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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-K

COMMISSION FILE NUMBER 0-28977

VARSITY GROUP INC.
(Exact name of registrant as specified in its charter)

1850 M Street, NW, Suite 1150
WASHINGTON, D.C. 20036
(Address of principal executive offices) (Zip Code)

Registrant’s telephone number, including area code: (202) 667-3400

SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NONE

SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:

COMMON STOCK, $.0001 PAR VALUE

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes  [X]  No  [  ]

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [  ]

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes  [  ]  No  [ X ]

The aggregate market value of common stock held by non-affiliates of the registrant was $14,226,035 based on the last reported sale price of $1.80 on March 25, 2003.

As of March 25, 2003, there were 16,475,625 shares of common stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

The registrant intends to file a definitive Proxy Statement for its Annual Meeting of Stockholders pursuant to Regulation 14A within 120 days of the end of the fiscal year ended December 31, 2002. Portions of such proxy statement are incorporated by reference into Part III of this report.

Forward-Looking Statements

This Annual Report on Form 10-K (“Form 10-K”) contains forward-looking statements within the meaning of Section 27A of the Securities and Exchange Act of 1934, which statements can be identified by the use of forward looking terminology, such as “may”, “will”, “expect”, “anticipate”, “estimate”, or “continue” or the negative thereof or other variations thereon or comparable terminology. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of many factors, including those set forth elsewhere in this Form 10-K. See the “Risk Factors” section of Item 1 “Business” for cautionary statements identifying important factors with respect to such forward-looking statements, including risks and uncertainties, that could cause actual results to differ materially from results referred to in forward-looking statements.

PART I

ITEM 1.      BUSINESS

GENERAL

We are an online retailer of textbooks and educational materials targeting the private middle and high schools, colleges, and distance and continuing education markets. Through eduPartners, our program serving schools directly, we offer educational institutions an online bookstore solution that allows them to focus their resources on the education process while offering their students the speed and convenience of purchasing their textbooks and other learning materials online. EduPartners was the first online bookstore solution focused on meeting the needs of private middle and high schools nationwide. As of March 2003, we serve over 160 educational institutions through our eduPartners program.

Each eduPartners school has a personalized virtual bookstore hosted on our website that contains the required and optional educational materials selected by their school organized by grade, academic discipline and class. Student and parent customers from our eduPartners schools access their co-branded bookstore via a direct link from their school’s homepage or searching for their school bookstore link by region and state on our homepage located at www.varsitybooks.com. Once they reach the entry page to their customized online bookstore, the customers can navigate the site by clicking on the appropriate grade, discipline and class to select required and optional books.

EduPartners schools benefit from the decreased costs, inconveniences and inefficiencies inherent in the seasonal business of purchasing, inventory management and selling learning materials directly to students on campus. In addition, eduPartners schools have access to our unique program administration website that provides them with sales and inventory reports, among other valuable features. Student and parent customers value the convenience of our online shopping experience and take comfort in the knowledge that our posted booklists have been reviewed for content and accuracy and approved by their school.

Throughout 2002, we have continued the transformation of our business to a profitable and scalable enterprise. During the year ending December 31, 2002, we recorded the first profitable fiscal year in the history of our company and second consecutive fiscal year with positive cash flow from operations. We have continued to grow eduPartners, expanding our nationwide network of schools at a compounded annual growth rate of over 86% during the last three years.

Our overall success and ability to maintain and increase profitability from operations will depend, in part, upon our ability to attract additional schools to our eduPartners program, provide a compelling and satisfying shopping experience to our retail customers and manage our relationship with our fulfillment partner, Baker and Taylor, a leading distributor of books, videos and music products. Disruption in the supply of these services during our busy selling season could materially harm our business. The controlling shareholder of Baker & Taylor was a 13% owner of the Company’s outstanding common stock at December 31, 2002.

Substantially all of the Company’s computer and communications hardware and software systems are located at a single facility that is owned, maintained and serviced by a third party. Any damage, failure or delay that causes interruptions in the Company’s systems operations could materially harm the Company’s business.

In 2002, as part of our commitment to providing our customers superior service and products, we offered our customers the opportunity to purchase used textbooks as part of their eduPartners buying experience. While new textbooks represent the overwhelming majority of our textbook revenues, our used book offering was an important step toward the continued growth and extension of eduPartners. As we grow eduPartners, we will continue to look for opportunities to enhance and improve the attractiveness of our core textbook offering and further extend these school relationships into new sources of profitable revenue.

Finally, we must continue to attract and retain experienced personnel to effectively grow and maintain our business.

Varsity Group Inc. was founded in 1997. We are a Delaware corporation with our principal executive offices located at 1850 M Street, NW, Suite 1150, Washington, D.C. 20036, and our telephone number is 202.667.3400.

We have not historically provided website access to our periodic and current reports because it was our belief that these were conveniently available online through the Securities and Exchange Commission’s Electronic Data Gathering, Analysis and Retrieval (EDGAR) system and website located at http://www.sec.gov. However, commencing with the filing of this document, we will make this information available, free of charge, on our website located at http://www.varsity-group.com as soon as reasonably practicable after it is filed with the Commission.

MARKET OVERVIEW

The retail textbook market is presently dominated by on-campus bookstores, with most educational institutions either operating their own bookstore or contracting these services to a third party. However, both selling and purchasing new textbooks through traditional retail outlets can be expensive and inconvenient.

Each year students and parents often face the prospects of long lines, inconvenient bookstore hours of operation and out-of-stock inventory problems causing delays and necessitating multiple trips to the bookstore.

Educational institutions also face many challenges associated with operating an efficient and profitable bookstore on campus. These challenges are exacerbated at smaller schools where operating economies of scale are not present and profitability is more difficult to achieve. This is particularly true at the private middle and high school market, where there is typically only one major textbook buying season (Fall back-to-school) and clothing, school supplies and electronic sales are limited or non-existent.

Online commerce provides the opportunity to better serve and more efficiently reach the college and private middle and high school student markets. We believe that, for a variety of reasons, few businesses have succeeded in offering students a comprehensive solution tailored to meet their varied needs in a convenient and cost-effective manner.

The private school market represents approximately 10% of all elementary and secondary students and 25% of all elementary and secondary schools, according to the National Center of Education Statistics (NCES). More than 5.2 million students are enrolled in private schools, with approximately 2.84 million students in elementary level schools, 830,000 students in secondary level schools and 1.55 million students in combined elementary and secondary level schools. Almost half of all private school students attend schools that are located in urban areas. According to the Council on American Private Education, secondary school enrollment is expected to increase as much as 8% between 2000 and 2006.

Based upon market research conducted by us, we believe there are at least 2,200 private middle and high schools nationwide that present an excellent fit with the strengths and benefits or our eduPartners model. Factors we considered in our research include school policy requiring students to purchase their own textbooks, school enrollment, the absence of state subsidy of textbooks. We believe less than 200 schools in this segment had adopted an online textbook solution similar to our eduPartners model by the start of the 2002 back-to-school selling season.

The college student market is large and growing. The U.S. Census Bureau reports that there are 15.5 million undergraduate and graduate students at more than 4,000 colleges and universities in the United States. According NCES, college enrollment will increase to approximately 16 million students by 2008.

Although the college market is large and diverse, students still have common needs. For instance, students typically must buy expensive school related goods and services such as textbooks and school supplies. In fact, textbooks are most students’ single largest school related expenditure after tuition, room and board. The Almanac 2000-2001 reports that the average expense per college student for books and supplies is $625 to $700, and does not vary significantly between two and four year colleges, or private and public institutions. Overall textbook and course material sales were approximately $7.1 billion in the academic year 2000-2001, based on statistics published by the National Association of College Stores.

STRATEGY

Build a Significant and Profitable Retail Book Business.

During the last three years we have taken the steps necessary to create an online book business with significant growth potential and the ability to deliver contribution dollars sufficient to reach annual operating profitability. We have succeeded in growing our network of eduPartners schools year over year while maintaining strong margins and growing revenues much faster than increases in marketing, sales and overhead expenses. We will look to extend our current leadership position in the private middle and high school marketplace while expanding our presence in the higher education and distance learning markets.

Increase the Number of eduPartners.

We intend to continue to invest in the development of eduPartners and expand our reach into private middle and high schools, traditional two and four year colleges, distance learning and other continuing education programs. Our eduPartners program was

the first online bookstore solution focused on meeting the needs of private middle and high schools nationwide. The number of eduPartners schools has grown from approximately 20 schools during the 1999 Fall back-to-school season to over 130 schools in 2002, representing an 86% compounded annual growth rate over the last three years. We have eduPartners schools located in many key markets nationwide and are aggressively targeting remaining areas to establish a comprehensive nationwide network of member schools. We have been successful extending our presence in new markets by leveraging the positive experience and word-of-mouth generated once our initial account in that market has completed a successful back-to-school selling season.

THE VARSITY SOLUTION

We provide students, parents and schools with a reliable and convenient alternative to the traditional campus bookstore model. We are able to reduce the overhead associated with textbook sales because we do not maintain individual stores and we outsource our ordering, inventory, warehousing and fulfillment needs to Baker & Taylor. In addition to providing new textbooks at competitive prices, we are committed to providing best-in-class customer service, dedicated account management, customized websites for each partner school and same-day shipment of orders.

eduPartners

Through eduPartners, we provide an opportunity for educational institutions to maximize their resources and offer increased convenience to their students by outsourcing new textbook sales to us. We believe that for many schools the expense and inconvenience of maintaining a bookstore exceed the schools’ financial return. We provide an innovative solution for schools and enable them to offer increased convenience and value to students, their parents, and the entire school community. Our program has been uniquely designed to meet the needs of these schools and a number of compelling program features and benefits for schools, students and parents alike. These include:

	•		Dedicated account managers to serve schools;
	•		Customized online bookstores featuring detailed course and book information;
	•		Communications and training materials for each school community;
	•		Innovative website program management tools providing school administrators access to sales and inventory reports;
	•		Convenience and simplicity of a user-friendly online shopping experience;
	•		Freedom to purchase books for the upcoming semester/year from anywhere, anytime; and
	•		Toll-free ordering options and superior customer service.

Through these relationships, we are endorsed as the exclusive textbook retailer at our eduPartners schools and gain direct access to their students. As a result, eduPartners is an attractive and economical way for us to acquire customers.

As of March 2003, we were the exclusive new textbook supplier for over 160 educational institutions. Our exclusive relationships generally are for a period of one to four years and typically automatically renew on a year-to-year basis. As of March 2003, approximately 16 agreements expire before the 2003 back-to-school selling season. As per the terms of these agreements, each of these 16 agreements automatically renew for one year if neither party serves notice of intent to terminate 90 days prior to the date of expiration. We have historically enjoyed very high retention rates for school contracts.

With eduPartners, we create a personalized virtual bookstore for each school on our website. Students are able to search by region and state on our homepage to locate the link to their co-branded bookstore. Parents and students can be linked directly to their school bookstore page from their school’s homepage. Once they reach the entry page to their customized online bookstore, the student or parent can navigate the site by clicking on the appropriate grade, discipline and class to select required and optional books. The school benefits from the decreased costs, inconveniences and inefficiencies inherent in the seasonal business of purchasing, inventory management and selling learning materials directly to students on campus. In addition, schools have access to our unique program administration website that provides them with sales and inventory reports, among other valuable features.

User Experience

Our website, www.varsitybooks.com, offers several benefits to students including convenience, ease of use and depth of product selection. When logging on to our website, visitors are presented with several shopping options, including:

•

Searching by School. Students at eduPartners schools can use our customized map to locate their school. Once they find their school they can link through a list of departments to a list of classes and to the specific booklists for the courses they are taking. Our customers have the option of placing all the textbooks for a particular class in their shopping cart with a single click or selecting only those titles that interest them.

•

Searching for Books. If we have not posted a specific school’s booklist, our customers can search for the books they need by author, title, keyword, publisher or ISBN. Our website offers additional book verification for many selections, including pictures of jacket art, editor’s name, volume number, table of contents and other identifying characteristics.

Ordering and Delivery

When our customers are ready to place an order, they can proceed through our shopping cart function directly to our checkout page. Orders can be placed online through our website or via our toll-free telephone number where customer service agents are available to take orders from customers that do not have access to the Internet or are uncomfortable placing an order online. We presently accept Visa, Discover, MasterCard, money orders and personal checks as payment for our products. At our eduPartners schools, we also offer school and student credit accounts. During the ordering process, we ask our customers for basic information about themselves, which we maintain in our customer database. Once a customer places an order, he or she immediately receives an e-mail that includes a unique order number and confirms that the order has been received and processed. If a book is not in stock at the time an order is processed, that title is automatically placed on backorder and shipped to the customer as soon as it returns to stock. Customers are not charged for any book until it has been shipped. After an order is shipped, the customer receives a second e-mail that includes a UPS tracking number, a description of titles shipped and placed on backorder, the amount charged to their credit card for this shipment and a link to a page on our website where they can follow their order through the delivery process. We use a variety of UPS services to ensure our customers will receive their orders timely.

Customer Service

We are committed to delivering superior customer service to all of our customers, including eduPartners schools, parents and students. We currently manage customer service in-house, leveraging the experience and commitment of our own employees to provide a best-in-class level of service. We believe this allows us to more directly control the quality and content of each customer interaction with our company and provides important real-time insight into the performance of our eduPartners program. We offer extended customer service hours and increase our staffing levels during the busy back-to-school season, providing our customers convenient toll-free access to our customer service representatives and fast response to their queries. The customer service page of our website offers answers to frequently asked questions and enables our customers to ask their own questions through e-mail. We also have a toll-free customer service telephone number.

Fulfillment

We fulfill most of our textbook orders through Baker & Taylor, a leading distributor of books, videos and music products with which we have a series of written agreements, the original term of which expired on October 1, 2002. Consistent with the terms of these agreements, each agreement automatically renewed for one year as neither party notified the other of any intention not to renew 180 days prior to the initial expiration date. These agreements will continue to automatically renew for one year terms unless either party notifies the other in writing of their intent not to renew 180 days prior to the subsequent expiration dates. The agreements are terminable upon up to 30 days’ notice by either party in the event of a default. Under these agreements, we agree to provide Baker & Taylor with our written demand forecasts for each upcoming semester and we agree to use Baker & Taylor as our principal supplier of textbooks and drop-ship and fulfillment services. We pay fees and expenses related to the services Baker & Taylor provides and we purchase products from Baker & Taylor at a discount to the suggested price. In return, Baker & Taylor agrees not to provide drop-ship services to any person or entity that has as its principal business activity the goal of establishing exclusive relationships with educational institutions for the purpose of selling textbooks via the Internet, unless the retailer was an existing customer of Baker & Taylor on or prior to June 10, 1998, the date we initially contracted with Baker & Taylor. Our agreements with Baker & Taylor provide us access to, and use of, an electronic set of data elements from Baker & Taylor’s title file database that contains bibliographic records. In addition, under these agreements, Baker & Taylor provides us with promotional, customer service, and database management services. The controlling shareholder of Baker & Taylor was a 13% owner of our outstanding common stock at December 31, 2002.

As a result of the data access our agreements provide, information on availability of book titles is automatically updated on our website on an hourly basis from 8:00 a.m. to 10:00 p.m. eastern time based on a direct feed from Baker & Taylor, ensuring our customers receive accurate in-stock inventory information. Orders placed on our website are automatically transmitted to Baker & Taylor within twenty minutes of their receipt. At the Baker & Taylor warehouse currently used for fulfillment, the order is processed, packaged in a VarsityBooks.com branded box and shipped directly to our customers via UPS. We extend a convenient return policy to our customers under which returns are shipped directly to Baker & Taylor to expedite processing. Finally, providing Baker & Taylor with our demand forecasts for each semester helps to ensure they maintain an adequate and relevant inventory to meet the demands of our customers.

Technology

We use an array of site management, search, customer interaction, transaction-processing and fulfillment services and systems using a combination of proprietary technologies and commercially available, licensed technologies. Our strategy is to license commercially available technology whenever possible rather than seek internally developed solutions.

Our technology environment is designed to provide:

	•		a satisfying customer experience;
	•		consistent system availability and good performance;
	•		high security for all transactions, particularly, our customers’ commerce transactions;
	•		scalability for continued growth; and
	•		the collection, maintenance and security of valuable information.

We currently use a Microsoft Windows 2000 operating system platform and multiple Compaq application servers that house our web servers. These servers are able to handle applications including accepting and validating customer orders, handling multiple shipment methods and accepting, authorizing and charging customer credit cards. In addition, our system maintains ongoing automated e-mail communications with customers throughout the ordering process. These systems entirely automate many routine communications, facilitate management of customer e-mail inquiries and allow customers to, on a self-service basis, check order and tracking information.

We manage user requests and other traffic-using load balancing devices that work across the entire complement of our hardware. This strategy of balancing traffic allows all customers and site users to enjoy favorable response times and other performance measures, regardless of traffic fluctuations. Although we own and maintain our hardware and software systems, Qwest Communications located in Sterling, Virginia, hosts our server environment and acts as our Internet service provider and we lease the space in which our hardware system resides from Qwest. A group of in-house systems administrators and network engineers and Qwest personnel monitor and operate our website, network operations and transaction-processing systems.

Our agreement with Qwest currently provides for service to be provided on an annual basis, subject to renewal. We pay for the space in which our hardware system resides and our Internet access based on our usage, on a monthly basis. We may terminate this agreement on any annual renewal date without penalty.

We use the Microsoft suite of tools for our development environment, including Microsoft Visual Studio 6.0 and .Net editions with SQL Server 2000 for relational database management. Additionally, we have separate database servers that capture and retain transaction “logs” of all activity that occurs on the site. These log databases can, among other things, trace a transaction from its inception to its completion. Our databases generate and deliver reports and interfaces for our marketing, operations and financial systems.

We employ SSL data encryption technology to protect credit card data while it is passed from the customer through the site during a purchase transaction. This prevents outside parties from intercepting the customer’s credit card data during transaction processing.

COMPETITION

E-commerce, in general, and online textbooks, more specifically, are highly competitive markets. The number of e-commerce websites competing for customers’ attention has increased rapidly, and the market for online textbook sales is relatively new, intensely competitive and changing. We currently or potentially compete, directly and indirectly, for retail customers with the following categories of companies:

	•		traditional new and used textbook retailers, such as campus bookstores;
	•		traditional used textbook retailers, some of which have or are expected to begin online selling;
	•		textbook retailers and distributors such as the Follett Corporation, MBS Textbook Exchange and Adams Book Company; and
	•		Internet-based booksellers such as Amazon.com, Wal-Mart.com and BarnesandNoble.com.

We believe that the principal competitive factors in attracting and retaining retail customers are:

	•		entering relationships with educational institutions;
	•		convenience;
	•		competitive pricing;
	•		selection of available products;
	•		customer service;
	•		quality of content and navigability tools;
	•		brand recognition; and
	•		reliability and speed of fulfillment.

INTELLECTUAL PROPERTY

We regard our trademarks, service marks, trade dress, copyrights, trade secrets, proprietary technology and similar intellectual property as critical to our success. We rely on trademark and copyright law, trade secret protection and confidentiality and license agreements with our employees, customers, independent contractors, sponsors and others to protect our proprietary rights. We are currently in the process of reviving our application originally filed on January 6, 2002 to register VarsityBooks.com as a service mark with the United States Patent and Trademark Office.

We may be required to obtain licenses from others to refine, develop, market and deliver new products and services. There can be no assurance that we will be able to obtain any such license on commercially reasonable terms or at all, or that rights granted pursuant to any licenses will be valid and enforceable.

Domain names are the user’s Internet “address.” Domain names have been the subject of significant trademark litigation in the United States. Domain names derive value from the individual’s ability to remember such names, therefore there can be no assurance that our domain name will not lose its value if, for example, users begin to rely on mechanisms other than domain names to access online resources.

GOVERNMENT REGULATION

Internet Regulation

There are an increasing number of laws and regulations pertaining to the Internet. In addition, a number of legislative and regulatory proposals are under consideration by federal, state, local and foreign governments and agencies. Laws or regulations may be adopted relating to issues such as to liability for information retrieved from or transmitted over the Internet, online content regulation, user privacy, taxation and quality of products and services. Moreover, it may take years to determine whether and how existing laws such as those governing intellectual property ownership and infringement, privacy, libel, copyright, trade mark, trade secret, obscenity, personal privacy, taxation and the regulation of the sale of other specified goods and services apply to the Internet. The requirement that we comply with any new legislation or regulation, or any unanticipated application or interpretation of existing laws, may decrease the growth in the use of the Internet, which could in turn decrease the demand for our Internet-based services, increase our cost of doing business or otherwise materially harm our business.

Privacy Concerns

Federal, state and foreign governments have enacted or may enact laws or consider regulations regarding the collection and use of personal identifying information obtained from individuals when accessing websites, with particular emphasis on access by minors. Such regulations may include requirements that companies establish procedures to:

	•		give adequate notice to consumers regarding information collection and disclosure practices;
	•		provide consumers with the ability to have personal identifying information deleted from a company’s data;
	•		provide consumers with access to their personal information and with the ability to rectify inaccurate information;
	•		clearly identify affiliations or a lack thereof with third parties that may collect information or sponsor activities on a company’s website;
	•		obtain express parental consent prior to collecting and using personal identifying information obtained from children; and
	•		the Federal Children’s Online Privacy Act.

Such regulation may also include enforcement and redress provisions. While we have implemented programs designed to enhance the protection of the privacy of our users, including children, there can be no assurance that such programs will conform to applicable laws or regulations. Moreover, even in the absence of such regulations, the Federal Trade Commission has begun investigations into the privacy practices of companies that collect information on the Internet. One such investigation has resulted in a consent decree pursuant to which an Internet company agreed to establish programs to implement the privacy safeguards described above.

It is also possible that “cookies” may become subject to laws limiting or prohibiting their use. The term “cookies” refers to information keyed to a specific server, file pathway or directory location that is stored on a user’s hard drive, possibly without the user’s knowledge, and which is used to track demographic information and to target advertising. Some of the currently available Internet browsers allow users to modify their browser settings to remove cookies or prevent cookies from being stored on their hard drives.

We currently obtain and retain personal information about our website users with their consent. We have a stringent privacy policy covering this information. However, if third persons were able to penetrate our network security and gain access to, or otherwise misappropriate, our users’ personal information, we could be subject to liability. Such liability could include claims for

misuses of personal information, such as for unauthorized marketing purposes or unauthorized use of credit cards. These claims could result in litigation, our involvement in which, regardless of the outcome, could require us to expend significant financial resources.

Data Protection

Legislation pending in Congress, if passed, would afford broader rights to owners of databases of information, such as stock quotes and sports scores. Such protection already exists in the European Union. If enacted, this legislation could result in an increase in the price of services that provide data to websites. In addition, such legislation could create potential liability for unauthorized use of such data.

Internet Taxation

A number of legislative proposals have been made at the federal, state and local levels, and by foreign governments, that would impose additional taxes on the sale of goods and services over the Internet and some states have taken measures to tax Internet-related activities. Although Congress has placed moratorium on state and local taxes on Internet access or on discriminatory taxes on e-commerce, existing state or local laws have been expressly excepted from this moratorium. Further, once this moratorium is lifted, some type of federal or state taxes may be imposed upon Internet commerce. Such legislation or other attempts at regulating commerce over the Internet may substantially impair the growth of commerce on the Internet and, as a result, adversely affect our opportunity to derive financial benefit from such activities.

Jurisdiction

Due to the global reach of the Internet, it is possible that, although our transmissions over the Internet originate primarily in the Commonwealth of Virginia, the governments of other states and foreign countries might attempt to regulate Internet activity and our transmissions or take action against us for violations of their laws.

RISK FACTORS

We Have a Limited Operating History Upon Which to Evaluate an Investment in Our Company.

We were founded in December 1997 and began selling textbooks on our website in August 1998. Due to the seasonality of textbook sales, our peak selling periods are currently in July, August and September, when the new academic year begins and students purchase the majority of their textbooks. During 2002, approximately 87% of our textbook revenues were recognized in this period. We expect this trend to continue as we extend eduPartners’ leadership position in the private middle and high school market. As a relatively new company, we face significant risks and uncertainties relating to our ability to successfully implement our strategy. You must consider the risks and uncertainties that an early stage company like ours faces. If we are unsuccessful in addressing these risks and uncertainties or are unable to execute our strategy, our business would be harmed.

Our Business and Revenue Model is Unproven.

Our ability to generate significant revenues and profits from the sale of textbooks and other products and services we may offer in the future is uncertain. To be successful, we must attract and retain a significant number of schools to our eduPartner program. Ultimately, we must attract the students and parents from each eduPartner school to our website at a reasonable cost. Any significant shortfall in the expected number of purchases occurring through our website will negatively affect our financial results. Conversion of schools from traditional on campus bookstore operations to eduPartners’ online bookstore solution may not occur as rapidly as we expect, if at all. Therefore, we may not achieve the customer traffic we believe is necessary to become successful. Specific factors that could prevent widespread customer acceptance of our business and our ability to increase retail revenues include:

	•		lack of consumer awareness of our eduPartner program;
	•		pricing that does not meet consumer expectations;
	•		consumer concerns about the security of online transactions;
	•		shipping charges, which do not apply to shopping at traditional retail stores and are not always charged by some of our online competitors;
	•		delivery time associated with online orders, as compared to the immediate receipt of products at traditional retail stores;
	•		product damage from shipping or shipments of the wrong products, which may result in a failure to establish trust in purchasing our products online;
	•		delays in responses to consumer inquiries or in deliveries to consumers; and
	•		difficulty in returning or exchanging orders.

We may not be able to retain existing eduPartners member schools or sign-up new eduPartners member schools.

We Rely on One Supplier to Meet Our Fulfillment Demands.

We depend on Baker & Taylor, Inc. as the primary supplier of the textbooks we offer. Our relationship with Baker & Taylor is critical to our success. If we were unable to rely on them for inventory maintenance and shipping services, our business would be materially harmed.

Baker & Taylor warehouses most of our inventory and we rely on them to maintain adequate inventory levels and rapidly fill our customers’ orders. Prices we pay for promotional, customer service and database management services and credits that we receive from Baker & Taylor are currently based on volume and average cost requirements. Failure to meet these benchmarks could increase our costs. If they do not maintain sufficient inventory, or if they are unable to deliver the specific books our customers order or deliver these books in a timely fashion, we would not be able to meet our obligations to our customers, our revenues would decrease and we would likely experience a reduction in the value of our brand. Baker & Taylor fills orders for a number of textbook retailers. Baker & Taylor has advised us that it fills all the orders it receives on a first-come, first-served basis without providing preferential treatment for us or any of our competitors. If other Baker & Taylor customer orders depleted Baker & Taylor’s inventory, and Baker & Taylor was unable to quickly replenish its inventory, our orders would not be processed or filled in a timely manner. If our relationship with Baker & Taylor is disrupted or does not continue for any reason and we are unable to establish a comparable vendor relationship or open our own warehouse before the Baker & Taylor relationship discontinues, we would not be able to fulfill our customers’ orders. We cannot be certain that we would be able to establish new vendor relationships to ensure acquisition and distribution of textbooks in a timely and efficient manner or on acceptable commercial terms. In such event, we may determine that we need to maintain inventory, establish warehouse facilities and provide distribution services, which would require us to change our business model. In addition, a single publisher represented approximately 22% of our textbook revenues in 2002. If Baker & Taylor’s relationship with this publisher is disrupted or discontinued, our business would be harmed.

We benefit from the shipping discounts offered to Baker & Taylor by United Parcel Service and we rely on UPS and other third party carriers for all shipments to and from Baker & Taylor. If Baker & Taylor’s relationship with UPS is discontinued or disrupted for any reason, we cannot be certain we would be able to affordably obtain comparable delivery services and might not be able to deliver textbooks to our customers in a timely manner. In addition, because we rely on third party carriers to ship products to and from the single Baker & Taylor warehouse that our fulfillment is currently conducted from, we are subject to the risks, including employee strikes and inclement weather, that may prevent such third parties from meeting our fulfillment and delivery needs. Failure to deliver products to our customers in a timely and accurate manner would harm our reputation, our brand and our business.

We Face Significant Competition, and that Competition May Increase Substantially Because of the Low Barriers to Market Entry.

The e-commerce and online textbook markets are new, rapidly evolving and intensely competitive. We expect competition to intensify in the future. Barriers to entry are minimal, and current and new competitors can launch new websites at a relatively low cost. We currently compete with a variety of other companies in the sale of textbooks, and if we are able to add other product or service offerings we will have additional competition in those markets. Our current and potential competition includes the following categories of companies:

	•		traditional bookstore retailers, such as school-operated and contract-operated campus bookstores, as this represents the default method of meeting the textbook needs of the majority of educational institutions today;
	•		traditional used textbook retailers, some of which have or are expected to begin online selling;
	•		textbook retailers and distributors such as the Follett Corporation, MBS Textbook Exchange and Adams Book Company; and
	•		Internet-based booksellers such as Amazon.com, WalMart.com, eFollett.com (affiliated with The Follett Corporation) and BarnesandNoble.com.

We are not able to reliably estimate the number of our direct competitors. Many of our current and potential competitors have longer general retail operating histories, larger customer bases, greater brand recognition and significantly greater financial, marketing, technological, operational and other resources than we do. Some of our competitors may be able to secure textbooks from vendors on more favorable terms, devote greater resources to marketing and promotional campaigns, adopt more aggressive pricing, shipping policies or inventory availability policies and devote substantially more resources to website and systems development than we can. As competition increases, we may experience reduced operating margins, loss of market share and a diminished brand franchise. To remain competitive, we may from time to time make pricing, service or marketing decisions or acquisitions that could affect our financial condition and results of operations. It is possible that our supply channel (distributors and, indirectly, publishers) may enter the market and match our pricing through direct retail centers or that either or both our supply channel and traditional college bookstores may enter the online commerce market as our competitors. It is also possible

that companies that control access to transactions through network access or web browsers could promote our competitors or charge us a substantial fee for inclusion.

As Internet use becomes increasingly prevalent, it is possible that the full text of books we offer for sale will be available for viewing on the web or on other electronic devices such as virtual textbooks. If virtual textbooks become a reality and students rely on them in lieu of purchasing hard copies of textbooks, our business may decline.

We Have An Operating History of Losses and Negative Cash Flows.

Prior to the year ended December 31, 2002, we had incurred substantial losses in every fiscal year since our inception. For the year ended December 31, 2001, we incurred a loss from operations of approximately $2.8 million and positive cash flows from operations of $0.4 million. For the year ended December 31, 2000, we incurred a loss from operations of approximately $34.8 million and negative cash flows from operations of $27.5 million. For the year ended December 31, 1999, we incurred a loss from operations of approximately $31.9 million and negative cash flows from operations of $29.4 million. As of December 31, 2001 and 2002 we had accumulated deficits of approximately $70.5 million and $69.8 million, respectively.

Although our margins have increased and our overall expenses have been lowered significantly, our ability to sustain annual operating profitability depends on our ability to maintain and grow net revenues. We base our current and future expense levels on our operating plans and estimates of future revenues. In view of the rapidly evolving nature of our business and our limited operating history, we have limited experience forecasting our revenues. Therefore we believe that period-to-period comparisons of our financial results might not necessarily be meaningful and you should not rely on them as an indication of future performance. If we cannot sustain profitability or positive cash flow from operations, we may be unable to meet our working capital requirements or to obtain additional financing, which would adversely affect our business and may cause us to discontinue operations.

You Should Not Rely on Our Quarterly Operating Results as an Indication of Our Future Results Because They are Subject to Significant Fluctuations.

Our quarterly operating results may fluctuate significantly in the future due to a variety of factors that could affect our revenues or our expenses in any particular quarter. We expect to continue to experience significant seasonality in our business related to the academic calendar and the corresponding demand for textbooks and educational materials. Sales in the textbook industry traditionally are significantly higher in the first and third calendar quarters of each year compared with the second and fourth calendar quarters. Due to the concentration of private middle and high schools in our eduPartners program, our revenues are concentrated in the traditional Fall back-to-school season of July, August and September. During 2001 and 2002, approximately 81% and 87% of our textbook revenues were recognized in this period. We expect this trend to increase as the concentration of private middle and high schools in our eduPartners program increases. Fluctuations in our quarterly operating results could cause our stock price to decline. You should not rely on sequential quarter-to-quarter comparisons of our results of operations as an indication of future performance. Factors that may affect our quarterly results include:

	•		seasonal trends in the textbook industry and in the buying habits of students;
	•		concentration of private middle and high schools in our eduPartners program;
	•		our ability to manage or influence inventory and fulfillment operations;
	•		the level of merchandise returns we experience;
	•		our ability to attract new customers, retain existing customers and maintain customer satisfaction;
	•		introduction of enhancements or a change in pricing policies, by us or our competitors, or a change in pricing policy by our sole fulfillment source;
	•		changes in the amount and timing of expenditures related to marketing, information technology and other operating expenses to support future growth;
	•		technical difficulties or system downtime affecting the Internet generally or the operation of our website specifically;
	•		increasing consumer acceptance and use of the Internet for the purchase of consumer products;
	•		potential acquisitions or strategic alliances either by us or our competitors; and
	•		general economic conditions and economic conditions specific to the Internet, online commerce or book industry.

As a result of the seasonal fluctuations and because the online sale of textbooks and online selling in general is new and it is difficult to predict consumer demand, it is possible that in some future periods our results of operations may be below the expectations of public market analysts and investors. In that event, it is likely that the price of our stock would decline.

Loss of Any of Our Key Management Personnel or the Inability of Our Key Management Personnel to Work Together Effectively or Successfully Manage Our Growth Could Negatively Affect Our Business.

Our future success depends to a significant extent on the continued service and coordination of our management team, particularly Eric J. Kuhn, our co-founder, Chief Executive Officer, President and Chairman of the Board. We have entered into an agreement with Mr. Kuhn that provides, among other things, that he be compensated in the event he is terminated without cause. We have not entered into similar agreements with any other personnel. Nonetheless, the loss or departure of any of our executive officers or key employees could harm our ability to implement our business plan. We do not maintain key person insurance on any member of our management team.

If We Are Unable to Adapt as Internet Technologies and Customer Demands Continue to Evolve, Our Services and Products Could Become Less Desirable.

The satisfactory performance, reliability and availability of our website, transaction-processing systems and network infrastructure are critical to our reputation and our ability to attract and retain customers and maintain adequate customer service levels. An unanticipated dramatic increase in the volume of traffic on our website or the number of orders placed by our customers may force us to expand and upgrade our technology, transaction-processing systems and network infrastructure. There can be no assurance that we will be able to accurately project the rate or timing of increases, if any, in the use of our website or timely expand and upgrade our systems and infrastructure to accommodate such increases. To be successful, we must adapt to our rapidly changing market by continually enhancing the technologies used in our Internet products and services and introducing new technology to address the changing needs of our business and customers. If we are unable, for technical, legal, financial or other reasons, to adapt in a timely manner in response to changing market conditions or business and customer requirements, our business could be harmed.

As an Internet-Based Retailer, We Depend Heavily on Our Information Technology Infrastructure and Our Operations Could be Jeopardized by any System Failure Or Inadequacy.

Our operations are dependent on our ability to maintain our computer and communications software and equipment in effective working order and to protect our systems against damage from fire, natural disaster, power loss, communications failure or similar events. In addition, the growth of our customer base may strain or exceed the capacity of our computer and communications systems and lead to degradations in performance or systems failure. Our success, in particular our ability to successfully receive and fulfill orders and provide high-quality customer service, largely depends on the efficient and uninterrupted operation of our computer and communications hardware systems. We use an internally developed system for our website, search engine and substantially all aspects of transaction processing, including order management, cash and credit card processing, purchasing, inventory management and shipping.

Substantially all of our computer and communications hardware and software systems are located at a single facility in Sterling, Virginia. That facility is owned, maintained and serviced by Qwest Communications. Although we own and maintain our hardware and software systems, including the software which is central to the sales, ordering and shipping processes, we rely on Qwest to ensure our computer and communications hardware and software operate efficiently and continuously. We do not presently have fully redundant systems or a formal disaster recovery plan and do not carry sufficient business interruption insurance to compensate for losses that may occur. Despite our implementation of network security measures, our servers are vulnerable to computer viruses, physical or electronic break-ins, fire, flood, power loss, telecommunications failure, break-ins, earthquake and similar disruptions, which could lead to interruptions, delays, loss of data or the inability to accept and fulfill customer orders. Any damage, failure or delay that causes interruptions in our system operations could have a material adverse effect on our business.

In addition to our offsite software and hardware related to our website, at our headquarters we maintain a local area network, or LAN, which we use for our financial reporting systems, customer service operations, monitoring of our customer orders, e-mails and other internal processes. Any loss of service or other failure of this LAN, regardless of the availability of our website, would significantly impair our ability to service our customers and monitor and fulfill customer orders, which could have a material adverse effect on our business.

The failure of either our website or our LAN or any other systems interruptions that results in unavailability of our website or reduced order fulfillment performance, especially during the peak Fall sales period of July/August/September, could result in negative publicity or could reduce the volume of goods sold and attractiveness of our website and would seriously impair our ability to service our customers’ orders, all of which could negatively affect our revenues. Because our servers are located at a third-party’s facility and because some of the reasons for a systems interruption may be outside of our control, we also may not be able to exercise sufficient control to remedy the problem quickly or at all. Regardless of whether we or a third-party controls or creates system failure, the occurrence of system failure could adversely affect our reputation, seriously harm our business and cause us to lose a significant and disproportionate amount of revenues.

Concerns About Security on the Internet May Reduce the Use of Our Website and Impede Our Growth.

A significant barrier to confidential communications over the Internet has been the need for security. We rely on SSL encryption technology to prevent the misappropriation of customer credit card data during the transaction process. Under current credit card

practices, a merchant is liable for fraudulent credit card transactions where, as is the case with the transactions we process, that merchant does not obtain a cardholder’s signature. A failure to adequately control fraudulent credit card transactions could reduce our collections and harm our business. Internet usage could decline if any well-publicized compromise of security occurred. Our site could be particularly affected by any such breach because our online commerce model requires the entry of confidential customer ordering, purchasing and delivery data over the Internet, and we maintain a database of this historical customer information. Until more comprehensive security technologies are developed, the security and privacy concerns of existing and potential customers may inhibit the growth of the Internet as a medium for commerce. We cannot be certain that advances in computer capabilities, new discoveries in the field of cryptography or other developments will not result in the compromise or breach of the algorithms we use to protect content and transactions on our website or proprietary information in our databases. Anyone who is able to circumvent our security measures could misappropriate proprietary, confidential customer or company information or cause interruptions in our operations. We may incur significant costs to protect against the threat of such security breaches or to alleviate problems caused by these breaches.

We May Become Subject to Burdensome Government Regulations and Legal Uncertainties Affecting the Internet That Could Adversely Affect Our Business.

To date, governmental regulations have not materially restricted use of the Internet in our markets. However, the legal and regulatory environment that pertains to the Internet is uncertain and may change. Uncertainty and new regulations could increase our costs of doing business and prevent us from delivering our products and services over the Internet. The growth of the Internet may also be significantly slowed. This could delay growth in demand for our online services and limit the growth of our revenues. In addition to new laws and regulations being adopted, existing laws may be applied to the Internet. New and existing laws may cover issues, which include:

	•		sales and other taxes;
	•		user privacy;
	•		pricing controls;
	•		characteristics and quality of products and services;
	•		consumer protection;
	•		libel and defamation;
	•		copyright, trademark and patent infringement; and
	•		other claims based on the nature and content of Internet materials.

As Internet Technology and Regulation Advances, We May Not Be Able to Protect Our Domain Names.

We currently hold various Internet domain names relating to our brand, including the “VarsityBooks.com” domain name. Governmental agencies and their designees generally regulate the acquisition and maintenance of domain names. The regulation of domain names in the generic category of domain names (i.e.,      .com, .net and .org) is now controlled by a non-profit corporation, which may create additional top-level domains. Requirements for holding domain names have also been affected. As a result, there can be no assurance that we will be able to acquire or maintain relevant domain names. Furthermore, the relationship between regulations governing domain names and laws protecting trademarks and similar proprietary rights is unclear. Therefore, we may be unable to prevent third parties from acquiring domain names that are similar to, infringe upon or otherwise decrease the value of our trademarks and other proprietary rights. Any such inability could harm our business.

Some States May Impose a New Sales Tax On Our Business.

A 1992 Supreme Court decision held that the Commerce Clause of the United States Constitution limits a state’s ability to impose a sales or use tax collection responsibility on an out-of-state vendor unless such vendor maintains a physical presence, i.e., substantial nexus, in the taxing state. Based on this Supreme Court decision, we have determined that we do not have a substantial nexus in several jurisdictions where our products are received by customers, and, therefore, do not collect or remit sales or use tax in such jurisdictions. Because the scope of the 1992 Supreme Court decision is unclear, states may challenge our determination of substantial nexus. If successful, such challenges could result in significant liabilities for sales and use taxes with a material and adverse effect on our business. We currently collect and remit sales or use tax on all shipments to nine states. In one of these jurisdictions, we are currently appealing an assessment of sales and use taxes related to audit periods before we began collecting and remitting sales and use taxes in such jurisdiction. There is a risk that our appeal of this assessment will not be successful and may result in additional liabilities for sales and use taxes that could have an adverse effect on our business. An additional state, unrelated to the jurisdictions where we currently collect and remit sales and use taxes, has contacted the Company to inquire about possible exposure for sales and use taxes. As of the date of this form, this state has determined that the Company has no sales tax liability for the audit period in question. The 1992 Supreme Court decision also established that Congress has the power to enact legislation that would permit states to require collection of sales and use taxes by mail-order companies. Congress has from time to time considered proposals for such legislation. We anticipate that any legislative change, if adopted, would be applied on a prospective basis. While there is no case law on the issue, we believe that this analysis could also apply to our online business. Recently, several states and local jurisdictions have expressed an interest in taxing e-commerce

companies who do not have any contacts with their jurisdictions other than selling products online to customers in such jurisdictions. The Internet Tax Freedom Act imposed a moratorium on new taxes or levies on e-commerce for a three-year period and originally was due to expire in October 2001. However, Congress has extended the Internet Tax Freedom Act through October 2003. There is no guarantee that Congress will subsequently extend this Act. If the Act is not extended new taxes could result that could have an adverse effect on online commerce, including our business.

Our Executive Officers, Directors and Existing Stockholders, Whose Interests May Differ from Other Stockholders, Have the Ability to Exercise Significant Control Over Us.

Our executive officers, directors and entities affiliated with them, in the aggregate, beneficially own approximately 53.0% of our outstanding common stock. These stockholders will be able to exercise significant influence over all matters requiring stockholder approval, including the election of directors, the approval of significant corporate transactions and the power to prevent or cause a change of control. The interests of these stockholders may differ from the interests of our other stockholders.

There May Be No Active Trading Market In Our Common Stock.

Effective with the open of business on March 21, 2001, our common stock was delisted from The Nasdaq National Market. Presently, our common stock is eligible to be traded on the OTC Bulletin Board and we believe that a limited number of broker/dealers are making a market in our common stock. These broker/dealers are under no obligation to make a market and there can be no assurance that they will continue to make such a market or that they will not decide to discontinue making a market without notice to us or our stockholders. Since we have been delisted from Nasdaq, we cannot assure you that an active trading market for our common stock will continue. If an active trading market for our common stock is not sustained, you may not be able to sell your common stock when you desire or need to do so, or at a price acceptable to you, or even at all.

The Trading Price For Our Common Stock May Drop And This Could Affect Our Ability To Raise Capital And Your Ability To Resell Your Shares At Or Above The Price You Paid To Purchase Such Shares.

The stock market, in general, and the trading prices of shares in public technology companies, particularly those such as ours that offer Internet-based products and services, have been extremely volatile and have experienced a substantial drop in market price. Indeed, the trading price of our common stock dropped significantly during the year ended December 31, 2000, thereby precipitating our delisting from Nasdaq. We believe that this drop resulted from many factors, some of which are beyond our control, such as:

	•		investor perception of us and online retailing services in general;
	•		general economic conditions both in the United States and in foreign countries;
	•		our results in operations;
	•		adverse business developments;
	•		changes in financial estimates by securities analysts; and
	•		announcements by our competitors of new products and services.

As a result of these factors, and due to the risks related to the absence of an active trading market for our common stock (which are described above) we cannot assure you that the trading price of our common stock will not drop or stay at its current price. The significant decreases in the trading price of our common stock and the current trading price of our stock is likely to affect our visibility and credibility in our market and will likely limit our ability to raise capital in the future. Additionally, as a result of our delisting from NASDAQ, recent trading price and daily traded share volumes, you may not be able to resell your shares of common stock when you need to or at prices higher than what you paid to purchase such shares.

If Our Stock Price is Volatile, We May Become Subject to Securities Litigation Which is Expensive and Could Result in a Diversion of Resources.

Securities class action litigation has often been brought against companies that experience volatility in the market price of their securities. Litigation brought against us could result in substantial costs to us in defending against the lawsuit and a diversion of management’s attention that could cause our business to be harmed.

Future Sales of Our Common Stock May Negatively Affect Our Stock Price.

The market price of our common stock could decline as a result of sales of a large number of shares of our common stock in the market, or the perception that such sales could occur. These sales also might make it more difficult for us to sell equity securities in the future at a time and at a price that we deem appropriate.

It May Be Difficult for a Third Party to Acquire Our Company and this Could Depress Our Stock Price.

Delaware corporate law and our amended and restated certificate of incorporation and our by-laws contain provisions that could have the effect of delaying, deferring or preventing a change in control of Varsity Group or a change of our management that stockholders may consider favorable or beneficial. These provisions could discourage proxy contests and make it more difficult for you and other stockholders to elect directors and take other corporate actions. These provisions could also limit the price that investors might be willing to pay in the future for shares of our common stock. These provisions include those which:

	•		authorize the issuance of “blank check” preferred stock, which is preferred stock that can be created and issued by the board of directors without prior stockholder approval, with rights senior to those of common stock;
	•		provide for a staggered board of directors, so that it would take three successive annual meetings to replace all directors;
	•		prohibit stockholder action by written consent; and
	•		establish advance notice requirements for submitting nominations for election to the board of directors and for proposing matters that can be acted upon by stockholders at a meeting.

EMPLOYEES

As of March 2003, we had approximately 25 employees. We hire temporary employees, particularly at the beginning of the Fall school semester to support our customer service efforts, and contract service providers as necessary. None of our employees is represented by a labor union or is the subject of a collective bargaining agreement. We believe that relations with our employees are good.

ITEM 2.      PROPERTIES

Our headquarters is located at 1850 M Street, Suite 1150, Washington, D.C. We currently lease approximately 4,400 square feet pursuant to a lease that is scheduled to expire on November 14, 2004. The Company was previously headquartered at 1130 Connecticut Avenue, Suite 350, Washington, D.C. At this previous site, we leased an aggregate of approximately 3,200 square feet pursuant to a lease that expired on November 30, 2002.

ITEM 3.      LEGAL PROCEEDINGS

The Company is a party to various legal proceedings and claims incidental to its business. Management does not believe that these matters will have a material adverse effect on the results of operations or financial condition of the Company.

ITEM 4.      SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None.

PART II

ITEM 5.      MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

Our common stock traded on the Nasdaq National Market under the symbol VSTY from February 15, 2000 until March 20, 2001. Beginning on March 21, 2001 our common stock traded on the OTC Bulletin Board under the symbol VSTY.OB. Prior to February 15, 2000, our common stock was not publicly traded. For the period from January 1, 2001 to December 31, 2002, the high and low closing prices per share of our Common stock were as follows:

On March 25, 2003, the closing price per share of our common stock was $1.80 and we had approximately 232 stockholders of record and approximately 3,181 beneficial holders of our common stock.

On March 8, 2001 we appeared before a Nasdaq Listing Qualifications Panel (the “Panel”) to present our case for continued inclusion on The Nasdaq National Market pursuant to an exception to the bid price and market value of public float requirements, as set forth in Nasdaq Marketplace Rules 4450(a)(5) and 4450(a)(2). However, in a letter dated March 20, 2001 the Panel informed us of their decision to delist our securities from The Nasdaq National Market, effective with the open of business on March 21, 2001. The letter also informed us we did not satisfy all the requirements for continued listing on The Nasdaq SmallCap Market. Effective with the Panel decision, our securities immediately became eligible to trade on the OTC Bulletin Board.

We have never declared or paid any cash dividends on our common stock. Any decision regarding the declaration of future cash dividends will be made by the Company’s Board of Directors.

On October 19, 2001 we purchased 957,063 previously issued and outstanding shares of Varsity Group Inc. Common Stock for $574,338 in a privately negotiated transaction.

ITEM 6.      SELECTED FINANCIAL DATA

The selected financial data presented below as of and for the fiscal years ended December 31, 1998, 1999, 2000, 2001 and 2002 have been derived from our audited consolidated financial statements. This data should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations, our Consolidated Financial Statements and Notes thereto, and other financial information appearing elsewhere in this Form 10-K.

ITEM 7.      MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

OVERVIEW

We are a leading online retailer of textbooks and educational materials targeting private middle and high schools, colleges, and distance and continuing education markets. Through eduPartners, our program serving schools and organizations directly, we provide an opportunity for educational institutions to maximize their resources and offer increased convenience and value to their students by outsourcing to us the sale of textbooks and other learning materials.

We were incorporated in December 1997 and began offering books for sale on our website on August 10, 1998. For the period from inception through August 9, 1998, our primary activities consisted of:

	•		developing our business model;
	•		establishing, negotiating and consummating a relationship with our supplier, Baker & Taylor;
	•		initial planning and development of our website;
	•		developing our information systems infrastructure;
	•		developing our marketing plans; and
	•		establishing finance and administrative functions.

Since the launch of our website, we have continued these activities and have also focused on increasing sales, expanding our product and service offerings, improving the efficiency of our order and fulfillment process, recruiting and training employees, enhancing finance and administrative functions and increasing customer service operations and the depth of our management team to help implement our growth strategy.

We began to generate sales when we launched our website in August 1998. To date, our revenues have consisted primarily of sales of new textbooks. Our original sales model focused on building a broad consumer brand offering promotions and deeply discounted textbook prices to entice college students visit our website and purchase their textbooks from us.

In January 1999 we created eduPartners, whereby we became the exclusive provider of new books and learning materials to a variety of learning institutions. This program is a cost-effective model that enables us to increase the number of customers to our website and generate book sales that does not require the significant marketing and brand building expenses associated with our earlier model which focused on building a broad consumer brand offering promotions and deeply discounted textbook prices to entice college students to visit our website and purchase their textbooks from us. During 2000, we began to focus resources on the growth and development of our eduPartner program and it is the foundation of our business today. In the quarter ending September 30, 2002, revenues from eduPartners accounted for approximately 98% of total book related revenues, an increase from the 69% share of total book related revenues eduPartners represented during the quarter ending September 30, 2000. The number of eduPartners schools has grown from approximately 20 schools during the 1999 Fall back-to-school season to over 130 schools in 2002, representing an 86% compounded annual growth rate over the last three years.

We expect eduPartners to remain the primary source of textbook revenues moving forward. Net sales consist of sales of books and charges to customers for outbound shipping and are net of allowances for returns, promotional discounts and coupons. Revenues from sales of textbooks are recognized at the time products are received by the customer.

The Company has also provided marketing services for other businesses seeking to reach the college and private middle and high school demographics by marketing to students online through its website and on college campuses utilizing a nationwide network of student marketing representatives. During the fourth quarter of fiscal 1999, we began generating revenues from marketing programs. In 2000, for example, we executed marketing campaigns for companies such as AT&T Wireless, Inc., Papa John’s, Inc, Polariod, Inc., Palm, Inc. and Ben & Jerry’s Homemade, Inc. These campaigns were developed to meet the goals of each client. Marketing activities included online marketing, traditional flyering and postering, peer-to-peer marketing, on-campus events, product trial and demonstrations, and sponsorship opportunities.

During 2001, we made a strategic decision to focus resources on the growth and development of the eduPartners program. We determined that the eduPartners model presented the greatest prospects for long-term growth and shareholder value creation and elected to concentrate the resources and energy of the entire organization on maximizing this opportunity. We completed all outstanding on-campus marketing services contracts during 2001 and ceased new development of on-campus marketing services programs. We anticipate future marketing services revenue will likely represent a relatively small percentage of textbook revenues and will be focused on delivering solutions compatible with our target eduPartners market.

Revenues from our marketing programs are recognized straight-line over the contract term, provided that no significant performance obligations remain and the collection of the related receivable is probable. Costs associated with our marketing programs are recognized as incurred.

Recording the first profitable fiscal year in the history of our Company, the year ended December 31, 2002 marked a significant milestone for the Company. This was accomplished through a combination of revenue growth, margin enhancement and cost reduction efforts initiated during 2000. We have successfully lowered our overall expense structure and improved the margins of our retail book business while growing revenues. As a result, we recorded the first profitable fiscal quarter in our history during the three months ending September 30, 2001 and our first profitable fiscal year during the year ended December 31, 2002. We have also now recorded two consecutive fiscal years with positive cash flow from operations.

Although our margins have increased and our overall expenses have been lowered significantly, our ability to sustain annual operating profitability depends on our ability to maintain and grow net revenues. We base our current and future expense levels on our operating plans and estimates of future revenues. In view of the rapidly evolving nature of our business and our limited operating history, we have limited experience forecasting our revenues. Therefore we believe that period-to-period comparisons of our financial results might not necessarily be meaningful and you should not rely on them as an indication of future performance.

Prior to the fiscal year ended December 31, 2002, we had incurred substantial losses in every fiscal year since inception. For the year ended December 31, 2001, we incurred a loss from operations of approximately $2.8 million and positive cash flows from operations of $0.4 million. For the year ended December 31, 2000, we incurred a loss from operations of approximately $34.8 million and negative cash flows from operations of $27.5 million. For the year ended December 31, 1999, we incurred a loss from operations of approximately $31.9 million and negative cash flows from operations of $29.4 million. As of December 31, 2001 and 2002 we had accumulated deficits of approximately $70.5 million and $69.8 million, respectively.

CRITICAL ACCOUNTING POLICIES

Our consolidated financial statements are prepared in conformity with accounting principles generally accepted in the United States. For a comprehensive discussion of our accounting policies, see Note 2 in the accompanying consolidated financial statements included in this Annual Report on Form 10-K. We do not have any ownership interest in any special purpose or similar entities and do not have any significant related party transactions except for those associated with our relationship with Baker & Taylor. Pursuant to recent guidance published by the SEC regarding disclosure about critical accounting policies, we have identified the following accounting policies as critical to the understanding of our results of operations.

Revenue Recognition

We recognize revenue from textbook sales, including sales under our eduPartners program, net of any discounts and coupons, when the textbooks are received by our customers. We take title to the textbooks sold upon transfer to the shipper and assume the risks and rewards of ownership including the risk of loss for collection. We do not function as an agent or broker for our supplier. Outbound shipping charges are included in net sales. We provide allowances for sales returns, promotional discounts and coupons based on historical experience in the period of the sale. To date, our revenues have consisted primarily of sales of textbooks.

YEAR ENDED DECEMBER 31, 2002 COMPARED TO YEAR ENDED DECEMBER 31, 2001

Net Sales

Net sales increased to $16.6 million for the year ended December 31, 2002 from $12.5 million for year ended December 31, 2001, driven by higher textbook and shipping revenues as a result of our focus on the growth and development of our eduPartners program. Net product and shipping revenues generated from our eduPartners program increased to approximately $16.0 million for the year ended December 31, 2002 from approximately $10.0 million for the year ended December 31, 2001. The increase in overall revenues is largely attributed to the continued growth of eduPartners during 2002. During the July/August/September 2002 back-to-school season, we served approximately 130 schools through eduPartners, up from approximately 90 schools during the same period in 2001.

Marketing services revenues decreased to approximately $27,000 for the year ended December 31, 2002 from $0.9 million for the year ended December 31, 2001. The majority of revenues recognized in 2001 were associated with contracts signed during 2000 to execute collegiate on-campus marketing campaigns for companies like Ben & Jerry’s Homemade, Papa John’s and AT&T Wireless. However, during 2001 we made a strategic decision to focus resources on the growth and development of the eduPartners program. We determined that this course presented the greatest prospects for long-term growth and value creation and, accordingly, completed all outstanding on-campus marketing services contracts during 2001 and ceased new development of on-campus marketing services programs. No new marketing services contracts with an aggregate contract amount greater than $100,000 were signed during 2002. We anticipate marketing services revenues in the future will remain a very small percentage of overall revenues and will be focused on delivering online solutions compatible with our target eduPartners market.

Net sales consist of sales of books and charges to customers for outbound shipping and are net of allowances for returns, promotional discounts and coupons. Revenues from sales of textbooks are recognized at the time products are received by the

customer. Revenues from our marketing programs are recognized straight-line over the contract term, provided that no significant performance obligations remain and the collection of the related receivable is probable.

Operating Expenses

Cost of Product — Related Party (Baker & Taylor)

Cost of product — related party consists of the cost of products sold to customers. Cost of product — related party increased to $10.6 million for the year ended December 31, 2002 from $7.9 million for year ended December 31, 2001. This increase was primarily attributable to our increased sales volume. We expect that cost of product — related party will increase in absolute dollars as eduPartners and our customer base expands.

Cost of Shipping — Related Party (Baker & Taylor)

Cost of shipping — related party consists of outbound shipping. Cost of shipping increased to $1.0 million for the year ended December 31, 2002 from $0.7 million for year ended December 31, 2001. This increase was primarily attributable to our increased sales volume. Also, for the year ended December 31, 2002, shipping revenue exceeded cost of shipping — related party by $0.3 million or 34%. For the year ended December 31, 2001, shipping revenue exceeded cost of shipping — related party by $0.2 million or 36%. We will continue to offer competitive, value-based shipping prices to our customers and we expect that shipping revenue will continue to exceed cost of shipping in 2003. We recognize this action, when compared to free or flat-rate shipping models, may negatively impact our ability to aggressively expand eduPartners and our customer base.

Effective October 1, 1999 we amended the documents governing our relationship with Baker & Taylor. The amendment provides for assignment of separate values to the separate services provided by Baker & Taylor: supply of books, shipping and other services, including website content and customer database management. Such assignment is based on the relative fair value of each element as determined by Baker & Taylor. Effective with the amendment of our agreement with Baker & Taylor on October 1, 1999, we have included in “cost of product—related party” in our statement of operations the cost of purchased books from Baker & Taylor, we included in “cost of shipping—related party” the cost of shipping charges from Baker & Taylor and we included in marketing and sales the cost of other services including website content and customer database management charged from Baker & Taylor. These agreements have served to reduce cost of product—related party (Baker & Taylor) as a percentage of revenue and increase marketing and sales expense as a percentage of revenue.

Cost of Marketing Services

Cost of marketing services includes personnel costs associated with the implementation of our on campus marketing programs and other directly identifiable costs associated with our online advertising and on campus promotions. There were no significant costs of marketing services for the year ended December 31, 2002, a decrease from the approximate $45,000 of expenses recorded during the year ended December 31, 2001. This decrease was primarily attributable to our decision to cease development of our on-campus marketing services programs.

Marketing and Sales

Marketing and sales expense consists primarily of advertising and promotional expenditures, credit card processing fees and payroll and related expenses for personnel engaged in marketing and sales. Marketing and sales expense increased to $2.8 million for the year ended December 31, 2002 from $2.5 million for the year ended December 31, 2001. This increase was primarily attributable to higher costs associated with sales and marketing fees related to our agreement with Baker & Taylor, increased credit card processing fees associated with higher sales levels and higher sales staffing levels and related expense.

Certain marketing and sales expenses associated with our agreement with Baker & Taylor are the product of the classification of services such as website content and customer database management as marketing and sales expense and we expect these costs will increase in absolute dollars as we expand our business.

There were no significant advertising expenses recorded for the year ended December 31, 2002, a decrease from approximately $30,000 recognized during the year ended December 31, 2001. This decrease was primarily attributable to the elimination of marketing and brand building expenses associated with the promotion of our on-campus marketing services programs and original mass-market collegiate textbook sales model.

We anticipate future marketing services revenue will focus on online solutions compatible with our eduPartners focus that leverage our website and opt-in customer email database and can be managed internally with existing resources. As a result of this focus and the considerably lower costs associated with marketing and promoting eduPartners, we expect advertising and sales and marketing staffing expenses to grow as we expand our business, but remain lower in absolute dollars than historical levels associated with our original mass-market collegiate textbook sales model and on-campus collegiate marketing services network. We anticipate credit card processing fees will continue to increase in absolute dollars as our revenues increase.

Product Development

Product development expense consists of payroll and related expenses for development and systems personnel and consultants. Product development expense decreased to $0.2 million for the year ended December 31, 2002 from $0.3 million for year ended December 31, 2001. This decrease was primarily attributable to general cost reductions associated with our technology development efforts and the streamlining and simplification of our website consistent with our eduPartner model. We anticipate our product development expenses will increase modestly during 2003 to support the continued growth of eduPartners and to update and maintain a functional, stable and scalable eCommerce enterprise.

General and Administrative

General and administrative expense consists of payroll and related expenses for executive and administrative personnel, facilities expenses, professional services expenses, travel and other general corporate expenses. General and administrative expense decreased to $1.3 million for the year ended December 31, 2002 from $3.1 million for year ended December 31, 2001. This decrease was primarily attributable to lower executive compensation, professional services, depreciation, administrative expenses and the recovery of previously written off receivables during the year ended December 31, 2002. During the year ended December 31, 2002, we received a $252,000 payment for a prepaid marketing balance that was previously written off as uncollectable. Consistent with efforts taken in other areas of our business, we have worked to reduce the overhead associated with managing and growing our enterprise. As a result of these efforts and the considerably lower costs associated with supporting our eduPartners model, we expect general and administrative expenses to grow as we expand our business, but remain lower in absolute dollars than historical levels associated with our original mass-market collegiate textbook sales model and on-campus collegiate marketing services network.

Non-Cash Compensation

Non-cash compensation expense consists of expenses related to the granting of employee options measured based on the intrinsic value of the stock option. Non-cash compensation expense decreased to $0.4 million for the year ended December 31, 2002 from $0.8 million for year ended December 31, 2001. This decrease was primarily attributable to lower residual un-amortized non-cash compensation balances associated with employee options during the year ended December 31, 2002.

Other Income/Expense

During the year ended December 31, 2001 and December 31, 2002 we sold or disposed of certain fixed assets that were no longer critical to the successful execution of our business plan. The disposal of these assets resulted in a loss or expense of approximately $4,000 and $38,000 during the year ended December 31, 2002 and 2001, respectively.

Interest Income, net

Interest income, net consists of interest income on our cash and cash equivalents and investments, and interest expense attributable to our convertible notes payable. Interest income, net was $0.3 million for the year ended December 31, 2002 compared to $0.6 million for the year ended December 31, 2001. This decrease was primarily attributable to lower interest rates earned on cash and cash equivalent and short-term investment balances during the year ended December 31, 2002.

Income Taxes

As of December 31, 2002 and December 31, 2001, we had net operating loss carryforwards for federal income tax purposes of $61.3 million and $59.2 million, respectively, which expire beginning in 2018. We have provided a full valuation allowance on the resulting deferred tax asset because of uncertainty regarding its realizability. Changes in the ownership of our common stock, as defined in the Internal Revenue Code of 1986, as amended, may restrict the utilization of such carryforwards. See Note 10 to our consolidated financial statements.

YEAR ENDED DECEMBER 31, 2001 COMPARED TO YEAR ENDED DECEMBER 31, 2000

Net Sales

Net sales decreased to $12.5 million for the year ended December 31, 2001 from $28.5 million for year ended December 31, 2000, from lower textbook and marketing services revenues as a result of our focus on the growth and development of our eduPartners program. Net product revenues in our eduPartners program increased to approximately $9.3 million for the year ended December 31, 2001 from approximately $7.3 million for the year ended December 31, 2000. The decrease in overall revenues is attributed largely to a sharp reduction in revenues from our original mass-market college targeted textbook sales model. This reduction was largely attributed to our focused growth from our eduPartners program and the elimination of significant national marketing expenditures and promotions historically expended to drive college students to our website.

Marketing services revenues decreased to $0.9 million for the year ended December 31, 2001 from $2.6 million for the year ended December 31, 2000. The majority of revenues recognized in 2001 were associated with contracts signed during 2000. No new marketing services contracts with an aggregate contact amount greater than $100,000 were signed during the last six months of 2001.

Net sales consist of sales of books and charges to customers for outbound shipping and are net of allowances for returns, promotional discounts and coupons. Revenues from sales of textbooks are recognized at the time products are received by the customer. Revenues from our marketing programs are recognized straight-line over the contract term, provided that no significant performance obligations remain and the collection of the related receivable is probable.

Operating Expenses

Cost of Product — Related Party (Baker & Taylor)

Cost of product — related party consists of the cost of products sold to customers. Cost of product — related party decreased to $7.9 million for the year ended December 31, 2001 from $21.3 million for year ended December 31, 2000. This decrease was primarily attributable to our decreased sales volume.

Cost of Shipping — Related Party (Baker & Taylor)

Cost of shipping — related party consists of outbound shipping. Cost of shipping decreased to $0.7 million for the year ended December 31, 2001 from $2.2 million for year ended December 31, 2000. This decrease was primarily attributable to our decreased sales volume. Also, for the year ended December 31, 2001, shipping revenue exceeded cost of shipping — related party by $0.2 million or 36%. For the year ended December 31, 2000, cost of shipping – related party actually exceeded shipping revenue by $0.4 million or 24%. In the fourth quarter of 2000, we increased our shipping rates to ensure that shipping revenue exceeded cost of shipping on most orders and have continued that policy in 2001.

Cost of Marketing Services

Cost of marketing services includes personnel costs associated with the implementation of our on campus marketing programs and other directly identifiable costs associated with our online advertising and on campus promotions. Cost of marketing services for the year ended December 31, 2001 decreased to approximately $45,000 from $0.4 million for the year ended December 31, 2000. This decrease was primarily attributable to our decreased marketing services revenue.

Marketing and Sales

Marketing and sales expense consists primarily of advertising and promotional expenditures, credit card processing fees and payroll and related expenses for personnel engaged in marketing, including the expenses previously associated with the maintenance and development of our nationwide network of student representatives. Marketing and sales expense decreased to $2.5 million for the year ended December 31, 2001 from $24.2 million for the year ended December 31, 2000. This decrease was primarily attributable to the elimination of marketing and brand building expenses associated with the promotion of our original mass-market collegiate textbook sales model, lower sales and marketing expenses associated with our agreement with Baker & Taylor and the elimination of our network of student representatives.

Advertising expense decreased from $7.0 million for the year ended December 31, 2000 to approximately $30,000 for the year ended December 31, 2001. This decrease was primarily attributable to the elimination of marketing and brand building expenses associated with the promotion of our original mass-market collegiate textbook sales model in 2001. We made similar reductions in the headquarter staffing associated with our consumer marketing effort and management of our student representative network.

Certain marketing and sales expenses associated with our agreement with Baker & Taylor are the product of the classification of services such as website content and customer database management as marketing and sales expense.

During 2001 we continued to reduce the marketing and sales overhead associated with our business. We focused resources on the growth and development of our eduPartners program. During the first quarter of 2001 we scaled back our network of student representatives to focus more closely on markets and campuses most frequently targeted by our marketing services clients. In the second half of 2001 we evaluated the prospects for continued growth, broader economic factors and the costs associated with maintaining a best-in-class on-campus network of student representatives. Based upon this analysis, we determined the most effective utilization of our resources was to focus on the growth and development of our eduPartners program. Consistent with that decision, we ceased operating and maintaining our student representative network and focused our marketing services efforts on developing opportunities consistent with our on-line eduPartner model. We anticipate future marketing services revenue will focus on online solutions compatible with our eduPartners focus that leverage our website and opt-in customer email database and can be managed internally with existing resources.

Product Development

Product development expense consists of payroll and related expenses for development and systems personnel and consultants. Product development expense decreased to $0.3 million for the year ended December 31, 2001 from $4.2 million for year ended December 31, 2000. This decrease was primarily attributable to overall reductions in technology staffing levels, the streamlining and simplification of our website consistent with our eduPartner model and the elimination of booklist development for non-eduPartner schools. We believe that the majority of site features and functionality necessary to support and expand our businesses have been successfully implemented. Based upon our decision to focus resources on the growth and development of our eduPartner program, we made a strategic decision to eliminate the development of detailed “booklists” for non-eduPartners institutions on our site.

General and Administrative

General and administrative expense consists of payroll and related expenses for executive and administrative personnel, facilities expenses, professional services expenses, travel and other general corporate expenses. General and administrative expense decreased to $3.1 million for the year ended December 31, 2001 from $6.4 million for year ended December 31, 2000. This decrease was primarily attributable to reduction in executive and administrative personnel and professional services expenses during 2001. Consistent with efforts taken in other areas of our business, we have worked to reduce the overhead associated with managing and growing our enterprise. During 2001 we renegotiated vendor agreements associated with our previous cost structure and reduced ongoing administrative expenses.

Non-Cash Compensation

Non-cash compensation expense consists of expenses related to the granting of employee options measured based on the intrinsic value of the stock option. Non-cash compensation expense decreased to $0.8 million for the year ended December 31, 2001 from $4.6 million for year ended December 31, 2000. This decrease was primarily attributable to reduction in staffing levels and the cancellation of non-vested employee options for employees who left the Company during 2000 and 2001.

Other Expense

During the year ended December 31, 2001 we sold or disposed of certain fixed assets that were no longer critical to the successful execution of our business plan. The disposal of these assets resulted in a loss or expense of approximately $38,000 during the year ended December 31, 2001 compared to a loss of approximately $0.3 million for the year ended December 31, 2000.

Interest Income, net

Interest income, net consists of interest income on our cash and cash equivalents and investments, and interest expense attributable to our convertible notes payable. Interest income, net was $0.6 million for the year ended December 31, 2001 compared to $1.0 million for the year ended December 31, 2000. This decrease was primarily attributable to lower interest rates and lower average cash and cash equivalent and short-term investment balances during the year ended December 31, 2001.

Income Taxes

As of December 31, 2000 and December 31, 2001, we had net operating loss carryforwards for federal income tax purposes of $54.8 million and $59.2 million, respectively, which expire beginning in 2018. We have provided a full valuation allowance on the resulting deferred tax asset because of uncertainty regarding its realizability. Changes in the ownership of our common stock, as defined in the Internal Revenue Code of 1986, as amended, may restrict the utilization of such carryforwards. See note 10 to our consolidated financial statements.

SEASONALITY

We experience significant seasonality in our results of operations. Due to the academic calendar and the seasonal nature of the textbook industry, our peak selling periods have historically been August/September and January/February, when college students return to school and new semesters begin. However, consistent with our focus on the expansion of eduPartners and its current concentration of private middle and high school institutions, our peak selling period during the year ended December 31, 2001 and 2002 was the July/August/September back-to-school season. During 2002, approximately 87% of our revenues were recognized in this period. We expect this trend to continue as we extend eduPartners’ leadership position in the private middle and high school market. While many private middle and high school institutions have an active book buying season in December/January, the volume of purchases are typically significantly lower than the initial back-to-school season. Part of our strategy is to expand eduPartners more deeply into the college and distance learning markets. This would result in more balanced selling seasons between fall and winter. However, based upon our current eduPartners school mix, we may continue to experience fluctuations in quarterly operating results.

LIQUIDITY AND CAPITAL RESOURCES

As of December 31, 2002, we had $18.5 million of cash, cash equivalents and short term investments. As of that date, our principal commitments consisted of obligations outstanding under operating leases, accounts payable and accrued liabilities. Although we have no material commitments for capital expenditures, we may experience increases in our capital expenditures and lease commitments consistent with anticipated growth in operations, infrastructure and personnel.

During the year ended December 31, 2002, we generated $1.6 million in cash from operating activities. Net cash generated from operating activities was $0.4 million for the year ended December 31, 2001. Net cash used in operating activities was $27.5 million the year ended December 31, 2000, consisting primarily of net losses adjusted for changes in accounts receivable, accounts payable and accrued expenses.

During the year ended December 31, 2002, net cash used in investing activities was $1.5 million, consisting primarily of the purchase of short-term investments. Net cash generated from investing activities was $0.8 million for the year ended December 31, 2001, consisting primarily of the sale of short-term investments and decrease in restricted cash. Net cash used in investing activities was $1.4 million for the year ended December 31, 2000, consisting primarily of purchases of computer equipment and fixtures and furniture.

Net cash provided by financing activities was $21,000, $0.2 million, and $36.5 million for the years ended December 31, 2002, 2001 and 2000, respectively. Net cash provided by financing activities during the year ended December 31, 2002 consisted of net proceeds of $21,000 from the exercise of employee stock options. Net cash provided by financing activities during the year ended December 31, 2001 consisted primarily of net proceeds of $0.7 million from an outstanding warrant receivable and $0.6 million cash used to purchase treasury shares. Net cash provided by financing activities during the year ended December 31, 2000 consisted primarily of net proceeds of $35.8 million from the issuance of common stock.

The following table provides an overview or our aggregate contractual obligations as of December 31, 2002:

Based upon our current and expected cost structure and recent growth levels within the eduPartners program, we believe we are positioned to improve upon the financial performance of 2002. However, we intend to increase spending on the development of eduPartners and relationships with other related businesses. Failure to generate sufficient revenues or, if necessary, reduce discretionary spending could harm our results of operations and financial condition.

RECENT ACCOUNTING STANDARDS

Under Statement of Financial Accounting Standards No. 146 (“FAS 146”), “Accounting for Costs Associated with Exit or Disposal Activities,” new accounting standards are adopted for the recognition, measurement and reporting of costs associated with exit and disposal activities, including restructuring activities. FAS 146 is effective for exit or disposal activities initiated after December 31, 2002. The Company does not expect adoption of the new accounting standards will have a material effect on its financial position or results of operations.

In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure” (“SFAS 148”). SFAS 148 amends SFAS 123, “Accounting for Stock-Based Compensation,” to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, this Statement amends the disclosure requirements of SFAS 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method

used on reported results. We have no plans to transition to the fair value based method of accounting for stock-based employee compensation.

FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others,” was issued by the Financial Accounting Standards Board in November 2002, and FASB Interpretation No. 46, “Consolidation of Variable Interest Entities,” was issued in January 2003. We do not expect adoption of the new accounting interpretations will have a material effect on its financial position or results of operations.

ITEM 7A.      QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Substantially all of our cash equivalents are at fixed interest rates, and, therefore, the fair value of these instruments is affected by changes in market interest rates. However, as of December 31, 2002, all of our cash equivalents mature within three months. As of December 31, 2002, we believe the reported amounts of cash equivalents and short-term investments to be reasonable approximations of their fair values. As a result, we believe that the market risk arising from our holdings of financial instruments is minimal. As of December 31, 2002 we were not subject to any material variable rate indebtedness.

ITEM 8.      CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA REPORT OF INDEPENDENT ACCOUNTANTS

To the Board of Directors and Stockholders
Varsity Group Inc.

In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, of stockholders’ equity and of cash flows present fairly, in all material respects, the financial position of Varsity Group Inc. and its subsidiaries at December 31, 2002 and 2001, and the results of their operations and their cash flows for the three years ended December 31, 2002 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

/s/ PricewaterhouseCoopers LLP

McLean, Virginia
March 7, 2003

VARSITY GROUP INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
Years ended December 31, 2000, 2001 and 2002
(in thousands, except share and per share data)

See accompanying notes to consolidated financial statements.

VARSITY GROUP INC.
CONSOLIDATED BALANCE SHEETS
As of December 31, 2001 and 2002
(in thousands, except share and per share data)

See accompanying notes to consolidated financial statements.

VARSITY GROUP INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ (DEFICIT) EQUITY
YEARS ENDED DECEMBER 31, 1998 AND 1999
(IN THOUSANDS, EXCEPT SHARE DATA)

Varsity Group, Inc.
Consolidated Statements of Stockholders’ Equity
Years ended December 31, 2000, 2001 and 2002
(in thousands, except share data)