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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-Q

For the quarterly period ended September 30, 2002

For the transition period from ______________ to ______________

Commission File Number 0-32613

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 report(s), and (2) has been subject to such filing requirements for the past 90 days.

Indicate the number of shares outstanding of each of the issuer’s classes of common stock as of the latest practicable date: Common Stock, $0.01 par value, 8,381,704 shares outstanding as of November 7, 2002.

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EXCELLIGENCE LEARNING CORPORATION

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PART I: FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS.

EXCELLIGENCE LEARNING CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except for par value and share amounts)

See accompanying notes to condensed consolidated financial statements.

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EXCELLIGENCE LEARNING CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except for share and per share amounts)
(Unaudited)

See accompanying notes to condensed consolidated financial statements.

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EXCELLIGENCE LEARNING CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)

See accompanying notes to condensed consolidated financial statements.

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EXCELLIGENCE LEARNING CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

1.   The Business

Excelligence Learning Corporation (formerly known as LearningStar Corp.), a Delaware corporation (“the Company”), is a developer, manufacturer and retailer of educational products, which are sold to child care programs, preschools, elementary schools and consumers. The Company’s business is primarily conducted through its wholly-owned subsidiaries, Earlychildhood, LLC, a California limited liability company (“Earlychildhood”), Educational Products, Inc., a Texas corporation (“EPI”), and SmarterKids.com, Inc., a Delaware corporation (“SmarterKids.com”).

On May 3, 2002, the Company changed its corporate name to “Excelligence Learning Corporation” following receipt of stockholder approval of the new name at the Company’s annual meeting of stockholders held on May 1, 2002.

The Company was incorporated in the State of Delaware on November 6, 2000 for the purpose of effecting the combination of the businesses of Earlychildhood and SmarterKids.com. Prior to the combination of Earlychildhood and SmarterKids.com (the “Combination”), the Company was nominally capitalized and its balance sheet was comprised solely of common stock subscriptions receivable of $10.00 and common stock of $10.00, representing 1,000 shares of outstanding common stock at a par value of $0.01 per share. The Combination was completed on April 30, 2001 and Earlychildhood and SmarterKids.com each became a wholly-owned subsidiary of the Company.

Basis of Presentation

Immediately following the Combination, the former holders of outstanding membership interests in Earlychildhood and options to purchase membership interests in Earlychildhood owned approximately two-thirds of the capital stock of the Company and the former holders of outstanding common stock of SmarterKids.com and options to purchase shares of common stock of SmarterKids.com owned approximately one-third of the capital stock of the Company. As the former Earlychildhood members had a controlling interest in the Company immediately following the Combination, the transaction has been recorded as if Earlychildhood acquired SmarterKids.com, with Earlychildhood deemed to be the predecessor of the Company. Accordingly, the accompanying consolidated financial statements reflect the financial position and results of operations of Earlychildhood and its predecessors prior to April 30, 2001 and the financial position and results of operations of the Company thereafter. A further discussion of the Combination is included in Note 2.

RECLASSIFICATIONS

Certain reclassifications, not affecting net loss, have been made to prior year amounts in order to conform to the 2002 financial statement presentation.

INCOME TAXES

The Company is taxed as a C corporation. Prior to the Combination, Earlychildhood was a limited liability company (“LLC”) that had elected to be taxed as a partnership for federal and state income tax purposes. As an LLC taxed as a partnership, Earlychildhood’s income or loss, and deductions, were reported by its members, who were taxed on such income or loss. EPI is a C corporation and therefore is subject to federal and state income taxes. The Company’s condensed consolidated statements of operations reflect the income tax expense based on the actual tax position of the Company and its subsidiaries, Earlychildhood and EPI, in effect for the respective periods. In addition, the condensed consolidated statements of operations for the three and nine months ended September 30, 2001 reflect income tax expense (benefit), on a pro forma basis as if Earlychildhood had elected to be taxed as a C corporation for federal and state income tax purposes prior to the Combination.

RECENT ACCOUNTING PRONOUNCEMENTS

In October 2001, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, which addresses financial accounting and reporting for the impairment or disposal of long-lived assets. While SFAS No. 144 supersedes SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of, it retains many of the fundamental provisions of that Statement. The

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Company adopted the provisions of SFAS No. 144 commencing January 1, 2002. The effects of adopting SFAS No. 144 did not have a significant impact on the Company’s financial position or results of operations.

On January 1, 2002, the Company adopted SFAS No. 142, Goodwill and Other Intangible Assets. SFAS No. 142 requires that goodwill resulting from a business combination no longer be amortized to earnings, but instead be reviewed for impairment. A further discussion of the adoption of SFAS No. 142 and its effect on the Company is included in Note 5.

In May 2002, the FASB approved for issuance SFAS No. 145, Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections.  SFAS No. 145 requires gains and losses from extinguishment of debt to be classified as an extraordinary item only if the criteria in APB No. 30 have been met.  Further, lease modifications with economic effects similar to sale-leaseback transactions must be accounted for in the same manner as sale-leaseback transactions.  While the technical corrections to existing pronouncements are not substantive in nature, in some instances they may change accounting practice.  The Company plans to adopt the provisions of SFAS No. 145 required for financial statements on January 1, 2003. Once adopted the Company’s extraordinary loss for debt extinguishments will be recorded as an other expense.

In June 2002, the FASB approved for issuance SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities.  SFAS No. 146 addresses accounting and reporting for costs associated with exit and disposal activities and supercedes Emerging Issues Task Force Issue No. 94-3 (EITF 94-3), Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).  SFAS No. 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred, as defined by the Statement.  Under EITF 94-3, an exit cost was recognized at the date an entity committed to an exit plan.  Additionally, SFAS No. 146 provides that exit and disposal costs should be measured at fair value and that the associated liability will be adjusted for changes in estimated cash flows.  The provisions of SFAS 146 are effective for exit and disposal activities that are initiated after December 31, 2002. The Company is currently evaluating the impact of the provisions of SFAS No. 146.

2.   BUSINESS COMBINATION AND MERGER INTEGRATION

On November 14, 2000, Earlychildhood entered into a Contribution Agreement and Plan of Reorganization and Merger (as amended, the “Combination Agreement”) to combine with SmarterKids.com. The Combination Agreement provided for (i) the holders of all of Earlychildhood’s outstanding membership interests to contribute their entire ownership interest in Earlychildhood in exchange for common stock of the Company and (ii) S-E Educational Merger Corp., a wholly-owned subsidiary of the Company, to be merged with and into SmarterKids.com and the outstanding shares of SmarterKids.com to be converted into shares of common stock of the Company. In addition, the Combination Agreement provided for holders of options to purchase Earlychildhood membership interests to have their options exchanged for options to purchase the common stock of the Company, holders of options to purchase SmarterKids.com common stock to have their options converted into options to purchase the common stock of the Company and holders of warrants to purchase SmarterKids.com common stock to have their warrants cancelled. Immediately after the exchange, Earlychildhood’s members and option holders owned approximately two-thirds of the common stock of the Company on a fully-diluted basis.

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On April 30, 2001, the Combination was completed. The following table sets forth the Company common shares and options to purchase common shares that were issued upon completion of the Combination:

The Combination was accounted for as a purchase of SmarterKids.com by Earlychildhood. The purchase price of $49,065,000 was based on the estimated fair value of shares of the common stock of the Company and options issued upon conversion of shares of SmarterKids.com common stock and options and cancellation of SmarterKids.com warrants, plus transaction costs of $4,489,000.

The purchase price allocation is summarized as follows (in thousands):

In conjunction with the Combination, the Company terminated certain SmarterKids.com employees and determined that the acquired lease for the Needham, Massachusetts facility was an unfavorable lease. As a result, liabilities of $1,452,000 and $1,065,000 were recorded for severance and unfavorable leases, respectively.

In the fourth quarter of 2001, the Company approved a restructuring plan to aid in the reduction of operating costs. Specifically, the Company closed its Needham facility in January 2002. The closure of the Needham facility was designed to consolidate information systems and marketing functions in Monterey, California and reduce the administrative costs associated with operating an additional facility.

Restructuring and related charges of $1,773,000 were expensed in 2001. Of this amount, $1,304,000 related to exit costs associated with the Needham lease and various equipment leases that will no longer be utilized in the Company’s operations. The remaining $469,000 was related to other merger and integration costs.

During the nine months ended September 30, 2002, the Company paid $401,000 and $1,021,000 relating to severance and Needham facility costs, respectively. Of these costs, $226,000 related to severance costs for terminations announced in the first quarter of 2002 and therefore was recorded as an expense in the first quarter of 2002. During the third quarter of 2002, the Company determined that based on the current real estate market conditions in Needham, Massachusetts its assumptions for sublease income should be reduced and an additional lease abandonment charge of $653,000 was recorded in selling, general and administrative expense.

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A rollforward of activity in merger integration related liabilities included in accrued expenses follows (in thousands):

3.   UNAUDITED BASIC AND DILUTED NET INCOME LOSS PER SHARE

The basic and diluted net income per share information for the three and nine months ended September 30, 2002 included in the accompanying statements of operations is based on the weighted average number of shares of common stock outstanding during the period including shares issued in the Combination.

The following table sets forth the computation of basic and diluted net income per share for the three months and nine months ended September 30, 2002 (in thousands, except for share and per share amounts).

The unaudited pro forma basic and diluted net income (loss) per share information included in the accompanying statements of operations for the three and nine months ended September 30, 2001 reflects the impact of the exchange of all Earlychildhood membership interests for shares of the Company common stock in the Combination as of January 1, 2001, or date of issuance, if later. The per share disclosures have been calculated based on pro forma net income (loss) as if the Company had been subject to income taxes as a C corporation for the entire period.

The following table sets forth the computation of pro forma basic and diluted net income (loss) per share for the three months and nine months ended September 30, 2001  (in thousands, except for share and per share amounts).

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Potential dilutive securities of 220,870 for the nine months ended September 30, 2001 have been excluded in the computation of diluted net loss per share as the effect is anti-dilutive. Potential dilutive securities consist of shares issuable upon the exercise of stock options.

4.   SEGMENT INFORMATION

In fiscal year 2001, the Company operated in three segments, Educational Products, Fundraising and Consumer. During the first quarter of 2002, the Company renamed the Educational Products segment the Early Childhood segment and the Fundraising segment became the Elementary School segment. In addition to the name changes, the Consumer segment has become the consumer distribution channel of the Early Childhood segment and ceased being reported by the Company as a separate business segment. Prior year segment numbers have been restated to reflect this change. The Consumer segment was created as a result of the Combination and therefore not part of the Company in the first quarter of 2001. The Early Childhood segment includes the brand names Discount School Supply, SmarterKids.com, and Earlychildhood NEWS. The Early Childhood segment develops, manufactures and sells educational products through multiple distribution channels to early childhood professionals and parents. The Early Childhood segment also provides information to teachers and other education professionals regarding development of children from infancy through age eight. The Elementary School segment sells school supplies and other products specifically targeted for use by children in first through sixth grade to elementary schools, teachers and other education organizations for fundraising activities.

The accounting policies of the reportable segments are the same as those described in the summary of significant accounting policies in the Company’s annual report filed on Form 10-K. There were no intersegment sales. The Company’s profit measure is Adjusted EBITDA which represents operating income (loss) adding back depreciation and amortization, stock compensation, website impairment and merger integration charges. Merger integration charges for the three and nine months ended September 30, 2002 relate to the closure of the Needham, Massachusetts facility. In the first quarter of 2002, the Company recorded an expense of $226,000 related to severance for Needham facility employees who were terminated. In the third quarter of 2002, the Company recorded a charge of $653,000 related to the lease abandonment. This charge was primarily based on the excess of required lease payments over estimated sublease income. Merger integration charges of $187,000 and $543,000 for the three and nine months ended September 30, 2002, respectively, were primarily one-time charges for professional services that were necessary for integration after the merger. Adjusted EBITDA information should not be considered as an alternative to any measure of performance as promulgated under generally accepted accounting principles (such as operating income or income before extraordinary items) nor should it be considered as an indicator of the Company’s overall financial performance. The calculations of Adjusted EBITDA may be different from the calculations used by other companies and therefore comparability may be limited. The Company will continue to use Adjusted EBITDA throughout 2002 for comparative purposes against 2001. Beginning with the first quarter of 2003, the Company plans to replace Adjusted EBITDA as its measure of operating performance with EBITDA and/or net income. EBITDA is calculated by adding back to operating income (loss) depreciation and amortization. Revenues by segment and reconciliation of operating income (loss) to Adjusted EBITDA follows (in thousands):

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The Early Childhood segment performs limited administrative activities, including certain accounting and information system functions on behalf of the Elementary School segment. Such intersegment charges are based on estimates of its actual costs for such activities. Intersegment charges have been eliminated in the consolidation and amounted to $144,168 and  $-0- for the three months ended September 30, 2002 and 2001, respectively and $432,504 and $45,000 for the nine months ended September 30, 2002 and 2001, respectively.

The segment asset information available is as follows (in thousands):

5. GOODWILL AND INTANGIBLES

On January 1, 2002, the Company adopted SFAS No. 141, Business Combinations and SFAS No. 142, Goodwill and Other Intangible Assets. SFAS No. 141 requires that the purchase method of accounting be used for all business combinations and that certain acquired intangible assets be recognized as assets apart from goodwill. SFAS No. 142 provides that goodwill should not be amortized but instead be tested for impairment annually at the reporting unit level.

The Company reevaluated its intangible asset lives and no adjustments to the useful lives were determined to be necessary. In accordance with SFAS No. 142, the Company completed a transitional goodwill impairment test as of January 1, 2002 in the second

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quarter of 2002 and determined no additional impairment charge was necessary. Going forward, the annual impairment test required by SFAS No. 142 will be performed in the 4th quarter. No reclassification of intangible assets was necessary as a result of the adoption of SFAS No. 142.

The following table identifies the major classes of intangible assets at September 30, 2002 (in thousands):

Total amortization expense on intangible assets was approximately $72,000 and $216,000 for the three and nine months ended September 30, 2002, respectively.

The carrying amount of goodwill was $4,701,000 at September 30, 2002 and December 31, 2001. There was no impairment loss recorded during the three or nine months ended September 30, 2002.

The following table reflects the consolidated results of operations adjusted as though the adoption of SFAS No. 142 occurred at January 1, 2001 (in thousands, except per share amounts):

6. DEBT

On April 30, 2001, the Company entered into a secured credit facility with GMAC Business Credit, LLC (the “GMAC Facility”). At the same time, Earlychildhood repaid its obligations aggregating $16.4 million under its then-existing credit facility with BNP Paribas (the “Paribas Credit Facility”) and the Paribas Credit Facility was terminated.

The GMAC Facility includes a $25 million line of credit with a maturity of April 30, 2004, an interest rate of LIBOR plus 3.0% (6.5% at September 30, 2002) and, except as described in the following paragraph, a minimum excess availability requirement of $4 million

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at all times, which effectively limits the Company’s borrowing capacity to a maximum of $21 million. The GMAC Facility has a credit limit at any time of an amount equal to the sum of 80% of the aggregate face amount of eligible accounts receivable plus the lowest of (i) 50% of the Company’s inventory; (ii) 85% times net liquidation percentage of inventory (the liquidation percentage is periodically set by the lender); or (iii) the result of $18 million minus the eligible portion of EPI’s inventory. The credit line also requires adherence to certain financial covenants and restrictions on capital expenditures during the term of the GMAC Facility. As of September 30, 2002, the Company had no amounts outstanding with an available borrowing capacity of $14.7 million under the GMAC Facility.

The GMAC Facility requires adherence to certain financial covenants and contains restrictions related to capital expenditures during the term of the facility. As of December 31, 2001, the Company was in violation of one of the financial covenants under the GMAC Facility. On March 13, 2002, the Company entered into an amendment to the GMAC Facility, pursuant to which GMAC waived the covenant violation and reset the financial covenants. On March 21, 2002, the Company entered into a second amendment to the GMAC Facility, pursuant to which GMAC reduced the minimum excess availability requirement from $4.0 million to $2.5 million through July 31, 2002, thus providing additional availability of $1.5 million during the Company’s peak inventory purchasing season. In connection with the second amendment, the Company’s Chief Executive Officer agreed to guarantee up to $500,000 of additional loan availability under the GMAC Facility. On July 31, 2002, the minimum excess availability requirement was reset to $4.0 million and the guarantee by the Chief Executive Officer expired.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

The following discussion contains forward-looking statements that involve risks and uncertainties that could significantly affect anticipated results in the future. Those risks and uncertainties include, but are not limited to, (1) changes in general economic and business conditions and in e-retailing, or the educational products industry in particular, (2) the impact of competition, including the development of competing proprietary products by the Company’s competitors, (3) the level of demand for the Company’s products, (4) fluctuations in the value of the U.S. dollar and (5) the Company’s inability to diversify its product offerings and expand in new and existing markets.  Excelligence Learning Corporation makes these forward-looking statements under the provision of the “Safe Harbor” section of the Private Securities Litigation Reform Act of 1995. Actual results may vary materially from those projected, anticipated or indicated in any forward-looking statements. In this Form 10-Q, the words “anticipates,” “believes,” “expects,” “intends,” “future,” “could,” and similar words or expressions (as well as other words or expressions referencing future events, conditions, or circumstances) identify forward-looking statements. The Company assumes no obligation to update publicly any forward-looking information, whether as a result of new information, future events or otherwise, except to the extent the Company is required to do so in connection with its ongoing requirements under Federal securities laws to disclose material information.  The following discussion and analysis should be read in conjunction with the financial statements and related notes included elsewhere in this Quarterly Report on Form 10-Q.  Investors should also refer to  Item 3 —“Risk Factors” in the Company’s Annual Report on Form 10-K for a discussion of various risk factors relating to the Company’s business.  Given these risks and uncertainties, we can give no assurance that any forward-looking statements, which speak only as of the date of this report, will in fact transpire and, therefore, we caution investors not to place undue reliance on them.

OVERVIEW

The Company was incorporated in the State of Delaware on November 6, 2000 for the purpose of effecting the Combination. Prior to the Combination, the Company was nominally capitalized and its balance sheet was comprised solely of common stock subscriptions receivable of $10.00 and common stock of $10.00, representing 1,000 shares of outstanding common stock at a par value of $0.01 per share. The Combination was completed on April 30, 2001 and Earlychildhood and SmarterKids.com each became a wholly-owned subsidiary of the Company.

Immediately following the Combination, the former holders of outstanding membership interests in Earlychildhood and options to purchase membership interests in Earlychildhood owned approximately two-thirds of the capital stock of the Company and the former holders of outstanding common stock of SmarterKids.com and options and warrants to purchase shares of common stock of SmarterKids.com owned approximately one-third of the capital stock of the Company. As the former Earlychildhood members had a controlling interest in the Company immediately following the Combination, the transaction has been recorded as if Earlychildhood acquired SmarterKids.com, with Earlychildhood deemed to be the predecessor of the Company. Accordingly, the following discussion addresses the results of operations of Earlychildhood and its predecessor prior to April 30, 2001 and the financial position and results of operations of the Company thereafter. A further discussion of the Combination is included under “Combination with SmarterKids.com” below.

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The Company is a developer, manufacturer and retailer of educational products, which are sold to child care programs, preschools, elementary schools and consumers. Through a predecessor entity, the Company began operations in 1985. The Company utilizes multiple sales, marketing and distribution channels, including:

All of the foregoing is supported by a national sales force which, as of September 30, 2002, numbered 60 people.

On May 3, 2002, the Company changed its corporate name to “Excelligence Learning Corporation” following receipt of stockholder approval of the new name at the Company’s annual meeting of stockholders held on May 1, 2002.

In fiscal year 2001, the Company operated in three segments, Educational Products, Fundraising and Consumer. During the first quarter of 2002, the Company renamed the Educational Products segment the Early Childhood segment and the Fundraising segment became the Elementary School segment. In addition to the name changes, the Consumer segment has become the consumer distribution channel of the Early Childhood segment and ceased being reported by the Company as a separate business segment. The Early Childhood segment includes the brand names Discount School Supply, SmarterKids.com and Earlychildhood NEWS. The Early Childhood segment develops, manufactures and sells educational products through multiple distribution channels to early childhood professionals and parents. The Early Childhood segment also provides information to teachers and other education professional regarding the development of children from infancy through age eight. The Elementary School segment sells school supplies and other products specifically targeted for use by children in first through sixth grade to elementary schools, teachers and other education organizations for fundraising activities.

COMBINATION WITH SMARTERKIDS.COM

On November 14, 2000, Earlychildhood entered into the Combination Agreement to combine with SmarterKids.com. The Combination Agreement provided for (i) the holders of all of Earlychildhood’s outstanding membership interests to contribute their entire ownership interest in Earlychildhood in exchange for the Company common stock and (ii) S-E Educational Merger Corp., a wholly-owned subsidiary of the Company, to be merged with and into SmarterKids.com and the outstanding shares of SmarterKids.com to be converted into shares of common stock of the Company. In addition, the Combination Agreement provided for holders of options to purchase Earlychildhood membership interests to have their options exchanged for options to purchase the Company common stock, holders of options to purchase SmarterKids.com common stock to have their options converted into options to purchase the Company common stock and holders of warrants to purchase SmarterKids.com common stock to have their warrants cancelled. Immediately after the exchange, Earlychildhood’s members and option holders owned approximately two-thirds of the Company common stock on a fully-diluted basis.

On April 30, 2001, the Combination was completed. The following table reflects the Company’s common shares and options to purchase common shares which were issued upon completion of the Combination:

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