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SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-K

Commission file number 0-27975

eLoyalty Corporation

(Exact Name of Registrant as Specified in Its Charter)

150 Field Drive, Suite 250

Lake Forest, Illinois 60045

(Address of Registrant’s Principal Executive Offices) (Zip Code)

Registrant’s telephone number, including area code: (847) 582-7000

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, par value $0.01 per share

Preferred Stock Purchase Rights

      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 þ          No o

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

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

      The aggregate market value of Common Stock held by non-affiliates of the registrant, based upon the closing price per share of registrant’s Common Stock on June 26, 2004, as reported by the NASDAQ National Market System, is approximately $39,718,759.

      The number of shares of the registrant’s Common Stock, $0.01 par value per share, outstanding as of March 17, 2005 was 7,407,387.

DOCUMENTS INCORPORATED BY REFERENCE

      Portions of eLoyalty’s Proxy Statement for its 2005 Annual Meeting of Stockholders, to be filed within 120 days after the end of eLoyalty’s fiscal year, are incorporated herein by reference into Part III where indicated.

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TABLE OF CONTENTS

PART I

PART I

      This Annual Report on Form 10-K (this “Form 10-K”) contains 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 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 in Item 7, Part II of this Form 10-K. Readers should also carefully review the risk factors described in other documents that eLoyalty Corporation files from time to time with the United States Securities and Exchange Commission (“SEC”).

      Readers are cautioned not to place undue reliance on forward-looking statements. They reflect opinions, assumptions and estimates only as of the date they are made, and 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 or otherwise.

Introduction

      eLoyalty Corporation (together with its subsidiaries and predecessors “eLoyalty,” “we” or the “Company”), an enterprise Customer Relationship Management (“CRM”) services and solutions company, was incorporated in Delaware in May, 1999 as a wholly-owned subsidiary of Technology Solutions Company (“TSC”). The Company’s business was initiated in May, 1994 as a call center business unit within TSC. This business unit was subsequently renamed the Enterprise Customer Management (“ECM”) business unit, and later the eLoyalty division. Since its inception and under its various names, this business unit has developed management consulting, technology systems integration, and managed services capabilities in an effort to lead the development of, and stay at the forefront of, the CRM market, with a specific focus on incorporating new technologies into CRM solutions.

      In February of 2000, TSC transferred the businesses of its eLoyalty division to the Company and declared a dividend, payable to the stockholders of record of TSC, based upon a ratio of one share of the Company’s common stock, par value of $0.01 per share, for every one share of TSC common stock held. Effective February 15, 2000, all of the outstanding shares of common stock were distributed to TSC’s stockholders. eLoyalty became a separate publicly traded company as of the same date.

      On December 19, 2001, eLoyalty sold for gross proceeds of $23.3 million approximately 4.6 million shares of a new class of 7% Series B Convertible Preferred Stock (“Series B stock”), par value $0.01 per share, in a private placement to funds managed by Technology Crossover Ventures (“TCV”) and Sutter Hill Ventures (“Sutter Hill”) and, in a concurrent rights offering, to eLoyalty stockholders. Immediately prior to the closing of these transactions, (1) eLoyalty amended its certificate of incorporation to increase the number of its authorized shares of common stock from 100 million to 500 million and its authorized shares of preferred stock from 10 million to 40 million, and (2) affected a one-for-ten reverse stock split of its outstanding common stock. See Note Eleven to the Consolidated Financial Statements of eLoyalty included in Item 8, Part II of this Form 10-K for more information about the Series B stock.

      In connection with the closing of the private placement, eLoyalty, TCV and Sutter Hill entered into an Amended and Restated Investor Rights Agreement. Under that agreement, in 2002 eLoyalty registered on Form S-3 the shares of common stock issuable upon the conversion of the Series B stock issued in the private placement, plus certain previously owned TCV shares. eLoyalty is required to maintain the effectiveness of the Registration Statement until all of the common stock underlying the Series B stock issued in the private placement can be sold in any and all three month periods under Rule 144 under the Securities Act of 1933

(without giving effect to Rule 144(k)). The agreement also provides TCV and Sutter Hill with certain piggyback registration rights.

      On July 16, 2004, eLoyalty acquired substantially all of the net assets and business of Interelate, Inc. for approximately $5.4 million of cash consideration (before transaction costs). The acquired business, employees, customers and net assets have been integrated into eLoyalty and it operates as eLoyalty’s Marketing Managed Services group.

      Our executive office is located at 150 Field Drive, Suite 250, Lake Forest, Illinois 60045 (telephone number 847-582-7000).

Overview

      eLoyalty is a leading management consulting, systems integration, and managed services company focused on optimizing customer interactions. With professionals in offices throughout North America and Europe, eLoyalty’s broad range of enterprise CRM services and solutions include creating customer strategies; defining technical architectures; selecting, implementing and integrating best-of-breed CRM and analytics software applications; providing ongoing support for multi-vendor systems; and hosting application environments. The combination of eLoyalty’s methodologies and technical expertise enables eLoyalty to deliver the tangible economic benefits of customer loyalty for its clients.

      eLoyalty provides a broad array of services to help clients increase efficiency and improve effectiveness in the customer-facing functions of marketing, sales and customer service. In many cases eLoyalty helps clients build capabilities in these functional areas through management consulting and technology integration projects. Within the marketing and customer service functions, eLoyalty also offers clients maintenance and support services and hosted solutions to mitigate capital investment and to reduce time-to-market.

      Over the past two years, eLoyalty has developed four service lines in which the Company has invested to create leading-edge capabilities and differentiated solutions for its clients:

      Leveraging these service lines as our new business drivers, revenue is generated primarily from Consulting services that involve designing, integrating or building systems for clients. These Consulting services are billed on a time and materials basis or on a fixed-fee basis. These services generally include a combination of the following:

      In addition, in fiscal years 2004, 2003 and 2002, Managed services, in the aggregate, accounted for 21%, 13% and 8%, respectively, of our annual revenue. We provide a comprehensive range of Contact Center Managed Services from routine maintenance and technology upgrades to the resolution of highly complex issues that involve multiple technology components and vendors. Our support and monitoring services reduce the cost and impact of contact center downtime and anticipate problems before they occur. Through the acquisition of the assets of Interelate, Inc. in 2004, we added the ability to provide Marketing Managed Services to our clients. Using proprietary tools for complex data management and our off-premise hosting model we offer customer data analytics, campaign management and mass e-mail fulfillment solutions.

      We also generate revenue from reselling third-party software and hardware and occasionally from sales of our internally developed Loyalty Suite^tm software. In total, these product-related sales accounted for approximately 4% of our revenue in fiscal years 2004 and 2003, respectively, and 3% in fiscal year 2002.

      Our Consulting services, Managed services and sale of software are highly interdependent. It is not uncommon for a Consulting services engagement surrounding the design and implementation of service or marketing solutions to lead to the sale of a long-term maintenance and support or hosting relationship. In addition, in substantially all cases, the sale of software is paired with a maintenance and support contract. These services and products are packaged and marketed within the four service lines described previously and are sold through a common business development team. Our Consulting services and Managed services delivery teams often work together and leverage common tools and methodologies to deliver this spectrum of solutions to our clients.

      We operate in two reportable 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.

      Our international operations create special risks, including those relating to the economic conditions in each country, potential currency exchange and credit volatility, restrictions on the movement of cash and certain technologies across national borders, tax issues resulting from multiple tax laws, compliance with a variety of other foreign national and local laws and regulations, political instability and management of a geographically dispersed organization. If not adequately addressed, these risks may adversely affect our business.

      For information regarding our segment reporting, including domestic and foreign revenue, operating income and total assets, see Note Fourteen to the Consolidated Financial Statements of eLoyalty, appearing under Item 8, Part II of this Form 10-K.

Intellectual Property Rights

      A majority of our clients require that we grant to them some or all proprietary and intellectual property rights with respect to the original work product resulting from our services, including the intellectual property rights to any custom software developed for them. While, absent agreement to the contrary, each grant of proprietary and intellectual property rights limits our ability to reuse work product components with other clients, it is our practice to retain the rights in the underlying core intellectual property on which it is based, including methodologies, workplans and software. We regard these software and methodologies as proprietary and intend to protect our rights, where appropriate, with registered copyrights, patents, and trademarks, applicable trade secret laws and contractual restrictions on disclosure and transferring title. Further, it is our policy to obtain from our clients a license to permit us to market custom software and other original materials to other clients. These arrangements may be nonexclusive or exclusive, and licensors to us may retain the right to sell products and services that compete with those of eLoyalty. In addition, to protect our proprietary information, we rely upon a combination of trade secret and common law, employee nondisclosure policies and third-party confidentiality agreements.

Seasonality

      We typically experience seasonal revenue and earnings fluctuations globally in the fourth quarter, as the total number of effective billing days is reduced due to holidays and vacations. Additionally, our European operations historically have experienced decreased revenue and earnings in the third quarter because of extended summer vacation periods.

Clients

      During fiscal year 2004, our five and twenty largest clients accounted for 52% and 80%, respectively, of our revenue. Three clients each accounted for 10% or more of our total revenue during the fiscal year. Crowe, Chizek and Company LLP, United HealthCare Services, Inc. and Allstate Insurance Company provided 14%, 13% and 10% of our 2004 revenue, respectively. For fiscal year 2004, fourteen clients each accounted for over $1 million of revenue. While our focus, consistent with the nature of our services, is on developing long-term relationships with our clients, the nature of our business is such that our activities with specific clients will

fluctuate periodically as individual projects are initiated and progress through their lifecycle. As a result, the percentage of revenue contributed by any particular client can be expected to vary, perhaps significantly, among periods (see Note Two to the Consolidated Financial Statements of eLoyalty included in Item 8, Part II of this Form 10-K).

Competition

      We operate in a highly competitive and rapidly changing market and compete with a variety of organizations that offer services similar to ours. The market includes a variety of participants that compete with us at various levels of our business, including strategic consulting firms, systems integrators, web-consulting firms, software vendors, online agencies and firms that provide both consulting and systems integration services, including certain of our vendors. In our opinion, few competitors offer the full range of CRM services that we can provide. We believe that our principal competitors are the “Big 5” consultancies: Accenture, Cap Gemini Ernst & Young, Deloitte Consulting, Bearing Point Consulting and IBM IGS.

      Many of our competitors have longer operating histories, more clients, longer relationships with their clients, greater brand or name recognition and significantly greater financial, technical, marketing and public relations resources than we do. As a result, our competitors may be in a better position to respond quickly to new or emerging technologies and changes in client requirements. They may also develop and promote their products and services more effectively than we do. New market entrants also pose a threat to our business. Existing or future competitors may develop or offer solutions that are comparable or superior to ours at a lower price.

Employees

      As of January 1, 2005, we employed 335 people. Of the 335 employees, 315 were located in North America, with the balance in Europe. As our business consists primarily of the provision of professional services, it is inherently people intensive. We believe we have a satisfactory relationship with our employees. Our average annualized voluntary turnover of field employees was 20% in 2004. Our employees are not represented by a union. Our Vice Presidents and many European employees have employment agreements generally requiring a three month notice period of termination by us. In addition, the laws and regulations of the foreign countries in which we operate may increase the cost of involuntarily terminating employees in those countries, should we have the need to do so. We maintain various programs and strategies to retain and recruit employees.

Available Information and Other

      Our principal internet address is www.eloyalty.com. We make available free of charge on our website our Annual, Quarterly and Current Reports on Forms 10-K, 10-Q and 8-K, and any amendments thereto, as well as the Forms 3, 4 and 5 beneficial ownership reports filed with respect to our stock, as soon as reasonably practicable after such material is filed with, or furnished to, the SEC. However, the information found on our website is not part of this or any other report filed by us with the SEC.

      Our principal physical properties employed in our business consist of our leased office facilities in Lake Forest, Illinois; Eden Prairie, Minnesota; and Austin, Texas. Our total employable leased square footage is approximately 41,000. This excludes properties where we remain as the lessee but where the property has been closed as part of cost-reduction efforts and the anticipated costs therefore have been reserved for as part of severance and related costs (see Note Four to the Consolidated Financial Statements of eLoyalty included in Item 8, Part II of this Form 10-K). We do not own any real estate. We believe that our leased facilities are appropriate for our current and anticipated business requirements.

      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, there are 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, and cash flows.

      eLoyalty is a party to various agreements, including substantially all major services agreements and intellectual property licensing agreements, under which it may be obligated to indemnify the other party with respect to certain matters, including, but not limited to, indemnification against third-party claims of infringement of intellectual property rights with respect to software and other deliverables provided by us in the course of our engagements. These obligations may be subject to various limitations on the remedies available to the other party, including, without limitation, limits on the amounts recoverable and the time during which claims may be made, and may be supported by indemnities given to us by applicable third parties. Payment by eLoyalty under these indemnification clauses is generally subject to the other party making a claim that is subject to challenge by eLoyalty and dispute resolution procedures specified in the particular agreement. Historically, eLoyalty has not been obligated to pay any claim for indemnification under its agreements and management is not aware of future indemnification payments that it would be obligated to make.

      No matters were submitted to a vote of security holders, through the solicitation of proxies or otherwise, during the fourth quarter of our fiscal year 2004.

      The following table includes the name, age (as of March 24, 2005), current position and term of office of each of our executive officers.

      Except as required by individual employment agreements between executive officers and the Company, there exists no arrangement or understanding between any executive officer and any other person pursuant to which such executive officer was elected. Each executive officer serves until his or her successor is elected and qualified or until his or her earlier removal or resignation.

      The principal business experience of the executive officers for at least the last five years is as follows:

      Kelly D. Conway has been the President and Chief Executive Officer and a Director of eLoyalty since its incorporation in May 1999. Mr. Conway joined TSC in November 1993 as Senior Vice President, assumed the position of Executive Vice President in July 1995 and became Group President in October 1998. Prior to joining TSC, Mr. Conway served as a Partner in the management consulting firm of Spencer, Shenk and

Capers and held various positions, including President and Chief Executive Officer with Telcom Technologies, a manufacturer of automatic call distribution equipment.

      Karen Bolton has been Vice President, Client Services since December 2004. Ms. Bolton joined TSC in 1998 as a Vice President of its Australian subsidiary, which became a subsidiary of eLoyalty prior to its spin off from TSC. She relocated to the United States in 2002, becoming a Vice President of eLoyalty, and was elected Vice President, Global Accounts in 2003.

      Christopher J. Danson has been Vice President, Delivery of eLoyalty since December 2004. From February 1993 until joining eLoyalty as Senior Vice President, Research & Development in February 2000, Mr. Danson held various positions with TSC in its ECM/Call Center practice, including Senior Vice President from September 1998 until February 2000, Vice President from June 1996 until September 1998 and Senior Principal for TSC Europe from June 1995 until June 1996. From 2002 until 2004, Mr. Danson served as a Vice President and Delivery Team Leader for eLoyalty’s Technology Delivery Team.

      Jay A. Istvan has been the Vice President, Strategy and Marketing, of eLoyalty since February 2001. Mr. Istvan was affiliated with The Boston Consulting Group, Inc., a global strategic consulting firm, for more than fourteen years prior to joining eLoyalty, most recently as Midwest Regional Leader of its Healthcare practice from 1997.

      Steven C. Pollema has been Vice President, Operations and Chief Financial Officer of eLoyalty since December 2004. Prior to that Mr. Pollema served as Vice President, Delivery and Operations of eLoyalty since August 2001, after joining eLoyalty in June 2001 as Senior Vice President, Operations. Prior to joining eLoyalty, Mr. Pollema had been with MarchFirst, Inc. and its predecessor, Whittman-Hart, Inc., since June 1997, most recently as its President from March 2001 to May 2001. Prior to assuming the office of President, Mr. Pollema was Executive Vice President-Global Operations of MarchFirst from October 2000 through March 2001 and Managing Executive — Chicago Office/Region from October 1998 to October 2000. Prior to July 1997, Mr. Pollema was with Andersen Consulting, LLC, most recently as an Associate Partner.

      Robert S. Wert has been Vice President, General Counsel and Corporate Secretary of eLoyalty since December 2004. Prior to that Mr. Wert served as Vice President and General Counsel of eLoyalty since October 2001. He joined eLoyalty in January 2001 as Vice President and Senior Counsel. Prior to joining the Company, Mr. Wert was Associate General Counsel and Assistant Secretary of Katy Industries, Inc., a publicly held, diversified holding company since August 1998. From 1989 to 1998, Mr. Wert was with the Chicago law firm of Holleb & Coff, most recently as a Partner in its Business Department.

      Please note that, in February 2002, we ceased using the title Senior Vice President for any of our officers. All persons previously holding that title currently hold the title of Vice President. For simplicity, the current office of each of the executive officers, other than Mr. Conway, is characterized as that of Vice President with respect to his or her current role in the organization. Certain of the executive officers were Senior Vice Presidents at the time they assumed those roles.

PART II.

      Our common stock, par value $0.01 per share, is traded on the NASDAQ National Market System under the symbol ELOY. The following table sets forth, for the periods indicated, the quarterly high and low sales prices of the common stock on the NASDAQ National Market.

      There were approximately 391 owners of record of our common stock as of March 16, 2005.

      On December 19, 2001, we raised an aggregate of $23.3 million of gross cash proceeds in connection with the sale, pursuant to a private placement and related rights offering, of shares of our Series B stock, par value $0.01 per share. See “Introduction” in Item 1, Part I of this Form 10-K for more information regarding the private placement. Each share of Series B stock is convertible into one share of our common stock, at the option of the holder. This conversion ratio is subject to adjustment in the future in the event of certain transactions. The Series B stock will automatically convert into our common stock at any time after June 19, 2002, if the last sale price of our common stock is at least five times the original sale price per share of Series B stock ($5.10) for 30 consecutive trading days, subject to certain limitations.

Unregistered Sales of Equity Securities and Use of Proceeds

      The following table provides information relating to the Company’s purchase of shares of its common stock in the fourth quarter of 2004. All of these purchases reflect shares withheld upon vesting of restricted stock or installment stock, to satisfy tax-withholding obligations.

      See Item 12 included in Part III of this Form 10-K for information about securities authorized for issuance under our various compensation plans.

Dividends

      Historically, we have not paid cash dividends on our common stock, and do not expect to do so in the future. However, cash dividends of approximately $1.5 million, in the aggregate, were paid in January and July of 2004 on the Company’s Series B stock, which accrues dividends at the rate of 7% per year, payable semi-annually. A dividend payment of approximately $0.7 million was paid in January 2005 on the Series B stock. In addition, a semi-annual dividend payment of approximately $0.7 million is expected to be paid in future periods on the Series B stock. The amount of each such dividend would decrease by any conversions of the Series B stock into common stock, although such conversions would require us to pay accrued but unpaid dividends at time of conversion. Conversions of Series B stock became permissible at the option of the holder after June 19, 2002.

      The following tables summarize our selected financial data. This information should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations, and the Consolidated Financial Statements of eLoyalty and notes thereto, which are included elsewhere in this Form 10-K. The statements of operations data for the fiscal years 2004, 2003, 2002, 2001 and 2000 and the balance sheet data as of January 1, 2005, December 27, 2003, December 28, 2002, December 29, 2001 and December 30, 2000, below, are derived from our audited financial statements. Fiscal year 2004 consisted of fifty-three weeks instead of fifty-two weeks, which did not have a material impact on our financial position or results of operations.

Consolidated Statements of Operations Data

(In thousands, except share and per share data)

Consolidated Balance Sheet Data

(In thousands)

Forward-Looking Statements

      The following Management’s Discussion and Analysis and other parts of this Form 10-K 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 associated 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 elsewhere in Item 7, Part II of this Form 10-K.

      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 Form 10-K, whether as a result of new information, future events or circumstances, or otherwise.

Background

      eLoyalty is a leading management consulting, systems integration, and managed services company focused on optimizing customer interactions. With professionals in offices throughout North America and Europe, eLoyalty’s broad range of enterprise CRM services and solutions include creating customer strategies; defining technical architectures; selecting, implementing and integrating best-of-breed CRM and analytics software applications; providing ongoing support for multi-vendor systems; and hosting application environments. The combination of eLoyalty’s methodologies and technical expertise enables eLoyalty to deliver the tangible economic benefits of customer loyalty for its clients.

Overview of the Results of Operations and Financial Position

      The following is an overview of our operating results and financial position for our 2004, 2003 and 2002 fiscal years, which includes a discussion of significant events, revenue, gross profit margins, expenses and cash flows for those periods. The fiscal year ends for 2004, 2003 and 2002 were January 1, 2005, December 27, 2003

and December 28, 2002, respectively. Fiscal year 2004 consisted of fifty-three weeks instead of fifty-two weeks, which did not have a material impact on our financial position or results of operations.

     As a result of the economic slowdown beginning in fiscal year 2001, many companies significantly reduced the size and scope of their information technology (“IT”) spending. These spending reductions contributed to the decrease in annual revenue experienced by eLoyalty from $146.7 million in fiscal year 2001 to $62.6 million in fiscal year 2003. In fiscal year 2004, our revenue grew to $72.6 million, a 16% increase over fiscal year 2003.

      Revenue levels are driven by the ability of our professional business development teams, account partners, and senior delivery personnel to secure new client engagements and to deliver services and solutions that add value to our clients. Beginning in the second quarter of 2003, we have consistently experienced strong new account growth, adding 9 or more clients in each of the last seven quarters. In fiscal year 2004, we added a total of 60 new customers. While not all of these relationships are or become economically significant or are ultimately sustainable over the long term, they do provide the opportunity to build the type of lasting relationships that we achieve with many of our clients — 80% of our fiscal year 2004 revenue came from clients who were also clients in fiscal year 2003.

      Our operational results are also affected by the levels of business activity, economic conditions, and the pace of technological change in the industries and geographies that we serve. Over the past four to six quarters, the strengthening economic recovery appears to be positively affecting the IT spending patterns at many companies. Certain CRM related technological advances, including voice over IP in the contact center, speech-enabled self-service and advance speech recognition capabilities, are beginning to drive higher levels of spending on both growth-oriented and cost-reduction initiatives. While we are pleased with this improved economic environment, there is no assurance that it will consistently lead to a higher level of revenue for eLoyalty. Companies remain conservative regarding their increasing use of outside professional services.

      The Company continues to experience high levels of customer revenue concentration, though these levels have decreased (improved) somewhat from fiscal year 2003. Our top customer accounted for 14% of our revenue in fiscal year 2004 compared to 24% of our revenue for our top customer in fiscal year 2003. Our top 5 and top 10 customers accounted for 52% and 66% of revenue, respectively in fiscal year 2004. This compares to 57% and 73% of revenue for those same categories in fiscal year 2003. As a result of these concentration levels, significant reductions in spending by these top customers may result in fluctuations in revenue and profitability.

      We continue to achieve an increasing percentage of our revenue from our Managed services offerings. In fiscal years 2004, 2003 and 2002, Managed services, in the aggregate, accounted for 21%, 13% and 8%, respectively, of our total revenue. During fiscal year 2004, we acquired substantially all of the net assets and business of Interelate, Inc. (“Interelate”) for approximately $5.4 million of cash consideration (before transaction costs) (the “Interelate Acquisition”). The Interelate Acquisition accounted for $3.6 million, or about 54%, of the growth in Managed services revenue in fiscal year 2004. The remaining growth occurred in

our existing Contact Center Managed Services. Managed services contracts typically have longer terms than consulting contracts and provide a more stable and predictable revenue stream with lower overall selling costs. In addition, because of continued rate and margin pressure in our Consulting services business, Managed services revenue tends to yield higher gross profit margins (revenue excluding reimbursed expenses less cost of services excluding reimbursed expenses).

      In fiscal year 2004, we saw only slight growth in our Consulting services revenue as clients remained cautious regarding their use of outside resources and the competition for that business remains fierce. From 2003 to 2004, Consulting services revenue grew to $50.2 million, or about 4%, over fiscal year 2003. We experienced significant quarter over quarter growth in Consulting services revenue from the first quarter of 2004 to the second quarter of 2004 as a large client engagement ramped up during that timeframe. This level of quarterly Consulting services revenue remained largely unchanged in the third and fourth quarters of fiscal year 2004.

      The primary categories of operating expenses include cost of services, selling, and general and administrative expenses. Cost of services is primarily driven by the costs associated with our delivery personnel, third-party pass-through services related to our Managed services business and cost of third-party software and hardware. Cost of services as a percentage of revenue is driven primarily by the prices we obtain for our solutions and services, the billable utilization of our consulting services delivery personnel and our relative mix of business between Consulting services and Managed services. Selling expense is driven primarily by business development activities, the ongoing development of our service lines, targeted marketing programs, and CRM thought leadership publications. General and administrative costs primarily include costs for our global support functions, technology infrastructure and applications and office space.

      Gross profit margins for fiscal years 2004 and 2003 were 28% and 24% respectively. This increase resulted primarily from higher levels of billable utilization in fiscal year 2004 of 74% compared to fiscal year 2003 of 61%. The higher utilization was partially offset by a reduction in the average hourly billing rate from $175 in fiscal year 2003 to $161 in fiscal year 2004. Rates have continued to decline due to pressure from competitors and from our existing clients as they seek to control costs. To combat margin compression, as we replaced attrition and grew headcount to support our revenue growth in fiscal year 2004, we worked to improve the leverage model within our delivery teams by hiring personnel primarily at the lower levels of our career path. With a better leverage model and high levels of utilization we could maintain or possibly improve consulting gross margins in a flat or decreasing rate environment. While we have recently experienced increases in demand for our services and while margins in our consulting business have improved, it is too early to tell if these developments will translate into sustainable improvements in our pricing or margins over the long term.

      In fiscal years 2004, 2003 and 2002, we recognized charges in the amount of $0.9 million, $2.4 million and $9.1 million, respectively, primarily for employee severance payments, facility reductions and related activities. Although we believe that eLoyalty has sized its operations to the level appropriate for its anticipated revenue and business requirements, technology shifts affecting our mix of revenue, as well as unexpected declines in demand for our offerings, may result in future charges related to additional personnel reductions. See Note Four to our Consolidated Financial Statements included in Part II, Item 8.

      In December 2001, we received $20 million of net cash related to the issuance of the 7% Series B Convertible Preferred Stock (“Series B stock”) and ended December 2001 with total cash of $52.1 million. As of January 1, 2005, total cash was $27.8 million, or a $24.3 million reduction since the end of fiscal year 2001. The fiscal year end 2004 cash balance also represents a $10.1 million reduction since the end of fiscal year 2003. Due to improved working capital management, evidenced by improving days sales outstanding (“DSO”) by 30 days (from 80 days to 50 days) over the last three fiscal years, the Company was able to fund the Interelate Acquisition (purchase price of $5.4 million in fiscal year 2004), operating losses, modest capital expenditures, and Series B stock cash dividends out of cash balances.

      In fiscal year 2005, we expect certain of our large clients to reduce their spending compared to their 2004 expenditure levels. Although we are encouraged by the improving economic conditions and by the addition of new customers in fiscal year 2004 and expect to add more new clients in fiscal year 2005, the initial strength of, and rate of increase in, the spending of new customers is difficult to predict. Our ability to successfully respond

to these uncertainties and to improve operating profit will depend, in part, on our ability to continue to offer innovative solutions via our service lines and to continue to execute our cost management strategy to maintain our lower cost structure. There can be no assurance, however, that we will be able to successfully execute these strategies.

      In fiscal year 2005, the Company continues to have cash obligations related to an expectation of Series B stock cash dividends, modest capital expenditure requirements and severance and related charges recognized in previous periods. We believe that our efforts to right-size our cost structure, in conjunction with expected revenue improvement and consistent levels of utilization will move our Company closer to profitability in fiscal year 2005. However, the uncertainty with respect to the size of spending by new customers and the anticipated reduced spending of certain existing large clients makes it difficult to predict when or if eLoyalty will achieve this goal. Notwithstanding these uncertainties, we believe that the Company’s significant total cash balances at January 1, 2005, together with other expected internally generated funds, are more than adequate to fund our operations over the next twelve months.

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 ongoing basis, we evaluate our estimates, including those related to the costs and timing of completion of client projects, collectability 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 affect more significant judgments and estimates used in the preparation of our consolidated financial statements.

      eLoyalty derives substantially all of its revenue from professional services. Most of this revenue is from Consulting services that involve integrating or building a system for clients. eLoyalty provides Consulting services on a time and materials basis or on a fixed-fee basis. For the integration or the building of a system, eLoyalty recognizes revenue utilizing the percentage-of-completion method as services are performed. Percentage-of-completion estimates are based on the ratio of actual hours incurred to total estimated hours. For all other Consulting services, we recognize revenue as the service is performed. Revenue from fixed price Managed services contracts is recognized ratably over the contract period of the services. For all other Managed services we recognize revenue as the work is performed. Revenue from the sales of software/hardware is recorded at the gross amount of the sale when the contracts satisfy the requirements of Emerging Issues Task Force (“EITF”) 99-19. We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required 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.

      We have recorded full income tax valuation allowances on our net deferred tax assets to account for the unpredictability surrounding the timing of realization of our US and non-US net deferred tax assets due to uncertain economic conditions. The valuation allowances may be reversed at a point in time when management determines realization of these tax assets has become more likely than not, based on a return to predictable levels of profitability.

      We have recorded accruals for severance and related costs associated with our cost reduction efforts undertaken during fiscal years 2001 through 2004. A substantial portion of the accruals relate to office space reductions, office closures and associated contractual lease obligations that are 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. That portion of the accruals relating to employee severance represents contractual severance for identified employees and is not subject to a significant revision. To the extent estimates of the success of our sublease efforts change in the future, adjustments increasing or decreasing the related accruals will be recognized.

Year Ended January 1, 2005 Compared with the Year Ended December 27, 2003

      Our revenue increased $10.0 million, or 16%, to $72.6 million in fiscal year 2004 from $62.6 million in fiscal year 2003. Revenue from Consulting services increased $1.9 million, or 4%, to $50.2 million in fiscal year 2004 from $48.3 million in fiscal year 2003. Consulting services revenue represented 69% and 77% of total revenue for fiscal years 2004 and 2003, respectively. The increase in Consulting services revenue is primarily due to a stronger global economic environment that led to increased demand for the CRM Consulting services provided by us. Revenue from Managed services increased $6.7 million, or 82%, to $14.9 million in fiscal year 2004 from $8.2 million in fiscal year 2003. Managed services revenue represented 21% and 13% of total revenue for fiscal years 2004 and 2003, respectively. The increase in Managed services revenue is driven primarily by the Interelate Acquisition and the continued growth in our Cisco Internet Protocol Contact Center (“IPCC”) offerings. Revenue from software sales increased $1.0 million, to $3.2 million in fiscal year 2004 from $2.2 million in fiscal year 2003. Software sales represented 4% of total revenue for fiscal years 2004 and 2003, respectively. Quarterly software revenue fluctuates significantly depending on the demand for various software products. Revenue from sales of our Loyalty Suite^tm and third-party software was $0.8 million, $1.5 million, $0.4 million, $0.4 million $1.1 million, $0.1 million, $0.1 million and $1.0 million, for the fourth quarter of 2004, third quarter of 2004, second quarter of 2004, first quarter of 2004, fourth quarter of 2003, third quarter of 2003, second quarter of 2003 and first quarter of 2003, respectively.

      Revenue from North American operations increased $9.4 million, or 17%, to $65.9 million in fiscal year 2004 from $56.5 million in fiscal year 2003. International operations revenue (which primarily represents revenue from Europe and Australia) increased $0.6 million, or 10%, to $6.7 million in fiscal year 2004 from $6.1 million in fiscal year 2003. As a percentage of consolidated revenue, revenue from International operations represented 9% and 10% of total revenue for fiscal years 2004 and 2003, respectively.

      Utilization of billable consulting personnel was 74% and 61% for fiscal years 2004 and 2003, respectively, 72% in the fourth quarter of 2004 and 61% in the fourth quarter of 2003. Utilization is defined as billed time as a percentage of total available time. We continue to experience pricing pressures that resulted in an average hourly billing rate of $161 and $175 for fiscal years 2004 and 2003, respectively, $151 in the fourth quarter of 2004 and $164 in the fourth quarter of 2003. In certain instances, we include the cost of otherwise reimbursable expenses in the average hourly billing rate we charge our clients for professional services. Excluding these otherwise reimbursable expenses from our billed fees results in an effective average hourly billing rate of $152 and $164 for fiscal years 2004 and 2003, respectively, $141 for the fourth quarter of 2004 and $155 for the fourth quarter of 2003. Our revenue per billable consultant increased to $287,000 in the fourth quarter of 2004 from $265,000 in the fourth quarter of 2003. This increase was primarily driven by improved utilization partially offset by the lower billing rates.

      Our revenue concentration has decreased as our top 10 customers accounted for 66% and 73% of our revenue in fiscal year 2004 and fiscal year 2003. In addition, the top 20 customers accounted for 80% of our revenue in fiscal year 2004 and 86% of our revenue in fiscal year 2003. Three clients each accounted for 10% or more of our revenue in fiscal year 2004. Crowe, Chizek and Company LLP accounted for 14% of our revenue in fiscal year 2004, 1% of our revenue in fiscal year 2003 and 0% of our revenue in fiscal year 2002. United HealthCare Services, Inc. accounted for 13% of our revenue in fiscal year 2004, 24% of our revenue in fiscal year 2003 and 14% of our revenue in fiscal year 2002. Allstate Insurance Company accounted for 10% of our revenue in fiscal year 2004, 10% of our revenue in fiscal year 2003 and 11% of our revenue in fiscal year 2002. Higher concentration of revenue with a single customer or a limited group of customers can result in increased revenue risk should one of these clients significantly reduce its demand for our services. The top 5 customers in fiscal year 2004 increased their demand for our services by approximately $1.9 million compared to the top 5

customers in fiscal year 2003. The top 5 customers in fiscal years 2004 and 2003 represented approximately 52% and 57% of revenue, 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, third-party software and support costs and other expenses of a billable and non-billable nature.

      Cost of services increased $4.5 million, or 9%, to $53.2 million in fiscal year 2004 from $48.7 million in fiscal year 2003. The increase is primarily due to additional software costs, Managed services third-party contract costs, increased personnel costs related to the Interelate Acquisition and subcontractor costs. Cost of services as a percentage of revenue decreased to 73% in fiscal year 2004 compared to 78% in fiscal year 2003. This percentage decrease was primarily due to the impact of a thirteen-percentage point improvement in utilization compared to 2003 partially offset by lower average hourly billing rates.

      Selling, general and administrative expenses consist primarily of salaries, incentive compensation and employee benefits for business development, marketing, administrative personnel, facilities cost, a provision for uncollectable amounts and costs for our technology infrastructure and applications.

      Selling, general and administrative expenses decreased $4.2 million, or 18%, to $19.5 million in fiscal year 2004 from $23.7 million in fiscal year 2003. This decrease was primarily the result of $2.8 million savings due to personnel reductions, $0.5 million savings related to reduced rent and lease costs, $0.5 million favorable adjustment resulting from the final determination of a previous estimate related to the collection of a receivable, as well as a $0.4 million reduction in spending on outside services such as telecommunications costs and professional fees.

      In response to the current business environment and shifting skill and geographic requirements, and in prior periods, an overall decrease in demand for IT consulting services, we have undertaken a number of cost reduction activities consisting of personnel reductions in fiscal year 2004, and personnel reductions, office space reductions and office closures in fiscal year 2003 and prior. As a result of these activities, we recognized a charge of $0.9 million in fiscal year 2004 and $2.4 million in fiscal year 2003 reducing our headcount by 14 employees and 67 employees in fiscal years 2004 and 2003, respectively. We expect substantially all severance and related costs associated with cost reduction activities to be paid out by the end of the first quarter of 2006, pursuant to agreements entered into with affected employees. Facility costs related to office space reductions and office closures in fiscal years 2002 and 2001 will be paid pursuant to contractual lease terms through fiscal year 2007.

      Severance and related costs decreased $1.5 million, or 63% to $0.9 million in fiscal year 2004 compared to $2.4 million in fiscal year 2003. This is a result of fewer involuntary personnel reductions in fiscal year 2004 versus fiscal year 2003 as well as favorable adjustments in fiscal year 2003 related to changes in estimated sublease rental income from previous office space reductions. Annual savings related to the cost reduction actions in fiscal year 2004 are expected to be $2.4 million and will be realized in fiscal year 2005. Annual savings resulting from the cost reduction actions initiated in fiscal year 2003 approximated $10.7 million and were realized in fiscal year 2004.

      Depreciation expense decreased $0.1 million, or 2%, to $5.2 million in fiscal year 2004 compared to $5.3 million in fiscal year 2003. This decrease is due to assets becoming fully depreciated or disposed of,

partially offset by the incremental depreciation of $0.7 million associated with the assets from the Interelate Acquisition.

      Amortization of intangibles increased $0.3 million, or 300%, to $0.4 million in fiscal year 2004 compared to $0.1 million in fiscal year 2003. This increase is primarily due to the amortization of the intangibles related to the Interelate Acquisition.

      Goodwill impairment decreased $0.6 million, or 100%, in fiscal year 2004 from $0.6 million in fiscal year 2003. Goodwill was reviewed in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets”. For fiscal year 2004, in conjunction with the annual planning cycle, the Company evaluated the goodwill amounts on the balance sheet for its reporting units and no impairment was identified. In fiscal year 2003, the Company tested the valuation of the goodwill for its North American and International reporting units. As a result of this evaluation, the Company determined that goodwill relating to a 1996 acquisition in Europe could not continue to be supported by the fair value of the International reporting unit and recognized a goodwill impairment charge of $0.6 million in the fourth quarter of 2003.

      Primarily as a result of the above-described business conditions, we experienced an operating loss of approximately $6.7 million for the fiscal year 2004, compared to an operating loss of approximately $18.1 million for the fiscal year 2003.

      Non-operating interest income (expense) and other decreased $0.1 million, or 33%, to $0.2 million in fiscal year 2004 compared to $0.3 million in fiscal year 2003. The $0.1 million decrease in non-operating other income was primarily related to lower yields on our investments.

      Income taxes were a benefit of $0.6 million compared to a provision of $0.4 million in fiscal years 2004 and 2003, respectively. The $0.6 million benefit in fiscal year 2004 related to a favorable adjustment to a previous estimate of a foreign income tax liability. The $0.4 million in fiscal year 2003 related to income taxes, city trade taxes and withholding taxes related to cash distributions to the US operating unit, all relating to our foreign operations. As of January 1, 2005, total deferred tax assets of $52.6 million are fully offset by a valuation allowance. In response to revenue declines, we have implemented cost reduction actions to lower the point at which our operations break even. The level of uncertainty in predicting when we will return to acceptable levels of profitability, sufficient to utilize our net US and non-US operating losses and realize our deferred tax assets requires that a full income tax valuation allowance be recognized in the financial statements.

      We reported a net loss available to common stockholders of $7.4 million for fiscal year 2004 as compared with a net loss available to common stockholders of $19.8 million in fiscal year 2003. We reported a net loss of $1.22 per share on a basic and diluted basis in fiscal year 2004 compared to a net loss of $3.48 per share on a basic and diluted basis in fiscal year 2003. Improved performance in fiscal year 2004 is primarily driven by stronger utilization, higher percentage of revenue generated from Managed services and lower selling, general and administrative expenses. The losses in fiscal year 2003 were primarily attributable to declines in our business and the charges for severance and related costs.

Year Ended December 27, 2003 Compared with the Year Ended December 28, 2002

      Our revenue decreased $24.1 million, or 28%, to $62.6 million in 2003 from $86.7 million in 2002. Revenue from Consulting services decreased $21.1 million, or 30%, to $48.3 million in 2003 from $69.4 million in 2002. The decrease in revenue is primarily due to a weak global economic environment that led to decreased demand for the CRM Consulting services provided by us. Revenue from Managed services increased $1.1 million, or 16%, to $8.2 million in 2003 from $7.1 million in 2002. Managed services revenue represented 13% and 8% of total revenue for the years ended December 27, 2003 and December 28, 2002, respectively. Revenue from software sales increased $0.1 million, to $2.3 million in 2003 from $2.2 million in 2002. Software sales represented 4% and 3% of total revenue for the years ended December 27, 2003 and December 28, 2002, respectively. Quarterly software revenue fluctuates significantly depending on the demand for various software products. Revenue from sales of our Loyalty Suite^tm and third-party software was $1.1 million, $0.1 million, $0.1 million, $1.0 million, $0, $1.1 million $0 and $1.1 million, for the fourth quarter of 2003, third quarter of 2003, second quarter of 2003, first quarter of 2003, fourth quarter of 2002, third quarter of 2002, second quarter of 2002 and first quarter of 2002, respectively.

      Revenue from North American operations decreased $21.1 million, or 27%, to $56.5 million in 2003 from $77.6 million in 2002. International operations revenue (which primarily represents revenue from Europe and Australia) decreased $3.0 million, or 33%, to $6.1 million in 2003 from $9.1 million in 2002. As a percentage of consolidated revenue, revenue from International operations remained constant at 10% in 2003 and 2002. The impact of a weak US dollar in 2003, contributed 1% of total revenue, and 15% of revenue from International operations compared to 2002.

      Utilization of billable consulting personnel was 61% and 60% for the years 2003 and 2002, respectively, 61% in the fourth quarter of 2003 and 60% in the fourth 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 hourly billing rate of $164 in the fourth quarter of 2003 versus $184 in the fourth quarter of 2002. In certain instances, we include the cost of otherwise reimbursable expenses in the average hourly billing rate we charge our clients for professional services. Excluding these otherwise reimbursable expenses from our billed fees results in an effective average hourly billing rate of $155 for the fourth quarter of 2003 and $184 for the fourth quarter of 2002. Our revenue per billable consultant remained constant at $265,000 in the fourth quarter of 2003 and 2002. Incremental software revenue within our overall mix of revenue offsets the impact of lower billing rates in the fourth quarter of 2003.

      Our revenue concentration has remained constant as our top 10 customers accounted for 73% of our revenue in 2003 and 2002. In addition, the top 20 customers accounted for 86% of our revenue in 2003 and 87% of our revenue in 2002. Three clients each accounted for 10% or more of our revenue in 2003. United HealthCare Services, Inc. accounted for 24% of our revenue in 2003, 14% of our revenue in 2002 and 13% of our revenue in 2001. AT&T Wireless accounted for 11% of our revenue in 2003, 10% of our revenue in 2002 and 8% of our revenue in 2001. Allstate Insurance Company accounted for 10% of our revenue in 2003, 11% of our revenue in 2002 and 7% of our revenue in 2001. Higher concentration of revenue with a single customer or a limited group of customers can result in increased revenue risk should one of these clients significantly reduce its demand for our services. The top five clients in 2003 reduced their demand for our services by approximately $10.6 million compared to the top five clients in 2002. The top five clients in 2003 and 2002 represented approximately 57% and 53% of revenue, respectively. Our revenue is generated primarily from Consulting services, which is billed on a time and materials basis or on a fixed-fee basis. Revenue is recognized for time and material engagements as services are rendered, primarily utilizing the percentage-of-completion method. As a percentage of total revenue, revenue from Consulting services was 77% in 2003 compared to 80% in 2002.

      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, third-party software and support costs and other expenses of a billable and non-billable nature.

      Cost of services decreased $9.1 million, or 16%, to $48.7 million in 2003 from $57.8 million in 2002. This is due primarily to a 19% decrease in the number of our engageable consultants to 226 as of December 27, 2003 from 279 as of December 28, 2002. Cost of services as a percentage of revenue increased to 78% in 2003 compared to 67% in 2002. This percentage increase was primarily due to the impact of lower effective average hourly billing rates.

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

      Selling, general and administrative expenses decreased $5.2 million, or 18%, to $23.7 million in 2003 from $28.9 million in 2002. This decrease was primarily the result of a $2.0 million reduction in spending on outside services such as telecommunications costs and professional fees, as well as a $2.5 million savings due to personnel reductions and $0.7 million savings related to reduced rent and lease costs. The comparable headcounts were 58 at the end of fiscal 2003 and 89 at the end of 2002.

      In response to the current business environment and decreased demand for IT consulting services, we have undertaken a number of cost reduction activities consisting of personnel reductions in 2003, and personnel reductions, office space reductions and office closures in prior periods. These cost reduction activities have been designed to size our workforce to meet our expected business requirements. As a result of these activities, we recognized a charge of $2.4 million in 2003 and $9.1 million in 2002 reducing our headcount by 67 employees and 107 employees in 2003 and 2002, respectively. Substantially all severance and related costs associated with these plans were paid out by the end of the first quarter of 2004, pursuant to agreements entered into with affected employees. Voluntary and involuntary terminations, net of limited hiring, have reduced our headcount to 277 employees at the end of 2003 from 365 employees at the end of 2002. Facility costs related to office space reductions and office closures in 2002 and 2001 will be paid pursuant to contractual lease terms through 2007.

      Severance and related costs decreased $6.7 million, or 73%, to $2.4 million in 2003 compared to $9.1 million in 2002. This is the result of fewer involuntary personnel reductions in 2003 versus 2002, as well as an adjustment of $0.3 million primarily related to the favorable resolution of two matters involving former employees, $0.7 million related to favorable changes in estimated sublease rental income from previous office space reductions and $0.1 million of favorable adjustments to previous cost estimates, primarily due to the termination of an equipment lease. Annual savings resulting from the cost reduction actions initiated in 2003 were approximately $10.7 million and were realized in 2004. Annual savings resulting from 2002 involuntary personnel reductions were approximately $13.5 million and were realized in 2003.

      Research and development expenses decreased $0.2 million, or 100%, in 2003 from $0.2 million in 2002. This decrease is primarily due to lower investment in the Loyalty Lab, including headcount reductions. Effectively, we have ceased our investment in research and development activities as a result of continued unfavorable economic conditions.

      Depreciation expense decreased $0.2 million, or 4%, to $5.3 million in 2003 compared to $5.5 million in 2002. The $0.2 million decrease is primarily due to certain assets being fully depreciated in 2003 partially offset by depreciation related to 2003 capital expenditures.

      Amortization of intangibles increased $0.1 million to $0.1 million in 2003 compared to $0 in 2002. This increase is due to the amortization of a license, purchased in 2003, for certain intellectual property that will be utilized within our business.

      Effective January 2002, eLoyalty adopted SFAS No. 142, “Goodwill and Other Intangible Assets” which required that goodwill no longer be amortized. There was no goodwill amortization recorded in 2003 and 2002.

      Goodwill impairment increased $0.6 million to $0.6 million in 2003 compared to $0 in 2002. Goodwill was reviewed in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets”. In conjunction with the annual planning cycle, the Company evaluated the goodwill amounts on the balance sheet for its reporting units. The Company tested the valuation of the goodwill for its North American and International reporting units to determine whether or not these goodwill amounts were impaired under SFAS No. 142. As a result of this evaluation, the Company determined that goodwill relating to a 1996 acquisition in Europe could not continue to be supported by the fair value of the International reporting unit. Accordingly, the Company recognized a goodwill impairment charge of $0.6 million in the fourth quarter of 2003.

      Primarily as a result of the above-described business conditions and ongoing cost reduction actions, we experienced an operating loss of approximately $18.1 million for the year ended December 27, 2003, compared to an operating loss of approximately $14.8 million for the year ended December 28, 2002.

      Non-operating interest income (expense) and other decreased $0.5 million, or 63%, to $0.3 million in 2003 compared to $0.8 million in 2002. The $0.5 million decrease in non-operating interest income (expense) and other was due to the sale of an investment security in 2002 and reduced yields for funds classified as cash and restricted cash.

      Income taxes were $0.4 million in 2003 compared to $21.4 million in 2002. Our income tax provision for 2003 consisted of income taxes, city trade taxes and withholding taxes related to cash distributions to the US operating unit, primarily from our foreign operations.

      During fiscal 2002, eLoyalty established an income tax valuation allowance of $24.6 million related to deferred tax assets for the US. This is in addition to the valuation allowance established in 2001 for non-US deferred tax assets. As of December 27, 2003, total net deferred tax assets of $53.3 million are fully offset by a valuation allowance. The decision to establish a valuation allowance for the remaining US deferred tax assets and cease recording the benefit of losses incurred by US operating units was made in fiscal 2002 following our normal process of assessing current year results and forecasting financial performance for the next fiscal year and beyond. In response to revenue declines, we have implemented cost reduction actions to lower the point at which our operations break even. However, the level of uncertainty in predicting when we will return to acceptable levels of profitability, sufficient to utilize our net US and non-US operating losses and realize our net deferred tax assets, has grown to the point where generally accepted accounting principles (“GAAP”) required that a full income tax valuation allowance be recognized in the financial statements.

      We reported a net loss available to common stockholders of $19.8 million for 2003 as compared with a net loss available to common stockholders of $40.8 million in 2002. We reported a net loss of $3.48 per share

on a basic and diluted basis in 2003 compared to a net loss of $7.86 per share on a basic and diluted basis in 2002. The losses in 2003 and 2002 are primarily attributable to continued declines in our business, the charges for severance and related costs and factors associated with the establishment of a US income tax valuation allowance beginning in the fourth quarter of 2002.

Liquidity and Capital Resources

      Our principal capital requirements are to fund working capital needs, capital expenditures, other investments in support of revenue generation and growth and payment of Series B stock dividends. Our principal current capital resources consist of our cash and cash equivalent balances. At January 1, 2005, we had cash and cash equivalents of approximately $27.1 million and restricted cash of approximately $0.7 million. Our cash and cash equivalents position decreased $9.9 million, or 27%, to $27.1 million as of January 1, 2005 compared to $37.0 million at December 27, 2003. The cash and cash equivalents decrease is primarily related to the Interelate Acquisition of $5.6 million and the funding of working capital of $4.4 million. Restricted cash represents cash as security for our letters of credit. Restricted cash decreased $0.2 million, to $0.7 million as of January 1, 2005 compared to $0.9 million at December 27, 2003. The $0.2 million decrease in restricted cash is due to reducing the letters of credit.

      Cash flows from operating activities were a use of approximately $2.9 million and $9.6 million during fiscal years 2004 and 2003, respectively. Net cash outflows from operating losses, annual corporate insurance payments, prepaid software maintenance contracts and payments with respect to severance and related costs contributed to the use of cash. DSO of 50 days at January 1, 2005 represented an increase of 4 days compared to 46 days at December 27, 2003. We do not expect any significant collection issues with our clients. Unearned revenue was a $3.8 million source of cash during fiscal year 2004 compared to $0.2 million during fiscal year 2003. The increase of $3.6 million primarily reflects prepayments from our clients for Managed services contracts. At January 1, 2005, there remained $1.9 million of unpaid severance and related costs (see Note Four to the Consolidated Financial Statements included in Part II, Item 8).

      Cash flows used in investing activities increased $4.9 million, to $6.1 million during fiscal year 2004 from $1.2 million during fiscal year 2003. Net cash outflows consisted of $5.6 million related to the Interelate Acquisition and $0.5 million of capital expenditures, primarily related to our Managed services. During 2003, capital expenditures of $1.2 million were primarily related to $0.9 million of spending on investments in IT infrastructure and our Managed services and $0.3 million due to a license payment for intellectual property that is being utilized within our business. The level of capital expenditures for fiscal year 2005 may vary significantly depending on the number of new contracts for hosted services engagements into which we enter. In any event, we expect our capital expenditures to be less than $2.3 million for fiscal year 2005.

      Cash flows used in financing activities decreased $0.2 million, to $1.3 million during fiscal year 2004 from $1.5 million during fiscal year 2003. The $1.3 million of cash used in 2004 is attributable to cash dividends of $1.5 million, in the aggregate, paid in January and July of 2004 on the Series B convertible preferred stock (“Series B stock”) offset by $0.2 million decrease in restricted cash. The $1.5 million of cash used during 2003 is attributable to borrowings of $25.8 million, the required deposit of $8.6 million of cash security for the credit line, offset by aggregate payments of $34.4 million and cash dividends of $1.5 million, in the aggregate, paid in January and July of 2003 on the Series B stock. In addition, a semi-annual dividend payment of approximately $0.7 million is expected to be paid in future periods on the Series B stock. The amount of each

such dividend would decrease by any conversions of the Series B stock into common stock, although any such conversions would require that we pay 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. Our balance of cash and cash equivalents was $27.1 million and $37.0 million as of January 1, 2005 and December 27, 2003, respectively. In addition, our restricted cash of $0.7 million at January 1, 2005 is available to support letters of credit issued under our LaSalle credit facility (as described below) for operational commitments, and to accommodate a LaSalle Bank credit requirement associated with the purchase and transfer of foreign currencies.

      The Company maintains a Loan Agreement with LaSalle Bank National Association (the “Bank”). The maximum principal amount of the secured line of credit under the agreement remained at $2 million throughout the fiscal year 2004 (the “Facility”). The Facility requires eLoyalty to maintain a minimum cash and cash equivalent balance within a secured bank account at the Bank. The balance in the secured account cannot be less than the outstanding balance drawn on the line of credit, and letter of credit obligations under the Facility, plus a de minimis reserve to accommodate a LaSalle Bank credit requirement associated with the purchase and transfer of foreign currencies. eLoyalty had no borrowings under the Facility at January 1, 2005 and December 27, 2003, respectively. Available credit under the Facility has been reduced by approximately $0.7 million related to letters of credit issued under the Facility for operational commitments and a Bank credit requirement associated with the purchase and transfer of foreign currencies. Loans under the Facility bear interest at the Bank’s prime rate or, at eLoyalty’s election, an alternate rate of LIBOR (London InterBank Offering Rate) plus 0.75%. In fiscal year 2004, we did not have any borrowings or interest expense under the Facility. At December 27, 2003 the average annual interest rate was 2.0%. Interest expense was $0.1 million for the fiscal year ended 2003.

      At January 1, 2005 we had two customers each accounting for 10% or more of total net receivables. Crowe, Chizek and Company LLP accounted for 28% and United HealthCare Services, Inc. accounted for 23%, respectively of total net accounts receivable. Of these amounts, we have collected approximately 100% from Crowe, Chizek and Company LLP and 77% from United HealthCare Services, Inc., respectively, through March 21, 2005. Of total gross accounts receivable as of March 21, 2005, we have collected 90% subsequent to January 1, 2005. Because we have a high percentage of our revenue dependent on a relatively small number of customers, delayed payments by a few of our larger clients could result in a reduction of our available cash.

      We anticipate that our current unrestricted cash resources, together with other expected internally generated funds, should be sufficient to satisfy our working capital and capital expenditure needs for the next twelve months. We also anticipate that our unrestricted cash resources will be sufficient to meet our current expected needs. If, however, our operating activities or net cash needs for the next twelve months 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.

Contractual Obligations

      As of January 1, 2005, our remaining required payment obligations under lease and certain other commitments are shown in the following table:

      Letters of credit reflect standby letters of credit issued as collateral for operational leases.

      Operating leases reflect leases entered into by the Company for technology and office equipment as well as office space. The amounts listed have not been reduced by minimum sublease rentals of $50 due in the future for fiscal year 2005 under non-cancelable subleases.

      Severance and related costs reflect payments the Company will make in future periods for severance and other related costs due to cost reduction activities in fiscal year 2004 and prior years. The amounts listed have not been reduced by minimum sublease rentals of $167, $167 and $125 due in the future for fiscal years 2005, 2006 and 2007, respectively, under non-cancelable subleases.

      Purchase obligations reflect the costs of goods or services eLoyalty had received prior to January 1, 2005, but had not tendered payment. Purchase orders for third-party support costs associated with Managed services support agreements are also included.

Recent Accounting Pronouncements

      In December 2004, Financial Accounting Standards Board (“FASB”) issued SFAS No. 123R “Share-Based Payment” which replaces SFAS No. 123 and supersedes Accounting Principles Board (“APB”) Opinion No. 25. SFAS No. 123R requires all share-based payments to employees to be recognized in the financials statements at fair value and eliminates the intrinsic value-based method. The Statement is effective for periods beginning after June 15, 2005. We have reviewed SFAS No. 123R and do not anticipate the adoption of SFAS No. 123R to have a material impact on our future financial position or results of operations.

      In March 2004, the EITF reached a consensus on EITF Issue No. 03-06, “Participating Securities and the Two-Class Method under FASB Statement No. 128, Earnings per Share.” EITF 03-06 clarifies what constitutes a participating security and provides further guidance in applying the two-class method of calculating earnings per share (“EPS”). The consensus by the Task Force was effective for reporting periods beginning after March 31, 2004. eLoyalty adopted EITF Issue No. 03-06 in the quarter ended June 26, 2004. There was no impact of the adoption on the computation of EPS during the fiscal year ended 2004, as the effect is antidilutive. In periods of net income, eLoyalty will utilize the two-class method of computing EPS.

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-K include the following:

      We provide solutions to clients in a number of countries including the United States, Australia, Austria, Canada, Germany, Ireland and the United Kingdom. For the years ended January 1, 2005 and December 27, 2003, 15% and 14%, respectively, of our revenue was denominated in foreign currencies. Historically, we have not experienced material fluctuations in our results of operations due to foreign currency exchange rate changes. As a result of our exposure to foreign currencies, future financial results could be affected by factors such as changes in foreign currency exchange rates or weak economic conditions in those foreign markets. We do not currently engage, nor is there any plan to engage, in hedging foreign currency risk.

      We also have interest rate risk with respect to changes in variable rate interest on our revolving line of credit. Interest on the line of credit is currently based on either the bank’s prime rate, or LIBOR, which varies in accordance with prevailing market conditions. A change in interest rate impacts the interest expense on the line of credit and cash flows, but does not impact the fair value of the debt. This interest rate risk will not have a material impact on our financial position or results of operations.

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS OF eLOYALTY CORPORATION

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders of eLoyalty Corporation:

      In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of eLoyalty Corporation and its subsidiaries (the “Company”) at January 1, 2005 and December 27, 2003, and the results of their operations and their cash flows for each of the three years in the period ended January 1, 2005 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the accompanying index presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

      As discussed in Note Two to the consolidated financial statements, the Company changed its method of accounting for goodwill in connection with the adoption of Statement of Financial Account Standards No. 142, “Goodwill and Other Intangible Assets,” effective January 1, 2002.

PricewaterhouseCoopers LLP

Chicago, Illinois

February 19, 2005

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.

eLOYALTY CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

The accompanying Notes to Consolidated Financial Statements are

an integral part of this financial information.

eLOYALTY CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

The accompanying Notes to Consolidated Financial Statements are

an integral part of this financial information.

eLOYALTY CORPORATION

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

(ACCUMULATED DEFICIT) AND COMPREHENSIVE LOSS

(In thousands, except share data)

The accompanying Notes to Consolidated Financial Statements are

an integral part of this financial information.

eLOYALTY CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands, except per share data)

Note One — Description of Business

      eLoyalty is a leading management consulting, systems integration, and managed services company focused on optimizing customer interactions. With professionals in offices throughout North America and Europe, eLoyalty’s broad range of enterprise CRM services and solutions include creating customer strategies; defining technical architectures; selecting, implementing and integrating best-of-breed CRM and analytics software applications; providing ongoing support for multi-vendor systems; and hosting application environments. The combination of eLoyalty’s methodologies and technical expertise enables eLoyalty to deliver the tangible economic benefits of customer loyalty for its clients.

Note Two — Summary of Significant Accounting Policies

      Fiscal Year-End — The fiscal year ends for 2004, 2003 and 2002 were January 1, 2005, December 27, 2003 and December 28, 2002, respectively. Fiscal year 2004 consisted of fifty-three weeks instead of fifty-two weeks, which did not have a material impact on our financial position or results of operations.

      Consolidation — The consolidated financial statements include the accounts of eLoyalty and all of its subsidiaries. All significant intercompany transactions have been eliminated.

      Revenue Recognition — eLoyalty derives substantially all of its revenue from professional services. Most of this revenue is from consulting services that involve integrating or building a system for clients. eLoyalty provides consulting services on a time and materials basis or on a fixed-fee basis. For the integration or the building of a system, eLoyalty recognizes revenue utilizing the percentage-of-completion method as services are performed. Percentage-of-completion estimates are based on the ratio of actual hours incurred to total estimated hours. For all other Consulting services, we recognize revenue as the service is performed. Revenue from fixed price Managed services contracts is recognized ratably over the contract period of the services. For all other Managed services we recognize revenue as the work is performed.

      Revenue from the resale of third-party software and in certain circumstances from the licensing of proprietary software is recognized upon delivery provided the Company has no further obligations to install or modify the software. Revenue from the sales of software/hardware is recorded at the gross amount of the sale when the contracts satisfy the requirements of Emerging Issues Task Force (“EITF”) 99-19.

      Contracts containing multiple services are segmented into individual elements when the services represent separate earning processes and the fair value of the individual elements is objectively measured. Revenue for contracts with multiple elements is allocated based on the fair value of the elements and is recognized in accordance with our accounting policies for each individual element, as described above.

      eLoyalty uses subcontractors to supplement its resources on client engagements. Revenue generated through subcontractors is recognized as the service is performed, and the related subcontractor costs are included in cost of services.

      Losses on engagements, if any, are recognized when they are probable and estimable.

      Payments received for Managed services contracts in excess of the amount of revenue recognized for these contracts are recorded in Unearned Revenue until revenue recognition criteria are met.

      In accordance with EITF Issue No. 01-14, we record out-of-pocket expenses as revenue in the statements of operations. Out-of-pocket expenses included in revenue for the fiscal years ended 2004, 2003 and 2002 were $4,330, $3,802 and $7,899, respectively.

      Reclassifications — Certain amounts reported in previous years have been reclassified to conform to the fiscal year 2004 presentation. These reclassifications had no impact on net loss or stockholders’ equity.

eLOYALTY CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

      Cost of Services — Cost of services consist primarily of salaries, incentive compensation, billable and non-billable expenses, employee benefits for eLoyalty personnel available for client assignments, third-party software and support costs and fees paid to subcontractors for work performed on client projects.

      Cash and Cash Equivalents — eLoyalty considers all highly liquid investments readily convertible into known amounts of cash (with original maturities of three months or less) to be cash equivalents. These short-term investments are carried at cost plus accrued interest, which approximates market.

      Restricted Cash — Restricted cash principally represents cash as security for eLoyalty’s line of credit and letters of credit.

      Equipment and Leasehold Improvements — Computers, software, furniture and equipment are carried at cost and depreciated on a straight-line basis over their estimated useful lives. Leasehold improvements are amortized over the lesser of the useful life or the lease term. The useful life for computers and software is three years. For enterprise software applications where a longer useful life is deemed appropriate, five years is used. For furniture and equipment, a useful life of five years is used. Maintenance and repair costs are expensed as incurred. The cost and related accumulated depreciation of assets sold or disposed of are eliminated from the respective accounts and resulting gain or loss is included in the statements of operations. The carrying value of equipment and leasehold improvements is periodically reviewed to assess recoverability based on future undiscounted cash flows. An impairment loss, if any, would be measured as the excess of the carrying value over the fair value.

      eLoyalty accounts for software developed for internal use in accordance with Statement of Position 98-1, “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use.” As such, costs incurred that relate to the planning and post-implementation phases of development are expensed. Costs incurred during application development stage are capitalized and amortized over the asset’s estimated useful life, generally three to five years.

      Goodwill — eLoyalty adopted Statement of Financial Accounting Standards (“SFAS”) No. 142 “Goodwill and Other Intangible Assets” on January 1, 2002 and no longer amortizes goodwill. Goodwill is tested for impairment annually. The impairment test consists of a comparison of the implied fair value of the reporting unit with its carrying amount. If the carrying amount of the reporting unit exceeds the implied fair value of that reporting unit an impairment loss of goodwill will be recognized in an amount equal to that excess.

      As a result of the annual review of goodwill impairment as of January 1, 2005 no impairment was identified. For the year ended December 27, 2003, the Company determined that goodwill relating to a 1996 acquisition in Europe could not continue to be supported by the fair value of the International reporting unit. Accordingly, the Company recognized a goodwill impairment charge of $557 in the fourth quarter of 2003.

      Changes in the carrying value of goodwill as of January 1, 2005 are as follows:

eLOYALTY CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

      Intangible Assets — Intangible assets reflect intangibles related to the Interelate Acquisition (as discussed in Note Three) and the 2003 purchase of a license for certain intellectual property. These intangible assets are amortized over 12 months to 60 months. Unamortized intangible assets as of January 1, 2005 and December 27, 2003 were $1,713 and $262, respectively. eLoyalty did not have any intangible assets as of December 28, 2002. Accumulated amortization of intangible assets as of January 1, 2005 and December 27, 2003 was $412 and $63, respectively. Amortization expense will be $532, $370, $320, $320 and $171 for the fiscal years ended 2005, 2006, 2007, 2008 and 2009, respectively.

      Research and Development Costs — Research and development costs are expensed as incurred. Research and development expenses relate primarily to the dedicated research and development facility maintained by eLoyalty, and consist primarily of salaries, incentive compensation and employee benefits costs for dedicated personnel, occupancy costs, staff recruiting costs, administrative costs, travel expenses and depreciation.

      Stockholders’ Equity — Stockholders’ equity includes common stock issued, additional paid-in capital, retained earnings (deficit), accumulated other comprehensive loss related to foreign currency translation and unearned compensation related to stock-based compensation. The 4.2 million shares of Series B stock are not classified as permanent equity in the accompanying balance sheets as the preferred stockholders have the ability to initiate a redemption that is considered outside eLoyalty’s control.

      Earnings (Loss) Per Common Share — eLoyalty calculates earnings (loss) per share in accordance with SFAS No. 128, “Earnings per Share.” Basic net loss per common share has been computed by dividing the net loss available to common stockholders for each period presented by the weighted average shares outstanding. Diluted loss per common share has been computed by dividing the net loss available to common stockholders by the weighted average shares outstanding plus the dilutive effect of common stock equivalents, which consist of convertible preferred stock, restricted stock awards and options, using the “treasury stock” method. In periods in which there was a loss, the dilutive effect of common stock equivalents was not included in the diluted loss per share calculation as it was antidilutive.

      Foreign Currency Translation — The functional currencies for eLoyalty’s foreign subsidiaries are their local currencies. All assets and liabilities of foreign subsidiaries are translated to US dollars at end of period exchange rates. The resulting translation adjustments are recorded as a component of stockholders’ equity and comprehensive income. Income and expense items are translated at average exchange rates prevailing during the period. Gains and losses from foreign currency transactions of these subsidiaries are included in interest income (expense) and other within the consolidated statements of operations.

      Fair Value of Financial Instruments — The carrying values of current assets and liabilities approximated their fair values as of January 1, 2005 and December 27, 2003.

      Concentration of Credit Risk — Financial instruments that potentially subject eLoyalty to a concentration of credit risk consist of cash and cash equivalents, restricted cash and accounts receivable. Cash and cash equivalents and restricted cash are deposited with high credit quality financial institutions. The Company’s accounts receivable are derived from revenue earned from customers located primarily in the US and are denominated in US dollars. For the fiscal year ended 2004, eLoyalty had three clients each accounting for 10% or more of total revenue. These clients were Crowe, Chizek and Company LLP at 14%, United HealthCare Services, Inc. at 13% and Allstate Insurance Company at 10%. For the fiscal year ended 2003, eLoyalty had three clients each accounting for 10% or more of total revenue. These customers were United HealthCare Services, Inc. at 24%, AT&T Wireless at 11% and Allstate Insurance Company at 10%. For the fiscal year ended 2002, eLoyalty had four clients each accounting for 10% or more of total revenue. These customers were United HealthCare Services, Inc. at 14%, Eli Lilly at 12%, Allstate Insurance Company at 11% and AT&T Wireless at 10%. At January 1, 2005 we had two customers each accounting for 10% or more of total net receivables. Crowe, Chizek and Company LLP and United HealthCare Services, Inc. accounted for 28% and 23%, respectively, of total net accounts receivable.

eLOYALTY CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

      Stock-Based Compensation — eLoyalty accounts for stock-based compensation using Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” whereby compensation cost for stock options is measured as the excess, if any, of the fair market value of a share of the Company’s stock at the date of grant over the amount that must be paid to acquire the stock. SFAS No. 123, “Accounting for Stock-Based Compensation” issued subsequent to APB No. 25 and amended by SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure” defines a fair value-based method of accounting for employee stock options but allows companies to continue to measure compensation cost for employee stock options using the intrinsic value-based method described in APB No. 25.

      The following table illustrates the effect on net loss available to common stockholders and net loss per share if eLoyalty had applied the fair value recognition provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” as amended by SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure,” to stock-based employee compensation. No compensation costs have been recognized for awards of stock options in the accompanying Consolidated Statements of Operations. Compensation costs were recognized for restricted and installment awards as expense in the accompanying Consolidated Statements of Operations.

      Assumptions used for valuation of option grants calculated in accordance with SFAS No. 148 are as follows:

eLOYALTY CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

      In December 2004, Financial Accounting Standards Board (“FASB”) issued SFAS No. 123R “Share-Based Payment” which replaces SFAS No. 123 and supersedes APB Opinion No. 25. See discussion under New Accounting Standards.

      Income Taxes — eLoyalty uses an asset and liability approach, as required under SFAS No. 109, for financial accounting and reporting of income taxes. Deferred income taxes are provided when tax laws and financial accounting standards differ with respect to the amount of income for the year, the basis of assets and liabilities and for tax loss carryforwards. eLoyalty does not provide US deferred income taxes on earnings of US or foreign subsidiaries which are expected to be indefinitely reinvested.

      Use of Estimates — The preparation of the financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those amounts.

      New Accounting Standards — In December 2004, FASB issued SFAS No. 123R “Share-Based Payment” which replaces SFAS No. 123 and supersedes APB Opinion No. 25. SFAS No. 123R requires all share-based payments to employees to be recognized in the financials statements at fair value and eliminates the intrinsic value-based method. The Statement is effective for periods beginning after June 15, 2005. eLoyalty reviewed SFAS No. 123R and does not anticipate the adoption of SFAS No. 123R to have a material impact on the Company’s future financial position or results of operations.

      In March 2004, the EITF reached a consensus on EITF Issue No. 03-06, “Participating Securities and the Two-Class Method under FASB Statement No. 128, Earnings per Share.” EITF Issue No. 03-06 clarifies what constitutes a participating security and provides further guidance in applying the two-class method of calculating earnings per share (“EPS”). The consensus by the Task Force was effective for reporting periods beginning after March 31, 2004. eLoyalty adopted EITF Issue No. 03-06 in the quarter ended June 26, 2004. There was no impact of the adoption on the computation of EPS during the fiscal year ended 2004, as the effect is antidilutive. In periods of net income, eLoyalty will utilize the two-class method of computing EPS.

Note Three — Acquisition

      On July 16, 2004, eLoyalty acquired substantially all of the net assets and business of Interelate, Inc. (“Interelate”) for approximately $5,380 of cash consideration (before transaction costs of $207) (the “Interelate Acquisition”). The acquired business, employees, customers and net assets have been integrated into eLoyalty and it operates as eLoyalty’s Marketing Managed Services group.

      The acquisition was accounted for as a purchase transaction, and accordingly, the assets and liabilities of the acquired entity were recorded at their fair values as of the date of acquisition.

      The purchase price allocation was as follows:

eLOYALTY CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

      eLoyalty believes that the purchase price allocation, in accordance with SFAS No. 141, is substantially complete, although it will continue to be reviewed in subsequent quarters.

      The weighted average life of the computer equipment and furniture is approximately 1.6 years, with approximately 80% of this asset being fully depreciated in the first year following the Interelate Acquisition. Software has a weighted average life of approximately three years for depreciation purposes.

      The primary items that generated goodwill are the value of the assembled workforce, as well as the value of future expected earnings, neither of which qualify as an amortizable intangible asset. Although the goodwill is deductible for U.S. income tax purposes, the prospective value may be limited due to the uncertainty regarding the realization of eLoyalty’s net deferred tax assets. The amortizable intangible asset resulting from the transaction is Client Relationships, which has a weighted average life of approximately four and a half years.

      The fixed assets (inclusive of software), intangible asset and goodwill are reported as components of our North American segment.

      Pro forma results of operations are not presented for the Interelate Acquisition because the effect of the acquisition is immaterial to the consolidated sales and net income.

Note Four — Severance and Related Costs

      Severance costs are comprised primarily of contractual salary and related fringe benefits over the severance payment period. Facility costs include losses on contractual lease commitments, net of estimated sublease recoveries, and impairment of leasehold improvements and certain office assets. Other costs include laptop costs, contractual computer lease termination costs and employee related expenses.

      In response to the current business environment and shifting skill and geographic requirements, and in prior periods, an overall decrease in demand for information technology (“IT”) consulting services, a number of cost reduction activities were undertaken, principally consisting of personnel reductions in fiscal year 2004, and personnel reductions, office space reductions and office closures in prior periods. These cost reduction activities were designed to size the workforce to meet eLoyalty’s expected business requirements. During fiscal years 2004, 2003 and 2002, eLoyalty recognized pre-tax charges (including adjustments) of $947, $2,405 and $9,075, respectively. Severance and related costs for fiscal year 2004 included $1,318 for employee severance and related costs associated with the elimination of 14 positions, in both the North American and International segments. Total 2004 adjustments of $371 consisted of $362 primarily related to a favorable settlement of employment litigation in the International segment and $9 related to changes in estimated sublease rental income from previous office space reductions. Severance and related costs for fiscal year 2003 included $3,561 for employee severance and related costs associated with the elimination of 67 positions, in both the North American and International segments. Total fiscal year 2003 adjustments of $1,156 consisted of $347 primarily related to the favorable resolution of two matters involving former employees, $699 related to changes in estimated sublease rental income from previous office space reductions and $110 of favorable adjustments to previous cost estimates, primarily due to the termination of an equipment lease. The $9,075 charge for fiscal year 2002 included $5,486 of employee severance and related costs for the elimination of 107 positions, in both the North American and International segments and $3,589 of related office space reductions and office closures.

      During the fiscal year 2004, eLoyalty made cash payments of $2,637 related to cost reduction actions initiated in 2004 and earlier periods. eLoyalty expects substantially all severance and other charges to be paid out by the first quarter of 2006 pursuant to agreements entered into with affected employees. Facility costs related to office space reductions and office closures, reserved for in fiscal years 2002 and 2001, are to be paid pursuant to contractual lease terms through 2007.

eLOYALTY CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

      The severance and related costs and their utilization for the year ended January 1, 2005 are as follows: