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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Form 10-Q

                                          (Mark One)

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

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 28, 2002

OR

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

FOR THE TRANSITION PERIOD FROM ________ TO _________

Commission File Number 0-27975

eLoyalty Corporation

150 Field Drive
Suite 250
Lake Forest, Illinois 60045
(847) 582-7000
(Address, Including Zip Code, and Telephone Number, Including Area Code, of
Registrant’s Principal Executive Offices)

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

     The number of outstanding shares of the registrant’s common stock, $0.01 par value per share, as of November 4, 2002 was 6,489,012.

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Part I. Financial Information

Item 1. Financial Statements

eLoyalty Corporation
CONSOLIDATED BALANCE SHEETS
(In thousands, except share and per share data)

     The accompanying Notes to Consolidated Financial Statements are an integral part of this financial information.

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     The accompanying Notes to Consolidated Financial Statements are an integral part of this financial information.

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eLoyalty Corporation
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)

     The accompanying Notes to Consolidated Financial Statements are an integral part of this financial information.

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eLoyalty Corporation
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1—General

     In the opinion of management, the accompanying unaudited consolidated financial statements of eLoyalty Corporation (we or eLoyalty) include all normal and recurring adjustments necessary for a fair presentation of our consolidated financial position as of September 28, 2002, the consolidated results of our operations for the three months and nine months ended September 28, 2002 and September 29, 2001, and our consolidated cash flows for the nine months ended September 28, 2002 and September 29, 2001, and are in conformity with Securities and Exchange Commission (SEC) Rule 10-01 of Regulation S-X. Certain reclassifications have been made to the 2001 consolidated statements of operations to conform to the 2002 presentation. These reclassifications had no impact on net loss or stockholders’ equity. All share amounts have been adjusted to give effect to the one-for-ten reverse stock split effected December 19, 2001.

     The results of operations for any interim period are not necessarily indicative of the results for the full year. The accompanying financial statements should be read in conjunction with the audited consolidated financial statements and the notes thereto in our Annual Report on Form 10-K for the fiscal year ended December 29, 2001 and our Form 8-K filed on June 19, 2002.

Note 2—Severance and related costs

     eLoyalty recognized pre-tax charges of $3.1 million and $7.1 million for the three months ended September 28, 2002 and September 29, 2001, respectively. The $3.1 million charge in the quarter ended September 28, 2002, was primarily related to employee severance payments and other costs for the elimination of approximately 50 positions, in both the North American and International segments. The $7.1 million charge for the three months ended September 29, 2001 included employee severance payments for approximately 160 employees and related facility costs. For the nine months ended September 28, 2002 and September 29, 2001, the pre-tax charge was $5.6 million and $29.3 million, respectively. The charges in the nine months ended September 28, 2002 are primarily related to employee severance payments and related facility costs, while the charges in the nine months ended September 29, 2001 are for employee severance payments in the North American and International segments as well as facility and other costs.

     Severance costs include contractual salary and related fringe benefits over the severance payment period and outplacement costs. Facility costs primarily include expected losses on contractual lease commitments, net of estimated sublease recoveries, and write down of leasehold improvements. Other costs include laptop and other computer lease termination costs, legal expenses and, in 2001, the write down of deposits related to outside services, which have been terminated.

     During the nine months ended September 28, 2002, eLoyalty made cash payments of $6.6 million related to the foregoing actions. Substantially all of the employees affected by these actions have been terminated as of September 28, 2002. eLoyalty expects substantially all severance costs to be paid out by March 2003 pursuant to agreements entered into with affected employees, facility costs related to the office closures to be paid pursuant to contractual lease terms through 2007 and other costs to be paid pursuant to contractual commitments through 2003.

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The following table represents the activity related to these charges for the nine months ended September 28, 2002 (in thousands):

     The remaining reserve for facilities reflects an estimate of costs for closed facilities for which subletting is not expected to result in the full recovery of our total contracted lease payments. If we are unable to sublet any of these facilities, the additional charge would be approximately $0.9 million. The charges and adjustments during the nine months ended September 28, 2002 reflect a total charge of $4.8 million for employee severance and related costs and changes in estimates of prior accruals of $0.8 million for leases and severances.

     Of the $6.9 million that remains reserved as of September 28, 2002, $2.4 million related to future lease payments, net of estimated sublease recoveries, is reflected in Long-term liabilities, $2.1 million related to severance payments is reflected in Accrued compensation and related costs and the balance of $2.4 million is reflected in Other current liabilities.

Note 3—Comprehensive Net Loss

     Comprehensive net loss is comprised of the following (in thousands):

     The accumulated other comprehensive loss, which represents the cumulative effect of foreign currency translation adjustments, was $4.2 million at September 28, 2002 and $4.5 million at December 29, 2001.

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Note 4—Loss Per Share

     The following table sets forth the computation of the shares used in the calculation of our basic and diluted loss per share (in thousands):

     We have not included common stock equivalents in the diluted loss per share calculation as they are antidilutive in periods in which there is a loss. The total number of common share equivalents that would have been included in the computation of diluted loss per share if they had been dilutive was 4,400 and 2 for the three months ended September 2002 and 2001, respectively, and 3,894 and 105 for the nine months ended September 2002 and 2001, respectively.

Note 5—Segment Information

     We operate in one business segment focused exclusively on providing customer relationship management (“CRM”) related consulting services. As a result of organizational changes in 2001, we have two reportable geographic segments. Those segments are: North America and International. Our North American business includes our United States and Canadian operations. Our International business includes operations in Europe and Australia. The following table reflects revenue and operating results by reportable segment for the three and nine months ended September 28, 2002 and September 29, 2001, respectively, and total assets as of September 28, 2002 and December 29, 2001 (in thousands).

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     Total long-lived assets for our US operations are $16,795 and $19,055 at September 28, 2002 and December 29, 2001, respectively. For the three months and nine months ended September 28, 2002, 95% and 97%, respectively, of our revenues related to professional services.

Note 6—Income Taxes

     We have a deferred tax asset balance of $23.0 million at September 28, 2002, primarily reflecting the benefit of U.S. loss carryforwards, which expire in periods through 2021. Realization is dependent on generating sufficient taxable income in the U.S. prior to expiration of these loss carryforwards. Although realization is not assured, we believe that it is more likely than not that all of the deferred tax asset will be realized. The amount of the deferred tax asset considered realizable, however, could be reduced in the near term if current estimates of the timing and amount of future taxable income during the carryforward period are significantly revised.

     During the second quarter of 2001, we established a valuation allowance against the benefit of certain non-US operating unit tax losses previously recognized and ceased recognizing the benefit of losses incurred by these operating units. This decision was made following a company-wide review of expected financial results by geography under various alternative scenarios and the related assessments of recoverability of these net deferred tax assets in light of the period over which they arose and the predictability of a near-term return of non-US operating units to acceptable, continuing levels of profitability. As of September 28, 2002, we had a valuation allowance of $16.6 million relating to these non-US operating unit tax losses.

     eLoyalty’s ability to utilize its net operating loss (NOL) carryforwards could become subject to significant limitations under Section 382 of the U.S. Internal Revenue Code if eLoyalty were to undergo an ownership change. An ownership change would occur if the stockholders who own or have owned, directly or indirectly, 5% or more of eLoyalty’s common stock or are otherwise treated as 5% stockholders under Section 382 and the regulations promulgated thereunder, increase their aggregate percentage ownership of eLoyalty’s stock by more than 50 percentage points over the lowest percentage of the stock owned by these stockholders at any time during the testing period, which is generally the three-year period preceding the potential ownership change. In the event of an ownership change, Section 382 imposes an annual limitation on the amount of taxable income a corporation may offset with NOL carryforwards. Any unused annual limitation may be carried over to later years until the applicable expiration date for the respective NOL carryforwards.

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Note 7—Restricted Stock Grants

     In early 2002, management presented the Board of Directors with a proposed compensation program (the “Program”) for eLoyalty’s Vice Presidents, including those who previously held the title of Senior Vice President. As part of the Program, each Vice President was assigned to one of five tiers and total target cash compensation (base salary and target bonus) for all Vice Presidents within each tier was made uniform. Among the goals of the Program was to more closely align the interests of these senior level employees with those of the Company’s stockholders. To this end, under the Program, a target equity ownership level in eLoyalty was set for each tier. The Program was approved by the Compensation Committee of the Board of Directors on February 25, 2002 and was ratified by the entire Board of Directors thereafter.

     On February 28, 2002, each US Vice President received a grant of restricted eLoyalty Common Stock in an amount such that, when combined with previous equity grants to such Vice President, the aggregate equity granted to such Vice President approximately equaled the target equity ownership level for the tier to which such Vice President was assigned. The restrictions have and will lapse on such stock in 20 equal quarterly installments, beginning on May 31, 2002. During the restriction period, the holder of the restricted stock receives all of the benefits of ownership (right to dividends, voting rights, etc.), other than the right to sell or otherwise transfer any interest in the stock. Non-US Vice Presidents received an installment stock award that provides for the issuance, in the aggregate, of the same number of shares of eLoyalty Common Stock as would have been issued to them as restricted stock, had they been US employees, in 20 equal quarterly installments, beginning on May 31, 2002. The restricted stock awards are shares of eLoyalty common stock granted to an individual. Installment stock awards are grants to an individual of a contractual right to receive future grants of eLoyalty common stock in specified amounts on specified dates, subject to the individual remaining an eLoyalty employee on the date of the subject grant. In the first quarter of 2002, approximately 890,000 shares of eLoyalty Common Stock, in the aggregate, either were granted as restricted stock or reserved for issuance under installment stock grants in connection with the Program. Substantially all of this stock came from eLoyalty’s 1999 Stock Incentive Plan (the “1999 Plan”) and such stock constituted substantially all of the stock then available for issuance under the 1999 Plan. This issuance resulted in $5.8 million in noncash compensation that will be charged to income over the five-year restriction lapsing and installment grant period. During the second quarter of 2002, approximately 57,000 additional shares of eLoyalty Common Stock, either were granted as restricted stock or reserved for issuance under installment stock grants in connection with the above program which resulted in $0.3 million in noncash compensation that will be charged to income over the five year restriction lapsing and installment grant period. The grants are for persons hired as or promoted to Vice President and for Vice Presidents promoted to higher tiers with associated higher target levels of equity ownership. There were no grants made during the third quarter of 2002. Since the February 28, 2002 grant, a total of approximately 31,000 shares of unvested restricted stock and stock reserved for installment awards were cancelled or made available for future issuance due to termination of employment of Vice Presidents to whom they had been issued or for whom they had been reserved.

     At eLoyalty’s 2002 Annual Meeting of Stockholders, held on May 16, 2002, the stockholders approved a 500,000 share increase in the number of shares available for issuance under the 1999 Plan. This increase permitted the equity grants made to eLoyalty’s President and Chief Executive Officer and to the nonemployee members of its Board of Directors described in Note 11, “Subsequent Events,” with a reserve for grants to any additional directors added to the Board and to accommodate grants to persons hired as or promoted to Vice President and Vice Presidents promoted to tiers having higher target levels of equity ownership.

Note 8—Employee Benefit Plans

     eLoyalty froze its Employee Stock Purchase Plan effective March 31, 2002. eLoyalty retains the ability to reactivate this plan in the future.

Note 9—Recent Accounting Pronouncements

     In June 2001, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 141, “Business Combinations,” and SFAS No. 142, “Goodwill and Other Intangible Assets.” SFAS No. 141

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requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001. SFAS No. 142 eliminates amortization of goodwill and intangible assets with indefinite lives and requires a transitional impairment test of these assets within six months of the date of adoption and an annual impairment test thereafter and in certain circumstances. We adopted SFAS No. 141 effective July 1, 2001 and adopted SFAS No. 142 effective January 1, 2002. The Company has completed the transitional impairment test of goodwill as of January 1, 2002 and no impairment was noted.

     The following is a reconciliation of the net loss and the basic and diluted net loss per common share between the amounts reported by eLoyalty and the adjusted amounts reflecting the new accounting requirements related to goodwill amortization for the periods presented (in thousands, except per share data).

     In August 2001, the FASB issued SFAS No. 143, “Accounting for Asset Retirement Obligations”, which addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. SFAS No. 143 is required to be adopted for fiscal years beginning after June 15, 2002. We do not expect the adoption of SFAS No. 143 will have a material impact on our financial position or results of operations.

     In October 2001, the FASB issued SFAS No. 144, “Accounting for Impairment or Disposal of Long-Lived Assets”, which is effective for fiscal years beginning after December 15, 2001. SFAS No. 144 addresses financial accounting and reporting for the impairment or disposal of long-lived assets and supercedes SFAS No. 121, “Accounting for Impairment of Long-Lived Assets and for Long Lived Assets to be Disposed Of”, while retaining many of the provisions of that statement. The adoption of SFAS No. 144 did not have a material impact on our financial position or results of operations.

     In November 2001, the Emerging Issues Task Force (“EITF”) reached a consensus on “Income Statement Characterization of Reimbursements Received for ‘Out-of-Pocket’ Expenses Incurred.” The EITF concluded that reimbursements received for out-of-pocket expenses incurred should be characterized as revenue in the statement of operations. We adopted this policy in our Form 10-K for the fiscal year ended December 29, 2001, and beginning in 2002, we have reclassed prior period amounts in order to make the financial statements comparable. Out-of-Pocket expenses included in revenue for the three months ended September 2002 and 2001 were $1.8 million and $2.7 million, respectively, and for the nine months ended September 2002 and 2001 were $6.0 million and $13.4 million, respectively. This change in presentation does not affect the reported net loss.

     SFAS No. 145, “Rescission of SFAS No. 4, 44, and 64 and Technical Corrections,” was issued in April 2002 and is effective for fiscal years beginning after May 15, 2002 with early application encouraged. The provisions of SFAS No. 145 preclude gains and losses on the extinguishment of debt from being classified as extraordinary unless the criteria outlined in APB No. 30 “Reporting the Results of Operations-Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions” are met. We do not expect the adoption of SFAS No. 145 will have a material impact on our financial position or results of operations.

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     SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” was issued in June 2002 and will become effective for exit or disposal activities initiated after December 31, 2002. SFAS No. 146 nullifies Emerging Issues Task Force Issue No. 94-3 “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity.” SFAS No. 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred and states that an entity’s commitment to an exit plan, by itself, does not create a present obligation that meets the definition of a liability. SFAS No. 146 also establishes that fair value is the objective for initial measurement of the liability. The Company will adopt SFAS No. 146 effective January 1, 2003.

Note 10—Commitments and Contingencies

     We have a commitment to invest up to $14.7 million, through a related entity, in eLoyalty Ventures, L.L.C. (“eLoyalty Ventures”). eLoyalty Ventures is a $30 million venture capital fund formed in 2000 by eLoyalty, together with entities associated with Bain Capital, Sutter Hill Ventures and Technology Crossover Ventures, to focus on investing in early-stage CRM technology companies. We have not been requested to contribute any of our eLoyalty Ventures commitment and so remain subject to capital calls against that commitment on 10 business days’ prior written notice. The members of eLoyalty Ventures have decided to terminate the fund and are in the process of doing so. The fund termination is expected to occur in 2002. Accordingly, we do not expect any expenditures relating to this fund during the fourth quarter of 2002.

     eLoyalty, from time to time, has been subject to legal claims arising in connection with its business. While the results of these claims cannot be predicted with certainty, at September 28, 2002, there were no asserted claims against eLoyalty that, in the opinion of management, if adversely decided, would have a material effect on eLoyalty’s financial position, results of operations, or cash flows.

Note 11—Subsequent Events

     On November 7, 2002, the Compensation Committee of eLoyalty’s Board of Directors approved a new Employment Agreement for Kelly Conway, eLoyalty’s President and Chief Executive Officer. Also, on November 7, 2002, eLoyalty’s Board of Directors ratified the decision of the Compensation Committee and as of that date the Employment Agreement was executed by the parties. In connection with his Employment Agreement, on November 7, 2002, Mr. Conway received a grant of 350,206 shares of restricted eLoyalty Common Stock valued at $3.75, the closing price for eLoyalty Common Stock on November 7, 2002. The restrictions on such stock lapse with respect to 94,495 shares thereof on November 30, 2002, with the balance lapsing in substantially equal quarterly installments over the following 17 quarters, ending on February 28, 2007.

     On November 7, 2002, eLoyalty’s Board of Directors approved a grant of options to purchase 50,000 shares of eLoyalty Common Stock, having an exercise price equal to the closing price for eLoyalty Common Stock on November 7, 2002 (or $3.75), to each of the nonemployee members of the Board of Directors other than Jay Hoag, who declined to accept such a grant. A total of 200,000 options were granted to the nonemployee members of the Board of Directors and each of these option grants will vest in 20 substantially equal quarterly installments beginning on December 31, 2002.

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

Forward-Looking Statements

     The following Management’s Discussion and Analysis and other parts of this quarterly report contain forward-looking statements that are based on current management expectations, forecasts and assumptions. These include, without limitation, statements containing the words “believes,” “anticipates,” “estimates,” “expects,” “plans,” “intends,” “projects,” “future” and similar expressions, references to plans, strategies, objectives and anticipated future performance, and other statements that are not strictly historical in nature. These forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those expressed or implied by the forward-looking statements. Such risks, uncertainties and other

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factors that might cause such a difference include, without limitation, those noted under “Factors That May Affect Future Results or Market Price of Stock” included later in this quarterly report. Readers should also carefully review the risk factors described in other documents that eLoyalty files from time to time with the SEC, including our Annual Report on Form 10-K for the fiscal year ended December 29, 2001 and Form 8-K filed on June 19, 2002.

     Readers are cautioned not to place undue reliance on forward-looking statements. They reflect opinions, assumptions and estimations only as of the date they are made, and, subject to applicable law, eLoyalty Corporation undertakes no obligation to publicly update or revise any forward-looking statements in this report, whether as a result of new information, future events or circumstances.

Background

     eLoyalty is a leading management consulting and systems integration company focused on increasing profitability through customer service. With professionals in offices throughout North America and Europe, eLoyalty’s broad range of enterprise Customer Relationship Management (CRM) related services and solutions include creating customer strategies; defining technical architectures; selecting, implementing and integrating best-of-breed CRM software applications; and providing ongoing support for multivendor systems. The combination of eLoyalty’s methodologies and technical expertise enables eLoyalty to deliver the tangible economic benefits of customer loyalty for our Global 2000 clients.

     We operate in two primary business segments: North America (consisting of the US and Canada) and International. In 2001, we globalized and centralized our delivery, business development and infrastructure organizations and processes. Accordingly, there are no material distinctions between the character and nature of the two segments, other than financial results as discussed herein.

Performance Overview and General Outlook

     Our consolidated revenue was $20.7 million in the third quarter of 2002. This represents an approximate 29% decline as compared to the third quarter of 2001. The decrease in revenue is primarily due to a general economic slowdown contributing to decreased spending on information technology. On a sequential basis, our revenue decreased $1.0 million from the second quarter of 2002.

     Utilization was 60% for the third quarter of 2002 compared to 51% percent in the third quarter of 2001 and 59% in the second quarter of 2002. Utilization is defined as billed time as a percentage of total available time. We continue to experience pricing pressures that resulted in an average billing rate of $192 in the third quarter of 2002 versus $202 in the second quarter of 2002. Our revenue per billable consultant increased to $272 in the third quarter of 2002 from $227 in the third quarter of 2001 due to personnel reductions and improved utilization. On a sequential basis our revenue per billable consultant is up from $265 in the second quarter of 2002. Our revenue concentration has remained relatively flat as our top 10 customers accounted for 75% of our revenue in the third quarter of 2002 versus 76% in the second quarter of 2002, and 67% in the third quarter of 2001. In addition, the top 20 customers accounted for 89% of our revenue in the third quarter of 2002 versus 90% in the second quarter of 2002 and 86% in the third quarter of 2001.

     We presently expect the current economic slowdown and related uncertain client expenditure commitments and extended decision time frames to persist in the fourth quarter of 2002. The fourth quarter is also adversely affected by seasonal factors such as fewer billing days due to the impact of holidays and vacations. We anticipate revenue for the fourth quarter 2002 to decline as compared to the third quarter. We expect both our North American segment (which has historically accounted for more than 80% of our consolidated revenue) and our International segment to continue to suffer from a challenging business environment. Because of this we presently expect to hire three additional business development personnel, aggressively pursue new projects with customers and continue to actively manage our cost and organizational structures related to our expected revenue and business requirements.

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     Our revenue is generated primarily from professional services, which are billed principally on a time and materials basis. We have, on occasion, contracted projects on a fixed fee basis. Revenue is recognized for time and material and fixed fee engagements as services are rendered utilizing the percentage-of-completion method.

     Other revenue contributors include fees generated from Managed Loyalty Services (including Loyalty Support™ services, purpose-built hosted solutions and e-PROFILE™). Revenue from sales of our Managed Loyalty Services were 9% and 5% in the third quarter of 2002 and 2001, respectively. For the nine months ended September 2002 and 2001, revenue from sales of our Managed Loyalty Services was 8% and 4%, respectively. We had $1.1 million of software revenue in the third quarter of 2002 which was 5% of total revenue versus $0.4 million in the same period of 2001, or 1% of total revenue. Software revenue in the third quarter of 2002 was related to the sale of third party software products while revenue in the third quarter of 2001 consisted primarily of sales of Loyalty Suite™ software. Revenue from sales of our Loyalty Suite™ software and third party software were 3% and 1% of revenue for the nine months ended September 2002 and 2001, respectively.

     Revenue from international operations primarily represent revenue in Europe and Australia. International operations represented 9% and 18% of revenue for the three months ended September 28, 2002 and September 29, 2001, respectively, and 10% and 18% of revenue for the nine months ended September 2002 and 2001, respectively.

     Our most significant operating cost is cost of services associated with projects, which are primarily comprised of labor costs including salaries, fringe benefits and incentive compensation of engageable consultants. Cost of services also includes employee costs for training, travel expenses, laptop computer leases and other expenses of a billable and non-billable nature.

     Selling, general and administrative expenses consist primarily of salaries, incentive compensation and employee benefits for business development, marketing, and administrative personnel, and facilities cost plus a provision for uncollectible amounts.

     Research and development expenses for our personnel consist primarily of salaries, incentive compensation and employee benefits, administrative costs and travel expenses. Our Loyalty Lab™ is the center for our research and development activities, and we believe it improves the effectiveness of our loyalty solutions, allows us to work closely with emerging technology and serves as a demonstration center for our clients’ senior executives. We have decreased our investment in research and development to correspond to current economic conditions.

Critical Accounting Policies and Estimates

     Our management’s discussion and analysis of financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to the costs and timing of completion of client projects, collectibility of customer accounts receivable, the timing and amounts of expected payments associated with cost reduction activities, the realizability of net deferred tax assets and contingencies and litigation. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions.

     We believe the following critical accounting policies reflect the more significant judgments and estimates used in the preparation of our consolidated financial statements.

     We recognize revenue and profit from professional services performed for clients as work progresses using the percentage-of-completion method. Percentage-of-completion estimates are based on the ratio of actual hours incurred to total estimated hours. We follow this method because we believe that reasonably dependable estimates of the revenue and costs applicable to various stages of a client project can be made. Revisions in profit estimates are recorded in the period in which the facts that give rise to the revision become known. We have not historically had any significant revisions to our profit estimates. We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required

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payments and customers indicating their intention to dispute their obligation to pay for contractual services provided by us. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.

     In 2001 we recorded an income tax valuation allowance to reduce our non-US net deferred tax assets to zero, representing the amount that is considered more likely than not to be realized and have ceased recognizing any future benefits. The decision to establish a valuation allowance was made following an assessment of the recoverability of these net deferred tax assets in light of current estimates of a near-term return of non-US operating units to acceptable, continuing level of profitability. As of September 28, 2002, no valuation allowance has been recorded for the US net deferred tax assets of $23.0 million, as it is considered more likely than not that these net assets will be realized over the carryforward period. This conclusion was based on forecasts of future financial results that indicate that our US operations will return to profitability in fiscal 2002 and that the net deferred tax asset will be fully realized by 2004. The amount of the US net deferred tax asset that is considered realizable could be reduced in the near term through the recording of valuation allowances and a decrease to income if current estimates of the timing and amount of future taxable income during the carryforward period are significantly revised or if we undergo an ownership change for purposes of Section 382 of the Internal Revenue Code. In the event we were to determine that we would be able to more likely than not realize deferred tax assets for which valuation allowances had previously been provided, an adjustment to the deferred tax asset would be required, increasing income in the period such determination was made.

     We have recorded accruals for severance and related costs associated with the cost reduction efforts undertaken during 2002 and 2001. A substantial portion of the accruals represents contractual severance for identified employees and is not subject to significant revision. The portion of the accruals relating to office closures and associated contractual lease obligations is based in part on assumptions and estimates of the timing and amount of sublease rentals that are affected by overall economic and local market conditions. To the extent estimates of the success of our sublease efforts change in the future, adjustments increasing or decreasing the related accruals will be recorded.

Results of Operations

Third Quarter 2002 Compared with Third Quarter 2001

     Revenue

     Our revenue decreased $8.4 million, or 29%, to $20.7 million in the third quarter of 2002 from $29.1 million in the same quarter last year. Revenue from professional fees decreased $9.4 million, or 35%, to $17.8 million in the third quarter of 2002 from $27.2 million in the third quarter of 2001. The decrease in revenue is primarily due to a weak economic environment that led to decreased demand for the CRM services provided by us.

     Revenue from Managed Loyalty Services increased slightly to $1.8 million in the third quarter 2002 from $1.6 million in the comparable quarter of 2001. Managed Loyalty Services revenue represented 9% and 5% of total revenue for the three months ended September 2002 and 2001, respectively. Software revenue was $1.1 million in the third quarter of 2002 versus $0.4 million in the third quarter of 2001. Software revenue in the third quarter of 2002 consisted primarily of the sale of third party software while revenue in the third quarter of 2001 consisted primarily of sales of Loyalty Suite™ software.

     Revenue from North American operations decreased $4.9 million to $18.9 million in the third quarter of 2002 from $23.8 million in the third quarter of 2001. International operations revenue decreased $3.5 million to $1.8 million in the third quarter of 2002 from $5.3 million in the third quarter of 2001. This decrease is attributable to a weak economic environment as well as a reduced presence in Australia and France.

     We had three customers accounting for more than 10% of our revenue in the third quarter of 2002. These customers were Eli Lilly at 14%, UnitedHealth Group at 13%, and Allstate Insurance at 12%.

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     Cost of Services

     Cost of services decreased $9.3 million, or 40%, to $14.1 million in the third quarter of 2002 from $23.4 million in the comparable quarter of 2001. This is due to a 37% decrease in the number of engageable consultants to 289 as of September 28, 2002 from 456 as of September 29, 2001. Cost of services as a percentage of revenue decreased to 68% in the third quarter of 2002 compared to 80% in the comparable quarter of 2001. This decrease was primarily due to reduced engageable resources in the third quarter of 2002 compared to 2001. Cost of services for the third quarter of 2002 decreased $0.3 million or 2% to $14.1 million from $14.4 million in the second quarter of 2002. Excluding third party software costs and billable expenses, these costs were down $0.9 million, or 6%, from $12.0 million in the second quarter of 2002 to $11.1 million in the third quarter of 2002, respectively.

     Selling, General, Administrative and Research and Development Expenses

     These expenses decreased $4.6 million, or 39%, to $7.1 million in the third quarter of 2002 from $11.7 million in the third quarter of 2001. This decrease was primarily the result of personnel reductions, which contributed $2.0 million, and office closures, which contributed $0.3 million, in response to the decline of revenue, as well as discontinued new development of Loyalty Suite™ software which contributed $0.5 million. Lower spending on outside services such as telecommunications costs, professional fees, and marketing services further reduced these expenses by $1.8 million. The comparable headcounts for selling, general, administrative and research and development personnel for the third quarter of 2002 were 90 compared to 135 in the third quarter of 2001. This decrease is primarily related to personnel reductions of general, administrative and research and development employees.

     Total selling, general, administrative and research and development expenses increased $0.2 million, or 3%, in the third quarter of 2002 to $7.1 million from $6.9 million in the second quarter of 2002. Selling and marketing expenses increased $0.5 million to $3.3 million for the third quarter of 2002 compared to $2.8 million in the second quarter of 2002. This is primarily attributable to the hiring of additional business development personnel during the third quarter. General and administrative expenses declined $0.3 million from $4.1 million in the second quarter of 2002 compared to $3.9 million in the third quarter of 2002 due to further personnel reductions.

     Severance and Related Costs

     Severance and related costs decreased to $3.1 million in the third quarter of 2002 compared to $7.1 million in the comparable quarter of 2001. This reduction is the result of decreased need for additional personnel reductions, as earlier reductions had substantially sized the business to then expected revenues and business requirements. Annual savings resulting from the cost reduction actions initiated in the third quarter of 2002 are expected to be about $6.9 million and are expected to be fully realized in 2003.

     Depreciation Expense

     Depreciation expense was flat at $1.4 million in the third quarter of 2002 and the comparable quarter of 2001. This remained relatively unchanged due to a capital investment which matched the retirement of assets.

     Goodwill Amortization

     Goodwill amortization expense was zero in the third quarter of 2002 compared to $1.1 million in the comparable quarter of 2001. This decrease is due to the fact that, effective January 2002, we adopted SFAS 142 “Goodwill and Other Intangible Assets”, which requires that goodwill no longer be amortized. Goodwill amortization was primarily attributable to the acquisition of The Bentley Group in 1997.

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     Other Income

     We recognized other non-operating income of $0.1 million in the third quarter of 2002 compared to none in the comparable quarter of 2001. The $0.1 million increase in other non-operating income was primarily due to interest income in 2002, while in 2001 interest income was offset by a write down of an investment security.

     Income Tax Benefit

     We recognized a tax benefit of $0.6 million in the third quarter of 2002 compared to $5.7 million in the comparable quarter of 2001. The decrease in the tax benefit is due to the mix of pre-tax income/loss between US and non-US operations.

     Net Loss

     Due to the factors described above, we reported a net loss of $4.3 million for the third quarter of 2002 as compared with a net loss of $10.0 million in the third quarter of 2001. The loss for the third quarter of 2002 and 2001 is primarily attributable to a charge for severance and related costs. We reported a net loss of $0.92 per share on a basic and diluted basis in the third quarter of 2002 versus a net loss of $1.99 per share in the comparable quarter of 2001.

First Nine Months of 2002 Compared with First Nine Months of 2001

     Revenue

     Our revenue decreased $52.8 million, or 44%, to $68.3 million in the first nine months of 2002 from $121.1 million in the comparable period in 2001. Professional service fee revenue decreased $54.3 million to $60.8 million in the first nine months of 2002 from $115.1 million in the first nine months of 2001. Revenue from Managed Loyalty Services in the first nine months of 2002 and 2001, respectively, were $5.3 million, or 8% of 2002 revenue, and $5.2 million, or 4 % of 2001 revenue. Revenue from software sales increased $1.4 million to $2.2 million in the nine months ended September 2002 from $0.8 million in the nine months ended September 2001. This was due to sales of additional seats of our Loyalty Suite™ software and the sale of certain third party software products. The $52.8 million decrease in total revenue is primarily due to the overall softening of demand for technology investments as a result of ongoing economic weakness.

     Revenue from North American operations decreased $38.4 million to $61.3 million in the first nine months of 2002 from $99.7 million for the same period in 2001. International operations revenue decreased $14.4 million to $7.0 million in the first nine months of 2002 from $21.4 million for the same period in 2001. The decrease in North American and International revenue is attributable to a weak economic environment as well as a reduced presence in Australia and France.

     We had three customers accounting for more than 10% of our revenue in the first nine months of 2002. These customers were UnitedHealth Group at 13%, Eli Lilly at 12%, and AT&T Wireless at 11%.

     Cost of Services

     Cost of services decreased $49.7 million, or 52%, to $45.3 million in the first nine months of 2002 from $95.0 million in the comparable period in 2001. This is due primarily to a 37% decrease in the number of engageable consultants to 289 as of September 28, 2002 from 456 as of September 29, 2001. In addition, prior to September 29, 2001, we reduced cost of services personnel by approximately 300, but the carrying costs for these personnel are reflected in a significant portion of the results for the first nine months of 2001. Cost of services as a percentage of revenue decreased to 66% in the first nine months of 2002 compared to 78% for the comparable period in 2001. This decrease was primarily due to reduced engageable resources in 2002 versus 2001.

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     Selling, General, Administrative and Research and Development Expenses

     These expenses decreased $31.6 million, or 59%, to $22.2 million in the first nine months of 2002 from $53.8 million in the comparable period in 2001. This decrease was primarily the result of personnel reductions, which contributed $13.7 million, and office closures, which contributed $1.0 million, in response to the decline of revenue, as well as discontinued new development of Loyalty Suite™ software which further reduced these expenses by $5.0 million. It is also attributable to lower spending on outside services such as telecommunications costs, professional fees, and marketing services of $11.9 million. The comparable headcounts for selling, general, administrative and research and development personnel at September 28, 2002 and September 29, 2001 were 90 versus 135, respectively.

     Severance and Related Costs

     Severance and related costs decreased $23.7 million in the first nine months of 2002 to $5.6 million from $29.3 million for the comparable period in 2001. This reduction is the result of decreased need for additional personnel reductions, as earlier reductions had substantially sized the business to then expected revenues and business requirements. Annual savings resulting from the cost reduction actions initiated in the first nine months of 2002 are expected to be about $12.0 million and are expected to be fully realized in 2003.

     Depreciation Expense

     Depreciation expense decreased to $4.1 million for the first nine months of 2002 compared to $4.2 million in the comparable period in 2001. The $0.1 million decrease is due to the closure of facilities in 2001.

     Goodwill Amortization

     Goodwill amortization expense was zero in the first nine months of 2002 versus $3.6 million in the comparable period of 2001. This decrease is due to the fact that, effective January 2002, we adopted SFAS 142 “Goodwill and Other Intangible Assets”, which requires that goodwill no longer be amortized. Goodwill amortization was primarily attributable to the acquisition of The Bentley Group in 1997.

     Other Income

     We recognized other non-operating income of $0.6 million in the first nine months of 2002 compared to $1.2 million in the comparable period in 2001. The $0.6 million decrease in other non-operating income was primarily due to reduced yields for funds classified as cash and restricted cash.

     Income Tax Benefit

     We recognized a tax benefit of $0.8 million in the first nine months of 2002 compared to a tax benefit of $7.2 million in the comparable period in 2001. This decrease is due to lower severance costs in 2002 and thus a lower loss in 2002 compared to 2001.

     Net Loss

     Due to the factors described above, we reported a net loss of $7.4 million for the first nine months of 2002 as compared with a net loss of $56.4 million for the comparable period in 2001. The loss for the first nine months of 2002 is primarily attributable to a charge for severance and related costs. The loss for the comparable period in 2001 was primarily attributable to a charge for severance and related costs and the establishment of an income tax valuation allowance. We reported a net loss of $2.43 per share on a basic and diluted basis in the first nine months of 2002 compared to a net loss of $11.27 per share in the comparable period in 2001.

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Liquidity and Capital Resources

     Our principal capital requirements are to fund working capital needs, capital expenditures, payment of dividends, and other investments in support of revenue generation and growth. Our principal current capital resources consist of our cash and cash equivalent balances. At September 28, 2002, we had cash and cash equivalents of approximately $49.1 million and restricted cash of approximately $10.6 million, which included the proceeds of an $8.6 million borrowing under our revolving credit line. Our cash and cash equivalents position increased $6.4 million compared to December 29, 2001. Restricted cash represents cash as security for our line of credit and letters of credit. The increase in restricted cash is due principally to additional letters of credit supporting leases and sales of third party software.

     Operating activities provided net cash of approximately $10.1 million during the first nine months of 2002 compared to a use of cash of $1.6 million during the same period in 2001. This was due primarily to the collection of tax refunds of $7.1 million in the first nine months of 2002. Another contributor to the increase in cash from operations during 2002 was the reduction of accounts receivable of $10.4 million due to an improved days sales outstanding of 58 days at September 28, 2002 compared to 78 days at December 29, 2001.

     Cash flows used in investing activities consisted of capital expenditures of $1.9 million during the first nine months of 2002, as compared to capital expenditures of $8.9 million for the comparable period of 2001. The 2002 spending was primarily related to investment in customer management software as well as spending on additional internal software. A significant portion of the 2001 spending was related to investments in computer hardware and software as part of our development of infrastructure as a stand-alone company following the February 15, 2000 spin-off from Technology Solutions Company.

     We have a commitment to invest up to $14.7 million, through a related entity, in eLoyalty Ventures, L.L.C. (“eLoyalty Ventures”). eLoyalty Ventures is a $30 million venture capital fund formed in 2000 by eLoyalty, together with entities associated with Bain Capital, Sutter Hill Ventures and Technology Crossover Ventures, to focus on investing in early-stage CRM technology companies. We have not been requested to contribute any of our eLoyalty Ventures commitment and so remain subject to capital calls against that commitment on 10 business days’ prior written notice. The members of eLoyalty Ventures have decided to terminate the fund and are in the process of doing so. The fund termination is expected to occur in 2002. Accordingly, we do not expect any expenditures relating to this fund during the fourth quarter of 2002.

     Cash flows from financing activities decreased $11.6 million to $1.9 million used in financing activities for the first nine months of 2002 from $9.7 million provided by financing activities in the comparable period of 2001. Cash from such activities decreased as proceeds from our revolving credit agreement of $9.0 million was received in 2001. The $1.9 million used in 2002 is primarily attributable to the increase in restricted cash offset by the freezing of the employee stock purchase plan at the beginning of the second quarter of 2002 and cash dividends of $0.9 million paid in July 2002 on the 7% Series B preferred stock. In addition, two semi-annual dividend payments of approximately $0.8 million each are expected to be paid in 2003 on the Series B stock. The amount of the semi-annual dividend would decrease by any conversions of the Series B stock into common stock which would include payment of accrued but unpaid dividends at time of conversion.

     Our near-term capital resources consist of our current cash balances, together with anticipated future cash flows from operations and availability under an external credit line. Our balance of cash and cash equivalents was $49.1 million and $42.7 million as of September 28, 2002 and December 29, 2001, respectively. In addition, our restricted cash of $10.6 million at September 28, 2002 is available to retire our indebtedness under the Facility as described below.

     We entered into a Loan Agreement with LaSalle Bank National Association (the “Bank”) effective as of December 17, 2001, providing for a secured revolving line of credit in a maximum principal amount of $15 million through December 28, 2002 (the “Facility”). The Facility requires us to maintain cash and cash equivalents within a secured account at the Bank. The balance in this secured account cannot be less than the total line of credit and letter of credit obligations under the Facility. The Facility replaced our previous revolving credit facility with Bank of America, N.A. At September 28, 2002, our borrowings under the

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Facility equaled $8.6 million. Available credit under the Facility has been reduced by an additional $2.0 million related to letters of credit issued under the Facility to support operational commitments. Loans under the Facility bear interest at the Bank’s prime rate or, at our election, an alternate rate of LIBOR (London InterBank Offering Rate) plus 0.75%. Under the Facility, we agreed to pay a commitment fee of $25,000 which was paid in 2001.

     We had three customers accounting for more than 10% of our revenue in the third quarter of 2002. These customers were Eli Lilly, UnitedHealth Group, and Allstate and which accounted for 16%, 14%, and 14%, respectively, of our total net accounts receivable. Our five largest receivable balances account for 63% of our total accounts receivable as of September 28, 2002. We have collected approximately 40% of these amounts subsequent to September 28, 2002. With a higher percentage of our revenue dependent on fewer customers, delayed payments by a few of our larger clients could result in reduced liquidity and reductions in our unrestricted cash balances.

     We anticipate that our current cash resources, together with other expected internal and external sources of liquidity, should be sufficient to satisfy our working capital and capital expenditure needs for the next twelve months. We also anticipate that our cash resources will be sufficient to meet our current expected needs. If, however, our operating activities or net cash needs for the year were to differ materially from current expectations due to uncertainties surrounding the current capital market, credit and general economic conditions, competition, potential for suspension or cancellation of a large project, there could be no assurance that we would have access to additional external capital resources on acceptable terms.

Recent Accounting Pronouncements

     In June 2001, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 141, “Business Combinations,” and SFAS No. 142, “Goodwill and Other Intangible Assets.” SFAS No. 141 requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001. SFAS No. 142 eliminates amortization of goodwill and intangible assets with indefinite lives and requires a transitional impairment test of these assets within six months of the date of adoption and an annual impairment test thereafter and in certain circumstances. We adopted SFAS No. 141 effective July 1, 2001 and adopted SFAS No. 142 effective January 1, 2002. The Company has completed the transitional impairment test of goodwill as of January 1, 2002 and no impairment was noted.

     In August 2001, the FASB issued SFAS No. 143, “Accounting for Asset Retirement Obligations”, which addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. SFAS No. 143 is required to be adopted for fiscal years beginning after June 15, 2002. We do not expect the adoption of SFAS No. 143 will have a material impact on our financial position or results of operations.

     In October 2001, the FASB issued SFAS No. 144, “Accounting for Impairment or Disposal of Long-Lived Assets”, which is effective for fiscal years beginning after December 15, 2001. SFAS No. 144 addresses financial accounting and reporting for the impairment or disposal of long-lived assets and supercedes SFAS No. 121, “Accounting for Impairment of Long-Lived Assets and for Long Lived Assets to be Disposed Of”, while retaining many of the provisions of that statement. The adoption of SFAS No. 144 did not have a material impact on our financial position or results of operations.

     In November 2001, the Emerging Issues Task Force (“EITF”) reached a consensus on “Income Statement Characterization of Reimbursements Received for ‘Out-of-Pocket’ Expenses Incurred.” The EITF concluded that reimbursements received for out-of-pocket expenses incurred should be characterized as revenue in the statement of operations. We adopted this policy in our Form 10-K for the fiscal year ended December 29, 2001, and beginning in 2002, we have reclassed prior period amounts in order to make the financial statements comparable. Out-of-Pocket expenses included in revenue for the three months ended September 2002 and 2001 were $1.8 million and $2.7 million, respectively, and for the nine months ended September 2002 and 2001 were $6.0 million and $13.4 million, respectively. This change in presentation does not affect the reported net loss.

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     SFAS No. 145, “Rescission of SFAS No. 4, 44, and 64 and Technical Corrections,” was issued in April 2002 and is effective for fiscal years beginning after May 15, 2002 with early application encouraged. The provisions of SFAS No. 145 preclude gains and losses on the extinguishment of debt from being classified as extraordinary unless the criteria outlined in APB No. 30 “Reporting the Results of Operations-Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions” are met. We do not expect the adoption of SFAS No. 145 will have a material impact on our financial position or results of operations.

     SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” was issued in June 2002 and will become effective for exit or disposal activities initiated after December 31, 2002. SFAS No. 146 nullifies Emerging Issues Task Force Issue No. 94-3 “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity.” SFAS No. 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred and states that an entity’s commitment to an exit plan, by itself, does not create a present obligation that meets the definition of a liability. SFAS No. 146 also establishes that fair value is the objective for initial measurement of the liability. The Company will adopt SFAS No. 146 effective January 1, 2003.

Factors That May Affect Future Results or Market Price of Stock

     Some of the factors that may affect our future results or the market price of our stock and cause or contribute to material differences between actual results and those reflected in forward-looking statements contained in this Form 10-Q include the following:

	•		uncertainties associated with the attraction of new clients, the continuation of existing and new engagements with existing clients and the timing of related client commitments, including potential client delays or deferrals of new engagements or existing project extensions in light of prevailing general economic conditions and uncertainties;
	•		reliance on a relatively small number of customers for a significant percentage of our revenue, reliance on major suppliers, including CRM software providers and other alliance partners, and maintenance of good relations with key business partners;
	•		management of the risks associated with increasingly complex client projects in general as well as new services offerings, including risks relating to the variability and predictability of the number, size, scope, cost and duration of, and revenue from, client engagements, unanticipated cancellations or deferrals of client projects or follow-on phases of engagements in process, collection of billed amounts, shifts from time and materials-based engagements to alternative pricing or value-based models and variable employee utilization rates, project personnel costs and project requirements;
	•		management of growth, expansion into new geographic and market areas and development and introduction of new services offerings, including the timely and cost-effective implementation of enhanced operating, financial and other infrastructure systems and procedures;
	•		challenges in attracting, training, motivating and retaining highly skilled management, strategic, technical, product development and other professional employees in a competitive information technology labor market;
	•		continuing intense competition in the information technology services industry generally and, in particular, among those focusing on the provision of CRM services and software, including firms with both significantly greater financial and technical resources than eLoyalty and new entrants;

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	•		the rapid pace of technological innovation in the information technology services industry, including frequent technological advances and new product introductions and enhancements, and the ability to create innovative and adaptable solutions that are consistent with evolving standards and responsive to client needs, preferences and expectations;
	•		access in tightened capital and credit markets to sufficient debt and/or equity capital on acceptable terms to meet our future operating and financial needs;
	•		protection of our technology, proprietary information and other intellectual property rights or challenges to our intellectual property by third parties;
	•		future legislative or regulatory actions relating to the information technology or information technology services industries including those relating to data privacy;
	•		maintenance of our reputation and expansion of our name recognition in the marketplace;
	•		risks associated with global operations, including those relating to the economic conditions in each country, potential currency exchange and credit volatility, compliance with a variety of foreign laws and regulations and management of a geographically dispersed organization;
	•		the overall demand for CRM services and software and information technology consulting services generally;
	•		the continued impact of the current economic slowdown, as well as other future general business, capital market and economic conditions and volatility; and
	•		significant revisions to current estimates of the timing and amount of future taxable income during the carryforward period may affect the realizability of deferred tax assets.

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