UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Form 10-Q

(Mark One)

FOR THE QUARTERLY PERIOD ENDED APRIL 2, 2005

OR

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

FOR THE TRANSITION PERIOD FROM                     TO

Commission File Number 0-27975

eLoyalty Corporation

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

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

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

     The number of outstanding shares of the registrant’s common stock, $0.01 par value per share, as of May 12, 2005 was 7,407,597.

TABLE OF CONTENTS

Part I. Financial Information

Item 1. Financial Statements

eLoyalty Corporation
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited and in thousands, except share and per share data)

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

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eLoyalty Corporation
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited and in thousands, except per share data)

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

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eLoyalty Corporation
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited and in thousands)

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

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eLoyalty Corporation
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited and dollars in thousands, except per share data)

Note 1 — General

          In the opinion of management, the accompanying unaudited condensed consolidated financial statements of eLoyalty Corporation (“we” or “eLoyalty” or the “Company”) include all normal and recurring adjustments necessary for a fair presentation of our condensed consolidated financial position as of April 2, 2005, the condensed consolidated results of our operations for the three months ended April 2, 2005 and March 27, 2004 and our condensed consolidated cash flows for the three months ended April 2, 2005 and March 27, 2004, and are in conformity with Securities and Exchange Commission (“SEC”) Rule 10-01 of Regulation S-X.

          The results of operations for any interim period are not necessarily indicative of the results for the full year. The accompanying financial statements should be read in conjunction with the audited consolidated financial statements and the notes thereto in our Annual Report on Form 10-K for the fiscal year ended January 1, 2005.

Note 2 — Revision in the Classification of Certain Securities

          In connection with the preparation of this report, we concluded that it was appropriate to classify our auction rate municipal bonds and auction rate preferred funds as short-term investments. Previously, such investments had been classified as cash and cash equivalents. Accordingly, we have revised the classification to report these securities as short-term investments in a separate line item on our Condensed Consolidated Balance Sheet as of January 1, 2005. We have also made corresponding adjustments to our Condensed Consolidated Statement of Cash Flows for the period ended March 27, 2004, to reflect the gross purchases and sales of these securities as investing activities rather than as a component of cash and cash equivalents. This change in classification does not affect previously reported cash flows from operations or from financing activities in our previously reported Consolidated Statements of Cash Flows, or our previously reported Consolidated Statements of Operations for any period. As of January 1, 2005, $6,975 of these short-term investments were previously classified as cash and cash equivalents in our Consolidated Balance Sheet. For the fiscal years ended January 1, 2005 and December 27, 2003, and for the three months ended March 27, 2004, net cash provided by (used in) investing activities related to these short-term investments of $2,875, $(9,850) and $(1,025), respectively, were previously included in cash and cash equivalents in our Consolidated Statement of Cash Flows.

Note 3 — Short-term Investments

          At April 2, 2005 and January 1, 2005, we held $3,972 and $6,975, respectively, of short-term investments. These short-term investments consisted of auction rate municipal bonds, auction rate preferred funds and United States Agency Discounted Notes at April 2, 2005, and auction rate municipal bonds and auction rate preferred funds at January 1, 2005. All of these short-term investments are classified as available-for-sale securities. These auction rate securities are recorded at cost, which approximates fair market value due to their variable interest rates, which typically reset at the regular auctions every 7 to 35 days. Despite the long-term nature of their stated contractual maturities, we have the ability to liquidate these securities primarily through the auction process. In between auctions, while there is not a formal, established secondary market for these securities, our investment advisors have informed us that they are readily salable. The United States Agency Discounted Notes are recorded at cost, which approximates fair market value since the maturity date is within a short period of time, less than 110 days from our balance sheet date. As a result, we had no material cumulative gross unrealized holding gains (losses) or gross realized gains (losses) from our short-term investments. All income generated from these short-term investments was recorded as interest income.

Note 4 — 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-

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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 associated with the installation or set-up of long-term Managed service contracts is deferred until the installation is complete and is recognized over the estimated life of the customer relationship. Installation costs incurred are deferred up to an amount not to exceed the amount of deferred installation revenue and additional amounts that are recoverable based on the contractual arrangement. Such costs are amortized over the term of the contract.

          Revenue from the sales of Product, which consists of software and 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.

Note 5 — 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. Statement of Financial Accounting Standards (“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.

          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 Recent Accounting Pronouncements.

          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 Condensed Consolidated Statements of Operations. Compensation costs were recognized for restricted and installment awards as expense in the accompanying Condensed Consolidated Statements of Operations.

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          There were no stock options granted during the first quarter of 2005 or 2004.

Note 6 — 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 $203) (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 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.

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          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 7 — 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 fiscal year 2004, in response to the current business environment and shifting skill and geographic requirements, a number of cost reduction activities were undertaken, principally consisting of personnel reductions. These actions were designed to shape the workforce to meet eLoyalty’s expected business requirements. There were no severance and related costs in the first quarter of 2005 compared to $234 of income in the first quarter of 2004. The income recorded in the first quarter of 2004 primarily related to a favorable settlement of employment litigation in the International segment with former employees who were terminated in prior years.

          During the first quarter of 2005, eLoyalty made cash payments of $415 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.

          The severance and related costs and their utilization for the first quarter of 2005 are as follows:

          Of the $1,530 that remained reserved as of April 2, 2005, $567 related to future lease payments, net of estimated sublease recoveries, is recorded in “Long-term liabilities,” $472 related to severance payments is recorded in “Accrued compensation and related costs” and the balance of $491 is recorded in “Other current liabilities.” Of the balance in “Other current liabilities,” $422 relates to facility lease payments, net of estimated sublease recoveries, and is expected to be paid over the next twelve months.

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Note 8 — Comprehensive Net Loss

          Comprehensive net loss is comprised of the following:

          The accumulated other comprehensive loss, which represents the cumulative effect of foreign currency translation adjustments, was $3,667 and $3,451 at April 2, 2005 and January 1, 2005, respectively.

Note 9 — Loss Per Share

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

          In periods in which there is a loss, the dilutive effect of common stock equivalents, which is primarily related to the 7% Series B Convertible Preferred Stock, was not included in the diluted loss per share calculation as it was antidilutive. The total number of common share equivalents that would have been included in the computation of diluted loss per share if they had been dilutive was 4,813 and 4,383 for the first quarter of 2005 and 2004, respectively.

Note 10 — Segment Information

          eLoyalty focuses exclusively on providing customer relationship management (“CRM”) related professional services. eLoyalty has two reportable geographic segments: North America (consisting of US and Canada) and International. The following table reflects revenue and operating results by reportable segment for the first quarter of 2005 and 2004, respectively, and total assets by reportable segment as of April 2, 2005 and January 1, 2005.

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          Total tangible long-lived assets for US operations are $5,767 and $7,398 at April 2, 2005 and January 1, 2005, respectively.

          Percentage of total revenue for the first quarter of 2005 and 2004 is as follows:

Note 11 — Recent Accounting Pronouncements

          In December 2004, FASB issued SFAS No. 123R “Share-Based Payment” which replaces SFAS No. 123 and supersedes APB 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. SFAS No. 123R was amended in April 2005 for compliance dates. eLoyalty plans to adopt SFAS No. 123R at the beginning of next fiscal year, January 1, 2006, and to use the modified prospective method. 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 Emerging Issues Task Force (“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 first quarter ended 2005, as the effect is antidilutive. In periods of net income, eLoyalty will utilize the two-class method of computing EPS.

Note 12 — Litigation and Other Contingencies

          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.

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          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 eLoyalty 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.

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

Forward-Looking Statements

          The following Management’s Discussion and Analysis and other parts of this Form 10-Q 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 this Form 10-Q.

          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-Q, 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. Revenue across our various service lines is generated from professional services primarily and, to a minor degree, resale of products (software and hardware). Consulting services involve evaluating, selecting, building or integrating CRM systems for clients. Managed services involve a range of contact center services from routine maintenance and technology upgrades to the resolution of highly complex issues that involve multiple technology components and vendors. Due to the Interelate Acquisition in the third quarter of 2004, Managed services also includes our hosted customer data management and campaign management services. The combination of eLoyalty’s methodologies and technical expertise enables eLoyalty to deliver the tangible economic benefits of customer loyalty for its clients. We operate in two primary business segments — North America (consisting of the United States and Canada) and International.

Overview of the Results of Operations and Financial Position

          The following is an overview of our operating results and financial position for the first quarter of 2005, which includes a discussion of significant events, revenue, gross profit margins, expenses and cash flows for this period. The following table summarizes the major components of our revenue over the last six quarters.

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          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 eight quarters. In the first quarter of 2005, we added 15 new customers, 12 new customers were added in the fourth quarter of 2004 and 17 new customers were added in the first quarter of 2004. 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 — 69% of our first quarter 2005 revenue came from clients who were also clients in first quarter of 2004.

          Our operational results also are 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 several quarters, the strengthening economic recovery appears to be positively affecting the information technology spending patterns at many companies, though companies remain conservative regarding increasing the use of outside professional services. Certain CRM related technological advances, including voice over internet protocol 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.

          We continue to experience high levels of customer revenue concentration, though these levels have decreased (improved) somewhat from fiscal year 2003. Customer concentration for our top customer for fiscal year 2003 was 24% of revenue. Our top customer accounted for 17%, 20% and 16% of our revenue in the first quarter of 2005, fourth quarter of 2004 and first quarter of 2004, respectively. Our top 5 and top 10 customers accounted for 46% and 64% of revenue, respectively, in the first quarter of 2005. This compares to 50% and 68% of revenue for those same categories in the first quarter of 2004. As a result of these concentration levels, changes 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. Managed services revenue accounted for 26%, 26% and 19% of our total revenue in the first quarter of 2005, fourth quarter of 2004 and first quarter of 2004, respectively. During the third quarter of 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 86% and 78% of the growth in Managed services revenue in the first quarter 2005 and the fourth quarter 2004, respectively, compared to the Managed services revenue in the first quarter of 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,

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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 a decline of 7% in Consulting services revenue from the fourth quarter of 2004 to the first quarter of 2005. We believe there were two primary reasons for this variance: a reduction in consulting services spending by four of our five largest customers from the fourth quarter of 2004 and longer than expected cycle times in finalizing agreements with several new clients.

          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 products. 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 marketing of our service lines, other 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 the first quarter of 2005, fourth quarter of 2004 and first quarter of 2004 were 26%, 29% and 24%, respectively. The increase in first quarter 2005 gross profit margin compared to the first quarter of 2004 resulted primarily from a change in the mix of our business from Consulting services to Managed services. The impact of this favorable mix was partially offset by the higher than normal application of resources to the development and deployment of our Behavioral Analytics solution. The effect of higher levels of billable utilization when comparing the first quarter of 2005, 71%, to the first quarter of 2004, 64%, and improvement in our Consulting services leverage model were partially offset by a reduction in the average hourly billing rate, $156 in the first quarter of 2005 compared to $174 in the first quarter of 2004. While the previous decline in rates appears to have reversed in the first quarter of 2005 (fourth quarter 2004 average hourly billing rate was $151), there can be no guarantee that declines will not continue 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 and in the first quarter of 2005, 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 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 April 2, 2005, total cash was $20.7 million, or a $31.4 million reduction since the end of fiscal year 2001, which includes the effect of our $4.0 million investment in short-term securities, which is discussed in Note 3 to our Condensed Consolidated Financial Statements. Total cash decreased slightly, $0.1 million in the first quarter of 2005. Proceeds received from the sale of short-term investments in the first quarter of 2005 offset cash used in operating activities, primarily payment of accrued 2004 non-VP bonuses, annual insurance premiums, previous accrued restructuring charges and the payment of Series B dividends. Days sales outstanding (“DSO”) increased slightly to 51 days in the first quarter of 2005 from 50 days in the fourth quarter of 2004 and decreased 5 days compared to 56 days in the first quarter of 2004, respectively.

          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.

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          In fiscal year 2005, the Company continues to have cash obligations related to an expectation of Series B stock cash dividends, capital expenditure requirements and severance and related charges recognized in previous periods. We believe that our improved operational efficiency, 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 expected fluctuations in spending by 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 April 2, 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 condensed 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 condensed 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 associated with the installation or set-up of long-term Managed service contracts is deferred until the installation is complete and is recognized over the estimated life of the customer relationship. Installation costs incurred are deferred up to an amount not to exceed the amount of deferred installation revenue and additional amounts that are recoverable based on the contractual arrangement. Such costs are amortized over the term of the contract.

          Revenue from the sales of Product, which consists of software and 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 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

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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.

First Quarter 2005 Compared with First Quarter 2004

     Revenue

          Our revenue increased $5.1 million, or 35%, to $19.5 million in the first quarter of 2005 from $14.4 million in the first quarter of 2004. Revenue from Consulting services increased $1.6 million, or 15%, to $12.1 million in the first quarter of 2005 from $10.5 million in the first quarter of 2004. Consulting services revenue represented 62% and 72% of total revenue for first quarter 2005 and 2004, 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 $2.3 million, or 85%, to $5.0 million in the first quarter of 2005 from $2.7 million in the first quarter of 2004. Managed services revenue represented 26% and 19% of total revenue for first quarter 2005 and 2004, respectively. The increase in Managed services revenue is driven primarily by the Interelate Acquisition and the continued growth in our Converged Internet Protocol Contact Center offerings. Revenue from Product sales increased $1.0 million, to $1.4 million in the first quarter 2005 from $0.4 million in the first quarter 2004. Product sales represented 7% and 3% of total revenue for first quarter 2005 and 2004, respectively. Quarterly Product revenue fluctuates significantly depending on the demand for various products as reflected in the table in the Overview of the Results of Operations and Financial Position.

          Revenue from North American operations increased $5.1 million, or 40%, to $17.8 million in the first quarter of 2005 from $12.7 million in the first quarter of 2004. International operations revenue (which primarily represents revenue from Europe and Australia) remained constant at $1.7 million in the first quarter of 2005 and 2004, respectively. As a percentage of consolidated revenue, revenue from International operations represented 9% and 12% of total revenue for the first quarter of 2005 and 2004, respectively.

          Utilization of billable consulting personnel was 71% and 64% for the first quarter of 2005 and 2004, respectively, and 72% in the fourth quarter of 2004. 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 $156 and $174 for the first quarter of 2005 and 2004, respectively, and $151 in the fourth quarter of 2004. 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 $147 and $166 for the first quarter of 2005 and 2004, respectively, and $141 for the fourth quarter of 2004. Our revenue per billable consultant remained flat at $287,000 in the first quarter of 2005 compared to the fourth quarter of 2004 and increased from $267,000 in the first quarter of 2004. 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 64% and 68% of our revenue in the first quarter of 2005 and 2004, respectively. In addition, the top 20 customers accounted for 79% of our revenue in the first quarter of 2005 and 85% of our revenue in the first quarter of 2004. Two clients each accounted for 10% or more of our revenue in the first quarter of 2005. United HealthCare Services, Inc. accounted for 17% of our revenue in the first quarter of 2005 and 7% of our revenue in the first quarter of 2004. Crowe, Chizek and Company LLP accounted for 11% of our revenue in the first quarter of 2005 and 7% of our revenue in the first quarter of 2004. 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 the first quarter of 2005 and 2004 represented approximately 46% and 50% of revenue, respectively.

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     Cost of Services

          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 product and support costs and other expenses of a billable and non-billable nature.

          Cost of services increased $3.6 million, or 32%, to $14.7 million in the first quarter of 2005 from $11.1 million in the first quarter of 2004. The increase is primarily due to additional product 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 76% in the first quarter of 2005 compared to 77% in the first quarter of 2004. This percentage decrease was primarily due to a change in our mix of business from Consulting services to Managed services.

     Selling, General and Administrative

          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 increased $0.3 million, or 6%, to $5.1 million in the first quarter of 2005 from $4.8 million in the first quarter of 2004. This increase was primarily the result of increased personnel costs.

     Severance and Related Costs

          There were no severance and related costs in the first quarter of 2005 compared to $0.2 million of income in the first quarter of 2004. In the first quarter of 2004, an adjustment of $0.2 million primarily related to a favorable settlement of employment litigation in the International segment. In fiscal year 2004, in response to the current business environment and shifting skill and geographic requirements, a number of cost reduction activities were undertaken, principally consisting of personnel 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. 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. We expect substantially all severance and related costs associated with cost reduction activities initiated in prior periods to be paid out by the end of the first quarter of 2006, pursuant to agreements entered into with affected employees.

     Depreciation and Amortization

          Depreciation and amortization expense increased $0.5 million, or 42%, to $1.7 million in the first quarter of 2005 compared to $1.2 million in the first quarter of 2004. This increase is primarily due to the incremental depreciation and amortization associated with the assets from the Interelate Acquisition.

     Operating Loss

          Primarily as a result of the above-described business conditions, we experienced an operating loss of approximately $2.0 million for the first quarter of 2005, compared to an operating loss of approximately $2.3 million for the first quarter of 2004.

     Interest Income (Expense) and Other, net

          Non-operating interest income (expense) and other increased $0.1 million, or 100%, to $0.1 million in the first quarter of 2005 compared to $0 in the first quarter of 2004. The $0.1 million increase in non-operating other income was primarily related to higher yields on our investments.

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     Income Tax Benefit

          Income taxes were $0 in the first quarter of 2005 and 2004, respectively. As of April 2, 2005, total deferred tax assets of $53.2 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.

     Net Loss Available to Common Stockholders

          We reported a net loss available to common stockholders of $2.3 million in the first quarter of 2005 as compared with a net loss available to common stockholders of $2.7 million in the first quarter of 2004. We reported a net loss of $0.37 per share on a basic and diluted basis in the first quarter of 2005 compared to a net loss of $0.45 per share on a basic and diluted basis in the first quarter of 2004. Improved performance in the first quarter of 2005 was primarily driven by stronger utilization, higher percentage of revenue generated from Managed services and a lower percentage of selling, general and administrative expenses. The loss in 2004 was primarily attributable to declines in demand for our services.

Liquidity and Capital Resources

     Introduction

          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 and our short-term investments. At April 2, 2005, we had cash and cash equivalents of approximately $20.1 million, restricted cash of approximately $0.7 million and short-term investments of $4.0 million. Our cash and cash equivalents position remained constant at $20.1 million as of April 2, 2005 and January 1, 2005. We have classified our investments in auction rate securities as short-term investments see Note 2. Short-term investments decreased $3.0 million as of April 2, 2005. The proceeds from the sale of short-term investments were used to fund operating activities as discussed below. Restricted cash represents cash as security for our letters of credit. Restricted cash remained constant at $0.7 million as of April 2, 2005 and January 1, 2005.

     Cash Flows from Operating Activities

          Cash flows from operating activities were a use of approximately $2.1 million and $2.8 million during the first quarter of 2005 and 2004, respectively. Net cash outflows from operating losses, annual corporate insurance payments, prepaid product maintenance contracts and payments with respect to severance and related costs contributed to the use of cash. DSO of 51 days at April 2, 2005 represented an increase of 1 day compared to 50 days at January 1, 2005. We do not expect any significant collection issues with our clients. At April 2, 2005, there remained $1.5 million of unpaid severance and related costs (see Note Seven).

     Cash Flows from Investing Activities

          Cash flows from investing activities increased $4.0 million, to a source of cash of $2.9 million during the first quarter of 2005 from a use of cash of $1.1 million during the first quarter of 2004. Short-term investments during the first quarter of 2005 provided $3.0 million of cash offset by $0.1 million of capital expenditures, primarily related to our Managed services. 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.

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     Cash Flows from Financing Activities

          Cash flows used in financing activities increased $0.2 million, to $0.7 million during the first quarter of 2005 from $0.5 million during the first quarter of 2004. Net cash outflows of $0.7 million during the first quarter of 2005 is attributable to cash dividends of $0.7 million, paid in January of 2005 on the Series B convertible preferred stock (“Series B stock”). The $0.5 million of cash used during the first quarter of 2004 is attributable to a $0.2 million decrease in the required deposit of cash security for the credit line, offset by cash dividends of $0.7 million, paid in January of 2004 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.

     Near-Term Liquidity

          Our near-term capital resources consist of our current cash balances and our short-term investments, together with anticipated future cash flows. Our balance of cash and cash equivalents was $20.1 million as of April 2, 2005 and January 1, 2005, respectively. In addition, our restricted cash of $0.7 million at April 2, 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. As of April 2, 2005 and January 1, 2005, we held short-term investments of $4.0 million and $7.0 million, respectively.

     Bank Facility

          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 through the first quarter of fiscal 2005 (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 April 2, 2005 and January 1, 2005, 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%. We did not have any borrowings or interest expense under the Facility during the first quarter 2005 or during fiscal year 2004.

     Accounts Receivable Customer Concentration

          At April 2, 2005 we had two customers each accounting for 10% or more of total net receivables. United HealthCare Services, Inc. accounted for 22% and Crowe, Chizek and Company LLP accounted for 11%, respectively of total net accounts receivable. Of these amounts, we have collected approximately 85% from United HealthCare Services, Inc. and 63% from Crowe, Chizek and Company LLP, respectively, through May 16, 2005. Of total gross accounts receivable as of May 16, 2005, we have collected 67% subsequent to April 2, 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.

     Summary

          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.

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Recent Accounting Pronouncements

          In December 2004, Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“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. SFAS No. 123R was amended in April 2005 for compliance dates. eLoyalty plans to adopt SFAS No. 123R at the beginning of next fiscal year, January 1, 2006, and to use the modified prospective method. 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 first quarter ended 2005, 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-Q include the following:

	•	uncertainties associated with the attraction of new clients, the continuation of existing and new engagements with existing clients and the timing of related client commitments, including potential client delays or deferrals of new engagements or existing project extensions in light of prevailing general economic conditions and uncertainties; reliance on a relatively small number of customers for a significant percentage of our revenue, reliance on major suppliers, including CRM software providers and other alliance partners, and maintenance of good relations with key business partners;
	•	risks involving the variability and predictability of the number, size, scope, cost and duration of, and revenue from client engagements, including risks to our ability to achieve revenue from projects that have been awarded to us as a result of unanticipated deferrals or cancellations of engagements due to changes in customers’ requirements or preferences for the company’s services (because the company’s business is relationship-based, substantially all of the company’s customers retain the right to defer or cancel the company’s engagement, regardless of whether there is a written contract);
	•	management of the other risks associated with increasingly complex client projects and new services offerings, including risks relating to the collection of billed amounts, shifts from time and materials-based engagements to alternative pricing or value-based models and variable employee utilization rates, project personnel costs and project requirements;
	•	management of growth, expansion into new geographic and market areas and development and introduction of new service offerings, including the timely and cost-effective implementation of enhanced operating, financial and other infrastructure systems and procedures;
	•	challenges in attracting, training, motivating and retaining highly skilled management, strategic, technical, product development and other professional employees in a competitive information technology labor market;

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	•	continuing intense competition in the information technology services industry generally and, in particular, among those focusing on the provision of CRM services and software, including firms with both significantly greater financial and technical resources than eLoyalty and new entrants;
	•	the rapid pace of technological innovation in the information technology services industry, including frequent technological advances and new product introductions and enhancements, and the ability to create innovative and adaptable solutions that are consistent with evolving standards and responsive to client needs, preferences and expectations;
	•	access in tightened capital and credit markets to sufficient debt and/or equity capital on acceptable terms to meet our future operating and financial needs;
	•	protection of our technology, proprietary information and other intellectual property rights or challenges to our intellectual property by third parties;
	•	future legislative or regulatory actions relating to the information technology or information technology services industries including those relating to data privacy;
	•	our ability to execute our strategy of reducing costs, achieving the benefits of costs reduction activities and maintaining a lower cost structure;
	•	our ability to successfully and timely integrate acquired operations into our business;
	•	maintenance of our reputation and expansion of our name recognition in the marketplace;
	•	risks associated with global operations, including those relating to the economic conditions in each country, potential currency exchange and credit volatility, compliance with a variety of foreign laws and regulations and management of a geographically dispersed organization;
	•	the overall demand for CRM services and software and information technology consulting services generally; and
	•	the uncertain scope of the current economic recovery and its impact on our business, as well as the impact of other future general business, capital market and economic conditions and volatility.

Item 3. Qualitative and Quantitative Disclosures about Market Risk

          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 first quarter of 2005 and 2004, 16% and 17%, 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.

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Item 4. Controls and Procedures

          An evaluation has been carried out under the supervision and with the participation of eLoyalty’s management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) as of April 2, 2005. Based on their evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that the Company’s disclosure controls and procedures are effective to ensure that information required to be disclosed by eLoyalty in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms. There have not been any changes in our internal controls over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fiscal quarter to which this report relates that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.

Part II. Other Information

Item 2. 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 first quarter of 2005. All of these purchases reflect shares withheld upon vesting of restricted stock or installment stock, to satisfy tax withholding obligations.

Item 6. Exhibits

31.1 Certification of Kelly D. Conway under Section 302 of the Sarbanes-Oxley Act of 2002.

31.2 Certification of Steven C. Pollema under Section 302 of the Sarbanes-Oxley Act of 2002.

32.1 Certification of Kelly D. Conway and Steven C. Pollema under Section 906 of the Sarbanes-Oxley Act of 2002.

99.1 Summary of eLoyalty Corporation’s Vice President Compensation Program, as amended, May 11, 2005.

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SIGNATURES

          Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Lake Forest, State of Illinois, on May 17, 2005.

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