E learning the engine of the knowledge economy ( e learning industry report)

However, we havedeveloped a unique “eLearning matrix” which allows a company to also be characterized by which sector of the learning market it serves academic, corporate or consumer and

MORGAN KEEGAN ELEARNING INDUSTRY REPORT

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TABLE OF CONTENTS

EXECUTIVE SUMMARY 5

SECTION I: INVESTMENT THESIS ELEARNING FOR THE KNOWLEDGE AGE 10

LEARNING IN THE 21ST CENTURY 15

SEEKING PROFITABILITY IN THE ELEARNING INDUSTRY 20

VALUATION AND PERFORMANCE OF THE ELEARNING STOCKS 22

RISK FACTORS 26

KEY TRENDS AND SIGNPOSTS FOR INVESTING IN THE ELEARNING INDUSTRY 28

SECTION II: A TOPOLOGY OF THE ELEARNING INDUSTRY A BRIEF HISTORY: THE FORMATIVE YEARS OF THE ELEARNING INDUSTRY 32

THE BUSINESS MODELS OF ELEARNING 37

SECTION III: THE LEARNING MARKET THE ACADEMIC MARKET 50

THE CORPORATE MARKET 66

THE CONSUMER MARKET 74

SECTION IV: LEARNING TECHNOLOGIES FROM ABACUS TO LMS: THE EVOLUTION OF LEARNING TECHNOLOGIES 78

NEXT ON THE AGENDA FOR ELEARNING? 84

ELEARNING STANDARDS: CREATING A BLUEPRINT FOR THE FUTURE 89

CONCLUSION 98

MORGAN KEEGAN ELEARNING INDUSTRY REPORT

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EXECUTIVE SUMMARY

The following is a summary of the four main sections of the report For more information on any of thetopics mentioned in this summary, please refer to the corresponding section in the body of the report

Section I: Investment Thesis

eLearning will be critical to the success of individuals, organizations, communities and economies in thedawning knowledge economy Much touted are the benefits of the Internet for the various functions oforganizations ranging from procurement to marketing to customer service However, the digital age hasspawned an overwhelming mass of raw information that is frequently difficult to retrieve and to use Weargue that the critical and distinguishing strength of countries, organizations, and individuals lies in theirintelligence and knowledge in this new economy Network technology has enabled a proliferation ofcustomized and timely educational tools that optimize investment in human capital: eLearning solutionsfacilitate the delivery of the right information and skills to the right people at the right time Theglobalization of the economy, shortage of skilled workers, free agent mentality, new flexible worksituations (telecommuting, for example) and numerous other factors have created problems not easilysolved by traditional education, spurring the initial growth of the eLearning industry Companies in this

space are addressing these problems using technology-basedlearning resources targeting the academic, corporate, and consumerspheres with managed, interactive, just-in-time, current, and user-centric education tools These factors, and others, set the stage forwhat we believe are exceptional investment opportunities in theeLearning space

Although profitable Internet companies are still few and far between, we think that, with rapid top-linegrowth and highly scalable business models, select eLearning companies should reward investors withsignificant returns

• Rapid Top-Line Growth: We estimate that expenditures by organizations on education in the United

States alone exceed $750 billion and worldwide reach $2 trillion Swelling demand for educationalproducts (particularly U.S products), a shortage of teachers and other learning resources, and thecentrality of education in the knowledge economy should drive growth in the education and trainingindustry Revenue growth for eLearning should considerably outstrip revenue growth in all sectors ofthe education industry as eLearning companies capture an increasing share of the industry total In thecorporate space alone, IDC is projecting eLearning revenues to grow from right around $1 billion in

1999 to $11.4 billion in 2003 We expect growth in the academic and consumer markets to besignificant as well

• Highly Scalable Business Models: We believe that eLearning companies will benefit from the same

favorable cost structures that other “e” businesses, in theory, will Whereas traditional education andtraining providers have high fixed costs in the form of real estate and high G&A expenses, eLearningcompanies are considerably leaner An eLearning company is

also likely to be better able to leverage its content over a larger

body of learners, as they are generally not reliant on live

instructors for delivery of their services Over time, we expect

that more and more content will be developed in the form of

learning objects that can be assembled on the fly into highly

customized courses, analogous to a just-in-time inventory system We believe that the maturation ofthe industry should bring declining costs and, therefore, increasing profitability

eLearning solutions facilitate

the delivery of the right

information and skills to the

right people at the right time.

We believe that the maturation

of the industry should bring declining costs and, therefore, increasing profitability.

Given that most of the players are still losing money, traditional profit-based valuation techniques will not

be effective in the early stages of the eLearning industry Since first-mover advantage, market share, andthe possibility of leveraging costs will be central to determining the winners in this industry, we thinkrevenue-based valuations are most germane However, given the variety of companies competing in thespace and the rapid evolution of the space itself, companies will succeed due to a variety of competitiveadvantages Therefore, treating revenue as a predictor of profitability is an exercise that must be conductedwith care and must be tailored to specific companies

Section II: A Topology of the eLearning Industry

The eLearning industry has emerged only within the last couple of years, and like many new high-growthindustries, it is highly fragmented and populated mainly with young, unprofitable start-ups and a few of the

more traditional companies in transition to e-companies Many of theyounger players are getting financial support from venture capitalists, whohave invested a total of $6 billion in education and training companies since

1990 Of this figure, $931 million was invested in the first quarter of 2000alone, with 64% going to eLearning companies in particular Given thisgrowing support from the financial community and assuming continuedproduct adoption by customers, we expect that today’s relatively small publiccompany comp group will grow significantly over the years

eLearning companies are difficult to categorize because they offer such a wide range of products andservices to a number of different target markets, using several different revenue models In broad terms,

we divide the industry into three main categories: content, services, and technology However, we havedeveloped a unique “eLearning matrix” which allows a company to also be characterized by which sector

of the learning market it serves (academic, corporate or consumer) and by what type of revenue model itemploys (contracts, pay-per-use, or ads/sponsors) We also break down the content, services andtechnology categories into several subcategories, which enable a more detailed look at a company’sbusiness model

Section III: The Learning Market

Our method of analysis divides the overall learning marketplace into three main categories: academic,corporate and consumer Each of the three categories is characterized by different drivers of growth that,when considered in aggregate, suggest the potential for sizable growth in the overall learning market Webelieve that each of the three sectors presents a set of unique challenges to the eLearning vendorcommunity in terms of providing the products and services that will truly meet the needs of learners

• The Academic Market: In the U.S alone, 76 million people (more than a quarter of the population)

are directly or indirectly involved in providing or receiving formal education from the pre-primarylevel through the upper reaches of higher education Educational

expenditures in the U.S are second only in size to healthcare, and

represent 7.3% of the GDP These expenditures have grown by over

42% since 1991 While efforts have begun in recent years to use

technology as an instructional tool, we believe that the academic

world has barely scratched the surface in terms of utilizing the

Internet to improve academic performance Growth drivers of the

academic market include

• a growing student population as a result of both changes in demographics and greater rates ofparticipation in the upper levels of education;

• public demand for a more effective education system that will prepare students to becompetitive in the knowledge economy;

• a shrinking base of teachers, as expertise is better rewarded in the private sector; and

•

We expect that today’s

relatively small public

company comp group

will grow significantly

over the years.

Educational expenditures

in the U.S are second only in size to healthcare, and represent 7.3% of the GDP.

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• The Corporate Market: In 1999, U.S organizations spent more than $62 billion on training-related

resources, salaries, and technology Other estimates put government spending on training at $40billion While the eLearning component of these expenditures totaled only about $1 billion, allindications are that training in the future will be delivered less and less by instructors in a classroomand increasingly by networked technology All areas of the workplace, from the manufacturing line tothe boardroom, are beginning to see this type of shift For the same reasons that businesses have come

to rely on technology-based systems to manage their human resource and sales efforts, we believe thatthe task of managing a company’s training initiatives will increasingly fall to learning systems that areintegrated into the enterprise framework Some of the key growth drivers for eLearning in thecorporate market include

• a shrinking labor pool and, at the same time, an increasing demand for skilled labor,particularly in technology-related fields;

• organizations’ need for learning resources that are both accessible and timely; and

• globalization of the enterprise demands flexible training programs

• The Consumer Market: In the consumer market, we include not only “lifelong learners” pursuing

avocational learning experiences (gardening or wine selection, for example), but also individualprofessionals who seek out educational opportunities either because it is mandated for or is conducive

to the purpose of career advancement The size of the consumer learning market is much harder to pindown, but we believe that it could eventually prove to be one of the largest growth markets for thefollowing reasons

• Consumers who currently use the Internet for informally researching avocational interests willtransition to more formal educational opportunities as the quality of content itself and themethod of delivery improves

• The flexibility of eLearning will draw those requiring and/or desiring professional continuingeducation

Section IV: Learning Technologies

We believe that education is one of the last bastions of society that has been largely unchanged by thetechnological advancements that have revolutionized almost every other facet of life Certainly we haveseen technology begin to pop up in the world of education and training in recent years However, inacademia, computers are generally utilized as expensive typewriters, and in the corporate training world,computer-based training has generally been limited to stand-alone, linear course modules that typicallyelicit a groan of boredom from users

However, as a result of the ubiquity and growing capabilities of the Internet, we believe that technologywill increasingly play a role in learning across all sectors of the market Web-based collaboration toolsenable people in far reaches of the world to share an educational

experience, while sophisticated learning management systems allow a

user’s progress and preferred instructional style to be tracked so that

adjustments can be made to a personalized curriculum in order to

effectively address learning objectives Technologies such as these

are in use today, but are, we believe, a pale version of the

manifestations of eLearning that we are likely to see in the future

Beyond technologies that are specific to the field of learning, we

believe that advancements in the overall capabilities of networked technology (e.g., broadband access,wireless networks, etc.) will serve as a catalyst for acceptance of eLearning technologies on a morewidespread basis in all markets Such improvements will make user concerns about the capabilities of thetechnological medium secondary to actually providing meaningful educational experiences

As a result of the ubiquity and growing capabilities of the Internet, we believe that technology will increasingly play a role in learning across all sectors of the market.

Finally, we believe that the emergence of a set of open, industry-wide eLearning standards will be a criticalturning point for the industry as a whole eLearning standards will allow learning content to be easilyaccessed and reused in various formats and will enable the interoperability of learning technologies fromdifferent vendors Virtually no emerging industry has ever experienced dramatic growth without theacceptance of a set of common standards on which all product and service offerings are based We expectthat the eLearning industry will be no different.

Conclusion

We believe that the eLearning industry holds much promise for profitable investments over the comingyears However, given the immature state of the industry, the wide array of target markets and thedifficulty of keeping up with changes in learning technologies, we believe that discrimination is warranted.Careful research must be undertaken in order to determine which companies will eventually emerge aswinners, and we believe that this report addresses the issues that will be key in making investmentdecisions

• How eLearning addresses the needs of the knowledge age

• The potential for profitable business models in the eLearning industry

• Valuing the emerging eLearning industry

• Cautionary points regarding investments in eLearning

• Our outlook for the industry

ELEARNING FOR THE KNOWLEDGE AGE

“The biggest growth in the Internet, and the area that will prove to be one of the biggest agents of change, will be in online training, or eLearning.” – John Chambers, CEO, Cisco

Keeping up with new information and knowing how to use it are “mission critical” activities to businessesand individuals alike in a market where competition is no longer characterized by the big beating up thesmall, but rather by the fast running past the slow If we define training and education as giving people theinformation and skills they need to compete effectively in the marketplace, many traditional learningmethods are anachronisms in today’s fast-paced, information-driven economy With that realization, webelieve that training and education as we know it today will give way to a new form of preparingindividuals to be productive and thrive in today’s society

Despite our reluctance to stick the letter “e” in front of anything else, we’ll call this new form of education

“eLearning”, as it is the use of networked technology that will make the learning revolution possible (andit’s the trendy term these days) However, its name is less important than the role it will play in changingthe way we work and live Many people have touted the ability of eLearning to provide information to

“anyone, anytime, anywhere”, and although we believe that this is the phrase that best describes it now, thisdescription is also appropriate for traditional distance learning methods or even the Internet in general Theabove description does not accurately encompass what eventually will be eLearning’s greatest strength

We believe that the true power of eLearning will be in its ability to bring the right information to the right people at the right time Therefore, we would urge investors to think of the “e” in eLearning as

standing for “effective”

The Growing Learning Industry

It should come as no surprise that learning in America, both in schools and the workplace, is already big

business According to The Digest of Education Statistics 1999, more than one out of every four

Americans participated in formal education, whether as a student, a teacher, an administrator, or a member

of support staff Education expenditures alone account

for over 7% of the GDP, making it second in size only to

the healthcare industry We believe that when

expenditures for both education and training for

medium-and large-sized organizations in the U.S are added

together, the sum reaches over $750 billion Worldwide,

this total reaches $2 trillion These numbers do not even

include government training, the hard-to-track stats on

training in small businesses, required continuing

education, or voluntary consumer learning, all of which

would fall into the learning expenditures category

“Until well into the 20 th century most workers were manual workers Today

in this country only about 20% do manual work Of the remainder, nearly half, 40% of our total work force, are knowledge workers.”

Peter Drucker

Source: Morgan Keegan estimates, National Center for Education Statistics, Training Magazine

Despite the often high costs, individuals and businesses are willing to invest great amounts of time andmoney in the development of knowledge and skills because of the simple fact that today’s economy is builtsolidly on the foundation of human capital Virtually all of the big players in the technology world (e.g.,Microsoft, Cisco, Oracle and Sun) have major internal initiatives in the area of eLearning At the fall 1999COMDEX show, Cisco CEO John Chambers, after provocatively suggesting that eLearning would be one

of the central catalysts of change in the development of the Internet, went on to say that online learning willmake e-mail usage look like a rounding error And he’s not the only one High profile names such as Paul

Allen (Microsoft), Larry Ellison (Oracle), and Michael Milken (yes, that one) have made major personal

investments in the industry

Workers who neglect to invest in their own intellectual capital do so at their own peril, as they can nolonger rely on a single set of skills for lifetime employ People starting out in the workforce today canexpect to change jobs, and even careers, numerous times during their working years The nature of today’seconomy is such that even within one particular job, the responsibilities a worker has and the challenges hefaces are likely to change drastically every few years Bearing this in mind, it’s easy to see why four years

of education in a person’s late-teens and early-twenties is hardly adequate these days if he or she wishes toget ahead or, in many cases, just maintain a standard of living

Propelling the need for technological innovation in education is technology itself The infiltration oftechnology into every part of society has made our lives both easier and more complicated Yes, we areable to generate infinitely more information with which to do our jobs and

make decisions in our daily lives, but managing all of that information has

become a cumbersome task, requiring a new and ever-changing set of skills

Ironically, the sheer volume of information that is available sometimes makes

it even more difficult to find the information we need The challenge of the

new century, then, is to take these stores of information and build useful and

manageable bases of knowledge, which can be tapped at any given time to help

solve any given problem that students and knowledge workers face on a daily

basis In other words, we believe that the much-vaunted “Information Age” is

giving way to the “Knowledge Age” and that the Internet (and eLearning by

association) is at the crux of this transformation

"Nothing in education is so astonishing as the amount of ignorance it accumulates in the form of facts."

Henry BrooksAdams (1838-1918)

The Knowledge Age: Investing in Human Capital

The industrial revolution was fueled by physical capital – the machines and the backs of the workers thatmade the goods, the factories that housed the machines, and the ships and trucks that delivered the goods tomarket The businesses that succeeded in the first half of the 20th century invested primarily in things youcould touch Around the middle of the century, however, the tide began to turn and our goods-basedeconomy began to give way to one based on services – people doing things for other people Suddenly, itwas not enough to teach a worker one task and put him to work for the rest of his life on an assembly line;workers had to learn to adapt to constantly shifting demands, both from their employers and from theircustomers The key outcome of the transformation from the industrial age to the information age was adramatic shift from investments in physical capital to investments in human (or intellectual) capital.The main currency of the economy today is unarguably information: information about customers,information about competitors, information about employees It’s a chicken-and-egg problem to determinewhether the advent of the computer age brought about the proliferation of information, or if the need forinformation drove the rapid development of computer technology (and we suspect it was some of both), butthe fact remains that the computer age and the information age hatched at about the same time However,even the notion of the information age, with its vast stores of computer-generated data locked away ininaccessible databases, is looking a bit

antiquated Information that is unavailable

to the right people at the right time is of

little use Fortunately, though, that is

precisely where the Internet comes into

play

The major impact that the Internet has

already had on the world and its promise

for the future is its ability to connect man

and machines to one another so that

information, whether it is stored in a brain

or on a server, can be organized into

meaningful knowledge bases that are

readily accessible to those who can benefit

from them The result of this connectivity has been our ability to take bits of information and transformthem into knowledge that is infinitely more valuable and powerful to the enterprise While the overtchanges from the information age to the knowledge age will be more subtle than those from the industrialage to the information age, we think that it is a shift with major implications As in the case of theinformation age, the knowledge age is still marked by the need for investment in human capital However,

we believe that the Internet, by creating greater connectivity, is generating marked improvements in theefficiency and productivity of that human capital

Hallmarks of the Knowledge Age

It has been suggested that the amount of stored information in the world doubles every 2.8 years Ourproblem is no longer that the needed information does not exist, it’s that specific information is difficult,sometimes impossible, to locate in the vast networks of technology in which it is stored It is here where

we believe eLearning meets the needs of the enterprise, for information and skills that are unobtainable by

the workers who need them are virtually useless Alan M Webber, in his 1993 Harvard Business Review

article, “What’s So New About the New Economy?” stated “In the end, the location of the new economy isnot in the technology be it microchip or the global telecommunication network It is in the human mind.”Students of all sorts must be taught, with the help of technology, the skills to harness the vast and often rawarray of information that technology itself has helped to generate

Gary S Becker, Nobel laureate and professor of economics and sociology at The University of Chicago, has estimated that around 70% of a country’s wealth today is in human capital, as opposed to physical capital He said, “The beginning

of this century, in my judgement, should be called,

‘The Age of Human Capital.’ This is because how well individuals and economies succeed will be determined mainly by how successful they are at investing in and commanding the growing stock of knowledge In the new economy, human capital is the key advantage.”

Page 13 of 107

The concepts of eLearning and knowledge management are beginning to make their mark on theorganization, but we believe that the characteristics of the “new economy”

are making the need for these tools even more apparent What are these

characteristics? Not surprisingly, they generally all relate to the humans

within an organization

• Global Economy: The workforces of today’s organizations are

increasingly spread out around the globe, creating the need for a

corporate knowledge base and learning tools that are just as accessible

(and perhaps even more so) to an account rep in Korea as they are to the

CEO in Chicago Barriers such as time, distance and language must be

overcome if strategies devised around the water cooler in the home

office are to be communicated to and implemented in far-flung branches,

and vice versa

• Need for Skilled Workers: Job growth today is occurring at the top end of the food chain, requiring

an increasingly better-educated workforce According to Futurework, a paper published by the U.S.

Department of Labor, occupations that require at least a college degree are growing twice as quickly asothers, and this is true throughout the economy

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• Shortage of Skilled Workers: The supply of skilled workers has failed to keep pace with the surge in

demand Organizations must be ready to take untrained workers and quickly bring them to a pointwhere they contribute to the organization’s goals The flip side of this problem is that in today’s fast-moving business environment, employers can rarely afford the luxury of pulling workers away fromtheir jobs to attend off-site training events Learning opportunities must be available in a just-in-timepackage

“This new economy is based more on brains than brawn – and moves more on broadband byways than concrete highways.”

Ray Smith, formerChairman, BellAtlantic

• “Free Agent” Mentality: The skilled workers who are participating in the marketplace today exhibit

little of the loyalty to their employers that characterized earlier generations Whereas career

advancement used to mean moving from the mailroom to the boardroom withinthe same company, today it often means a series of moves to positions ofgreater responsibility in different companies Recognizing this trend,companies increasingly understand their obligation to employees in terms ofthe cultivation of marketable skills rather than the promise of lifetimeemployment Also, individuals are now taking more responsibility for theirown career development by seeking outside educational opportunities, such assecond degrees or certifications, in order to enhance their prospects foradvancement The result of this trend for the organization is that valuableintellectual capital may walk out the door with the employee unless effortshave been made to integrate his personal intellectual capital into organizationalintellectual capital

• Training Viewed as a Benefit: Workers are more likely to leave an organization that does not give

them the opportunity to learn new skills because they know that it does not take long to become

unmarketable in an economy where the skill sets employers demand change so frequently Futurework

estimates that at 1,600 and growing, the number of “corporate universities” could exceed the number

of traditional universities by the year 2010

• Stretched Workforce: Putting in hours outside the time and space parameters of the traditional

workday is becoming more commonplace as both work and family responsibilities pull employees out

of the office on a more frequent basis Workers must have be able to pursue their education and haveaccess to company knowledge resources whether they’re sitting at their desk, in an airport, or at aweekend Little League game

It is largely these issues that have spurred the first wave of eLearning initiatives in the corporateenvironment Likewise, we look for similar factors (time constraints, access to distant resources, the needfor more learning opportunities) to drive growth in the academic and consumer

markets as more products come to market that efficiently meet the needs of

these groups Simply put, we believe that eLearning addresses many issues

that traditional learning methods cannot in today’s marketplace We will look

at the markets for eLearning and their growth patterns a little later, but first,

let’s outline exactly why it is we believe that eLearning is not just a neat

gimmick, but rather is a fundamentally better way of accomplishing education

and training goals

“The rise of Free

Agent Nation means

that big companies

no longer have an

advantage over

smaller ones when it

comes to getting the

best talent.”

Seth Godin,

Fast Company

We believe that eLearning addresses many issues that traditional learning methods cannot in today’s marketplace.

Page 15 of 107

LEARNING IN THE 21 CENTURY

We believe that of all the major components of daily life, formal learning is the one that has, to date, beenleast affected by the technological developments of the past 50 years Advances in technology haverevolutionized communication, transportation, and even household chores, but in fundamental respects, the

process of learning today is much the same as it has been throughout recorded

history In an interview in the March 2000 issue of Converge, Don Tapscott, author of Paradigm Shift, The Digital Economy and Growing Up Digital,

describes the current education model as one that has “teachers simply beingfactoid fountains at the front of the class.” Members of today’s wiredgeneration, he suggests, are no longer interested in this model Indeed,enlightened educators from ancient times have insisted that the cultivation of theability to think, rather than the accumulation of facts, is the proper goal ofeducation However, the ability to adapt and learn may have never been moreurgently required than in the 21st century economy, and these abilities can now be fostered in entirely newways with the help of networked technologies

To date, the use of technology in instruction has generally been limited to copy machines, calculators andoverhead projectors Certainly attempts have been made to utilize technologies such as audio- andvideotapes, and even non-networked computer based training (CBT), in the learning process, but withoutmechanisms that tie use of these sometimes expensive technologies to actual improvements inperformance, their broad-scale purchase could often not be justified In addition, the creation of these oldertypes of technology-based learning materials is often a time-consuming exercise, particularly when weconsider the fact that they are often not reusable outside of a narrow context

We believe that the concept of eLearning addresses a number of these issues, and below we will examine ingreater detail the primary benefits of eLearning

The Benefits of eLearning (or, Everything I Needed to Know I Learned on the Internet)

The main benefits of using networked technology for learning are, we believe, fairly obvious Theimmediacy of information on the Internet is an obvious advantage in comparison to the more traditionalmethods of information retrieval It is certainly a lot easier to flip over to your Internet browser and look

up information on almost any subject in the world than it is to trek down to the local library and hope thatthey have a relevant book that’s not checked out To date, the Internet has been used for primarily this type

of learning: random seek-and-find events that are not connected to your previous or next learningexperience Some early adopters of eLearning may have taken actual

classes on the Web, but in general, the percentage of the population that has

participated in a formal course of learning that took advantage of all the

possible facets of an eLearning experience is very small indeed We

believe that is about to change

As we stated in the beginning of this report, we believe that the true power

of eLearning lies not in the anyone, anyplace, anytime model, but rather in

its potential to provide the right information to the right people at the right

times and places This is the yet-to-be-fulfilled promise of eLearning So

what does the future of eLearning look like? We think that web-based

integrated learning systems will revolutionize eLearning by enabling

personalized, interactive, just-in-time, current, and user-centric learning

tools These systems will allow all facets of a course of study, including

pre-assessment, learning modules completed, practice items, collaboration,

and testing to be tracked Adjustments can then be made to the learning

program to make it more effective, and learners (and those to whom they are held accountable) will be able

to monitor progress We believe that eLearning will embrace the following characteristics

“Learning how to learn has become the most fundamental skill that

an educated person needs to master, and the instrument that enables learning in almost every field is the computer.”

Dr Peshe Kuriloff,Adjunct AssociateProfessor of English,University ofPennsylvania

The ability to adapt

and learn may have

never been more

urgently required

than in the 21 st

century economy.

• Personalized: Entire programs of study will be customized for the learner By analyzing the learner’s

objectives and existing skill level, courses will be assembled on the fly that address exactly what thelearner needs to know without wasting time working on areas in which the learner is already proficient

or uninterested This level of personalization will be achieved by using

small chunks of information, or learning objects, to assemble a course

from the ground up using pre-existing templates The reusability of

these learning objects will make this level of customization feasible in

terms of both time and expense We believe that these reusable

learning objects, the interoperability of which will be based on a set of

accepted industry standards, will be the key to the creation of an

expansive learning economy We will elaborate on the significance of

learning objects and the standards on which they are based later in the

report

• Interactive: Much of today’s technology-based learning is simply an

extension of traditional textbook-based learning, where the user reads

content from a screen instead of from a page Today’s interaction

generally consists of the learner being able to click on an unknown word for the definition on a linkedpage or the ability to play a short video clip We believe that coming manifestations of eLearning willtruly engage the learner in a give-and-take type of learning that involves simulations of real-worldevents and sophisticated collaborations with other learners and the instructor

• Just-in-Time: eLearning will move education and training away from the “just-in-case” model in

which learners engage in event-based sessions (i.e., classes) that require learning to take place outside

of the context in which it will be used Technologies such as electronic performance support systems(EPSS) will allow users to receive training at the exact time and place that it is needed to complete a

task Wearable computers will allow augmented reality experiences, in which the user can receive

real-time technology-based assistance in the actual work environment, as opposed to a simulation in avirtual environment

• Current: We believe that one of the most under-appreciated benefits of learning via networked

technology, as opposed to earlier non-networked versions of technology-based training (like ROMs or installed software), is its ability to always present up-to-date material It is relatively easyfor the content provider to remotely change and update material on a web page based on newinformation or new needs of the learner On the other hand, a CD-ROM

CD-is static, requiring a new product to be dCD-istributed anytime there CD-is a

change in the material

• User-centric: Finally, we believe that eLearning introduces an entirely

new model for learning – one that focuses primarily on the needs of the

learner, instead of on the abilities of the instructor With eLearning, the

learner is able to participate in custom-fitted learning experiences that

offer the exact material she needs in the form in which she learns best

The instructor, if there is one, goes from being the “sage on the stage” to

the “guide on the side.” We believe that this model of learning imparts

more responsibility to the learner, resulting in a richer and more dynamic

experience

We believe that coming manifestations of eLearning will truly engage the learner in a give-and-take type of learning that involves simulations of real- world events and sophisticated collaborations with other learners and the instructor.

We believe that eLearning introduces

an entirely new model for learning – one that focuses primarily on the needs of the learner, instead of on the abilities of the instructor.

Page 17 of 107

If Aristotle Had Been an “eInstructor”

We believe that the above attributes certainly make eLearning an exciting proposition for the learner.However, the learner is not today (and we believe never will be) alone in the learning process Theinstructor, whether it be a second grade teacher, a university professor, or a corporate trainer, also plays akey role In our opinion, eLearning holds similar promise for making the work of an instructor easier andmore effective

• Leverage: One benefit, in particular, that eLearning lends to the process of teaching is leverage of

time and resources In live collaborative learning environments, a teacher can only respond to so manystudents in a given amount of time Also, the number of students that can participate in the class will

be limited by those who can make the time (or simply fit in the room) We might place the leverage

we can get on instructors on a continuum, using Aristotle as our example instructor So, whenAlexander the Great hired Aristotle as his tutor, little leverage on the teacher was attained Moreleverage was achieved when Aristotle lectured in his Lyceum, still greater leverage would have beenpossible if Aristotle could have led a synchronous Internet seminar, and potentially the greatestleverage could be achieved with asynchronous Internet modules recorded by Aristotle While perhapsnot on the same level with Aristotle, in-demand business experts such as Tom Peters and Peter Druckerare leveraging their time and expertise by developing eLearning modules

• Organization: Even in a traditional learning environment, such as a college classroom, eLearning has

the potential to greatly aid instructors in the organization of a class Web-based tools are now on themarket that give an instructor the ability to centralize the management of a class on the web Such aweb-based forum allows the archival of notes (or even video files of lectures), communication withstudents outside of class, and possibly even the ability to monitor student performance At thecorporate level, a web-based learning system can track an employee’s progress through a trainingprogram and measure resulting changes in performance, enabling the corporate trainer to moreaccurately calculate ROI for training programs

Standards are Key to the Success of eLearning

In order for any of the above benefits of eLearning to be realized, however, we believe that a set ofeLearning standards must be developed and accepted by the vendor community In order to achieve truesophistication in terms of understanding the objectives of a learner and addressing those objectives with ahighly customized program of learning, all of the components of a technology-based learning system must

be speaking the same language In other words, if I have a web-based

content management tool from one vendor, but another vendor develops the

type of content modules that are crucial to meeting my learning objectives, I

want to know that my tool can search the various content repositories on the

web and be able to easily identify and deliver the proper materials, regardless

of their origination This requires that units of content be labeled to convey

information about themselves – things like subject matter, author, vintage,

format, and even price It is these labels that will form the basis of the

standardization effort and allow an organized “digital marketplace” for

We believe that a set

of eLearning standards must be developed and accepted by the vendor community.

Who are the Learners?

While some might think of learners as being students in the traditional sense, a learner today might be just

as likely to be found carrying a briefcase as a backpack And learning is not relegated just to those tasksassigned by a teacher or trainer, but also takes place on a learner’s own time, when reaching personalmilestones (whether in a professional or avocational sense) is the goal While we analyze the three sectors

of the learning market in greater detail in Section III, below we quickly review some of the factors that aredriving people in all three markets to seek out educational experiences

• The Academic Market: With 76 million people directly or indirectly

involved in providing or receiving formal education, the academic

market is huge As a percentage of GDP, educational expenditures have

held steady at 7.3% (representing the second largest component of GDP)

for about the past ten years, but the dollar figure has grown by over 42%

since 1991 We expect strong growth in expenditures throughout each of

the market’s segments, driven by the following factors

Pre-Primary

• Recognition of the advantages conferred by pre-primary education

• Growth in the number of working mothers

Primary and Secondary Schools

• Sustained school-age population growth as a result of the “baby boom echo”

• Increasing sponsorship of technology and expertise by the business community

• Technologically-inclined and ambitious kids

• Increased involvement by parents

• Growing shortage of teachers

• Government determined to tackle the digital divide

Higher Education

• Knowledge economy offers superior compensation for highly-educated workers

• Growth in adult learners

• International demand for U.S higher education

• Institutions reaching capacity

• The Corporate Market: While actually counting the number of people who are involved in

workplace-related training is virtually impossible, it is a little easier to come up with a dollar figure for

the size of the market; according to Training magazine’s 1999 Industry

Report, approximately $62.5 billion was budgeted for formal training byU.S organizations, which was about 24% higher than it was in 1993 Ofthis, approximately 44% is spent on trainer salaries, 24% goes to outsideproviders of training products and services, and the rest is spent on thingslike facilities, materials, hardware, seminars and conferences The mainpart that we are concerned about, of course, is the 24% that is outsourced,which currently represents about a $15-$17 billion market Morespecifically, we are looking at the eLearning component, which,according to IDC, totaled a little over $1 billion in 1999

According to Training

magazine’s 1999

Industry Report,

approximately $62.5

billion was budgeted

for formal training by

U.S organizations.

With 76 million people directly or indirectly involved in providing or receiving formal education, the academic market is huge.

Page 19 of 107

Chart 3 U.S Corporate eLearning Revenue by Component, 1997-2003E

IDC predicts that spending on outsourced services, content and

technology for training will grow from approximately $14.9 billion in

1998 to $33.7 billion in 2004 While information technology (IT)

training currently dominates the mix, outsourced business skills training

is expected to reach parity by 2004 IDC is currently projecting the

corporate eLearning market to grow to $11.4 billion in 2003,

representing an 83% CAGR since 1997

Primary Growth Drivers

• The demand for skilled workers will overwhelm the internal resources of companies to train theiremployees; competitive pressure demands quick response to this disparity

• The global economy means that an organization’s workforce may be spread out all over the world,creating difficulties in keeping all members up to date with the latest developments

• The U.S government is actively pushing integration of technology in its workforce

• The Consumer Market: The size of the consumer learning market is a little harder to pin down than

that of the academic or corporate markets However, we believe that in time it could actually prove to

be one of the largest targets for eLearning vendors

Primary Growth Drivers

• The Internet is increasingly used for researching avocational interests and should transition tomore formal educational opportunities

• Instructional resources are easier to find and use when they are part of a learning portal

• The flexibility of eLearning will draw those requiring and/or desiring professional continuingeducation

IDC is currently projecting the corporate eLearning market to grow to

$11.4 billion in 2003.

SEEKING PROFITABILITY IN THE ELEARNING INDUSTRY

We will be the first to admit that several key factors caution against arguing for, or making predictionsabout, the profit potential of eLearning companies

• Actuality is the best proof of possibility, and few of the publicly traded pure play eLearning companiesare operating in the black In fact, as these companies strive first and foremost to gain market share,many suffer widening losses

• Making general assertions about the group as a whole may be unwise to the extent that the universe iscomprised of hundreds of companies with divergent business models What is true concerning thefixed and variable cost structures of technology providers may not be true of content or serviceproviders

• As we have intimated several times in this report, the health of the space may depend in large part onthe emergence of technological and content standards Failure of such standards to take hold on anindustry-wide basis would not only inhibit the growth of the whole sector, but would make comparison

of eLearning companies very difficult for users of eLearning products and investors alike

• The fact that eLearning companies are focusing almost exclusively on top-line growth at the moment(as we indeed think they should) may have important consequences Only a few companies those thatare cash rich may survive, thus reducing earnings visibility The companies that make it to the topmay not be those with the best business models or the most advanced technologies but those with thedeepest pockets and the best luck with the capital markets Also, “buying revenue” with deep discountsand/or aggressive marketing may distort attempts to evaluate companies and may even undermine theirlong-term profitability By burying revenue-generating costs deep in the income statement in line itemssuch as G&A, companies may understate their true operating costs Moreover, eLearning maycondition customers to subsidized products, and attempts in the later stages of the industry to removediscounts may cause newer customers to resent older customers, and longstanding customers may notstand for price increases More seriously, profitability in contested markets may be indefinitelydeferred as cash-rich companies, in an effort to win market share, undercut those seeking normal profitmargins So long as the capital markets are generous, companies can interminably “delaygratification.”

Having assembled these warnings, and in addition, cautioning the investor to consult our Risk Factorssection for further considerations, we still argue that investors should be excited about this space Webelieve that while the “land grab” strategy does carry real risks, it is the right one because in the formativestages of this fragmented industry, the number of companies that exist and that will shortly come into beinggreatly exceeds the number that can survive We think the winners by and large will be those that establish

or leverage brand names and become leaders in their respective segments

Also, more importantly, as we argue below, we think that eLearning

companies have the capacity to leverage their costs in a way that their

brick-and-mortar competitors do not Therefore, it makes sense for these

companies to aggressively ramp up revenue in the hunt for profitability

It is no surprise the investment promise of eLearning stocks, like other “e”

companies, lies in the purported scalability of their business models

Scalability suggests that small incremental costs are associated with growth

in revenue Or, conceived of differently, a higher proportion of a company’s

costs are fixed as opposed to variable so that as revenue ramps up, a company’s profitability increasesdramatically For example, while Amazon.com has to spend gobs of cash building its infrastructure andpromoting its goods and services, it does not, at least to the same extent as its brick-and-mortar rivals, have

to purchase expensive real estate, hire workers, and so on, when it wants to enter a new market In theory,after Amazon covers its overhead, it should cost considerably less to sell each additional book or CD versusits offline competitors In this sense, Amazon.com (and similar companies) should be able to leverage itsresources and attain superior returns on investments vis-à-vis its brick-and-mortar competitors

We think that eLearning companies have the capacity to leverage their costs in

a way that their and-mortar

brick-competitors do not.

Page 21 of 107

We think that eLearning companies should enjoy many of the same sort of leveraging opportunities In thelong run, companies should be able to enjoy better cost structures on some or all of the following: realestate, inventory, revenue per worker, quicker time to market, and so on

Hand in hand with the idea of scalability is the idea of the massive market

opportunity that the Internet provides For example, only those qualified

students willing to live in Nashville are able to get an MBA from

Vanderbilt’s Owen School Universities offering MBAs over the Internet,

on the other hand, can attract qualified students from all over the world In

an important sense, the Internet is a medium more perfectly adapted to

developing, advertising, and delivering educational products than it is for

books, CDs, and apparel In general, educational products can be digitized

without loss The eLearning module retrieved by the Mary Kay salesperson

in Siberia will serve her well while the digitized image of a warm coat from

Lands’ End will not cut the frigid winter winds The take-away point is that

the Internet allows education companies to hawk their goods and services to clients anywhere and anytime.The acquisition of new customers, in the long run, should cost Internet companies less than legacycompanies And lastly, the Internet is especially powerful when a company’s products are wholly digital orknowledge/information based

Clearly, Internet companies do not exist in a business Wonderland where these scalable business modelscome free Indeed, we have already discussed some of the costs and dangers associated with buying marketshare Also, having a greater proportion of costs fixed, with heavy required investments in technologyinfrastructure, IT workers and marketing, Internet companies may often have higher breakeven levels thanoffline counterparts It should be no surprise that higher risks attend higher anticipated rates of return.Nonetheless, we believe that due to the types of reasons articulated above, eLearning companies, like otherInternet companies, have the potential to attain excellent levels of profitability

The Internet is a medium more perfectly adapted to developing, advertising, and delivering

educational products than

it is for books, CDs, and apparel In general, educational products can

be digitized without loss.

VALUATION AND PERFORMANCE OF ELEARNING STOCKS

Valuation of stocks within the high-growth Internet sector is a science ofenormous imprecision While companies are currently being valued on somemultiple of revenue, we believe that valuations will eventually be based on amultiple of cash flow or at least gross operating cash flow We are currentlyvaluing pure play eLearning companies on a multiple of enterprise value(market capitalization plus debt less cash) to projected revenue Based onthis metric the average eLearning company is trading at 9.2x estimatedcalendar 2000 and 4.6x estimated calendar 2001 numbers There are manyquestions you as an investor may be asking

Why should pure play eLearning companies be valued today on multiples of enterprise value to forward revenues? We believe that using revenue multiples for the

valuation of the pure-play eLearning companies is justified because they are the best available predictor ofpotential profitability Given that more than 300 companies compete in this industry, we believe it is key tograb market share at this early stage Also, as we have argued, getting to scale as quickly as possible andbuilding brand identity are of paramount importance, and revenue growth is central to both Of course,other crucial factors such as management quality, strategic alliances, and aggressive marketing campaignsplay into market positioning and brand building However, the best quantitative measure of progress in theland-grab battle remains revenue and trends in revenue We believe that companies that do not gathermarket share early in the game will not be around in a few years when the valuation parameters shift tomultiples of earnings

Should these companies always be valued in this manner? No, is the short answer to the question.

While in the short term we believe this is the most effective way to quantitatively measure whichcompanies are gaining market share, the problem with valuing companies on a multiple of enterprise value

to projected revenue over the longer term is that revenue can be bought Revenue can be bought primarily

in two ways, first by using aggressive sales and marketing tactics, and secondly through deep discounting

or giveaways Many companies are laden with cash from the professional investment community and arespending it primarily on marketing and sales in order to grow the top line We believe that over the longterm, companies will be valued on the viability and profitability of their business models as measured by amultiple of operating cash flow

Why are there such big differences in group multiples? For our analysis, we have broken the eLearning

industry into three distinct groups: content, services and technology A description of the types ofcompanies we would include in each group can be found beginning on page 37 (For purposes ofcomparison, we are excluding DigitalThink when calculating the average multiple of the content group

We have done this for two reasons: 1) the company’s large multiple tends to skew the overall multiple forthe group, and 2) we believe that an argument could also be made for including the company in either ofthe other two categories.) There is a large spread in group multiples, primarily between the technology andcontent groups versus the service group Pure play eLearning companies that fall into our technologycategory are trading on average at 10.7x estimated 2000 enterprise value to revenue, which is slightlyabove the content group multiple and far exceeds the service group multiple We believe there are severalreasons for this differential

1) Market Cap: We have heard over and over again that “content is king” In the realm of investments,

however, we believe that market capitalization is king As all the unemployed small cap or micro capportfolio managers will tell you, Wall Street has rewarded the larger market cap companies eLearning

is an emerging industry and no company has more than a $2.5 billion market value (still relativelysmall in the bigger scheme of things) However, the larger market cap companies have welloutperformed the smaller Importantly the technology group has the largest average marketcapitalization of all the groups

Page 23 of 107

2) Coverage by Sell-side Analysts: In many cases, the companies with the most sell-side support have

performed the best over the last year In our opinion the eLearning industry, much like many otheremerging industries, is affected by the “herd mentality” Strong sell-side support increases acompany’s profile among investors, often resulting in better stock performance We would note thatwith the exception of SmartForce (which we include in the technology category), few eLearningcompanies have yet to be picked up by any sell-side firms other than the initial underwriters

3) Technology Companies the First to Benefit from the eLearning Growth Wave: Using the trusty

razor/razor blade model as an illustration of the eLearning industry, technology companies can beviewed as providing the razor, whereas services and content companies supply the razor blades Inorder to implement an eLearning strategy, a backbone (the razor) must be in place The backbone of

eLearning is technology We believe that as customers get past the point

of making major investments in the technology-based backbone of theireLearning system, they will begin to spend money on the content andservices (razor blades) that will actually make the technology investmentworthwhile In our opinion, select companies in the technology categorywill maintain a premium to the rest of the group, but only those thatcontinually stay one step ahead of the pack in terms of innovation in thefield of delivering and managing eLearning for the enterprise Being aleader in the technology field will not be easy – it will require significantinvestments in R&D This is why we suggest that only a select group oftechnology companies will maintain a premium to the eLearning group as

a whole The rest of the companies in the technology group will continue

to offer the products that have long since become commodities Thesecompanies will compete solely on price and therefore will not warrant apremium valuation

4) Visionary and Capable Management: Management that (a) can articulate a global vision by

technological revolution and, more particularly, the value created by transforming knowledgeresources by eLearning, and (b) can explain and execute these conceptions, will garner the favor of theinvestment community

5) Key Alliances: We think investors will look for substantial relationships between established players

& eLearning companies Such relationships can supplement young companies’ core strengths,establish advantages of scale and size, and validate technologies However, we would differentiatethese types of alliances with those that are made simply for press release purposes

Why are pure play eLearning companies compelling as an investment opportunity over the long term? We believe that three key issues will drive the eLearning sector over the long term.

• The shift to a knowledge economy has made investments in intellectual/human capital more crucial

• The learning market (corporate, academic, consumer) is big and getting bigger

• Given eLearning’s characteristics of scalability, easy access, and timeliness, we believe that theeLearning model is fundamentally better than that of its traditional education/training counterparts

In our opinion, select

companies in the

technology category

will maintain a

premium to the rest of

the group, but only

those that continually

stay one step ahead of

the pack in terms of

innovation in the field

of delivering and

managing eLearning

for the enterprise.

eLearning Comparable Table

Price

% Chg YTD

%Chg LTM Mkt Cap (Mil) Enterprise

*Enterprise Value is calculated by taking market value and adding debt and subtracting cash

**Morgan Keegan and company estimates

Page 25 of 107

Recent Performance of eLearning Stocks

Year-to-date stock performance data of the pure play eLearning companies show us that the content group(down 37%, excluding DigitalThink) and the services group (down 68%) have underperformed both theNASDAQ (down 5%) and eLearning technology group (up 16%) However, the stock performance trends

of the technology and content groups are somewhat more flattering when viewed over the last 12 months.These sectors both increased more than 53% and 57%, respectively, over the 12- month period compared to

a 47% rise in the NASDAQ

Why have the content and services stocks underperformed technology stocks since the beginning of the year? As we argue in our report, the eLearning technology companies provide the “backbone” of the

industry and therefore have been the first group to experience rapid and potentially predictable revenuegrowth We believe that once the technology backbone is better established this sector will undergo adramatic consolidation, leaving three to six leading technology companies We foresee that these leaderswill be able to sustain superior operating margins, and, in turn, superior stock price returns While webelieve that the content and services sectors will see similar consolidation, we think the industry cansupport many more of these types of companies In the long run, we believe that stocks in the content andservices groups will match or even exceed the performance of the technology group

RISK FACTORS

As with all new industries that have high growth potential, the eLearning industry presents investors withseveral risk factors that must be understood before making investments in companies within the industry.Below we list the major issues that we believe pose the most threat to eLearning as a viable investment

• Young Industry in Flux: While learning itself is certainly not a new concept and learning as a

for-profit venture has been around for a least a few decades, businesses that attempt to for-profit fromtechnology-mediated learning have appeared on the scene only within the last few years As a result,there is a great deal of uncertainty surrounding the industry and its participants Many traditionaleducation and training companies are making significant changes to their business models to capitalize

on the opportunities in eLearning, while many more companies are what

we would call “born on the web” and have little to no operating history toevaluate

• Revenues and Earnings Minimal (or Nonexistent): Many of the

players in this industry are recent entrants to the market, have very smallrevenue bases and are generally still losing money Even the moretraditional education and training companies are experiencing upheavals intheir revenue streams as they make the transition to an Internet-basedmodel While we believe that revenue growth rates for many companieswithin the industry are likely to be significant over the next few years, thevast majority are still one to two years away from profitability at the veryminimum

• Confusion Among Customers: Although few investors (or even analysts) would claim to have a

solid understanding of the dynamics at play in the eLearning industry, the investment communityactually has been more exposed to information about the overall marketplace than many of thecustomers that vendors are targeting There seems to be widespread confusion about the variousproducts and services that vendors are offering While many companies claim to be a “one-stop-shop”for learning needs, reality often falls somewhere short of that promise We believe that many potentialbuyers are holding off on making major purchases until they have had a chance to sort through thehype and gain an understanding of what vendors really have to offer

• Technology Ahead of Content: The technology involved in eLearning has made dramatic strides

over the past few years The content that is delivered via the technology, however, is still several stepsbehind in terms of sophistication and relevance to knowledge workers’ needs While we look for thecoming years to deliver a mature content development market in which a premium is placed on high-quality, specialized material, the content offerings of today are quite simplistic in comparison,representing more of a commodity-type good We believe that the biggest risk in delivering this type

of content over a sophisticated technology-based platform is that users may become disillusioned withthe concept of eLearning before it has had a chance to mature into the powerful tool that we believe itcan be

• Resistance to Using Technology in Learning: Although we believe that this is less of an issue in the

corporate world than in the academic one, both markets face reluctance by certain groups of people Inacademia, for example, there has been resistance from some members of college faculties, as theadvent of technology-mediated instruction introduces uncertainties into the professor’s traditional role.Likewise, in the corporate world, trainers may see their job as being usurped by enterprise learningsystems that do the work of organizing and delivering training While we believe that the benefits of

eLearning as a supplement to traditional learning methods are becoming more evident with the passing

months, we do recognize that there will always be opposition from some camps to using technology inthe pursuit of learning

While we believe that

revenue growth rates

for many companies

within the industry are

likely to be significant

over the next few years,

the vast majority are

still one to two years

away from profitability

at the very minimum.

Page 27 of 107

• Lack of eLearning Standards: Earlier in the report, we presented a detailed review of why we

believe that the development and adoption of a set of standards for the eLearning world is soimportant Here we feel that it is prudent to restate the fact that this body of standards is still in the

development stage and even upon completion is not guaranteedacceptance by all members of the industry We believe that customerswill only develop the comfort needed to make significant eLearningpurchases when they are free from the concern that a certain technology

or library of content will be rendered obsolete with the next productrelease We believe that only the industry-wide adoption of a set ofstandards, which create interoperability between tools and content, willcreate this assurance

• Legal Issues: As learning is essentially the transfer of knowledge

from one person to another, there will always be issues of intellectualproperty involved in the process of delivering instruction Colleges anduniversities face this problem in dealing with the research products offaculty members, and eLearning vendors will have to deal with it aswell Particularly when repurposing the instructional content of aprofessor who is employed by a college or university for an eLearning medium, companies will have

to deal with the issue of who owns the rights to the content – the professor, his employer, or theeLearning company As eLearning becomes more prevalent and begins to draw more content fromrecognized “experts”, the issue of intellectual property is likely to be raised often

We believe that

customers will only

develop the comfort

needed to make

significant eLearning

purchases when they

are free from the

concern that a certain

technology or library of

content will be rendered

obsolete with the next

product release.

KEY TRENDS AND SIGNPOSTS FOR INVESTING IN THE ELEARNING INDUSTRY

• Companies based on an eLearning model will be more successful than their counterparts in the traditional education and training industries We believe that using networked technology to

deliver or supplement learning resources is a fundamentally more effective way to educate and traincitizens of the 21st century The characteristics that we have used several times to describe eLearning –scalability, accessibility and timeliness – will drive its adoption as a mission-critical component ofbusiness and education We continue to assert that there will always be a role for traditional learningmethods, but only as one component of a more complete program that includes networked learningresources

• Capital will continue to flow into the learning market We strongly believe that investors are

beginning to latch on to the idea of learning as a growth industry To thatend, we look for private investments in the education and training sector(including non-eLearning companies) to continue to grow in 2000,ultimately quadrupling the dollars invested in 1999 This capital will serve

as the fertilizer needed for smaller companies to grow into the largercompanies that will look to the public markets for additional infusions overthe coming years We believe that the public comp group will besignificantly larger in a year’s time

• Having a recognizable brand name will be more important than being first to market While some have touted being first to market as the

best indicator of long-term success, we do not necessarily believe this is so

In some cases, we believe being an early entrant to the market may actually be a hindrance, as a user’searly experiences with eLearning may not live up to all the hype The factor that we do believe will becrucial to a company’s long-term viability is establishing (or aligning with) a recognizable brand name

We believe that for some companies, being first to market will result in becoming a known brandname, but other factors are also likely to come into play in determining who is to become the Yahoo!

of the eLearning industry

• Alliances and partnerships will continue to form, but with more meaningful results And

speaking of Yahoo!, the trend in the eLearning industry, as in many other sectors of the “new”economy, is to announce as many alliances and partnership agreements with big-name companies aspossible This, in essence, is an attempt to establish a brand name (or at least to bask in the reflectedglory of someone else’s) While a handful of these announcements may actually have somesignificance, we chalk most of them up to an attempt at generating

hype Rare (and probably nonexistent) is the “exclusive”

agreement with any major technology company However, we

believe that as the players with a clear edge on the competition

begin to emerge from the pack, we will see select cases of

eLearning companies formalizing meaningful agreements with

larger brand-name companies The larger technology companies

will play a role in the growth of the eLearning industry, and we

believe it will be through relationships with companies that have

already demonstrated success in the field

We look for private

investments in the

education and training

sector (including

in the field.

Page 29 of 107

• The next several years will be marked by rapid consolidation of the industry In any one niche of

the eLearning industry today, there are at least a half-dozen companies that each want to claim themarket for itself Many of these companies will simply disappear into the far-reaches of cyberspace,while others will join up with partners or the competition in mergers designed to increase vertical orhorizontal market share Again, we would emphasize that the established technology companies arenot likely to sit idly by while a few young upstarts take control of a rapidly growing industry, leading

us to believe that the Ciscos and IBMs of the world will be active participants in the M&A frenzy tocome

• Content will eventually be crowned king As much as we hate to use the phrase, we do believe that

five years out, content will indeed be king The field of companies offering eLearning’s technologicalbackbone will have been whittled down to just a few players who are consistent and effectiveinnovators The services field is likely to undergo a similar (if less dramatic) transformation Incontrast, we believe that there will be ample room in the field of content creation for a number ofproviders developing highly specialized content No longer will end-users be looking for a $19.95version of “Word Processors for Dummies;” buyers will instead put a premium on content that trulyaddresses the needs of their organizations Because we believe that content in the not-too-distantfuture will be delivered in a learning object format – capable of being sold for uses in a multitude ofcontexts – the content development sector will likely be much more profitable than it is today

• We will see an overall maturation of the eLearning industry In our opinion, many of the current

ailments of the eLearning industry will be cured with the simple passage of time As with anyemerging industry, there are too many players chasing the same

goal in too many different ways The market will determine

who will succeed and who will end up as just a footnote in

sell-side analysts’ industry reports We believe that as standards

begin to take hold, buyers will gain the confidence to make

major purchasing decisions without fear of near-term

obsolescence It will be at this point that the eLearning industry

will gain widespread acceptance and will experience the growth

we believe is possible

The market will determine who will succeed and who will end up as just a footnote

in sell-side analysts’ industry reports.

MORGAN KEEGAN ELEARNING INDUSTRY REPORT

Page 31 of 107

SECTION II:

In this section:

• A (brief) history of the eLearning industry

• Private equity investments in the eLearning industry

• eLearning business models characterized

• Descriptions of the companies that made our “pure play” list

A BRIEF HISTORY: THE FORMATIVE YEARS OF THE ELEARNING INDUSTRY

The eLearning industry today is still quite small in terms of revenues (and practically non-existent in terms

of profits), but is populated with literally hundreds of companies already and more are jumping into thefray everyday As we might expect from any industry with an “e” prefix, the eLearning industry is stillvery immature and highly fragmented With a tiny public comp group and a mass of private companieseach wanting to take a place in the public markets, the next several years will see more dramatic changes inthe industry landscape, including

• growing private investments,

• more IPOs,

• increased partnership and alliance activity followed by formal mergers and acquisitions, and

• a shake-out of the players that got edged out by competitors

What the industry will look like in a few years after all this has takenplace is anybody’s guess, but as the old saying goes, the only thingcertain is change The formative years of the eLearning company will

be marked by a great deal of change for all the players involved Ourgoal is to furnish the information that will help investors capitalize onthis change, regardless of which form it takes

First of all, though, where did all these eLearning companies comefrom? While some began as traditional learning companies that adopted a business model with morerelevance to the digital age, many others began in the nursery of the net economy – the proverbial garage(or dorm room or living room) Below we’ll review each type and give our analysis of how each will fitinto the eLearning marketplace

Teaching Old Dogs New Tricks

Several of the companies that we include in the eLearning group today emerged from the more traditionaleducation and training sectors While the core competency of these companies (educating people) did notchange with the advent of the Internet age, their methods of reaching their customers had to if they were toaddress issues such as scalability, access, and timeliness The traditional model of educating people via alive instructor lacked all three of these characteristics; an individual can only

teach so many people at a time, is not available anytime and anywhere to the

learner, and may not be up to date with the most recent information

Likewise, even a technology-based delivery medium like a CD-ROM does

not quite meet these standards, as it must be physically distributed to the user

(who may be on the other side of the world) and is rendered obsolete when

any new information surfaces We believe that only eLearning fits the three

characteristics: (1) It can be scaled almost infinitely, (2) it is available

anywhere there is an Internet connection, and (3) it can be continually

updated with new information relevant to the learner

The two companies we would give as examples of a successful shift from a

traditional education or training business model to an eLearning business model are Apollo Group andSmartForce

The formative years of the

eLearning company will be

marked by a great deal of

change for all the players

involved.

We believe that only eLearning can be scaled almost infinitely, is available anywhere there is an Internet connection, and can be continually updated with new information relevant to the learner.

Page 33 of 107

Apollo Group (APOL): Apollo Group’s largest subsidiary, the University of Phoenix (UoP), became the

first accredited for-profit university in the U.S targeting working adults in 1978 Today it is one of thelargest regionally accredited private universities in the U.S., enrolling more than 74,000 students.Realizing that its target market of working adults was growing busier by the year and consequently lessable to attend classes in person, UoP created an online arm of the school in 1989 The UoP courses offeredonline are in a shared, asynchronous format, meaning that students are in a “class” with other students andhave a common professor, but can log on anytime to receive and complete homework assignments or postmessages to the rest of the class Online enrollments at UoP have increased at a much more rapid pace thantraditional enrollments in recent years (up 43% from the end of 1998 to the end of 1999), and currentlyreach more than 13,800 students

SmartForce (SMTF): In the training sector, we believe that SmartForce has undergone one of the most

dramatic business model shifts, including a name change from its old CBT Systems The company hadlong had one of the largest libraries of internally-developed IT training titles In the old model, SmartForcerented its courses on a yearly basis and disseminated these via the customer’s internal network Forexample, a customer would decide at the beginning of the year which titles it wanted access to for the yearand would not have access to other titles until the contract was up the following year In October, however,SmartForce announced a dramatic shift when it unveiled its fully integrated eLearning solution delivered

on an Internet platform The platform allows SmartForce to offer content in a variety of formats developed

by itself and others and to tailor that information to individual learners

Born-on-the-Web Startups

In contrast to companies such as Apollo Group and SmartForce, which each had

to undergo fairly dramatic transformations in their old business models to meet

the learning needs of the 21st century, the vast majority of companies that fall

under the heading of eLearning are relative newcomers to the scene Being a

newbie in the world of eLearning has both its ups and downs

• Advantages: Start-up eLearning companies lack the baggage from the old

world; they’re more nimble and are free to start from scratch in their attempt

to leverage the Internet in the learning space There are a multitude of niches to be exploited, and webelieve that many of these start-ups have the potential to essentially create something from nothing –that is, get customers to spend money on products and services that have never been available before

• Disadvantages: The disadvantage, of course, is simply lack of credibility and resources Whereas the

more traditional companies may already have a well-recognized name, or at least a fairly establishedrevenue stream that can help fund new ventures, start-ups have to fight just to be heard in the midst ofthe chaos that characterizes the eLearning marketplace today Out of the hundreds of companies wehave listed at the back of this report, it is highly unlikely that most people (even within the educationand training industries) have heard of more than just a few of them Because the Internet is such anatural medium for addressing the needs of the learning industry, and because Internet companies havebeen relatively easy to launch, many companies have attacked the same small niches, making itdifficult to find sector leaders

The vast majority of companies that fall under the heading of eLearning are relative newcomers

to the scene.

Venture Capitalists Smell the Opportunities

The positive aspects of eLearning business models seem to be

outweighing the negative ones in the eyes of investors, though, because

venture capital investments have skyrocketed over the last couple of

years Eduventures.com, a company that aggregates news and research

pertaining to the education industry, reported that $6 billion of private

capital has been invested in the education industry since 1990 Close to

$1 billion of that ($931 million, to be exact) was raised in the first quarter

of 2000 alone The firm went on to predict that investments in 2000 will

grow to reach $4 billion, up from $2.6 billion in 1999

Chart 4Private Investments in Education

Eduventures.com reported that $6 billion

of private capital has been invested in the education industry since

1990 Close to $1 billion

of that was raised in the first quarter of 2000 alone.

Page 35 of 107

Chart 5Q1:2000 Private Investments in Education Companies (by Type)

to be accelerating

Chart 6Education Company IPOs

Performance of recent IPOs has been somewhat spotty, as the following table illustrates During a certainshort period around the beginning of February, the eLearning IPO market benefited from a little “irrationalexuberance” as eLearning was viewed as a hot, up-and-coming sector and investors went looking for anyentry into the group Given the pullback in the market since that time period, we expect that investors willfocus more on company fundamentals rather than dumping money into a stock that is simply reflecting thebright outlook of the eLearning industry as a whole Given the larger public comp group that we expect toexist by this time next year, we believe that investors will have a much greater selection of eLearningstocks from which to choose.

Filing Offering Filing Offer Offer Price % Close on % Return Offering Company Name Ticker Date Size Range Price Date 07/05/2000 Return Debut on Debut Amount

Saba Software SABA 01/31/2000 4,000,000 $12-$14 $ 15.00 04/07/2000 $ 19.00 26.7% $ 33.00 120.0% $ 60,000,000 DigitalThink, Inc DTHK 12/09/1999 4,400,000 $10-$12 $ 14.00 02/25/2000 $ 35.00 150.0% $ 29.00 107.1% $ 61,600,000 VarsityBooks.com, Inc VSTY 10/14/1999 4,075,000 $12-$14 $ 10.00 02/15/2000 $ 1.44 -85.6% $ 9.88 -1.3% $ 40,750,000 The Lightspan Partnership LSPN 11/01/1999 7,500,000 $10-$12 $ 12.00 02/10/2000 $ 5.81 -51.6% $ 13.50 12.5% $ 90,000,000 Centra Software, Inc CTRA 10/27/1999 5,000,000 $8-$10 $ 14.00 02/03/2000 $ 9.44 -32.6% $ 33.25 137.5% $ 70,000,000 SkillSoft Corporation SKIL 09/10/1999 3,100,000 $12-$14 $ 14.00 02/01/2000 $ 13.38 -4.5% $ 18.00 28.6% $ 43,400,000 eCollege.com ECLG 05/13/1999 5,000,000 $8-$10 $ 11.00 12/14/1999 $ 4.75 -56.8% $ 14.25 29.5% $ 55,000,000 SmarterKids.com SKDS 09/09/1999 4,500,000 $13-$15 $ 14.00 11/22/1999 $ 1.66 -88.2% $ 14.00 0.0% $ 63,000,000 ZapMe! IZAP 08/05/1999 9,000,000 $10-$12 $ 11.00 10/19/1999 $ 2.88 -73.9% $ 9.50 -13.6% $ 99,000,000 Scientific Learning Corp SCIL 06/10/1998 2,300,000 $14-$16 $ 16.00 07/21/1999 $ 21.81 36.3% $ 17.94 12.1% $ 36,800,000 Student Advantage, Inc STAD 04/07/1999 6,000,000 $10-$12 $ 8.00 06/17/1999 $ 7.13 -10.9% $ 8.00 0.0% $ 48,000,000

Page 37 of 107

THE BUSINESS MODELS OF ELEARNING

For as many eLearning companies as exist, there are almost as many business models The companieswithin the eLearning industry, as with many industries in the net economy, defy traditional categorizationmethodology Do we characterize them

• by the products or services they provide,

• by how they make money, or

• by the markets they serve?

The truth is that using any one of these characterizations alone would still leave vast holes in the picture ofalmost any company within the eLearning market In addition, whatever categorization method we usetoday is likely to be invalid in the near future, as business models are continually (and quickly) evolving inthis nascent industry As companies seek to define their territory, many are trying to stake out fairly large

areas in the marketplace by claiming to offer everything (content, services and technology) that everybody

(academic, corporate and consumer markets) needs While we understand the desire to not close any doors

to new business while companies are still in the process of developing their offerings, we also believe thatthese claims of being a “one-stop shop” are, for now, simply confusing the marketplace and causinghesitancy on the part of purchasers

Instead of using a traditional method of simply categorizing the companies by “what they do” alone (which

is actually not simple at all), we think that it is more instructive to plot the various characteristics andcompetencies of individual companies on a table that allows description by more than one variable Thistable uses three key variables, and, we believe, will enable us to provide the most complete description ofcompanies within this industry These variables are

• Markets Served: Academic, corporate and consumer

• Revenue Model: Contracts, pay-per-use, and ads/sponsors

• Core Offering: Content, services, and technology

• Types of Content: IT, business skills, lifestyle, academic and custom

• Types of Services: Content distribution, consulting, implementation, eCommerce, and

community portals

• Types of Technology: Learning management tool, content creation tool, delivery platform and

collaboration tool

The matrix that includes all of the various alternatives of these variables looks like this

The elements of this matrix are described in detail on the following pages In the sections that follow thedescription of the matrix, we give brief descriptions of all the public companies that we believe representpure plays in the eLearning industry Within each company’s matrix, we have highlighted the company’sprimary market, revenue model, and core offering in dark gray The lighter gray squares represent anyareas that we believe the company is focusing on or offering as well, but to a lesser extent

Revenue Model Contracts Pay-per-use Ads/Sponsors

IT Content Distribution Learning Mgmt ToolBusiness Skills Consulting Content Creation ToolLifestyle Implementation Delivery Platform

By mapping an eLearning company on a matrix like this, we are able to illustrate how it might fall intomore than one category Below, we expand upon the definitions of these variables and their variouscomponents in order to provide a clearer picture of the competitive landscape.

Market Served

In Section III we will examine the various markets that the eLearning industry serves in great detail As apreview, though, purchasers of eLearning include the following markets

• Academic: Includes people involved in formal education, from kids just starting out in preschool to

older adults going back to college and everything in between

• Corporate: Corporate customers typically spend money on eLearning for employee training

purposes, but they are increasingly focusing their dollars on other groups within their spheres ofinfluence, such as customers and suppliers

• Consumer: While the consumer market includes what we might deem “lifelong learners”, or people

who want to take a quick class on wine selection or building a doghouse, this is a fairly smallcomponent of the (paying) consumer market The largest part is made up of people taking continuingeducation courses Although some might argue that these learners should go in the corporate categorybecause of the work-related nature of their learning, we would counter that many of these people areprofessionals who bear the responsibility (and cost in many cases) of their continuing education

Revenue Model

As with business models in the eLearning industry, there are numerous different revenue models that arecurrently being used Pricing itself varies widely across competitors, as is

often the case in an immature market We believe that as the market matures,

we will begin to see some standardization in pricing and revenue models We

have broken the types of revenue models into three main categories

• Contracts: In this category we include any sort of long-term agreement,

whether it be a one-year subscription to all the courses you want, tuition

for an online degree program, or some type of service agreement

• Pay-per-use: As the name implies, this category represents one-time

purchases of products or services

• Ads/Sponsors: For companies who are in the business of providing free content or services,

advertising or other types of sponsorship relationships are usually the main cash generator

Core Offering

This is the area where definitions and categories really start to get hazy, as many companies could arguably

be put into any of the three categories of content, services, or technology However, for purposes oforganization we will at least attempt to put each public company into the one main category that bestdescribes the company’s core offering, while also specifying through the use of our eLearning Matrix anyother categories in which it offers products or services

We believe that as the market matures,

we will begin to see some standardization

in pricing and revenue models.

Page 39 of 107

• Content: In the content category we include companies who actually produce and publish their own

content, whether it be text-based, or some type of multimedia content If the company’s main business

is the development of content, it will fall into this category We break the content category down intofive types

• Information Technology (IT): IT includes any type of technical instruction

• Business Skills: This includes “soft skills” such as management and customer relations, but also

“harder” skills such as finance or specific instruction on a business system

• Lifestyle: Lifestyle content appeals more to the “lifelong learner” and includes a wide range oftopics ranging from Tai Chi to napkin folding that are typically not work-related (unless you’reMartha Stewart)

• Academic: This is simply content that is of an academic nature or intended for students in anacademic program

• Custom: Many companies will custom design content for certain applications or processes

• Services: This broad “catch-all” category can be roughly broken down into the following five areas.

• Content Distribution: This includes both learning portals and other types of content aggregators,such as online universities, who are distributing content that comes from an external source (e.g.,traditional publishers, eLearning publishers, university professors, subject matter experts)

Companies that primarily distribute their own internally-produced content would not fall into this

• Technology: Companies that fall into this area may be providing content or some type of service, but

it is their technological tools or platforms that constitute their core offering and give them theircompetitive advantage We break the technology category into these four areas

• Learning Management (Tool) System (LMS): An LMS integrates and adapts the overall learninginitiative (both technology- and non-technology-based learning) for the dynamic student

• Content Creation Tool: This type of tool allows end-users to develop content on their own

• Delivery Platform: A delivery platform provides a customized, technology-based (typicallybrowser-based) interface for learners to access eLearning content and services As eLearningtechnology matures, we foresee a melding together of the learning management tool and thedelivery platform into an integrated learning system (ILS), but at this point, we believe that manydelivery platforms are not sophisticated enough to be considered as a full-blown ILS

• Collaboration Tool: A collaboration tool allows real-time interaction between learners andinstructors via the Internet in the setting of a classroom or meeting This type of tool may or maynot have voice over IP capabilities