Back to GetFilings.com

Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

For the quarterly period ended March 31, 2003

For the transition period from                          to                         

Commission File Number 0-32613

EXCELLIGENCE LEARNING CORPORATION

(Exact Name of Registrant as Specified in Its Charter)

Registrant’s Telephone Number, Including Area Code: (831) 333-2000

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: Common Stock, $.01 par value, 8,523,345 shares outstanding as of May 6, 2003.

Table of Contents

EXCELLIGENCE LEARNING CORPORATION

TABLE OF CONTENTS

Table of Contents

PART I

FINANCIAL INFORMATION

Item 1. Financial Statements.

EXCELLIGENCE LEARNING CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except for par value and share amounts)

(Unaudited)

See accompanying notes to condensed consolidated financial statements.

1

Table of Contents

EXCELLIGENCE LEARNING CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except for share and per share amounts)

(Unaudited)

See accompanying notes to condensed consolidated financial statements.

2

Table of Contents

EXCELLIGENCE LEARNING CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

See accompanying notes to condensed consolidated financial statements.

3

Table of Contents

EXCELLIGENCE LEARNING CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

(1) The Business

Excelligence Learning Corporation, a Delaware corporation, is a developer, manufacturer and retailer of educational products, which are sold to child care programs, preschools, elementary schools and consumers. Excelligence Learning Corporation’s business is primarily conducted through its wholly-owned subsidiaries, Earlychildhood LLC, a California limited liability company (“Earlychildhood”), Educational Products, Inc., a Texas corporation (“EPI”), SmarterKids.com, Inc., a Delaware corporation (“SmarterKids.com”), and Marketing Logistics, Inc., a Minnesota corporation, d.b.a. Early Childhood Manufacturers’ Direct, (“ECMD”).

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and 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 generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (which are normal and recurring in nature) considered necessary for a fair presentation have been included. The balance sheet at December 31, 2002 was derived from the audited financial statements of Excelligence Learning Corporation (together with its wholly-owned subsidiaries, the “Company”) for the fiscal year ended December 31, 2002. For further information, refer to the consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2002.

Income Taxes

The Company is taxed as a C corporation. The Company recorded an income tax benefit of $853,000 for the three-month period ended March 31, 2003 and no benefit for the three-month period ended March 31, 2002. As of March 31, 2002, the Company was unable to conclude that the deferred tax assets generated as a result of its net loss would more likely than not be realized from the results of its operations. Accordingly, the Company provided a valuation allowance against such deferred tax assets.

Recent Accounting Pronouncements

In June 2001, the Financial Accounting Standards Board (FASB) approved for issuance Statement of Financial Accounting Standards (“SFAS”) No. 143, Accounting for Asset Retirement Obligations. SFAS No. 143 addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. SFAS No. 143 amends SFAS No. 19, Financial Accounting and Reporting by Oil and Gas Producing Companies. SFAS No. 143 requires that the fair value of a liability for an asset retirement obligation be recognized in the period in which it is incurred if a reasonable estimate of fair value can be made. The associated asset retirement costs are capitalized as part of the carrying amount of the long-lived asset. The provisions of SFAS No. 143 are effective for financial statements issued for fiscal years beginning after June 15, 2002. The effects of adopting SFAS No. 143 did not have a significant impact on the Company’s financial position, results of operations or footnote disclosures.

In May 2002, the FASB approved for issuance SFAS No. 145, Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections. SFAS No. 145 requires gains and losses from extinguishment of debt to be classified as an extraordinary item only if the criteria in Accounting Principles Board (APB) Opinion No. 30 have been met. In addition, lease modifications with economic effects similar to sale-leaseback transactions must be accounted for in the same manner as sale-leaseback transactions. While the technical corrections to existing pronouncements are not substantive in nature, in some instances they may change accounting practice. SFAS No. 145 became effective for financial statements with fiscal years beginning after May 15, 2002. The Company adopted the provisions of SFAS No. 145 on January 1, 2003. The Company’s future losses, if any, from the extinguishments of debt will no longer be reported as an extraordinary item but will be recorded as other expense.

In June 2002, the FASB approved for issuance SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities. SFAS No. 146 addresses accounting and reporting for costs associated with exit and disposal activities and supercedes Emerging Issues Task Force Issue No. 94-3 (EITF 94-3), Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring). SFAS No. 146 requires that a liability for a cost associated with an exit

4

Table of Contents

or disposal activity be recognized when the liability is incurred, as defined by SFAS No. 146. Under EITF 94-3, an exit cost was recognized at the date an entity committed to an exit plan. Additionally, SFAS No. 146 provides that exit and disposal costs should be measured at fair value and that the associated liability be adjusted for changes in estimated cash flows. SFAS No. 146 became effective for exit or disposal activities initiated after December 31, 2002. The Company did not participate in any exit or disposal activities during the first quarter of 2003.

In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based Compensation—Transition and Disclosure, which amends SFAS No. 123, Accounting for Stock-Based Compensation. SFAS No. 148 provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to require more prominent and more frequent disclosures in financial statements about the effects of stock-based compensation. In addition, SFAS No. 148 improves the timeliness of those disclosures by requiring that this information be included in interim as well as annual financial statements. SFAS No. 148 is effective for fiscal years ending after December 15, 2002. The effects of adopting SFAS No. 148 did not have a significant impact on the Company’s financial position, results of operations or footnote disclosures.

(2) Business Combinations

On February 19, 2003, the Company consummated its acquisition of Marketing Logistics, Inc., an online retailer of early childhood furniture and equipment now doing business as ECMD. Consideration for the acquisition included $800,000 in cash and 100,000 redeemable shares of the Company’s common stock. The seller of ECMD has a one-time opportunity, exercisable during the thirty-day period prior to February 19, 2004, to exchange the shares received by him in the acquisition for $400,000 in cash.

The allocation of the purchase price of $1.2 million plus transaction costs of $27,000 is summarized as follows (in thousands):

In April 2001, the Company completed the combination of Earlychildhood and SmarterKids.com. In conjunction with the combination, the Company terminated certain SmarterKids.com employees and determined that an acquired lease for a facility in Needham, Massachusetts was unfavorable. As a result, liabilities of $1.5 million and $1.1 million were recorded for severance and the unfavorable lease, respectively.

In the fourth quarter of 2001, the Company approved a restructuring plan to aid in the reduction of its operating costs. Specifically, the Company closed its Needham facility in January 2002. In accordance with the plan, the closure of the Needham facility consolidated information systems and marketing functions in Monterey, California and reduced the administrative costs associated with operating an additional facility. Additional charges related to the planned closure of the Needham facility and various equipment leases that are no longer being used in the Company’s operations totaled $1.3 million and were expensed in 2001. During the fiscal year ended December 31, 2001, the Company paid $1.3million and $112,000 related to severance and Needham facility costs, respectively.

During fiscal year 2002, the Company paid $401,000 and $1.3million related to severance and Needham facility costs, respectively. Of these costs, $226,000 related to severance costs for terminations announced in 2002 and therefore was recorded as an expense in the first quarter of 2002. The remaining payments for severance related to charges taken in 2001. Also during fiscal year 2002, the Company determined that, due to a continued decline in the Needham, Massachusetts real estate market, its assumptions for sublease income should be reduced and an additional charge of $653,000 related to the unfavorable lease was expensed.

5

Table of Contents

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

(3) Unaudited Basic and Diluted Net Loss Per Share

The basic and diluted net loss per share information for the three months ended March 31, 2003 and 2002 included in the accompanying statements of operations is based on the weighted average number of shares of common stock outstanding during the period.

The following table sets forth the computation of basic and diluted net loss per share for the three months ended March 31, 2003 and 2002 (in thousands, except for share and per share amounts):

Common stock equivalents of 533,935 and 62,246 for the three months ended March 31, 2003 and 2002, respectively, have been excluded in the computation of diluted net loss per share as their effect is anti-dilutive. Common equivalent shares consist of shares issuable upon the exercise of stock options.

Equity-Based Compensation

The Company has adopted SFAS No. 123, Accounting for Stock-Based Compensation. As permitted by SFAS No. 123, the Company measures compensation cost in accordance with APB Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. Accordingly, no accounting recognition is given at the date of grant to stock options granted to employees with an exercise price equal to the fair market value of the underlying common stock. Upon exercise, net proceeds, including income tax benefits realized, are credited to equity. Compensation cost for stock options granted with exercise prices below the fair market value of the underlying common stock is recognized over the vesting period. The pro forma impact on earnings has been disclosed in the notes to the financial statements as allowed by SFAS No. 123.

SFAS No. 148, Accounting for Stock-Based Compensation—Transition and Disclosure, amends SFAS No. 123, Accounting for Stock-Based Compensation. SFAS No. 148 provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to require more prominent and more frequent disclosures in financial statements about the effects of stock-based compensation.

The following table illustrates the effect on net income and earnings per share applying the fair value recognition provisions of SFAS No. 123 to stock-based employee compensation:

6

Table of Contents

(4) Segment Information

The Company operates in two business segments, the Early Childhood segment and the Elementary School segment. The Early Childhood segment includes the brand names Discount School Supply, SmarterKids.com, Early Childhood Manufacturers’ Direct, and Earlychildhood NEWS. The Early Childhood segment develops, manufactures and sells educational products through multiple distribution channels to early childhood professionals and parents. The Early Childhood segment also provides information to teachers and other education professionals regarding development of children from infancy through age eight. The Elementary School segment sells school supplies and other products specifically targeted for use by children in first through sixth grade to elementary schools, teachers and other education organizations for fundraising activities.

The accounting policies of the reportable segments are the same as those described in the summary of significant accounting policies in the Company’s Annual Report on Form 10-K for the year ended December 31, 2002. There were no intersegment sales. The Company’s profit measure is EBITDA, which represents operating income (loss) adding back depreciation and amortization. This information should not be considered as an alternative to any measure of performance as promulgated under generally accepted accounting principles (such as operating income or income before extraordinary items) nor should it be considered as an indicator of the Company’s overall financial performance. The Company’s calculations of EBITDA may be different from the calculations used by other companies and therefore comparability may be limited. Information regarding the Early Childhood and Elementary School segments and reconciliation of operating income (loss) to EBITDA (loss) is as follows (in thousands):

7

Table of Contents

The Early Childhood segment performs limited administrative activities, including certain accounting and information system functions for the Elementary School segment. Such intersegment charges are based on estimates of its actual costs for such activities. Intersegment charges have been eliminated in the consolidation and amounted to $144,922 and $144,168 for the three months ended March 31, 2003 and 2002, respectively.

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

(5) Goodwill and Intangibles

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

The Company reevaluated its intangible asset lives and no adjustments to the useful lives were determined to be necessary. In accordance with SFAS No. 142, the Company completed a transitional goodwill impairment test as of January 1, 2002 in the second quarter of 2002 and determined that no additional impairment charge was necessary. The Company performs its annual impairment test required by SFAS No. 142 in the fourth quarter. No reclassification of intangible assets apart from goodwill was necessary as a result of the adoption of SFAS No. 142.

The following table identifies the major classes of intangible assets at March 31, 2003 and December 31, 2002 (in thousands):

Total amortization expense on intangible assets was $75,000 and $72,000 for the three months ended March 31, 2003 and 2002, respectively.

The carrying amount of goodwill was $5.8 million and $4.7 million at March 31, 2003 and December 31, 2002, respectively. During the first quarter of 2003, the Company obtained $1.1 million in goodwill through its acquisition of Marketing Logistics, Inc. There was no impairment loss recorded during the three months ended March 31, 2003 and 2002.

(6) Debt

The Company has a secured credit facility with GMAC Business Credit, LLC (the “GMAC Facility”). The GMAC Facility includes a $25 million line of credit with a maturity of April 30, 2004, an interest rate of LIBOR plus 3.0% (6.0% at March 31, 2003) and a minimum excess availability requirement of $4 million at all times, which effectively limits the Company’s borrowing capacity to a maximum of $21 million. The GMAC Facility has a credit limit at any time of an amount equal to the sum of 80% of the aggregate face amount of eligible accounts receivable plus the lowest of (i) 50% of the Company’s inventory; (ii) 85% times net liquidation percentage of inventory (the liquidation percentage is periodically set by the lender); or (iii) the result of $18 million minus the

8

Table of Contents

eligible portion of EPI’s inventory. As of March 31, 2003, the Company had borrowings of $4.4 million and available borrowing capacity of $3.3 million under the GMAC Facility.

The GMAC Facility requires adherence to certain financial covenants and contains restrictions related to capital expenditures during the term of the GMAC Facility. As of March 31, 2003, the Company was in compliance with the financial covenants as set forth in the GMAC Facility.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

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

Overview

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

All of the foregoing is supported by a national sales force which, as of March 31, 2003, numbered 70 people.

The Company operates in two business segments, Early Childhood and Elementary School. The Early Childhood segment includes the brand names Discount School Supply, SmarterKids.com, Early Childhood Manufacturers’ Direct, and Earlychildhood NEWS. The Early Childhood segment develops, manufactures and sells educational products through multiple distribution channels to early childhood professionals and parents. The Early Childhood segment also provides information to teachers and other education professionals regarding the development of children from infancy through age eight. The Elementary School segment sells school

9

Table of Contents

supplies and other products specifically targeted for use by children in kindergarten through sixth grade to elementary schools, teachers and other education organizations for fundraising activities.

Results of Operations

Revenues

Revenues increased 11.8% to $17.4 million for the three months ended March 31, 2003, up $1.8 million from the $15.6 million recorded for the same period in 2002. The increase was primarily attributable to revenue growth of $1.8 million in the Early Childhood segment. The Early Childhood segment continues its trend of revenue growth through new product offerings, new customer solicitation and improved sales and marketing strategies. Sales in the Elementary School segment were consistent with the prior year’s quarter.

The Company’s goal in 2003 is to achieve revenue growth in the Early Childhood and Elementary School segments by increasing circulation of its Discount School Supply catalog, increasing childhood furniture sales by expanding the operations of ECMD, offering new proprietary products, soliciting new customers, implementing more aggressive sales and marketing strategies and enhancing the Company’s websites. The Company’s ability to realize this growth may be negatively affected by changes in the national economy that reduce government or private funding of educational programs or that increase joblessness and may result in parents removing their children from childcare programs.

Gross Profit

Gross profit was $6.1 million for the three-month period ended March 31, 2003, a $500,000 increase over the gross profit of $5.6 million for the same period in 2002. The increase is primarily attributable to increased revenue for the period. Gross profit as a percentage of sales decreased from 36.1% for the first quarter of 2002 to 35.1% for the first quarter of 2003. The decrease in gross profit percentage was due to increased product costs and freight charges.

The Company accounts for shipping costs as cost of goods sold for shipments made directly from vendors to customers and also for shipments from the Company’s warehouses. The amount of shipping costs related to shipments from the Company’s warehouses for the three months ended March 31, 2003 and 2002 was $1.4 million and $1.3 million, respectively, or 7.9% and 8.3% as a percentage of sales, respectively. The amount of shipping costs related to shipments made directly from vendors to customers for the three months ended March 31, 2003 and 2002 was $568,000 and $405,000, respectively, or 3.3% and 2.6% as a percentage of sales, respectively.

Selling, General and Administrative Expenses

Selling, general and administrative expenses include wages and commissions, catalog costs, operating expenses (which include customer service and certain warehouse costs), administrative costs (which include information systems, accounting and human resources), e-business costs, equity-based wages and depreciation of property and equipment. Selling, general and administrative expenses were $8.0 million and $8.4 million for the three months ended March 31, 2003 and 2002, respectively. The overall decrease is the result of a $607,000 reduction in the Early Childhood segment’s selling, general and administrative expenses, partially offset by an increase in the Elementary School segment’s operating expenses of $263,000.

The decrease in the Early Childhood segment’s selling, general and administrative expenses is primarily related to wages, bank fees and severance costs related to the Needham facility closure that occurred in 2002. The increase in the Elementary School segment’s selling, general and administrative expenses is the result of an increased sales force and the production of a new catalog.

Amortization of Other Intangible Assets

Amortization of other intangible assets was $75,000 and $72,000 for the three months ended March 31, 2003 and 2002, respectively.

Interest Expense

Interest expense was $32,000 and $102,000 for the three months ended March 31, 2003 and 2002, respectively. The decrease in interest expense is due to the Company carrying a much lower average outstanding balance on its credit facility during the three months ended March 31, 2003 compared to the same period in 2002.

10

Table of Contents

Income Taxes

The Company is taxed as a C corporation. The Company recorded an income tax benefit of $853,000 for the three-month period ended March 31, 2003 and no benefit for the three-month period ended March 31, 2002. As of March 31, 2002, the Company was unable to conclude that the deferred tax assets generated as a result of its net loss would more likely than not be realized from the results of its operations. Accordingly, the Company provided a valuation allowance against such deferred tax assets.

Recent Accounting Pronouncements

In June 2001, the Financial Accounting Standards Board (FASB) approved for issuance Statement of Financial Accounting Standards (“SFAS”) No. 143, Accounting for Asset Retirement Obligations. SFAS No. 143 addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. SFAS No. 143 amends SFAS No. 19, Financial Accounting and Reporting by Oil and Gas Producing Companies. SFAS No. 143 requires that the fair value of a liability for an asset retirement obligation be recognized in the period in which it is incurred if a reasonable estimate of fair value can be made. The associated asset retirement costs are capitalized as part of the carrying amount of the long-lived asset. The provisions of SFAS No. 143 are effective for financial statements issued for fiscal years beginning after June 15, 2002. The effects of adopting SFAS No. 143 did not have a significant impact on the Company’s financial position, results of operations or footnote disclosures.

In May 2002, the FASB approved for issuance SFAS No. 145, Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections. SFAS No. 145 requires gains and losses from extinguishment of debt to be classified as an extraordinary item only if the criteria in Accounting Principles Board (APB) Opinion No. 30 have been met. In addition, lease modifications with economic effects similar to sale-leaseback transactions must be accounted for in the same manner as sale-leaseback transactions. While the technical corrections to existing pronouncements are not substantive in nature, in some instances they may change accounting practice. SFAS No. 145 became effective for financial statements with fiscal years beginning after May 15, 2002. The Company adopted the provisions of SFAS No. 145 required for financial statements on January 1, 2003. The Company’s future losses, if any, from the extinguishments of debt will no longer be reported as an extraordinary item but will be recorded as other expense.

In June 2002, the FASB approved for issuance SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities. SFAS No. 146 addresses accounting and reporting for costs associated with exit and disposal activities and supercedes Emerging Issues Task Force Issue No. 94-3 (EITF 94-3), Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring). SFAS No. 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred, as defined by SFAS No. 146. Under EITF 94-3, an exit cost was recognized at the date an entity committed to an exit plan. Additionally, SFAS No. 146 provides that exit and disposal costs should be measured at fair value and that the associated liability be adjusted for changes in estimated cash flows. SFAS No. 146 became effective for exit or disposal activities initiated after December 31, 2002. The Company did not participate in any exit or disposal activities during the first quarter of 2003.

In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based Compensation—Transition and Disclosure, which amends SFAS No. 123, Accounting for Stock-Based Compensation. SFAS No. 148 provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to require more prominent and more frequent disclosures in financial statements about the effects of stock-based compensation. In addition, SFAS No. 148 improves the timeliness of those disclosures by requiring that this information be included in interim as well as annual financial statements. SFAS No. 148 is effective for fiscal years ending after December 15, 2002. The effects of adopting SFAS No. 148 did not have a significant impact on the Company’s financial position, results of operations or footnote disclosures.

Liquidity and Capital Resources

The Company’s primary cash needs have been for operations, capital expenditures and acquisitions. The Company’s primary source of liquidity is the GMAC Facility. As of March 31, 2003, the Company had net working capital of $14.9 million.

During the three months ended March 31, 2003, the Company’s operating activities used $2.4 million of cash. The use of cash was primarily related to operating losses and working capital. The Company used $1.2 million in cash for investing activities during the

11

Table of Contents

three months ended March 31, 2003 with which the Company acquired ECMD and purchased property and equipment. The Company obtained $4.4 million in cash from financing activities, mostly from borrowings under the GMAC Facility.

The GMAC Facility includes a $25 million line of credit with a maturity of April 30, 2004, an interest rate of LIBOR plus 3.0% (6.0% at March 31, 2003) and a minimum excess availability requirement of $4 million at all times, which effectively limits the Company’s borrowing capacity to a maximum of $21 million. The GMAC Facility has a credit limit at any time of an amount equal to the sum of 80% of the aggregate face amount of eligible accounts receivable plus the lowest of (i) 50% of the Company’s inventory; (ii) 85% times net liquidation percentage of inventory (the liquidation percentage is periodically set by the lender); or (iii) the result of $18 million minus the eligible portion of EPI’s inventory. As of March 31, 2003, the Company had borrowings of $4.4 million and available borrowing capacity of $3.3 million under the GMAC Facility.

The GMAC Facility requires adherence to certain financial covenants and contains restrictions related to capital expenditures during the term of the facility. As of March 31, 2003, the Company was in compliance with the financial covenants as set forth in the GMAC Facility.

The following summarizes the Company’s contractual obligations as of March 31, 2003 and the effect such obligations are expected to have on liquidity and cash flow in future periods (in thousands):

Included in non-cancelable operating leases is $1.8 million in future cash requirements related to the abandonment of the Needham facility. Such charges may be paid out over the remaining lease term, which expires October 2004. On November 12, 2002, the Company signed a 24-month lease agreement to sublease 25.5%, or 10,000 square feet, of the Needham, Massachusetts facility. The Company is actively seeking a subtenant for the remaining space but can offer no assurances as to when, or if, a subtenant will be found.

Management believes that availability under the GMAC Facility will provide adequate funds for the Company’s foreseeable working capital needs and planned capital expenditures. The Company’s working capital needs are greatest during the second calendar quarter as inventory levels are increased to meet seasonal demands. The Company’s ability to fund its operations, repay debt, make planned capital expenditures and to remain in compliance with its financial covenants under the GMAC Facility depends on its future operating performance and cash flow, which in turn are subject to prevailing economic conditions and to financial, business and other factors, some of which are beyond its control.

Business Outlook

The following forward-looking statements reflect the Company’s expectations for the second quarter of and full fiscal year 2003. Actual results may differ materially given the potential changes in general economic conditions and the various other risks discussed in Item 1—”Risk Factors” of the Company’s Annual Report on Form 10-K for the year ended December 31, 2002.

The Company’s goal in 2003 is to achieve revenue growth in the Early Childhood and Elementary School segments by increasing circulation of its Discount School Supply catalog, increasing childhood furniture sales through expanding the operations of its acquisition of ECMD, offering new proprietary products, soliciting new customers, implementing more aggressive pricing, marketing strategies and enhancing the Company’s websites. The Company’s ability to realize this growth may be negatively affected by changes in the national economy that reduce government or private funding of educational programs or that increase joblessness and may result in parents removing their children from childcare programs.

For the second quarter of 2003,

12

Table of Contents

For full fiscal year 2003,

EBITDA is calculated by adding back to operating income (loss): depreciation and amortization. This information should not be considered as an alternative to any measure of performance as promulgated under generally accepted accounting principles (such as operating income or income before extraordinary items) nor should it be considered as an indicator of the Company’s overall financial performance. The Company’s calculations of EBITDA may be different from the calculations used by other companies and therefore comparability may be limited.

Critical Accounting Policies and Estimates

The Company’s discussion and analysis of its financial condition and results of operations are based upon the Company’s 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 the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. On an on-going basis, the Company evaluates its estimates, including those related to bad debts, product returns, intangible assets, inventories, and merger integration. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

The Company believes the following critical accounting policies affect its more significant judgments and estimates used in the preparation of its consolidated financial statements.

Revenue Recognition and Accounts Receivable

The Company recognizes revenues from product sales upon the delivery of products. Provisions for estimated returns and allowances are recorded as a reduction to sales and cost of sales based on historical experience. The Company determines that collectibility of accounts receivable is reasonably assured through standardized credit review to determine each customer’s credit worthiness. The Company maintains allowances for doubtful accounts for estimated losses resulting from the inability of its customers to make required payments. If the financial condition of the Company’s customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.

Inventories

The Company values inventories at the lower of cost or market, using the first-in, first-out method. Inventory cost is based on amounts paid to vendors plus the capitalization of certain labor and overhead costs necessary to prepare inventory to be saleable. The Company writes down its inventory for estimated obsolescence, damaged or unmarketable inventory equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions. If actual market conditions are less favorable than those projected by management, additional inventory write-downs may be required.

Impairment of Long-Lived Assets

The Company assesses the need to record impairment losses on long-lived assets used in operations, including goodwill and other intangibles, when indicators of impairment are present. On an on-going basis, management reviews the value and period of amortization or depreciation of its long-lived assets. Recoverability of long-lived assets to be held and used is measured by comparison of the carrying amount the asset group to the undiscounted future cash flow expected to be generated by the asset group. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. Assets to be disposed of are reported at the lower of the carrying amount or fair value less cost to sell.

13

Table of Contents

On January 1, 2002, the Company adopted SFAS No. 142, Goodwill and Other Intangible Assets. SFAS No. 142 provides that goodwill should not be amortized, but should instead be tested for impairment annually at the reporting unit level. In accordance with SFAS No. 142, the Company completed a transitional goodwill impairment test as of January 1, 2002 and its annual impairment test as of December 31, 2002. The Company’s goodwill impairment tests are based on a comparison of carrying value and fair value of its two reporting units, the Early Childhood and Elementary School segments. As of January 1, 2002 and December 31, 2002, the fair value of the Company’s reporting units exceeded their carrying value.

Merger Integration Liabilities

The Company has established liabilities relating to the abandonment of the Needham facility. This liability was primarily based on the excess of required lease payments over estimated sublease income. Due to the volatility in the commercial real estate market, the estimate of sublease income is extremely subjective. If there is a further decline in the commercial real estate market, if it takes longer than expected to sublet the remaining space at the facility or if such space when sublet is subleased at rates lower than the Company’s current estimates, the amounts the Company will ultimately realize could be different from the amounts assumed in arriving at the Company’s estimate of the cost of the lease abandonment.

Income Taxes

The Company is taxed as a C corporation and files a consolidated tax return with its wholly-owned subsidiaries. The Company’s condensed consolidated statements of operations reflect the income tax benefit based on the actual tax position of the Company and its subsidiaries in effect for the respective periods.

The Company has recorded a deferred tax asset in an amount that is more likely than not to be realized. While the Company has considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the value of the deferred tax asset, in the event that the Company were to determine that it would be able to realize its deferred tax assets in the future in excess of its recorded amount, an adjustment to the deferred tax asset would increase income in the period such determination was made. Likewise, should the Company determine that it would not be able to realize all or part of its deferred tax asset in the future, an adjustment to the deferred tax asset would be charged to income in the period such determination was made.

Seasonality

The Company’s seasonal sales trends coincide with the start of each school year. Accordingly, approximately 50% of the Early Childhood and Elementary School segments’ consolidated annual sales are generated in the third calendar quarter. The Company’s working capital needs are greatest during the second calendar quarter as inventory levels are increased to meet seasonal demands.

Inflation

Inflation has and is expected to have only a minor effect on the Company’s results of operations and sources of liquidity.

Item 3. Quantitative and Qualitative Disclosures About Market Risk.

The following discussion of market risk includes “forward-looking statements” that involve risks and uncertainties that could significantly offset anticipated results in the future. Actual results could differ materially from those projected in the forward-looking statements. The Company does not use derivative financial instruments for speculative or trading purposes.

Interest Rate Risk

The Company’s financial instruments include cash and cash equivalents, accounts receivable, accounts payable and a revolving line of credit. Market risks relating to operations result primarily from a change in interest rates. The Company’s borrowings are primarily dependent upon LIBOR rates. As of March 31, 2003, the Company had borrowings of $4.4 million and available borrowing capacity of $3.3 million under the GMAC Facility. See “Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources.” The estimated fair value of borrowings under the GMAC Facility is expected to approximate its carrying value.

Credit Risk

Financial instruments, which potentially subject the Company to concentrations of credit risk, consist primarily of cash, cash equivalents, accounts receivable and its revolving line of credit. The Company has no customer comprising greater than 10% of its

14

Table of Contents

revenues. However, receivables arising from the normal course of business are not collateralized and management continually monitors the payment of its accounts receivable and the financial condition of its customers to reduce the risk of loss. The Company does not believe that its cash and cash equivalents are subject to any unusual credit risk beyond the normal credit risk associated with commercial banking relationships.

Foreign Currency Risk

The Company purchases some of its products from foreign vendors. Accordingly, the Company’s prices of imported products are subject to variability based on foreign exchange rates. However, the Company’s purchase orders are denominated in U.S. dollars and the Company does not enter into long-term purchase commitments.

Item 4. Controls and Procedures.

The Company maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in the Company’s Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and that such information is accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

Within 90 days prior to the date of this report, the Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and the Company’s Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures. Based on the foregoing, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective.

There have been no significant changes in the Company’s internal controls or in other factors that could significantly affect the internal controls subsequent to the date the Company completed its evaluation.

15

Table of Contents

PART II

OTHER INFORMATION

Item 1. Legal Proceedings.

The Company and its subsidiaries are, from time to time, party to legal proceedings arising in the normal course of business. In management’s opinion, there are no pending claims or litigation, the outcome of which would have a material effect on the Company’s consolidated results of operations, financial position or cash flows.

Item 2. Changes in Securities and Use of Proceeds.

None.

Item 3. Defaults Upon Senior Securities.

None.

Item 4. Submission of Matters to a Vote of Security Holders.

None.

Item 5. Other Information.

None.

Item 6. Exhibits and Reports on Form 8-K.

(a) Exhibits.

In accordance with SEC Release No. 33-8212, the following exhibit is being furnished, and is not being filed as part of this Form 10-Q or as a separate disclosure document, and is not being incorporated by reference into any Securities Act of 1933 registration statement.

* Filed herewith.

(b) Reports on Form 8-K.

None.

16

Table of Contents

SIGNATURE

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized in Monterey, California on the 9^th day of May, 2003.

17

Table of Contents

Section 302 Certifications:

Chief Executive Officer

I, Ronald Elliott, certify that:

Date: May 9, 2003

18

Table of Contents

Chief Financial Officer

I, Richard Delaney, certify that:

Date: May 9, 2003

19