 48.0%, an increase of 5.6 percentage points from the prior year.

Selling and Marketing expenses for fiscal 2012 were $7.7 million, a decline of $1.2 million and 13.5% from the prior year. Selling expenses decreased $911,000 primarily due to decreased revenue, resulting in lower selling commissions. Marketing expenses decreased $284,000 primarily due to lower catalog and promotion expense, offset by higher product sampling.

General and Administrative expenses for the year were $4.6 million, an increase of $256,000 and 5.8% from the prior year. The increase is primarily due to the write-off of selected trademarks.

INTEREST EXPENSE

Interest expense for the year was $313,000, which was comparable to the prior year.

INCOME TAX EXPENSE

Despite the net loss before taxes of $7.7 million, we recorded tax expense in the current year of $1.6 million as a result of the decision to fully-reserve for the company's $5.2 million deferred tax asset. For the year ended May 31, 2012, the effective tax rate was 38%.

NET LOSS

In fiscal 2012 we had a net loss of $9.3 million or $2.09 per share compared to a net loss of $0.5 million and $0.12 per share in the prior year. As a result of changes in the supplemental education market, specifically the transition to the Common Core Standards, we incurred additional inventory and prepublication amortization expense totaling $3.8 million. In addition, due to the decision to fully reserve for the Company's deferred tax assets, we incurred tax expense of $1.6 million in the current year instead of a benefit of $2.8 million.

LIQUIDITY AND CAPITAL RESOURCES

Net cash provided by operating activities for fiscal 2012 was $2.9 million, compared to $5.3 million in the prior year. Net cash provided by operating activities in 2012 was primarily provided by the decrease in accounts receivable, inventory, and prepaid marketing expenses offset by a decrease in accounts payable and accrued expenses.

Net cash used in investing activities, consisting primarily of expenditures for prepublication costs, was $2.9 million for fiscal 2012, which was $2.1 million lower than the prior year. The decrease from the prior year was a result of lower prepublication expenditures.

Net cash provided by financing activities was $727,000 for fiscal 2012 consisting of $2.3 million of borrowing under the line of credit, offset by $1.6 million in principal payment on long term debt.

We have a Credit Facility ("Facility") with Sovereign Bank ("Sovereign"). At May 31, 2012, the Facility consisted of a Revolving Line of Credit ("Revolver") that provided for advances up to $9.0 million, all of which was outstanding, and a Term Loan originally in the amount of $10.0 million, of which $1.95 million was outstanding. On August 15, 2012, we entered into an amendment to the Facility with Sovereign that extends the maturity date of the $9.0 million Revolver and the $1.95 million Term Loan from December 31, 2012 to June 30, 2013. At August 15, 2012, $9.0 million was outstanding under the Revolver and $-0- was available for borrowing. Our borrowings from Sovereign are secured by substantially all of the Company's assets.

The amendment also changed the interest rate under the Revolver to 6.25% through December 31, 2012, and 9.0% thereafter, interest is payable monthly. Prior to the amendment, the interest rate on the Revolver was based on LIBOR plus an interest rate spread of 2.0% to 2.25% through August 10, 2011, 2.75% to 3.00% through June 30, 2012, and 3.00% to 3.25% through August 15, 2012, with the exact interest rate based on the ratio of total funded debt to EBITDA. At May 31, 2012, the interest rate on the Revolver was 3.15%.

The Term Loan, as amended, provides for principal payments in the amount of $450,000 on August 31, 2012, which was paid, $250,000 on October 1, 2012, and November 1, 2012, and $167,000 on the first day of each month thereafter. Interest is payable monthly at the same rate as on the Revolver.

In June 2010, we entered into a swap agreement with respect to interest on $3 million then outstanding under the Term Loan, fixing our interest rate at 1.25% plus an interest rate spread of 2.00% to 2.25% based on the ratio of total funded debt to EBITDA. The swap agreement expired in February 2012.

The amended Facility contains certain financial covenants, calculated on a consolidated basis for the Company and its subsidiary, which, among other things, impose minimum levels of EBITDA, calculated monthly on a cumulative basis. These financial covenants restrict the payment of dividends on the Company's common stock. In addition, the Company has agreed to take certain actions to obtain additional funding from sources other than Sovereign by October 1, 2012, to support its operations, and has agreed to take certain steps to cover any projected operating deficits if such financing is not obtained. We anticipate that such additional funding will be in the form of subordinated debt. We were not in compliance with certain of the covenants under the credit agreement at May 31, 2012, but such non-compliance was waived by Sovereign in connection with entering into the amended credit agreement.

We believe that our cash and anticipated subordinated debt financing, together with cash generated from operations, will be sufficient to meet our normal cash needs in fiscal 2013. If we do not obtain the anticipated subordinated debt financing or other financing, we may be required to curtail portions of our operations. Subject to the availability of such financing, we intend to continue investing in prepublication costs for our proprietary products at our current spending level.

PRODUCT DEVELOPMENT

Product development expenditures in fiscal 2012 and 2011 were $2.8 million and $4.8 million respectively. We continue to actively develop new and revised products. We expect the current level of spending to continue in the future. Product development expenditures in 2012 consisted primarily of both print and digital products within the Testing, Assessment and Instruction product group, as we continued to introduce new and revised products within our existing states. The state test preparation market is changing with the adoption of the CCSS. However, the current high-stake tests will continue to be administered until 2014/2015, and there will continue to be a demand for higher academic performance from students. Our product development plan will reflect the market need to support the state-specific needs as it reflects the test in place today as well as the potential future needs as a result of the adoption and implementation of the CCSS. We also intend to expand our offering of web-based digital products. Presently, we publish Test Preparation and Assessment products for various grades in ten states and CCSS products on a national basis.

We will continue to produce proprietary college preparation supplements and ancillary materials. These products will be crafted as supplements to help teachers and students with their college preparation studies and will not compete with products we distribute under our existing publisher agreements.

We do not have plans in the upcoming year to develop new products for our Literacy product line. Our strategic growth plan calls for an emphasis on the internal development of products within the Test Preparation, Assessment and Instruction product lines. Under favorable circumstances, we would consider an acquisition to supplement our growth plan.

OFF-BALANCE SHEET ARRANGEMENTS

NONE

SEASONALITY

The supplementary education business is seasonal, cycling around the school year that runs from September through May. Typically, the major marketing campaigns, including mailings of new catalogs and focused sales efforts, begin in September when schools reopen. General marketing efforts, including additional sales and marketing campaigns, catalog mailings, and complimentary copies, continue throughout the school year. Teachers and districts generally review and consider products throughout the school year, make their decisions in the winter and spring, and place their purchase requests at that time.

Each of our product lines has its own seasonality. The average revenue percentage over the past two fiscal years by quarter is summarized in the table below.

                                         1st          2nd           3rd          4th
                                       Quarter      Quarter       Quarter      Quarter
                                        Ended        Ended         Ended        Ended
                                      August 31   November 30   February 28    May 31
Test Preparation, Assessment and
Instruction                              31%          22%           22%          25%
College Preparation                      63%          15%           6%           16%
Literacy                                 40%          18%           14%          28%
Total Revenue                            40%          18%           14%          28%