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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d)
OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended April 30, 2003

Commission File Number 0-20842

PLATO LEARNING, INC.

Not Applicable

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 whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act: Yes [X]   No [  ]

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

(This document contains 31 pages)

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Table of Contents

PLATO Learning, Inc.
Form 10-Q

INDEX

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PLATO Learning, Inc. and Subsidiaries
Consolidated Statements of Operations
(Unaudited, in thousands, except per share amounts)

See Notes to Consolidated Financial Statements

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PLATO Learning, Inc. and Subsidiaries
Consolidated Balance Sheets
(In thousands, except per share amounts)

Note: The balance sheet at October 31, 2002 has been derived from our audited financial statements at
that date. See Notes to Consolidated Financial Statements.

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PLATO Learning, Inc. and Subsidiaries
Consolidated Statements of Cash Flows
(Unaudited, in thousands)

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PLATO Learning, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands, except per share amounts)

1. Business

We enhance the learning process by providing computer-based and e-learning instruction software and related services, offering basic to advanced level courseware in reading, writing, math, science, social studies and life and job skills. Our PLATO™ Learning System and PLATO™ Web Learning Network provide more than 4,000 hours of objective-based, problem-solving courseware and include assessment, alignment and management tools to create standards-based curricula and facilitate the learning process. PLATO courseware is delivered via networks, CD-ROM, private intranets and the Internet. In addition, single topic PLATO courseware is available through our e-commerce web site and distributors. We market our courseware products and services primarily to K-12 schools. We also sell to colleges, job training programs, correctional institutions, military education programs, corporations and individuals.

We are subject to risks and uncertainties including, but not limited to, dependence on information technology spending by our customers, well-established competitors, customers dependent on government funding, fluctuations of our quarterly results, a lengthy and variable sales cycle, dependence on key personnel, dependence on our intellectual property rights, rapid technological change and our ability to integrate acquisitions.

2. Basis of Presentation

The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. We have included all normal recurring adjustments considered necessary to give a fair presentation of our operating results for the interim periods shown. Operating results for these interim periods are not necessarily indicative of the results to be expected for the full fiscal year. For further information, refer to the consolidated financial statements and accompanying notes included in our Annual Report on Form 10-K for the fiscal year ended October 31, 2002.

The accompanying unaudited consolidated financial statements include the accounts of PLATO Learning, Inc. and its wholly owned subsidiaries. All significant intercompany accounts and transactions have been eliminated.

Certain reclassifications of previously reported amounts have been made to conform to the current year presentation. On the consolidated statements of operations, sales and marketing expenses are now presented separately from general and administrative expenses. Previously, they were presented together as selling, general and administrative expenses. On the consolidated statement of cash flows, depreciation and amortization is now presented as depreciation and amortization of equipment and leasehold improvements, amortization of capitalized product development costs and amortization of identified intangible assets. For fiscal year 2002, the reclassifications by quarter are summarized as follows:

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PLATO Learning, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands, except per share amounts)

3. Summary of Significant Accounting Policies

Revenue Recognition

We recognize revenue in accordance with the provisions of Statement of Position No. 97-2, “Software Revenue Recognition”, as amended and modified, as well as Technical Practice Aids issued from time to time by the American Institute of Certified Public Accountants, and Staff Accounting Bulletin No. 101, “Revenue Recognition in Financial Statements.”

Revenue from the sale of courseware licenses and computer hardware is recognized upon meeting the following criteria: (i) a written customer order is executed, (ii) courseware and hardware are delivered, (iii) the license fee is fixed or determinable and (iv) collectibility of the fee is probable. For software arrangements that include more than one element, we allocate the total arrangement fee among each deliverable based on vendor-specific objective evidence of the relative fair value of each deliverable. Vendor-specific objective evidence of fair value is determined using the price charged when that element is sold separately. Upon delivery, future service costs, if any, are accrued. Future service costs represent our problem resolution and support “hotline” services for a one-year period. Revenue from our subscription-based products, primarily the PLATO Web Learning Network, is deferred and recognized ratably over the contract period.

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PLATO Learning, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands, except per share amounts)

Service revenue includes software support, which is deferred and recognized ratably over the support period, and revenue from installation and training services, which is recognized as services are performed. Installation and training services are customarily billed at a fixed daily rate. Deferred revenue represents services and products yet to be delivered.

4. Stock-Based Compensation

In December 2002, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure, an amendment of FASB Statement No. 123” (“SFAS 148”). This statement amends SFAS 123 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.

As permitted by SFAS 123, we have elected to continue to account for our stock-based compensation plans under the intrinsic value method of Accounting Principles Board Opinion No. 25 “Accounting for Stock Issued to Employees.” The intrinsic value method recognizes compensation expense equal to the excess, if any, of the fair market value of our stock on the grant date over the exercise price.

We have adopted the disclosure provisions of SFAS 148 and the following table compares net earnings (loss) and the related per share amounts to the pro forma amounts that would be reported had compensation expense been recognized in accordance with the fair value method of SFAS 123, as amended by SFAS 148:

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PLATO Learning, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands, except per share amounts)

5. Acquisitions

Unaudited Pro Forma Data

In May 2002, we acquired NetSchools Corporation (“NetSchools”). For further information regarding this acquisition, refer to Note 4 of Notes to Consolidated Financial Statements included in our Annual Report on Form 10-K for the fiscal year ended October 31, 2002.

The operating results of NetSchools were included in our consolidated statements of operations from the date of acquisition. Our unaudited pro forma consolidated results of operations, as if the NetSchools acquisition had occurred at the beginning of the period presented, were as follows:

The pro forma data gives effect to actual operating results prior to the acquisition and adjustments to reflect increased identified intangible asset amortization and income taxes. No effect has been given to cost reductions or operating synergies in this presentation. The unaudited pro forma consolidated results of operations are for comparative purposes only and do not necessarily reflect the results that would have occurred had the acquisition occurred at the beginning of the period presented or the results which may occur in the future.

6. Accounts Receivable

The components of accounts receivable were as follows:

Installment receivables to be billed beyond one year from the balance sheet date were $1,975 at April 30, 2003 and $1,144 at October 31, 2002, and are included in other assets on the consolidated balance sheets.

The provision for doubtful accounts, included in general and administrative expense on the consolidated statements of operations, was $527 and $300 for the three months and $1,052 and $901 for the six months ended April 30, 2003 and 2002, respectively.

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PLATO Learning, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands, except per share amounts)

7. Goodwill and Identified Intangible Assets

We account for goodwill and identified intangible assets in accordance with the provisions of Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”). Under SFAS 142, goodwill and intangible assets with indefinite lives are no longer amortized to expense and must be periodically reviewed for impairment. If such review indicates that the carrying amount of an intangible asset exceeds its fair value, an impairment loss would be recognized equal to that excess amount.

Goodwill

SFAS 142 requires that goodwill of a reporting unit be tested for impairment on an annual basis and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value. We operate one reporting unit and, therefore, we test goodwill impairment on an enterprise wide basis. As of October 31, 2002, our annual impairment test indicated that goodwill was not impaired; however, as of April 30, 2003, the market value of our common stock had declined to a point where our market capitalization was below our net book value. We consider the market capitalization, prevailing control premiums and other factors when we test goodwill impairment. Based on the weight of available evidence, we believe that events and circumstances do not indicate the need to test goodwill impairment as of April 30, 2003; however, should events and circumstances change, an interim goodwill impairment test may be necessary prior to the annual test on October 31, 2003. Such events and circumstances include a prolonged decline in our stock price and may result in a future impairment loss that could have a significant impact on our consolidated financial statements including a large non-cash charge to the statement of operations.

Goodwill was increased by $870 during the three months ended January 31, 2003 as a result of the finalization of the purchase price allocation relating to the NetSchools acquisition in May 2002. As provided by the purchase agreement, there may be additional consideration of up to approximately $6,000, contingent on the NetSchools product and services revenues generated through October 2004. Additional consideration will be recorded as additional goodwill as earned.

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PLATO Learning, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands, except per share amounts)

Identified Intangible Assets

Identified intangible assets subject to amortization were as follows:

Amortization expense for identified intangible assets was $494 and $243 for the three months ended April 30, 2003 and 2002, respectively, of which $75 was included in product development and customer support expense for each period. Amortization expense for identified intangible assets was $970 and $512 for the six months ended April 30, 2003 and 2002, respectively, of which $150 was included in product development and customer support expense for each period.

The estimated annual amortization expense for identified intangible assets is as follows:

8. Debt

There were no borrowings outstanding under our revolving loan agreement at April 30, 2003. We did not comply with the Minimum Debt Service Coverage covenant contained in our revolving loan agreement for the period ended April 30, 2003. We have received a waiver from our lender covering this noncompliance for such period. For further information regarding our revolving loan agreement, refer to Note 9 of Notes to Consolidated Financial Statements included in our Annual Report on Form 10-K for the fiscal year ended October 31, 2002.

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PLATO Learning, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands, except per share amounts)

9. Stockholders’ Equity

Common Stock Repurchased

We repurchased approximately 458,000 shares of our common stock for an aggregate cost of $2,161 during the six months ended April 30, 2003. These shares are presented as treasury stock in the consolidated balance sheet.

10. Restructuring Charge

The consolidated statement of operations for the six months ended April 30, 2003 included a restructuring charge of $380. In December 2002, we reduced the size of our workforce by approximately 30 positions and closed approximately 30 open job requisitions, all in the United States, which represented approximately 10% of our planned workforce. Substantially all of these severance costs were paid as of January 31, 2003.

In May 2003, we severed relationships with three senior executives (our Chief Operating Officer, our Managing Director of operations in the United Kingdom, and a co-founder of NetSchools) and three other employees. Severance charges of approximately $400 will be incurred in the third quarter of 2003.

11. Per Share Data

Basic earnings (loss) per share is calculated by dividing net earnings (loss) by the weighted average number of common shares outstanding during the period. Diluted earnings (loss) per share is calculated by dividing net earnings (loss) by the weighted average number of common and, where dilutive, potential common shares outstanding during the period. Potential common shares include options and warrants.

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PLATO Learning, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands, except per share amounts)

The calculation of basic and diluted net income (loss) per share was as follows:

The calculation of diluted loss per share for the three and six months ended April 30, 2003 excluded the effect of approximately 3,146,000 potential common shares from the conversion of outstanding options and warrants as they were antidilutive.

The calculation of diluted loss per share for the six months ended April 30, 2002 excluded the effect of approximately 2,454,000 potential common shares from the conversion of outstanding options and warrants as they were antidilutive.

12. Comprehensive Income (Loss)

Total comprehensive income (loss) was as follows:

13. Segment and Geographic Information

We operate in the single business segment of educational software. Revenues are attributed to geographic locations based upon the location of the customer. Revenues from foreign customers, primarily in Canada and the United Kingdom, were $407 and $1,630 for the three months and $831 and $2,507 for the six months ended April 30, 2003 and 2002, respectively.

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PLATO Learning, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands, except per share amounts)

14. New Accounting Pronouncements

In June 2002, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 146, “Accounting for Costs Associated with Exit or Disposal Activities” (“SFAS 146”). This statement requires that we recognize costs associated with exit or disposal activities when they are incurred rather than at the date of commitment to an exit or disposal plan. SFAS 146 is effective for any exit plans initiated after December 31, 2002. We do not believe that the adoption of SFAS 146 will have a material impact on our consolidated financial statements.

In November 2002, the FASB issued Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” This interpretation elaborates on the disclosures required in financial statements concerning obligations under certain guarantees. It also clarifies the requirements related to the recognition of liabilities by a guarantor at the inception of certain guarantees. We do not expect that the application of this interpretation will have a material impact on our consolidated financial statements.

In January 2003, the FASB issued Interpretation No. 46, “Consolidation of Variable Interest Entities.” This interpretation addresses the requirements for business enterprises to consolidate related entities in which they are determined to be the primary beneficiary as a result of their variable economic interest. The interpretation is intended to provide guidance in judging multiple economic interests in an entity and in determining the primary beneficiary. The interpretation outlines disclosure requirements for variable interest entities in existence prior to January 31, 2003, and outlines consolidation requirements for variable interest entities created after January 31, 2003. We do not expect that the application of this interpretation will have a material impact on our consolidated financial statements.

In May 2003, the FASB issued Statement of Financial Accounting Standards No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity” (“SFAS 150”). SFAS 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. Instruments that fall within the scope of SFAS 150 must be classified as a liability. SFAS 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003 (our fourth quarter of fiscal year 2003). We do not believe that the adoption of SFAS 150 will have a material impact on our consolidated financial statements.

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PLATO Learning, Inc.
Management’s Discussion and Analysis of Results of
Operations and Financial Condition
(Dollars in thousands, except per share amounts)

OVERVIEW

We enhance the learning process by providing computer-based and e-learning instruction software and related services, offering basic to advanced level courseware in reading, writing, math, science, social studies and life and job skills. Our PLATO^® Learning System and PLATO^® Web Learning Network provide more than 4,000 hours of objective-based, problem solving courseware and include assessment, alignment and management tools to create standards-based curricula and facilitate the learning process. PLATO courseware is delivered via networks, CD-ROM, private intranets and the Internet. In addition, single topic PLATO courseware is available through our e-commerce web site and distributors. We market our courseware products and services primarily to K-12 schools. We also sell to colleges, job training programs, correctional institutions, military education programs, corporations and individuals.

We are subject to risks and uncertainties including, but not limited to, dependence on information technology spending by our customers, well-established competitors, customers dependent on government funding, fluctuations of our quarterly results, a lengthy and variable sales cycle, dependence on key personnel, dependence on our intellectual property rights, rapid technological change and our ability to integrate acquisitions. As provided for in the Private Securities Litigation Reform Act of 1995, we caution investors that these factors could cause our future results of operations to vary from those anticipated in previously made forward-looking statements and any other forward-looking statements made in this document and elsewhere by or on behalf of us.

CRITICAL ACCOUNTING POLICIES

Our discussion and analysis of results of operations and financial condition is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. We continually evaluate our critical accounting policies and have identified revenue recognition, the valuation of accounts receivable, the capitalization of product development costs, the valuation of our deferred tax asset and goodwill and identified intangible asset impairment testing as the critical accounting policies that are significant to the financial statement presentation and require difficult, subjective and complex judgments.

See Notes 2 and 3 to Consolidated Financial Statements for additional discussion on these and other accounting policies and disclosures required by accounting principles generally accepted in the United States of America.

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PLATO Learning, Inc.
Management’s Discussion and Analysis of Results of
Operations and Financial Condition
(Dollars in thousands, except per share amounts)

Revenue Recognition

Revenue recognition rules for software companies are very complex. We follow specific and detailed guidelines in determining the proper amount of revenue to be recorded; however, certain judgments affect the application of our revenue recognition policy. Revenue results are difficult to predict, and any shortfall in revenue or delay in recognizing revenue could cause our operating results to vary significantly from quarter to quarter.

The most significant judgments for revenue recognition typically involve whether there are any significant uncertainties regarding customer acceptance and whether collectibility can be considered probable. In addition, our transactions often consist of multiple element arrangements which must be analyzed to determine the relative fair value of each element, the amount of revenue to be recognized upon shipment, if any, and the period and conditions under which deferred revenue should be recognized.

Allowance for Doubtful Accounts

We determine an allowance for doubtful accounts based upon an analysis of the collectibility of specific accounts, historical experience and the aging of the trade and installment accounts receivable. Bad debt expense is recorded as an operating expense in our consolidated statement of operations. The assumptions and estimates used to determine the allowance are subject to constant revision and involve significant assumptions and judgment. The primary factors that impact these assumptions include the efficiency and effectiveness of our billing and collection functions, our historical experience and our credit assessment process. We believe that the current budget difficulties facing many states will not have a significant impact on the collection of our accounts receivable. However, a change in the underlying conditions contributing to our belief could impact our assessment of collectibility and, therefore, require a change in the allowance for doubtful accounts and the amount of bad debt expense. Actual collection results could differ materially from those estimated and have a significant impact on our consolidated financial statements.

Capitalization of Product Development Costs

Our product development expense includes costs related to the development, enhancement and maintenance of our courseware products, and the effect of product development cost capitalization and amortization. Research and development costs, relating principally to the design and development of new products, and the routine enhancement of existing products are expensed as incurred. We capitalize product development costs when the projects under development reach technological feasibility, as defined by the accounting standards. Capitalization ends when a product is available for general release to our customers, at which time amortization of the capitalized costs begins. We amortize these costs using the greater of (a) the amount determined by the ratio of the product’s current revenue to total expected future

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PLATO Learning, Inc.
Management’s Discussion and Analysis of Results of
Operations and Financial Condition
(Dollars in thousands, except per share amounts)

revenue, or (b) the straight-line method over the estimated useful life of the product, which is generally three years. During all periods presented, we used the straight-line method to amortize the capitalized costs as this method resulted in greater amortization.

The most significant judgments regarding capitalization of product development costs typically involve the determination of whether development efforts should be expensed or have reached technological feasibility and can be capitalized, and the recoverability of capitalized costs. We continually evaluate our capitalized costs to determine if the unamortized balance related to any given product exceeds the estimated net realizable value of that product. Estimating net realizable value requires us to estimate future cash flows to be generated by the product and to use judgment in quantifying the amount, if any, to be written off. Actual cash flows and amounts realized from the courseware products could differ materially from those estimated. In addition, any future changes to our courseware product offerings could result in write-offs of previously capitalized costs and have a significant impact on our consolidated financial statements.