DOCUMENTS INCORPORATED BY REFERENCE

DOCUMENT		FORM 10-K REFERENCE
Portions of Proxy Statement for 2010 Annual Meeting of Shareholders		Part III

 

1

---

 

KENEXA CORPORATION

FORM 10-K

DECEMBER 31, 2009

PART I

 

This Annual Report on Form 10-K and the documents incorporated herein contain “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Those statements are therefore entitled to the protection of the safe harbor provisions of these laws. These forward-looking statements, which are usually accompanied by words such as “may,” “might,” “will,” “should,” “could,” “intends,” “estimates,” “predicts,” “potential,” “continue,” “believes,” “anticipates,” “plans,” “expects” and similar expressions, involve risks and uncertainties, and relate to, without limitation, statements about our market opportunities, our strategy, our competition, our projected revenue and expense levels and the adequacy of our available cash resources. There are important factors that could cause our actual results, level of activity, performance or achievements to differ materially from those expressed or forecasted in, or implied by, such forward-looking statements, particularly those factors discussed in “Item 1A - Risk Factors” in this Annual Report on Form 10-K.

 

Although we believe that the expectations reflected in these forward-looking statements are based upon reasonable assumptions, no assurance can be given that such expectations will be attained or that any deviations will not be material. In light of these risks, uncertainties and assumptions, the forward-looking events and circumstances discussed in this Annual Report on Form 10-K may not occur and our actual results could differ materially and adversely from those anticipated or implied in the forward-looking statements. We disclaim any obligation or undertaking to disseminate any update or revision to any forward-looking statement contained herein to reflect any change in our expectations with regard thereto or any change in events, conditions or circumstances on which any such statement is based.

 

 

Company History

 

We are a Pennsylvania corporation. We began our operations under predecessor companies, Insurance Services, Inc., or ISI, and International Holding Company, Inc., or IHC, in 1987. In December 1999, we reorganized our corporate structure by merging ISI and IHC with and into Raymond Karsan Associates, Inc., or RKA, a Pennsylvania corporation and a wholly owned subsidiary of Raymond Karsan Holdings, Inc., or RKH, a Pennsylvania corporation. Each of RKA and RKH were newly created to consolidate the businesses of ISI and IHC. In April 2000, we changed our name to TalentPoint, Inc. and we changed the name of RKA to TalentPoint Technologies, Inc. In November 2000, we changed our name to Kenexa Corporation, or Kenexa, and we changed the name of TalentPoint Technologies, Inc. to Kenexa Technology, Inc., or Kenexa Technology. Currently, Kenexa transacts business primarily through Kenexa Technology and its wholly owned subsidiaries.

 

Our principal executive offices are located at 650 East Swedesford Road, Second Floor, Wayne, PA 19087.

Our telephone number is (610) 971-9171. We maintain an Internet website at http://www.kenexa.com.  We are not incorporating by reference into this Annual Report on Form 10-K any material from our website.  The reference to our website is an inactive textual reference to the uniform resource locator (URL) and is for your reference only.

Recent Events

During the fourth quarter 2008, in response to the challenging macroeconomic environment, the strengthening U.S. dollar relative to other currencies of countries in which we do business, and the slowing or delaying of a number of projects by our customers, we announced a restructuring program involving reductions of approximately 200 employees and recorded severance and outplacement benefit costs totaling $2.0 million.  During the first quarter of 2009, as a result of the continued deterioration in the economic environment, we executed an additional reduction of approximately 159 employees and recorded severance and outplacement benefit costs totaling $1.2 million.

During the three months ended March 31, 2009, due to a 32.5% decline in our stock price and market capitalization from the previous quarter, lower projected net income, cash flow estimates and slower projected growth rates in our industry, we reevaluated our goodwill impairment analysis.  Our analysis was performed to determine the implied fair value of our goodwill with neither the write up or write down of any assets or liabilities, nor recording of any additional unrecognized identifiable intangible assets.  Based upon our analysis we recorded a goodwill impairment charge of $33.3 million during the quarter ended March 31, 2009. This goodwill impairment charge had no effect on our cash balances.

On January 20, 2009, we entered into an ownership interest transfer agreement (“the agreement”) with Shanghai Runjie Management Consulting Company, (“R and J”) in Shanghai, China for $1.3 million.  The initial investment provided us with a 46% ownership in the new entity Shanghai Kenexa Human Resources Consulting Co., Ltd., (the “variable interest entity”) and a presence in China’s human capital management market.  The agreement also provided for a 1% annual ownership increase based upon adjusted EBITDA, as defined, for each of the years ended 2008, 2009 and 2010.  In the third and fourth quarter of 2009, based upon the 2008 operating results for R and J, we paid an additional $0.2 million in total for an additional 1% ownership interest in the variable interest entity.  The variable interest entity was financed with $0.3 million in initial equity contributions from us and R and J, and has no borrowings for which its assets would be used as collateral.  On September 30, 2009, we provided $0.2 million of financing for the variable interest entity.  The creditors of the variable interest entity do not have recourse to our other assets.

On May 21, 2009, we elected not to renew our secured credit agreement with PNC Bank.  We believe that our cash, short-term investments, UBS Settlement Agreement (as described in Footnote 3 of the Notes to the Consolidated Financial Statements) for our auction rate securities and projected cash from operations will be sufficient to meet our liquidity needs for at least the next twelve months.

On June 11, 2009 and July 16, 2009, two putative class actions were filed against Kenexa Corporation and our Chief Executive Officer and Chief Financial Officer in the United States District Court for the Eastern District of Pennsylvania, purportedly on behalf of a class of our investors who purchased our publicly traded securities between May 8, 2007 and November 7, 2007. The complaint filed on July 16, 2009 has since been voluntarily dismissed.  In the pending action, Building Trades United Pension Trust Fund, individually and on behalf of all others similarly situated alleges violations of Section 10(b) of the Securities Exchange Act of 1934 ("Exchange Act"), Rule 10b-5 promulgated thereunder and Section 20(a) of the Exchange Act in connection with various public statements made by Kenexa.  This action seeks unspecified damages, attorneys’ fees and expenses.

 

4

---

 

Industry Overview

 

Talent acquisition is the sourcing, recruiting, screening and assessment of employees. Employee performance management is the systematic process by which an organization tracks, monitors and optimizes employee behavior and productivity, and evaluates performance through employee reviews, appraisals and business metrics.

 

Drivers of Demand for Talent Acquisition and Employee Performance Management Applications

 

According to the Bureau of Economic Analysis, an agency of the U.S. Department of Commerce, the amount spent on U.S. labor in 2009 was approximately $6.3 trillion, or approximately 49.5% of the total U.S. gross domestic product. We believe that the drivers for human capital are affected by intense competition for qualified employees as a result of an aging workforce, declining tenure of employees, increased globalization, the increasing service component of the U.S. economy and pressure on human resource departments to reduce costs.

 

Over the past two decades, many organizations have implemented software systems that systematize best practices and drive efficiency in most departments, including enterprise resource planning systems (“ERP”), customer relationship management systems and supply chain management systems. These software applications provide a wide array of benefits that both assist revenue growth and eliminate expenses. Based on our experience, however, we believe that the HR departments of many of these organizations have only implemented HR information systems, which track basic employee information for payroll and benefits purposes, or rudimentary applicant tracking systems. Although these systems provide some level of automation, they do little to increase the effectiveness of talent acquisition and employee performance management programs. We believe that few organizations have systemized best practices for talent acquisition and employee performance management or have implemented software applications to support these processes and provide HR professionals with critical analytics and metrics.

 

Our experience indicates that, presently, many organizations' talent acquisition functions consist of manual, paper-based processes, ad hoc outsourcing and third-party or custom software applications with limited functionality. As a result, we believe that they suffer from the following shortcomings:

 

•

Inefficiency. Many organizations rely on manual, paper-based processes and they cannot effectively manage the massive number of candidates presented by today's many recruiting resources, including unsolicited inquiries, internal referrals, career fairs, campus recruiting, Internet job boards and third-party referrals, among many others. As a result, they fail to identify high potential candidates or fail to process those candidates in a timely manner.

•

Redundancy. Many organizations do not maintain easily searchable databases of processed candidates and they often conduct redundant searches. A candidate who did not meet the criteria for a certain position may meet the criteria for alternative or future positions. Without an easily searchable database, a candidate may be overlooked.

•

Ineffectiveness. Organizations generally do not employ sophisticated screening and assessment mechanisms. As a result, most hiring decisions are at best loosely based on objective indicators of future success and fail to match high-potential candidates with roles or positions that leverage their unique abilities and experience. This lowers the probability that a new hire will succeed, and negatively impacts employee productivity and satisfaction.

•

Inconsistency. Many organizations screen applications and resumes based on rudimentary criteria, and do not conduct sophisticated and objective assessments and base hiring decisions primarily on subjective, ad hoc interviews. This process lacks consistency and objectivity. This inconsistency not only negatively impacts the effectiveness of recruiting programs, but also may expose organizations to regulatory liability.

•

High cost and inflexibility. As a result of their inflexibility and absence of a variable cost structure, organizations must either maintain larger HR departments or purchase a greater supply of third-party services in order to accomplish their recruiting goals, significantly increasing the costs of their talent acquisition programs.

 

5

---

 

Similarly, we believe that many organizations have neither automated nor applied best practices to employee performance management. In our experience, most organizations’ employee performance management processes consist of annual performance reviews and informal mentoring programs. We believe that effective employee performance management requires a consistent, systematized process that identifies employee strengths, weaknesses and issues in a timely manner, continually aligns employee goals with the evolving goals of the organization, monitors opportunities for internal advancement and enables management to analyze employee data over time. We believe that the absence of effective employee performance management systems and processes has the following negative implications:

 

•

Failure to retain top performers. The absence of systems and processes to ensure the fulfillment, motivation and internal mobility of key employees negatively impacts an organization's ability to retain its top performing employees. Management may not have the opportunity to rectify problems with valued employees before they depart from the organization without a system to highlight these issues. Reducing employee turnover can have a material impact on an organization’s expenses.

•

Failure to optimize productivity. Maximum productivity is obtained when employees believe their roles match their evolving skill sets, find their jobs challenging and have confidence in their upward mobility. The absence of strong employee performance management systems contributes to the failure to accomplish these goals, and even if organizations succeed in retaining employees, they may not be able to maintain maximum productivity from their employees.

•

Failure to remove poor performers. An employee who does not fulfill his or her role effectively may have a recurring negative impact on an organization. To the extent that a poor performer has managerial responsibility, this negative impact on the organization expands materially. Without systems that identify poor performers, organizations may not be able to address weaknesses within their human capital in a timely manner.

We believe that the failure to employ sophisticated systems in their talent acquisition and employee performance management processes inhibits organizations from leveraging valuable data generated through these functions. This can negatively impact organizations in several ways, including the failure both to identify overall trends that could improve the efficiency and effectiveness of its processes and to quickly identify problems that could lead to employee turnover.

 

6

---

 

Emergence of On-Demand Applications

Based on our experience, we believe that organizations have become increasingly dissatisfied with traditional enterprise software applications, resulting in the growing adoption of the on-demand model for enterprise software. Historically, organizations have purchased perpetual software licenses and deployed enterprise software applications on-site within their IT environment. This traditional method of purchasing and deploying enterprise software applications has left many organizations questioning whether the benefits of these technologies outweigh the following burdens:

 

•

Expensive and time consuming implementation. A traditional enterprise software application requires an organization to invest in ancillary IT such as hardware systems, application servers, databases, storage, and backup systems. In addition, the organization must employ consultants or additional IT staff to integrate the application into increasingly complicated IT environments and customize the application for specific needs. The ancillary costs of a complex deployment can be multiples of the perpetual license fee for the software application and can take several months or even years to complete.

•

Expensive maintenance. Once the software application has been deployed, the organization must make further investments to maintain the application. In addition to the maintenance fee paid to the software vendor, which is typically approximately 20% of the perpetual license fee for all software used in running the application, the organization must retain both an IT staff capable of maintaining and upgrading the software as well as personnel to train new users to operate the applications.  Such upgrades must be made to all applications required to run the software such as operating system, databases, security patches, etc. We believe that because of the expense that typical application upgrades significantly lag, denying end users the benefits of new technologies and solution functionalities.

•

Limited incentives to ensure customer success. A typical perpetual software license requires the customer to pay up-front a material amount for the license, with a significantly smaller amount, typically approximately 20%, paid annually for basic support and upgrades. This model leaves little incentive for the software vendor to ensure a successful implementation and on-going customer satisfaction.

 

Developments in technology have enabled software developers to offer enterprise software applications on an on-demand basis. By leveraging the Internet, multi-tiered architectures, advances in security and open standards for application integration, software vendors can offer software applications to their customers as a service, hosting the software on servers operated by the software vendor. Customers, using an Internet browser, access the applications, which are designed to be easily configured and integrated with a customer’s existing applications.

 

The on-demand model fundamentally changes both the purchasing and deployment of enterprise software from a customer perspective. Rather than making large, up-front investments in perpetual licenses, customers purchase limited term subscriptions for on-demand software applications. Further, because only an Internet browser is required to access on-demand software applications, which can be easily configured to meet the buyer’s specific needs, organizations eliminate the expense of ancillary technology and third-party services required to implement, configure and maintain the enterprise application on-site. Finally, the finite duration of customer subscriptions provides a strong incentive to software vendors to ensure that the software provides the expected benefits to the customer, resulting in consistent customer service. The on-demand model also reduces research and development support costs for the software developer. Because only limited versions of the software exist at any one time, the on-demand model relieves the burden of maintaining and upgrading historical versions of the software so that customers benefit from a steady stream of the most recent features and technologies.

 

We believe that talent acquisition and employee performance management applications are particularly well-suited to the on-demand model. Talent acquisition and employee performance management applications are generally purchased by an organization’s HR department. Because the HR departments of most organizations have little historical experience making capital expenditures for enterprise software applications, we believe that providing these departments the opportunity to license software applications on a subscription basis eliminates a major impediment to the adoption of talent acquisition and employee performance management applications.

 

7

---

 

Our Solution

 

We are a leading provider of integrated talent management solutions. Our solutions enable organizations to implement systematic talent acquisition practices that ensure the efficient, effective and consistent hiring of qualified and talented individuals. Our solutions also provide employee performance management systems that help to ensure that organizations retain and optimize the performance of qualified individuals, identify employees who fail to perform, and identify successors for critical positions. In addition, our solutions help organizations manage learning and assessment opportunities and events to develop employees for both current and desired future jobs. Finally, our solutions enable customers to determine its workforce’s engagement level, and diagnose where changes in behavior (for individual employees, managers and senior leaders) or HR programs will improve organizational performance and business outcomes.

 

 

Securities and Exchange Commission Filings

We file annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K and other information with the SEC.  Members of the public may read and copy materials that we file with the SEC at the SEC’s Public Reference Room at 100 F Street, N.E., Washington, D.C. 20549.  Members of the public may also obtain information on the Public Reference Room by calling the SEC at 1-800-732-0330.  The SEC also maintains an Internet web site that contains reports, proxy and information statements and other information regarding issuers, including us, that file electronically with the SEC.  The address of that site is www.sec.gov.  Our annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K and other information filed by us with the SEC are available, without charge, on our Internet web site, www.kenexa.com as soon as reasonably practicable after they are filed electronically with the SEC.

 

15

---

 

ITEM 1A.    Risk Factors

We operate in a market environment that involves significant risks, many of which are beyond our control. The following risk factors may adversely impact our results of operations, cash flows and the market price of our common stock. Although we believe that we have identified and discussed below the key risk factors affecting our business, there may be additional risks and uncertainties that are not presently known or that are not currently believed to be significant that may adversely affect our performance or financial condition.

Our business will suffer if our existing customers terminate or do not renew their software subscriptions.

We expect to continue to derive a significant portion of our revenue from renewals of subscriptions for our talent acquisition and employee performance management solutions. During the years ended December 31, 2009 and 2008, our customers renewed approximately 80% and 75%, respectively, of the aggregate value of multi-year subscriptions for our on-demand talent acquisition and performance management solution contracts subject to renewal, a rate which is lower than the approximately 90% rate at which our customers have historically renewed their subscriptions with us. If our customers terminate their agreements, fail to renew their agreements, renew their agreements upon less favorable terms to us, defer existing agreements or fail to purchase new solutions from us, our revenue may decline or our future revenue growth may be constrained.

Maintaining the renewal rate of our existing subscriptions is critical to our future success. Factors that may affect the renewal rate for our solutions include:

 

•

the price, performance and functionality of our solutions;

•

the availability, price, performance and functionality of competing products and services;

•

the effectiveness of our support services;

•

our ability to develop complementary products and services;

•

the willingness of our customers to continue to invest their resources in our solutions in light of other demands on those resources;

•

the macroeconomic environment.

Most of our existing customers have entered into subscription agreements with us that expire between one and three years from the initial contract date. Our customers have the right to terminate their contracts under certain circumstances and are not obligated to renew their subscriptions for our solutions after the expiration of the initial terms of their subscription agreements. In addition, our customers may negotiate terms which are less favorable to us upon renewal, or may request that we license our software to them on a perpetual basis, which may reduce recurring revenue from these customers. For example, some of our RPO customers restructured their RPO agreements with us during 2009 as a result of the economic downturn to decrease the amount of fixed fees and increase the amount of variable fees pursuant to the agreement.  Our future success also depends in part on our ability to sell new solutions to our existing customers.

If the unemployment rate increases or fails to materially decrease, our business may be harmed.

Demand for our solutions depends in part on our customers’ ability to hire and retain their employees.  According to the U.S. Bureau of Labor Statistics, the U.S. unemployment rate in January 2010 was 9.7%.  It is unknown whether unemployment will decrease, increase or remain constant throughout 2010 and beyond as a result of the general downturn in macroeconomic conditions in the U.S. and globally.  If the unemployment rate increases, or does not materially decrease, our existing and potential new customers may no longer consider improvement of their talent acquisition and employee performance management systems to be a necessity and may have less of a need to hire and retain employees, which could have a material adverse effect on our business, results of operations and financial condition.

 

16

---

 

If we fail to adequately protect our proprietary rights, our competitive advantage could be impaired, we may lose valuable assets, experience reduced revenue and incur costly litigation to protect our rights.

Our intellectual property rights are important to our business, and our success is dependent, in part, on protecting our proprietary software and technology and our brand, marks and domain names. We rely on a combination of patent, copyright, trademark, trade secret and other common laws in the United States and other jurisdictions as well as confidentiality procedures and contractual provisions to protect our proprietary technology, processes and other intellectual property. It may be possible for unauthorized third parties to copy our software and use information that we regard as proprietary to create products and services that compete with ours, which could harm our competitive position and cause our revenue to decline.

We have three issued patents, and additionally we have four pending patent applications. There is no guarantee that the U.S. Patent and Trademark Office will grant these patents, or do so in a manner that gives us the protection that we seek. We will not be able to protect our intellectual property if we are unable to enforce our rights or if we do not detect unauthorized use of our intellectual property. Existing intellectual property laws only afford limited protection.

To the extent that we expand our international activities, our exposure to unauthorized copying and use of our software and proprietary information may increase despite procedures and systems that control information access. Some license provisions protecting against unauthorized use, copying, transfer and disclosure of our licensed products may be unenforceable under the laws of certain jurisdictions and foreign countries in which we operate. Further, the laws of some countries, and in particular India, where we develop much of our intellectual property, do not protect proprietary rights to the same extent as the laws of the United States. For example, companies seeking to enforce proprietary rights in India can experience substantial delays in prosecuting trademarks and in opposition proceedings. In the event that we are unable to protect our intellectual property rights, especially those rights that we develop in India, our business would be materially and adversely affected.

Additional litigation may be necessary in the future to enforce our intellectual property rights and to protect our trade secrets. Litigation, whether successful or unsuccessful, could result in substantial costs and diversion of management resources, either of which could seriously harm our business.

 

Reductions in information technology spending could limit our ability to grow our business.

 

Our operating results may vary based on changes in the information technology spending of our customers. The revenue growth and profitability of our business depend on the overall demand for enterprise application software and services. We sell our solutions primarily to large organizations whose businesses fluctuate with general economic and business conditions. As a result, decreased demand for enterprise application software and services, and in particular talent acquisition and employee performance management solutions, caused by a weakening global economy, or otherwise, may cause a decline in our revenue.  Historically, corporate information technology spending has been one of the first costs that businesses cut, especially during economic downturns. In particular, software for talent acquisition and employee performance management software may be viewed by some of our existing and potential customers as a lower priority and may be among the first expenditures reduced, especially during unfavorable economic conditions. As a result, potential customers may decide to reduce their information technology budgets by deferring or reconsidering product purchases, which would negatively impact our operating results.

 

17

---

 

Because we recognize revenue from the sale of our solutions ratably over the term of the subscription period, a significant downturn in our business may not be immediately reflected in our operating results.

A decline in new or renewed subscriptions in any one quarter may not impact our financial performance in that quarter, but will negatively affect our revenue in future quarters. If a number of contracts expire and are not renewed in the same quarter, our revenue could decline significantly in that quarter and in subsequent quarters.

For the years ended December 31, 2009, 2008 and 2007, we derived approximately 84.9%, 80.2% and 81.7%, respectively, of our total revenue, from the sale of subscriptions for our solutions and expect that a significant portion of our revenue for the foreseeable future will be derived from those subscriptions. We recognize the associated revenue ratably over the term of the subscription agreement, which is typically between one and three years. As a result, a significant portion of the revenue that we report in each quarter reflects the recognition of deferred revenue from subscription agreements entered into during previous periods. Accordingly, the effect of significant declines in sales and market acceptance of our solutions may not be reflected in our short-term results of operations, making our results less indicative of our future prospects.

Historically, our customers have renewed more than 90% of the aggregate value of multi-year subscriptions for our on-demand talent acquisition and performance management solution contracts subject to renewal.  However, our renewal rates during the years ended December 31, 2009 and 2008 were approximately 80% and 75%, respectively.  We cannot assure you that our renewal rate will return to its historical levels, or that it will not decrease.

If our revenue does not meet our expectations, we may not be able to curtail our spending quickly enough and our cost of revenue, compensation and benefits and product development would increase as a percentage of revenue. Our subscription model also makes it difficult for us to rapidly increase our revenue through additional sales in any one period, as revenue from new customers is recognized over the applicable subscription term

.

Our revenue is highly susceptible to changes in general economic conditions, and a recession or other downturn in the U.S. economy, or in any geographic market in which we provide services, could substantially impact sales of our services and overall results of operations.

Our operating results may vary based on changes in the information technology spending of our customers. The revenue growth and profitability of our business depend on the overall demand for enterprise application software and services. We sell our solutions primarily to large organizations whose businesses fluctuate with general economic and business conditions. Our customers may reevaluate their expenditures on enterprise application software and services, and in particular talent acquisition and employee performance management solutions, especially given the recent financial crisis in today's economic environment, which could cause them to cancel all or any portion of our services or delay the payment of their bills for services previously performed by us.  As a result, in the event of a prolonged recession or even a less severe downturn in general economic conditions, our results of operations could be negatively impacted as a result of decreased demand for enterprise application software and services, and in particular talent acquisition and employee performance management solutions, and the impact could be more pronounced for us than for those businesses that deliver products or services that customers deem to be a higher priority. In particular, software for talent acquisition and employee performance management software may be viewed by some of our existing and potential customers as a lower priority and may be among the first expenditures reduced as a result of unfavorable economic conditions. As a result, potential customers may decide to reduce their information technology budgets by deferring or reconsidering product purchases, which would negatively impact our operating results. In addition, volatility and disruption of financial markets could limit our customers’ ability to obtain adequate financing or credit to purchase and pay for our services in a timely manner, or to maintain operations, and result in a decrease in demand for our services that could have a negative impact on our overall results of operations.

 

18

---

 

Our financial performance may be difficult to forecast as a result of our focus on large customers and the long sales cycle associated with our solutions.

 

Our sales cycles are generally up to nine months and in some cases even longer. This long sales cycle impedes our ability to accurately forecast the timing of sales in a given period which could adversely affect our ability to meet our forecasts for that period. We focus our sales efforts principally on large organizations with complex talent acquisition and employee performance management requirements. Accordingly, in any single quarter the majority of our revenue from sales to new customers may be composed of large sales made to a relatively small number of customers. Our failure to close a sale in any particular quarter may impede revenue growth until the sale closes, if at all. As a result, substantial time and cost may be spent attempting to close a sale that may not be successful. The period between an initial sales contact and a contract signing is relatively long due to several factors, including:

 

•

the need to educate potential customers about the uses and benefits of our solutions and the on-demand delivery model;

•

the discretionary nature of our customers’ purchase and budget cycles;

•

the competitive evaluation of our solutions;

•

fluctuations in the talent acquisition and employee performance management requirements of our prospective customers;

•

potential economic downturns and reductions in corporate IT spending;

•

announcements or planned introductions of new products or services by us or our competitors; and

•

the lengthy purchasing approval processes of our prospective customers.

 

If our efforts to attract new customers or to sell additional solutions to our existing customers are not successful, our revenue growth will be adversely affected.

 

To increase our revenue, we must continually add new customers and sell additional solutions to existing customers. If our existing and prospective customers do not perceive our solutions to be of sufficiently high value and quality, we may not be able to attract new customers or to increase sales to existing customers. Our ability to attract new customers and to sell new solutions to existing customers will depend in large part on the success of our sales and marketing efforts. However, our existing and prospective customers may not be familiar with some of our solutions, or may have traditionally used other products and services for some of their talent acquisition and employee performance management requirements. Our existing and prospective customers may develop their own solutions to address their talent acquisition and employee performance management requirements, purchase competitive product offerings or engage third-party providers of outsourced talent acquisition and employee performance management services. Additionally, some customers may require that we license our software to them on a perpetual basis or that we allow them the contractual right to convert from a term license to a perpetual license during the contract term, which may reduce recurring revenue from these customers.

 

Our quarterly operating results may fluctuate significantly, and these fluctuations may cause our stock price to fall.

 

As a result of fluctuations in our revenue and operating expenses, our quarterly operating results may vary significantly. We may not be able to curtail our spending quickly enough if our revenue falls short of our expectations. We expect that our operating expenses will increase substantially in the future as we expand our selling and marketing activities, increase our new product development efforts and hire additional personnel. Our operating results may fluctuate in the future as a result of the factors described below:

 

•

our ability to renew and increase subscriptions sold to existing customers, attract new customers, cross-sell our solutions and satisfy our customers’ requirements;

•

changes in our pricing policies;

•

the introduction of new features to our solutions;

•

the rate of expansion and effectiveness of our sales force;

•

the length of the sales cycle for our solutions;

•

new product and service introductions by our competitors;

•

concentration of marketing expenses for activities, such as trade shows and advertising campaigns;

•

concentration of research and development costs; and

•

concentration of expenses associated with commissions earned on sales of subscriptions for our solutions.

 

We believe that period-to-period comparisons of our results of operations are not necessarily meaningful as our future revenue and results of operations may vary substantially. It is also possible that in future quarters our results of operations will be below the expectations of securities market analysts and investors. In either case, the price of our common stock could decline, possibly materially.

 

19

---

 

Our business may not continue to grow if the markets for our products do not continue to grow.

Our growth is dependent upon the continued adoption of on-demand software as a key mechanism for delivering solutions in these markets. The rapidly evolving nature of this market reduces our ability to accurately evaluate our future prospects and forecast quarterly or annual performance. The adoption of on-demand talent acquisition and employee performance management solutions, particularly among organizations that have relied upon traditional software applications, requires the acceptance of a new way of conducting business and exchanging and compiling information. Because these markets are new and evolving, it is difficult to predict with any assurance the future growth rate and size of these markets which, in comparison with the overall market for enterprise software applications, is relatively small.

 

Interruptions or delays in service from our Web hosting facilities could impair the delivery of our service and harm our business.

We provide and manage our service through computer hardware and software that is currently located in a Qwest Web hosting facility in Sterling, VA USA and ServeCentric facility in Blanchardstown, Ireland. All Web hosting facilities are vulnerable to damage or interruption from earthquakes, floods, fires, power loss, telecommunications failures and similar events. These facilities are also subject to break-ins, sabotage, intentional acts of terrorism, vandalism and similar misconduct. Despite precautions that we take at these facilities, the occurrence of a natural disaster, act of terrorism or other unanticipated problem at any of these facilities could result in lengthy interruptions in our service. Interruptions in our service may reduce our revenue, cause us to issue credits or pay penalties, cause customers to terminate their subscriptions and adversely affect our renewal rates. Our business will be harmed if our customers and potential customers believe our service is unreliable or if our Disaster Recovery Plan (DRP) fails to provide adequate disaster recovery capabilities.

If our security measures are breached and unauthorized access is obtained to customer data, we may incur liabilities and customers may curtail or stop their use of our solutions, which would harm our business, operating results and financial condition.

Our solutions involve the storage and transmission of confidential information of customers and their existing and potential employees, and security breaches could expose us to a risk of loss of, or unauthorized access to, this information, resulting in possible litigation and possible liability. Although we have never sustained such a breach, if our security measures were ever breached as a result of third-party action, employee error, malfeasance or otherwise, and, as a result, an unauthorized party obtained access to this confidential data, our reputation could be damaged, our business may suffer and we could incur significant liability. Techniques used to obtain unauthorized access or to sabotage systems change frequently and generally are not discovered until launched against a target. As a result, we may be unable to anticipate these techniques or to implement adequate preventative measures. If an actual or perceived breach of our security occurs, the market perception of our security measures could be harmed and we could lose sales and customers.

Material defects or errors in our software could affect our reputation, result in significant costs to us and impair our ability to sell our solutions, which would harm our business.

Failure to implement the appropriate controls and procedures to manage our growth could harm our growth, business, operating results and financial condition.

We have and may continue to have periods of growth in our operations, which has placed, and may continue to place, a significant strain on our management, administrative, operational, technical and financial infrastructure. We increased our employee base from 522 employees in 2004 to 693 employees in 2005, to 1,220 employees in 2006, to 1,373 employees in 2007, and to 1,535 employees in 2008. In 2009 due to the challenging macroeconomic environment, the strengthening U.S. dollar relative to other currencies of countries in which we do business and the resulting slowing or delaying of a number of project implementations we announced, during the fourth quarter 2008, a restructuring program involving reductions of approximately 200 employees. As a result of the continued deterioration in the economic environment we executed an additional reduction of approximately 159 employees during the first quarter of 2009.

The increase in employees during 2006 was primarily due to the addition of 44 and 338 employees that we acquired as part of our acquisition of Webhire and BrassRing, respectively. The increase in employees during 2007 was primarily due to the addition of 134 and 25 employees that we acquired as part of our acquisition of Strategic Outsourcing Corporation and HRC Human Resources Consulting GmbH, respectively. The increase in employees during 2008 was primarily due to the addition of 135 employees that we acquired as a part of our acquisition of Quorum International Holdings Limited (“Quorum”). To manage our growth, we will need to continue to improve our operational, financial and management processes and controls and reporting systems and procedures. This effort may require us to make significant capital expenditures or to incur significant expenses, and may divert the attention of our personnel from our core business operations, any of which may adversely affect our financial performance. If we fail to successfully manage our growth, our business, operating results and financial condition may be adversely affected.

 

Evolving European Union regulations related to confidentiality of personal data may adversely affect our business.

In order to provide our solutions to our customers, we rely in part on our ability to access our customers’ employee data. The European Union and other jurisdictions have adopted various data protection regulations related to the confidentiality of personal data. To date, these regulations have not restricted our business as we have qualified for a safe harbor available for U.S. companies that collect personal data from areas under the jurisdiction of the European Union. To the extent that these regulations are modified in such a manner that our safe harbor no longer applies, our ability to conduct business in the European Union may be adversely affected.

Evolving regulation of the Internet may increase our expenditures related to compliance efforts, which may adversely affect our financial condition.

As Internet commerce continues to evolve, increasing regulation by federal, state and/or foreign agencies becomes more likely. We are particularly sensitive to these risks because the Internet is a critical component of our business model. For example, we believe that increased regulation is likely in the area of data privacy, and laws and regulations applying to the solicitation, collection, processing or use of personal or consumer information could affect our customers’ ability to use and share data, potentially reducing demand for solutions accessed via the Internet and restricting our ability to store, process and share data with our customers via the Internet. In addition, taxation of services provided over the Internet or other charges imposed by government agencies or by private organizations for accessing the Internet may also be imposed. Any regulation imposing greater fees for Internet use or restricting information exchange over the Internet could result in a decline in the use of the Internet and the viability of Internet-based services, which could harm our business.

ITEM 5.

Market for Registrant’s Common Equity, Related Stockholder Matters And Issuer Purchases of Equity Securities

 

Market Information and Dividends

 

Our common stock has been quoted on The Nasdaq Stock Market, LLC under the symbol “KNXA” since June 24, 2005. Prior to that date, there was no public market for our common stock. The following table sets forth, for the periods indicated, the high and low sales prices of our common stock reported by The Nasdaq Stock Market, LLC.

 

		Common Stock Price
		High				Low
Year Ended December 31, 2008:
First Quarter		$	22.81			$	16.07
Second Quarter		$	21.71			$	17.41
Third Quarter		$	24.01			$	14.77
Fourth Quarter		$	16.04			$	4.68
Year Ended December 31, 2009:
First Quarter		$	8.37			$	3.66
Second Quarter		$	14.20			$	5.27
Third Quarter		$	15.40			$	9.48
Fourth Quarter		$	14.77			$	10.39

 

On March 3, 2010, the last reported sale price of our common stock on The Nasdaq Stock Market, LLC was $11.16 per share. As of March 3, 2010, there were approximately 70 holders of record of our common stock.

 

We have not declared or paid any cash dividends on our common stock since our inception. We intend to retain future earnings, if any, to finance the operation and expansion of our business and do not anticipate paying any cash dividends in the foreseeable future. Consequently, shareholders will need to sell shares of our common stock to realize a return on their investment, if any.

Unregistered Sales of Equity Securities and Use of Proceeds

 

Not Applicable.

 

32

---

STOCK PERFORMANCE GRAPH AND CUMULATIVE TOTAL RETURN

 

The following graph shall not be deemed incorporated by reference into any of our filings under the Securities Act of 1933 or the Securities Exchange Act of 1934, except to the extent we specifically incorporate it by reference therein.

 

Prior to June 28, 2005, we were not publicly traded and there was no public market for our securities. The graph below compares the cumulative total return of our common stock with that of the Nasdaq Composite Index, the Nasdaq Computer & Data Processing Index and the S&P Smallcap 600 Index from June 28, 2005 (the date shares of our common stock began to trade publicly) through December 31, 2009. The graph assumes that you invested $100 at the close of market on June 28, 2005 in shares of our common stock and invested $100 on May 31, 2005 (the last day of the completed calendar month immediately preceding June 28, 2005) in each of these indexes, and in each case assumes the reinvestment of dividends. The comparisons in this graph are provided in accordance with Securities and Exchange Commission disclosure requirements and are not intended to forecast or be indicative of the future performance of shares of our common stock.

 

 

33

---

 

ITEM 6. Selected Consolidated Financial Data

SELECTED CONSOLIDATED FINANCIAL DATA

The selected consolidated financial data set forth below are derived from our consolidated financial statements and should be read in conjunction with our consolidated financial statements and related notes appearing elsewhere in this Annual Report on Form 10-K and "Management's Discussion and Analysis of Financial Condition and Results of Operations" section of this Annual Report on Form 10-K. The consolidated statements of operations data for each of the years ended December 31, 2009, 2008 and 2007 and the consolidated balance sheet data as of December 31, 2009 and 2008 are derived from, and qualified by reference to, our audited consolidated financial statements and related notes appearing elsewhere in this filing. The consolidated statements of operations data for each of the years ended December 31, 2006 and 2005 and the consolidated balance sheet data as of December 31, 2007, 2006 and 2005 are derived from our audited consolidated financial statements not included in this filing. All of the historical consolidated financial data set forth below gives retroactive effect to a 0.8-for-1 reverse stock split of our common stock on June 27, 2005. Our historical results are not necessarily indicative of results for any future period.

 

		For the year ended December 31,
		2009				2008				2007				2006				2005
		(in thousands, except share and per share data)
Consolidated Statements of Operations Data:
Revenues:
Subscription		$	133,854			$	163,420			$	148,662			$	90,470			$	50,974
Other			23,815				40,312				33,264				21,637				14,667
Total revenues			157,669				203,732				181,926				112,107				65,641
Cost of revenues			53,371				61,593				50,920				31,712				18,782
Gross profit			104,298				142,139				131,006				80,395				46,859
Operating expenses:
Sales and marketing			35,182				40,780				35,324				25,134				16,133
General and administrative			40,801				48,884				39,332				24,520				15,116
Research and development			9,757				15,555				17,737				8,618				3,986
Depreciation and amortization			14,264				12,088				7,584				3,487				2,112
Restructuring charges			—				1,979				—				—				—
Goodwill impairment charge			33,329				167,011				—				—				—
Total operating expenses			133,333				286,297				99,977				61,759				37,347
(Loss) income from operations			(29,035	)			(144,158	)			31,029				18,636				9,512
Interest (expense) income			(44	)			1,395				3,098				1,560				566
Investment loss			(12	)			—				—				—				—
Interest expense on mandatory redeemable preferred shares (1)			—				—				—				—				3,396
(Loss) income from operations before income tax			(29,091	)			(142,763	)			34,127				20,196				6,682
Income tax (benefit) expense			1,927				(38,071	)			10,579				4,303				591
Net (loss) income			(31,018	)			(104,692	)			23,548				15,893				6,091
Accretion of redeemable class B common shares and class C common shares			—				—				—				—				41,488
Income allocated to noncontrolling interests			(61	)			—				—				—				—
Net income (loss) applicable to common shareholders’		$	(31,079	)		$	(104,692	)		$	23,548			$	15,893			$	(35,397	)
Basic (loss) income per share:
Net (loss) income per share applicable to common shareholders - basic		$	(1.38	)		$	(4.60	)		$	0.94			$	0.80			$	(3.06	)
Weighted average shares used to compute net (loss) income applicable to common shareholders - basic			22,532,719				22,779,694				24,926,468				19,911,775				11,578,885
Net (loss) income per share applicable to common shareholders - diluted		$	(1.38	)		$	(4.60	)		$	0.93			$	0.78			$	(3.06	)
Weighted average shares used to compute net (loss) income applicable to common shareholders - diluted			22,532,719				22,779,694				25,327,004				20,425,794				11,578,885

 

34

---

 

SELECTED CONSOLIDATED FINANCIAL DATA

 

		For the year ended December 31,
		2009				2008				2007				2006				2005
		(in thousands)
Consolidated Balance Sheet Data:
Cash and cash equivalents		$	29,221			$	21,742			$	38,032			$	42,502			$	43,499
Short-term investments			29,570				4,512				58,423				—				—
Long-term investments			—				16,513				—				—				—
Total assets			202,343				218,465				347,889				267,459				73,899
Short-term debt, net			—				—				—				20,000				—
Capital lease obligations, short-term			211				143				140				229				219
Deferred revenue			49,964				38,638				35,076				31,251				12,588
Capital lease obligations, long-term			259				108				94				145				185
Term loan, long-term			—				—				—				45,000				—
Other liabilities (2)			1,981				1,319				138				225				163
Class A common stock			226				225				240				209				174
Total shareholders’ equity			130,138				156,536				287,648				147,161				50,742

 

(1)

We adopted SFAS 150 effective July 1, 2003, which required us to record the mandatory redeemable preferred stock at fair value at the date of adoption and reflect the difference between carrying value and fair value as a cumulative effect of a change in accounting principle. Changes in fair value after the initial adoption date are treated as interest expense. Dividends on mandatory redeemable preferred stock are also treated as interest expense. The interest and change in accounting principle charges to net income were discontinued with the redemption of our series A preferred stock and series B preferred stock in connection with the completion of our initial public offering in June 2005.

 

(2)	Amount in 2009 and 2008 consists of ASC 740 income tax liabilities related to uncertain tax positions of $1,890 and $1,256, respectively. See Critical Accounting Policies and Estimates, Accounting for Income taxes for further discussion.

 

35

---

 

ITEM 7.     Management’s Discussion and Analysis of Financial Condition and Results of Operations

You should read the following discussion and analysis of our financial condition and results of operations in conjunction with the “Selected Consolidated Financial Data” section and our consolidated financial statements and related notes appearing elsewhere in this Annual Report on Form 10-K. In addition to historical information, this discussion and analysis contains forward-looking statements based on current expectations that involve risks, uncertainties and assumptions, such as our plans, objectives, expectations and intentions. Our actual results and the timing of events may differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth in the “Item 1A-Risk Factors” section and elsewhere in this Annual Report on Form 10-K.

 

Overview

We provide business solutions for human resources which include a comprehensive suite of on-demand software applications and complementary services, including outsourcing services and consulting, to help global organizations recruit high performing individuals and to foster optimal work environments to increase employee productivity and retention. We employ a large force of organizational and industrial psychologists and statisticians who study the science of human behavior and its impact on business outcomes. This research is the foundation of our suite of software applications and supporting services that enable our customers to improve business results through human resources. Based on our 22 years of experience assisting customers in addressing their human resource requirements we believe our software applications and services form solutions that enable our customers to improve the effectiveness of their talent acquisition programs, increase employee productivity and retention, measure key HR metrics and make their talent acquisition and employee performance management program more efficient.

Since 1999, we have focused on providing talent acquisition and employee performance management solutions on a subscription basis and currently generate a significant portion of our revenue from these subscriptions. Our customers typically purchase multi-year subscriptions with an average length of approximately two years. For the years ended December 2009 and 2008 subscription revenue represented approximately 84.9% and 80.2% of our total revenue, respectively. We generate the remainder of our revenue from discrete professional services that are not provided as part of an integrated solution on a subscription basis. These subscription-based solutions provide us with a recurring revenue stream and we believe represent a more compelling opportunity in terms of growth and profitability than discrete professional services.

We sell our solutions to large and medium-sized organizations through our direct sales force. As of December 31, 2009, we had a customer base of approximately 4,900 companies, including approximately 170 companies on the Fortune 500 list published in May 2009. Our customer base includes companies that we billed for services during the year ended December 31, 2009 and does not necessarily indicate an ongoing relationship with each such customer. Our top 80 customers contributed approximately $86.5 million, or 54.9%, of our total revenue for the year ended December 31, 2009.

In October 2009, unemployment in the United States peaked at 10.1% which will likely adversely affect our business in 2010 and may affect our business thereafter. However, the extent or degree to which we may be affected by these events is extremely difficult to predict. The uncertain economic prospects being experienced by our customers will likely translate into slower growth, or contraction, for us, since a substantial portion of our business is dependent upon our customers’ hiring and human capital needs. However, we believe that, by optimizing our internal resources for the current business conditions, we can minimize these adverse effects and emerge from this economic crisis with a return to our historic operating margins.

 

Due to the economic downturn some of our customers, facing uncertainty and cost pressures in their own businesses, have indicated that they are waiting to purchase our products and are otherwise increasingly seeking purchasing terms and conditions that are less favorable to us. As a result, during the year ended December 31, 2009 and 2008, our customers renewed approximately 80% and 75%, respectively, of the aggregate value of multi-year subscriptions for our on-demand talent acquisition and performance management solution contracts subject to renewal during the period rather than our historical renewal rate of approximately 90%.  As the business environment improves we expect renewal rates to improve to the 90% range from a long-term perspective.

 

36

---

 

Background

We commenced operations in 1987 as a provider of recruiting services to a wide variety of industries. In 1993, we offered our first automated talent acquisition system and by 1997 we had expanded our business to provide employee research, employee performance management technology and consulting services. In late 1997, responding to a growing demand from our customers, we began to provide comprehensive human capital management services integrated with on-demand software. Between 1994 and 1998, we acquired 15 businesses that collectively enabled us to offer comprehensive Human Capital Management (“HCM”) services integrated with on-demand technology.

Over the past eleven years, we have pursued a strategy designed to focus our business on talent acquisition and employee performance management solutions and reduce our strategic focus on discrete professional services that generated less predictable revenue streams and lower margins. To that end:

 

•

in 1999, we exited our temporary staffing business;

•

in 2000 and 2001, we acquired four businesses which enhanced our screening and behavioral assessment solutions and skills testing technologies;

•

since 2002, we reduced our strategic focus on position-specific recruiting services;

•

in 2003, we discontinued our Oracle implementation business and discontinued and sold our pharmaceutical training division;

•

in 2005, we expanded our presence in North America and enhanced our customer base through our acquisition of Scottworks Solutions, Inc.;

•

in 2006, we enhanced our talent acquisition solutions and customer base through our acquisitions of Webhire, Inc., Knowledge Workers Inc., Gantz-Wiley Research Consulting Group Inc., Psychometric Services Limited., and BrassRing Inc.;

•

in 2007, we enhanced our talent acquisition solutions and customer base through our acquisitions of Strategic Outsourcing Corporation and HRC Human Resources Consulting GmbH,

•

in 2008, we expanded our global footprint in the talent acquisition space through our acquisition of Quorum International Holdings Limited; and

•

in 2009, we entered into an ownership interest transfer agreement with Shanghai Runjie Management Consulting Company to gain presence in China’s human capital management market.

As a result of our shift in strategic focus in 2000, we have focused on providing talent acquisition and employee performance management solutions on a subscription basis and currently generate a significant portion of our revenue from these subscriptions. We generate the remainder of our revenue from discrete professional services that are not provided as part of an integrated solution on a subscription basis. Subscription-based solutions provide us with a recurring revenue stream and we believe represent a more compelling opportunity in terms of growth and profitability than discrete professional services. In 2000, revenue derived from subscriptions for these solutions comprised approximately 54.4% of our total revenue. Since 2005, subscription revenue has represented approximately 80% of our total revenue. For the years ended December 2009 and 2008 subscription revenue represented approximately 84.9% and 80.2% of our total revenue, respectively. This shift to subscription based services has been driven by our customer’s adoption of the on-demand model for software delivery and need for solutions that improve employee recruiting and retention; we expect that trend to continue.

From our inception through 2001, our operations were funded primarily through internally generated cash flows and our line of credit, as well as private placements of our securities to institutional investors. On June 29, 2005, we completed our initial public offering and listed our common stock for trading on the Nasdaq Stock Market.

 

37

---

 

Recent Events

 

During the fourth quarter 2008, in response to the challenging macroeconomic environment, the strengthening U.S. dollar relative to other currencies of countries in which we do business, and the slowing or delaying of a number of projects by our customers, we announced a restructuring program involving reductions of approximately 200 employees and recorded severance and outplacement benefit costs totaling $2.0 million.  During the first quarter of 2009, as a result of the continued deterioration in the economic environment, we executed an additional reduction of approximately 159 employees and recorded severance and outplacement benefit costs totaling $1.2 million.

During the three months ended March 31, 2009 and December 31, 2008, due to a 32.5% and 49.5%, respectively, decline in our stock price and market capitalization from the previous quarter, lower projected net income, cash flow estimates and slower projected growth rates in our industry, we reevaluated our goodwill impairment analysis. Our analysis was performed to determine the implied fair value of our goodwill with neither the write up nor write down of any assets or liabilities, nor recording of any additional unrecognized identifiable intangible assets. Based upon our analysis we recorded a goodwill impairment charge of $33.3 million and $167.0 million during the three months ended March 31, 2009 and December 31, 2008, respectively. This goodwill impairment charge had no effect on our cash balances.

On January 20, 2009, we entered into an ownership interest transfer agreement with Shanghai Runjie Management Consulting Company, (“R and J”) in Shanghai, China for $1.3 million. The initial investment provided us with a 46% ownership in the new entity Shanghai Kenexa Human Resources Consulting Co., Ltd., (the “variable interest entity”) and a presence in China’s human capital management market. The agreement with R and J also provided for a 1% annual ownership increase based upon adjusted EBITDA, as defined, for each of the years ended 2008, 2009 and 2010. In the third and fourth quarter of 2009, based upon the 2008 operating results for R and J, we paid an additional $0.2 million for an additional 1% ownership interest in the variable interest entity. The variable interest entity was financed with $0.3 million in initial equity contributions from us and R and J, and has no borrowings for which its assets would be used as collateral. On September 30, 2009 we provided $0.2 million of financing for the variable interest entity. The creditors of the variable interest entity do not have recourse to our other assets.

 

On May 21, 2009, we elected not to renew our secured credit agreement with PNC Bank. We believe that our cash, short-term investments, UBS Settlement Agreement for our auction rate securities and projected cash from operations will be sufficient to meet our liquidity needs for at least the next twelve months.

 

On June 11, 2009 and July 16, 2009, two putative class actions were filed against Kenexa Corporation and our Chief Executive Officer and Chief Financial Officer in the United States District Court for the Eastern District of Pennsylvania, purportedly on behalf of a class of our investors who purchased our publicly traded securities between May 8, 2007 and November 7, 2007. The complaint filed on July 16, 2009 has since been voluntarily dismissed. In the pending action, Building Trades United Pension Trust Fund, individually and on behalf of all others similarly situated alleges violations of Section 10(b) of the Securities Exchange Act of 1934 ("Exchange Act"), Rule 10b-5 promulgated thereunder and Section 20(a) of the Exchange Act in connection with various public statements made by Kenexa. This action seeks unspecified damages, attorneys’ fees and expenses.

 

Sources of Revenue

We derive revenue primarily from two sources: (1) subscription revenue for our solutions, which is comprised of subscription fees from customers accessing our on-demand software, consulting services, outsourcing services and proprietary content, and from customers purchasing additional support that is not included in the basic subscription fee; and (2) fees for discrete professional services.

Our customers primarily purchase renewable subscriptions for our solutions. The typical term is one to three years, with some terms extending up to five years. The majority of our subscription agreements are not cancelable for convenience although our customers have the right to terminate their contracts for cause if we fail to provide the agreed upon services or otherwise breach the agreement. A customer does not generally have a right to a refund of any advance payments if the contract is cancelled. Due to the current economic slowdown, a greater number of our customers are delaying or seeking to revise the terms and conditions of our service agreements. As a result, during the year ended December 31, 2009 our customers renewed approximately 80% of the aggregate value of multi-year subscriptions for our on-demand talent acquisition and performance management solution contracts subject to renewal during the period rather than our historical renewal rate of approximately 90%. As the business environment improves we expect renewal rates to improve to the 90% range from a long-term perspective.

 

38

---

 

Consistent with our historical practices, revenue derived from subscription fees is recognized ratably over the term of the subscription agreement. We generally invoice our customers in advance in quarterly installments and typical payment terms provide that our customers pay us within 30 days of invoice. Amounts that have been invoiced are recorded in accounts receivable prior to the receipt of payment and in deferred revenue to the extent revenue recognition criteria have not been met. As of December 31, 2009, deferred revenue increased by $11.4 million or 29.5% to $50.0 million from $38.6 million at December 31, 2008. The increase in deferred revenue is a result of the increase in sales of our multiple elements or bundled arrangements. We generally price our solutions based on the number of software applications and services included and the number of customer employees. Accordingly, subscription fees are generally greater for larger organizations and for those that subscribe for a broader array of software applications and services.

We derive other revenue from the sale of discrete professional services, and translation services as well as from out-of-pocket expenses. The majority of our other revenue is derived from discrete professional services, which primarily consist of consulting and training services. This revenue is recognized differently depending on the type of service provided as described in greater detail below under “Critical Accounting Policies and Estimates.”

For the year ended December 31, 2009, approximately 79.1% of our total revenue was derived from sales in the United States. Revenue that we generated from customers in the United Kingdom and Germany was approximately 7.1% and 2.6%, respectively, for the year ended December 31, 2009. Revenue for other countries amounted to an aggregate of 11.2%. Other than the countries listed, no other country represented more than 2.0% of our total revenue for the year ended December 31, 2009. The increase in our percentage revenue derived from sales in the United States is primarily due to decreased foreign sales.

 

Cost of Revenue

Our cost of revenue primarily consists of compensation, employee benefits and out-of-pocket travel-related expenses for our employees and independent contractors who provide consulting or other professional services to our customers. Additionally, our application hosting costs, amortization of third-party license royalty costs, technical support personnel costs, overhead allocated based on headcount and reimbursed expenses are also recorded as cost of revenue. Many factors affect our cost of revenue, including changes in the mix of products and services, pricing trends, changes in the amount of reimbursed expenses and fluctuations in our customer base. Because cost as a percentage of revenue is higher for professional services than for software products, an increase in the services component of our solutions or an increase in discrete professional services as a percentage of our total revenue would reduce gross profit as a percentage of total revenue. As our revenues begin to increase, we expect our cost of revenue to increase proportionately, subject to pricing pressure related to economic conditions and slightly influenced by the mix of services and software. To the extent new customers are added, we expect that the cost of services, as a percentage of revenue, will be greater than those services associated with existing customers

 

Operating Expenses

We classify our operating expenses as follows:

Sales and Marketing. Sales and marketing expenses primarily consist of personnel and related costs for employees engaged in sales and marketing, including salaries, commissions, and other variable compensation, travel expenses and costs associated with trade shows, advertising and other marketing efforts and allocated overhead. We expense our sales commissions at the time the related revenue is recognized, and we recognize revenue from our subscription agreements ratably over the terms of the agreements. Over the past several years, our sales and marketing expense has increased in absolute terms and as a percentage of total revenue. Although we believe that our investment in sales and marketing commencing in 2003 resulted in significant revenue growth during 2004 through 2008, based on recent economic conditions we have reduced our sales and marketing expenditures to adjust for expected lower rates of growth projections. Consistent with our past practice, we intend to continue to invest in sales and marketing to pursue new customers and expand relationships with existing customers at levels we deem appropriate given our current economic conditions. We expect our sales and marketing expense to increase from current levels, mainly due to increased staff expense and continued emphasis on our rebranding effort.

General and Administrative. General and administrative expenses primarily consist of personnel and related costs for our executive, finance, human resources and administrative personnel, professional fees and other corporate expenses and allocated overhead. We expect general and administrative expenses to increase in the short term as we incur additional professional fees in connection with our patent infringement matter, however, in the longer term based upon the current state of the economy, we believe that general and administrative expenses will remain the same or slightly decrease in dollar amount and remain constant as a percentage of total revenue in 2010.

Research and Development. Research and development expenses primarily consist of personnel and related costs, including salaries, and employee benefits, for software engineers, quality assurance engineers, product managers, technical sales engineers and management information systems personnel and third party consultants. Our research and development efforts have been devoted primarily to new product offerings and enhancements and upgrades to our existing products. We believe that research and development expenses will increase in dollar amount in 2010.

 

39

---

 

Key Performance Indicators

The following tables summarize the key performance indicators that we consider to be material in managing our business, in thousands (other than percentages):

 

		For the Year Ended December 31,
		2009				2008				2007
Total Revenue		$	157,669			$	203,732			$	181,926
Subscription revenue as a percentage of total revenue			84.9	%			80.2	%			81.7	%
Non-GAAP income from operations			15,915				36,563				37,590
Net cash provided by operating activities			35,520				32,465				38,563

 

		For the Year Ended December 31,
		2009				2008				2007
Deferred revenue		$	49,964			$	38,638			$	35,076

 

The following is a discussion of significant terms used in the tables above.

 

Subscription revenue as a percentage of total revenue. Subscription revenue as a percentage of total revenue can be derived from our consolidated statements of operations. This performance indicator illustrates the evolution of our business towards subscription-based solutions, which provides us with a recurring revenue stream and which we believe to be a more compelling revenue growth and profitability opportunity. We expect that the percentage of subscription revenue will be within a target range of 78% to 82% of our total revenues in 2010.

 

40

---

 

Non-GAAP income from operations. Non-GAAP income from operations is derived from income (loss) from operations adjusted for noncash or nonrecurring expenses. We believe that measuring our operations, using non-GAAP income from operations provides more useful information to management and investors regarding certain financial and business trends relating to our financial condition and ongoing results. We use these measures to compare our performance to that of prior periods for trend analyses, for purposes of determining executive incentive compensation, and for budget and planning purposes. These measures are used in monthly financial reports prepared for management and in quarterly financial reports presented to our Board of Directors. We believe that the use of these non-GAAP financial measures provides an additional tool for investors to use in evaluating ongoing operating results and trends and in comparing its financial measures with other companies in our industry, many of which present similar non-GAAP financial measures to investors.

 

We do not consider such non-GAAP measures in isolation or as an alternative to such measures determined in accordance with GAAP. The principal limitation of such non-GAAP financial measures is that they exclude significant expenses that are required by GAAP to be recorded. In addition, they are subject to inherent limitations as they reflect the exercise of judgments by management about which charges are excluded from the non-GAAP financial measures.

 

In order to compensate for these limitations, we present our non-GAAP financial measures in connection with our GAAP results. We urge investors to review the reconciliation of our non-GAAP financial measures to the comparable GAAP financial measures included below, and not to rely on any single financial measure to evaluate our business.

 

		For the year ended December 31,
		2009				2008				2007
		(unaudited)				(unaudited)				(unaudited)
Income (loss) from operations		$	(29,035	)		$	(144,158	)		$	31,029
Share-based compensation expense			5,364				5,761				3,793
Amortization of intangibles associated with acquisitions			4,475				5,456				2,646
Professional fees associated with variable interest entity			687				—				—
Severance expense			1,156				—				—
Restructuring charges & legal fees associated with restructure charges			—				2,493				—
One time consulting fee related to R&D carryback			—				—				122
Goodwill impairment charge			33,329				167,011				—
Noncontrolling interests			(61	)			—				—
Non-GAAP income from operations		$	15,915			$	36,563			$	37,590

The Company’s non-GAAP financial measures as set forth in the table above exclude the following:

Share-based compensation. Share-based compensation consists of expenses for stock options and stock awards that we began recording in accordance with SFAS 123(R) during the first quarter of 2006. Share-based compensation was $5.4 million, $5.8 million and $3.8 million for the years ending December 31, 2009, 2008 and 2007, respectively. Share-based compensation expenses are excluded in our non-GAAP financial measures because share-based compensation amounts are difficult to forecast. This is due in part to the magnitude of the charges which depends upon the volume and timing of stock option grants, which are unpredictable and can vary dramatically from period to period, and external factors such as interest rates and the trading price and volatility of our common stock. We believe that this exclusion provides meaningful supplemental information regarding our operating results because these non-GAAP financial measures facilitate the comparison of results for future periods with results from past periods. The dilutive effect of all outstanding options is included in the calculation of diluted earnings per share on both a GAAP and a non-GAAP basis.

Amortization of intangibles associated with acquisitions. In accordance with GAAP, operating expenses include amortization of acquired intangible assets which are amortized over the estimated useful lives of such assets. Amortization of acquired intangible assets was $4.5 million, $5.5 million and $2.6 million for the years ending December 31, 2009, 2008 and 2007, respectively. Amortization of acquired intangible assets is excluded from our non-GAAP financial measures because we believe that such exclusion facilitates comparisons to its historical operating results and to the results of other companies in the same industry, which have their own unique acquisition histories.

 

41

---

 

Professional fees related to our Chinese expansion. The company incurred professional fees in connection with its Chinese expansion in the amount of $0.7 million during the first quarter of 2009. The Company believes that such exclusion facilitates comparisons to its historical operating results and to the results of other companies in the same industry, which have their own unique acquisition histories.

Severance expenses. We incurred charges in the amount of $1.2 million in relation to additional severance expenses in the first quarter of 2009. These charges were excluded them from its non-GAAP income to facilitate a more meaningful comparison to the prior year’s results.

Expenses related to restructuring charges and related legal fees. We incurred charges in the amount of $2.5 million in relation to the restructuring in the fourth quarter of 2008. Such charges consisted of severance and outplacement benefit costs of $2.0 million and certain legal fees of $0.5 million in relation to the termination of approximately 200 employees.

 

Research and development (“R&D”) credits and the related consulting fees incurred to identify those credits. R&D credits in 2008 relate to R&D activities performed during the entire year of 2008, and reduce the Company’s tax expense. These tax credits totaling $0.5 million were claimed in the Company’s fourth quarter tax filing and are reflected in the Company’s December 31, 2008 financial statements. The R&D tax credit is excluded from the Company’s non-GAAP financial measures in the current quarter to facilitate a more meaningful comparison to the prior year’s results.

Goodwill impairment charge. We recorded a non-cash goodwill impairment charge in the first quarter of 2009 of $33.3 million and $167.0 million in the fourth quarter of 2008 of as a result of a substantial decrease in our stock price, reflecting the impact of the unprecedented turmoil in world economies and the resultant impact on our operations.

Noncontrolling Interest. Non Controlling interest of $0.1 million includes income from operations due to our variable interest entity partner and is excluded from the calculation of non-GAAP net income from operations because it is unrelated to our ownership in the venture.

 

Net cash provided by operating activities. Net cash provided by operating activities is taken from our consolidated statement of cash flows and represents the amount of cash generated by our operations that is available for investing and financing activities. Generally, our net cash provided by operating activities has exceeded our operating income primarily due to the positive impact of deferred revenue, the add-back of non-cash goodwill impairment charges and more recently due to the collection of accounts receivables. It is possible that this trend may vary as business conditions change.

 

42

---

 

Deferred revenue. We generate revenue primarily from multi-year subscriptions for our on-demand talent acquisition and employee performance management solutions. We recognize revenue from these subscription agreements ratably over the hosting period, which is typically one to three years. We generally invoice our customers in quarterly or monthly installments in advance. Deferred revenue, which is included in our consolidated balance sheets, is the amount of invoiced subscriptions in excess of the amount recognized as revenue. Deferred revenue represents, in part, the amount that we will record as revenue in our consolidated statements of operations in future periods. As the subscription component of our revenue has grown and customer willingness to pay us in advance for their subscriptions has increased, the amount of deferred revenue on our balance sheet has grown. It is possible that this trend may vary as business conditions change.

The following table reconciles beginning and ending deferred revenue for each of the periods shown:

 

		For the Year Ended December 31,
		2009			2008					2007
		(in thousands)
Deferred revenue at the beginning of the year		$	38,638			$	35,076			$	31,251
Total invoiced subscriptions during the year			145,180				166,982				152,367
Deferred revenue from acquisition			—				—				120
Subscription revenue recognized during the year			(133,854	)			(163,420	)			(148,662	)
Deferred revenue at end of year		$	49,964			$	38,638			$	35,076

 

Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and consolidated results of operations are based upon our consolidated financial statements, which have been prepared in accordance with generally accepted accounting principles in the United States. The preparation of our consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to uncollectible accounts receivable and accrued expenses. We base these estimates on historical experience and various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Our actual results may differ from these estimates.

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

Revenue Recognition

We derive our revenue from two sources: (1) subscription revenues for solutions, which are comprised of subscription fees from customers accessing our on-demand software, consulting services, outsourcing services and proprietary content, and from customers purchasing additional support beyond the standard support that is included in the basic subscription fee; and (2) other fees for professional services, translation services and reimbursed out-of-pocket expenses. Because we provide our solutions as a service, we follow the provisions of Financial Accounting Standards Board (“FASB”) ASC 605-10, “Revenue Recognition” and FASB ASC 605-25 “Multiple Element Arrangements”. We recognize revenue when all of the following conditions are met:

 

•

there is persuasive evidence of an arrangement;

 

•

the service has been provided to the customer;

•

the collection of the fees is probable; and

•

the amount of fees to be paid by the customer is fixed or determinable.

 

Subscription Fees and Support Revenues. Subscription fees and support revenues are recognized ratably over the lives of the contracts.  Amounts that have been invoiced are recorded in accounts receivable and in deferred revenue or revenue, depending on whether the revenue recognition criteria have been met.

Other Revenue. Other revenue consists of discrete professional services, translation services and reimbursable out-of-pocket expenses. Discrete professional services, when sold with subscription and support offerings, are accounted for separately since these services have value to the customer on a stand-alone basis and there is objective and reliable evidence of fair value of the delivered elements.  Our arrangements do not contain general rights of return.  Additionally, when professional services are sold with other elements, the consideration from the revenue arrangement is allocated among the separate elements based upon the relative fair value. Revenues from professional services are recognized based upon proportional performance as value is delivered to the customer.

In determining whether revenues from professional services can be accounted for separately from subscription revenue, we consider the following factors for each agreement: availability of professional services from other vendors, whether objective and reliable evidence of the fair value exists of the undelivered elements, the nature and the timing of when the agreement was signed in comparison to the subscription agreement start date and the contractual dependence of the subscription service on the customer's satisfaction with the other services. If the professional service does not qualify for separate accounting, we recognize the revenue ratably over the remaining term of the subscription contract. In these situations we defer the direct and incremental costs of the professional service over the same period as the revenue is recognized.

In accordance with FASB ASC 605-45, “Principal Agent Considerations,” we record reimbursements received for out-of-pocket expenses as revenue and not netted with the applicable costs.  These items primarily include travel, meals and certain telecommunication costs.  Reimbursed expenses for the years ended December 31, 2009, 2008, and 2007, totaled $2.2 million, $4.7 million and $3.5 million, respectively.

 

44

---

 

Allowance for Doubtful Accounts

We maintain an allowance for doubtful accounts for estimated losses resulting from customers’ inability to pay us. The provision is based on our historical experience and for specific customers that, in our opinion, are likely to default on our receivables from them. In order to identify these customers, we perform ongoing reviews of all customers that have breached their payment terms, as well as those that have filed for bankruptcy or for whom information has become available indicating a significant risk of non-recoverability. We rely on historical trends of bad debt as a percentage of total revenue and apply these percentages to the accounts receivable associated with new customers and evaluate these customers over time. To the extent that our future collections differ from our assumptions based on historical experience, the amount of our bad debt and allowance recorded may be different.

Self-Insurance

We are self-insured for the majority of our health insurance costs, including claims filed and claims incurred but not reported subject to certain stop loss provisions. We estimate our liability based upon management’s judgment and historical experience. We also rely on the advice of consulting administrators in determining an adequate liability for self-insurance claims.  Self-insurance accruals totaled approximately $0.6 million as of and for the periods ended December 31, 2009 and 2008. We continuously review the adequacy of our insurance coverage. Material differences may result in the amount and timing of insurance expense if actual experience differs significantly from management's estimates. 

Capitalized Software Development Costs

In accordance with FASB ASC 985, “Software”, and FASB ASC 350, “Intangibles-Goodwill and Other”, costs incurred in the preliminary stages of a development project are expensed as incurred.  Once an application has reached the development stage, internal and external costs, if direct and incremental, will be capitalized until the software is substantially complete and ready for its intended use. Capitalization ceases upon completion of all substantial testing. We also capitalize costs related to specific upgrades and enhancements when it is probable the expenditures will result in additional functionality. Maintenance and training cost are expensed as incurred.  Internal use software is amortized on a straight-line basis over its estimated useful life, generally three years. Management evaluates the useful lives of these assets on an annual basis and tests for impairments whenever events or changes in circumstances occur that could impact the recoverability of these assets. There were no impairments to internal software in any of the periods covered in this report.

 

45

---

 

Goodwill and Other Identified Intangible Asset Impairment

Since 2002, we have recorded goodwill in accordance with the provisions of FASB ASC 350, “Intangibles-Goodwill and Other,” which requires us to annually review the carrying value of goodwill for impairment.  If goodwill becomes impaired, some or all of the goodwill would be written off as a charge to operations.  This comparison is performed annually or more frequently if circumstances change that would more likely than not reduce the fair value of the reporting unit below its carrying amount.

During the quarter ended December 31, 2008 we reevaluated our goodwill, due to adverse changes in the economic climate, a 49.5% decline in our market capitalization from October 1, 2008 (our annual testing date), and a downward revision in our earnings guidance for the quarter and year ended December 31, 2008.  These factors signaled a triggering event, which required us to determine whether and to what extent our goodwill may have been impaired as of December 31, 2008.  The first step of this analysis requires the estimation of our fair value, as an entity, and is calculated based on the observable market capitalization with a range of estimated control premiums as well as discounted future estimated cash flows.  This step yielded an estimated fair value for us which was less than our carrying value including goodwill at December 31, 2008.  The next step entails performing an analysis to determine whether the carrying amount of goodwill on our balance sheet exceeds our implied fair value.  The implied fair value of our goodwill, for this step was determined in the same manner as goodwill recognized in a business combination.  Our estimated fair value was allocated to our assets and liabilities, including any unrecognized identifiable intangible assets, as if we had been acquired in a business combination with our estimated fair value representing the price paid to acquire it.  The allocation process performed on the test date was only for purposes of determining the implied fair value of goodwill with neither the write up or write down of any assets or liabilities, nor recording any additional unrecognized identifiable intangible assets as part of this process as of December 31, 2008.  Based on the analysis, we determined that the implied fair value of goodwill was $32.4 million, resulting in a goodwill impairment charge of $167.0 million.  The goodwill impairment charge had no effect on our cash balances.

During the quarter ended March 31, 2009 we reevaluated our goodwill due to continued adverse changes in the economic climate, a 32.5% decline in our market capitalization from December 31, 2008 through March 31, 2009 and a downward revision in internal projections.  These factors signaled a triggering event, which required us to determine whether and to what extent our goodwill may have been impaired as of March 31, 2009.  The allocation process performed on the test date was only for purposes of determining the implied fair value of goodwill with no assets or liabilities written up or down, nor any additional unrecognized identifiable intangible assets recorded as part of this process.  Based on the analysis, a goodwill impairment charge of $33.3 million was recorded to write off the remaining balance of our goodwill for the quarter ended March 31, 2009. The goodwill impairment charge had no effect on the Company’s cash balances

 

46

---

 

Consolidated Historical Results of Operations

The following table sets forth certain consolidated historical results of operations data and expressed as a percentage of total revenue for the periods indicated. Period-to-period comparisons of our financial results are not necessarily meaningful and you should not rely on them as an indication of future performance.

		Kenexa Corporation Consolidated Statements of Operations (in thousands, except for percentages)
		For the Year Ended December 31,
		2009								2008								2007
		Amount				Percent of Revenues				Amount				Percent of Revenues				Amount				Percent of Revenues
Revenues:
Subscription revenue		$	133,854				84.9	%		$	163,420				80.2	%		$	148,662				81.7	%
Other revenue			23,815				15.1	%			40,312				19.8	%			33,264				18.3	%
Total revenues			157,669				100.0	%			203,732				100.0	%			181,926				100.0	%
Cost of revenues			53,371				33.9	%			61,593				30.2	%			50,920				28.0	%
Gross profit			104,298				66.1	%			142,139				69.8	%			131,006				72.0	%
Operating expenses:
Sales and marketing			35,182				22.3	%			40,780				20.0	%			35,324				19.4	%
General and administrative			40,801				25.9	%			48,884				24.0	%			39,332				21.6	%
Research and development			9,757				6.2	%			15,555				7.6	%			17,737				9.7	%
Depreciation and amortization			14,264				9.0	%			12,088				5.9	%			7,584				4.2	%
Restructuring charges			—				—	%			1,979				1.0	%			—				—
Goodwill impairment charge			33,329				21.1	%			167,011				82.0	%			—				—
Total operating expenses			133,333				84.5	%			286,297				140.5	%			99,977				55.0	%
(Loss) income from operations			(29,035	)			(18.4	) %			(144,158	)			(70.8	)%			31,029				17.1	%
Interest income (expense), net			(44	)			—	%			1,395				0.7	%			3,098				1.7	%
(Loss) gain on change in fair market value of ARS and put option, net			(12	)			—	%			—				—	%			—				—	%
(Loss) income before income tax			(29,091	)			(18.4	) %			(142,763	)			(70.1	)%			34,127				18.8	%
Income tax (benefit) expense			1,927				1.2	%			(38,071	)			(18.7	)%			10,579				5.8	%
Net (loss) income			(31,018	)			(19.6	) %			(104,692	)			(51.4	)%			23,548				12.9	%
Income allocated to noncontrolling interests			(61	)			(0.1	) %			—				—	%			—				—	%
Net income (loss) available to common shareholders’		$	(31,079	)			(19.5	) %		$	(104,692	)			(51.4	) %		$	23,548				12.9	%

Geographic Information

 

The following table summarizes the distribution of revenue by geographic region as determined by billing address for the years ended December 31, 2009, 2008 and 2007.

		For the year ended  December 31, 2009								For the year ended  December 31, 2008								For the year ended  December 31, 2007
Country		Revenue				Revenue as a percentage of total revenue				Revenue				Revenue as a percentage of total revenue				Revenue				Revenue as a percentage of total revenue
United States		$	124,652				79.1	%		$	149,225				73.6	%		$	155,247				85.3	%
United Kingdom			11,156				7.1	%			17,729				8.7	%			10,741				5.9	%
Other European Countries			7,818				4.9	%			11,660				5.5	%			5,389				3.0	%
Germany			4,073				2.6	%			9,765				4.8	%			2,832				1.5	%
The Netherlands			1,755				1.1	%			3,196				1.6	%			2,706				1.5	%
Canada			2,808				1.8	%			5,539				2.7	%			2,526				1.4	%
Other			5,407				3.4	%			6,618				3.1	%			2,485				1.4	%
Total		$	157,669				100.0	%		$	203,732				100.0	%		$	181,926				100.0	%

 

49

---

 

Comparison of Years Ended December 31, 2009 and 2008

Revenues

Total revenue decreased by $46.0 million or 22.6% to $157.7 million for the year ended December 31, 2009 from $203.7 million for the year ended December 31, 2008. Our subscription revenue decreased by $29.5 million to $133.9 million for the year ended December 31, 2009 from $163.4 million for the year ended December 31, 2008. Subscription revenue represented approximately 84.9% of our total revenue for the year ended December 31, 2009 compared to 80.2% of our total revenue for the year ended December 31, 2008. The decrease in revenue is attributable primarily to the effects arising from the global economic recession, increased pricing pressures, high unemployment, and reduced demand for our products and services and the effects of delayed revenue recognition associated with sales of our multiple element or bundled arrangements.  Based upon the current market conditions, we expect our subscription-based and other revenues to increase in 2010 over the prior year due to stabilization in the unemployment rate, slightly improved business environment and continued acceptance of our talent management solutions on-demand model.

Cost of Revenues

Cost of revenue decreased by $8.2 million or 13.3% to $53.4 million for the year ended December 31, 2009 from $61.6 million for the year ended December 31, 2008.  As a percentage of revenue, cost of revenue increased 3.7% to 33.9% for the year ended December 31, 2009 compared to 30.2% for the year ended December 31, 2008 due to decreased revenues in 2009. The $8.2 million decrease in the cost of revenue was primarily due to reduced staff expense, reimbursable expense and third party fees, including marketing and agency costs, of approximately $5.0 million, $2.5 million and $0.7 million, respectively, compared to the same period in 2008.  Many factors affect our cost of revenue, including changes in the mix of products and services, the number of initial implementations versus recurring engagements, pricing trends, changes in the amount of reimbursed expenses and fluctuations in our customer base.  As our overall revenue increases, we expect our cost of revenue will increase proportionately, subject to pricing pressure related to economic conditions and slightly influenced by the mix of services and software. To the extent new customers are added, we expect that the cost of services, as a percentage of revenue, will be greater than those services associated with existing customers.

Sales and Marketing

Sales and marketing expense decreased by $5.7 million or 13.7% to $35.1 million for the year ended December 31, 2009 compared to $40.8 million for the year ended December 31, 2008. The $5.7 million decrease was primarily due to reduced staff related expense, commissions, travel expenses and reserve for bad debt of approximately $0.7 million, $1.4 million, $1.1 million, and $3.1 million, respectively, partially offset by an increase in other expenses of $0.6 million, compared to the same period in 2008.  As a percentage of total revenue, sales and marketing expense increased by 2.3% to 22.3% for the year ended December 31, 2009 from 20.0% for the year ended December 31, 2008 due to decreased revenue.  Consistent with our past practice, we intend to continue to invest in sales and marketing to pursue new customers and expand relationships with existing customers at levels we deem appropriate given our current economic conditions.  We expect our sales and marketing expense to increase from current levels, mainly due to increased staff expense, including variable compensation and continued emphasis on our rebranding effort.

General and Administrative

General and administrative expense decreased by $8.1 million or 16.5% to $40.8 million for the year ended December 31, 2009 compared to $48.9 million for the year ended December 31, 2008. The $8.1 million decrease was primarily due to reduced staff related expense, bonus, share-based compensation and travel expenses of approximately $2.8 million, $1.7 million, $0.6 million and $1.4 million, respectively.  In addition, phone, entertainment and infrastructure expenses such as supplies, insurance and other expenses contributed approximately $0.5 million, $0.4 million, and $0.7 million, respectively, of the decrease in expense compared to the same period in 2008.  As a percentage of total revenue, general and administrative expense increased by 1.9% to 25.9% for the year ended December 31, 2009 compared to 24.0% for the year ended December 31, 2008 due to decreased revenues in 2009.  In the short term, we expect general and administrative expense to increase as we incur additional professional fees in connection with our patent infringement matter, however, in the longer term based upon the current state of the economy, we believe that general and administrative expenses will remain the same or slightly increase in dollar amount and remain constant as a percentage of total revenue in 2010.

 

50

---

 

Research and Development

Research and development expense decreased by $5.8 million or 37.3% to $9.8 million for the year ended December 31, 2009 compared to $15.6 million for the year ended December 31, 2008. The $5.8 million decrease in research and development expense was primarily due to reduced staff related expense and an increase in capitalized software development costs.  Capitalized software development costs increased by $1.5 million or 18.3% to $9.7 million for the year ended December 31, 2009 from $8.2 million for the year ended December 31, 2008.  The increase in capitalized software development costs was directly attributable to an increase in the software development projects qualifying for capitalization, pursuant to ASC 350-40, “Internal-Use Software”, and a decrease of research and development expenses.  The increase in capitalized software development costs was due in part to greater use of third party software developers.  As a percentage of total revenue, research and development expense decreased 1.4% to 6.2% for the year ended December 31, 2009 compared to 7.6% the year ended December 31, 2008.  A small portion of our research and development expense relates to the efforts of our Kenexa Research Institute scientists, which is more fixed in nature. This cost structure will result in future research and development expense being more constant.  We expect research and development expenses to remain flat or increase slightly as we continue to execute on our strategies which include furthering the common services enterprise architecture, introducing Kenexa 2x modules, and continuing to develop feature enhancements.

Depreciation and Amortization

Depreciation and amortization expense increased $2.3 million or 18.0% to $14.3 million for the year ended December 31, 2009 compared to $12.0 million for the year ended December 31, 2008.  The $2.3 million increase was due in part to increased amortization expense associated with our acquisitions and increased depreciation expense associated with our capitalized software and our capital purchases including our building in Vizag.  In the future, we expect depreciation and amortization expense to increase as we place our software development into service and due to recent capital purchases.

Goodwill Impairment

During the quarter ended March 31, 2009 we reevaluated our goodwill due to continued adverse changes in the economic climate, a 32.5% decline in our market capitalization from December 31, 2008 through March 31, 2009 and a downward revision in internal projections.  These factors signaled a triggering event, which required us to determine whether and to what extent our goodwill may have been impaired as of March 31, 2009.  We reviewed our goodwill by comparing the carrying values to the estimated fair values of the enterprise.  Fair value is based on our estimate of the future discounted cash flows to be generated by the enterprise and our market capitalization. Such cash flows consider factors such as future operating income, historical trends, as well as demand and competition. Comparable company multiples are based upon public companies in sectors relevant to our business based on our knowledge of the industry. Changes in the underlying business could affect these estimates, which in turn could affect our assessment of the recoverability of goodwill.  Based on the analysis a goodwill impairment charge of $33.3 million for was recorded to write off the remaining balance of our goodwill for the quarter ended March 31, 2009.. The goodwill impairment charge had no effect on our cash balances.  See Critical Accounting Policies and Estimates for additional details.

Interest Income

Net interest expense was less than $0.1 million for the year ended December 31, 2009 compared to $1.4 million net interest income for the year ended December 31, 2008. The $1.4 million decrease is due primarily to significantly lower rates of interest in 2009 and 2008 and the write off of deferred financing fees as a result of the termination of our Credit Agreement with PNC Bank.

 

51

---

 

Income Tax Expense

An income tax expense of $1.9 million was recorded on a loss from operations of $29.0 for the year ended December 31, 2009 as compared with an income tax benefit of $38.1 million for the year ended December 31, 2008. The current year income tax expense is primarily attributable to an increase in the valuation allowance of $7.0 million on federal, state and foreign net operating losses and the recognition of a goodwill impairment loss of $33.3 million that is only partially deductible for U.S. tax purposes.

Webhire and BrassRing were two domestic companies which we acquired in 2006. During the year ended December 31, 2007, Webhire and BrassRing each made retroactive elections under Section 338(g) of the Internal Revenue Code with the effect of increasing the tax basis of certain acquired intangible assets to equal the deemed purchase price of these assets. We are amortizing the increased tax basis of these acquired intangibles over a 15-year period for federal and state income tax purposes.  The amortization of these intangibles gives rise to temporary differences between the book basis and tax basis of these assets.

The goodwill impairment loss claimed in 2009 included certain intangible assets recorded by Webhire and BrassRing during their respective acquisitions.  These intangibles are characterized as component-1 goodwill as we expect to recognize tax deductions as we amortize the tax basis of these assets over their remaining useful lives. The portion of impaired goodwill that has no tax basis is considered to be component-2 goodwill.  We have allocated the impairment charge of $33.3 million between component-1 goodwill ($20.3 million) and component-2 goodwill ($13.0 million) and recorded a deferred tax asset computed on the difference between the book and tax bases of component-1 goodwill.

Changes to deferred income taxes are generally based on management's evaluation of our positive and negative evidence bearing upon the realizability of its deferred tax assets and the determination that it is more likely than not that we will realize a portion of the benefits of federal and state tax assets.  In assessing the need for a valuation allowance, management considers all available information within each taxing jurisdiction, including past operating results, estimates of future taxable income and the feasibility of tax planning strategies. Any changes in management’s assessment of the amount of deferred tax assets that may be realized will result in an adjustment to its valuation allowance with a corresponding increase or decrease to income tax expense in the period in which such determination is made.

Comparison of Years Ended December 31, 2008 and 2007

Revenues

Total revenue increased by $21.8 million or 12.0% to $203.7 million for the year ended December 31, 2008 from $181.9 million for the year ended December 31, 2007. Our subscription revenue increased by $14.7 million to $163.4 million for the year ended December 31, 2008 from $148.7 million for the year ended December 31, 2007. Subscription revenue represented approximately 80.2% of our total revenue for the year ended December 31, 2008 compared to 81.7% of our total revenue for the year ended December 31, 2007. The increase in revenue is attributable primarily to an increase in sales volumes of our talent management solutions and the continued acceptance of our on-demand model. Revenue generated by Quorum comprised approximately 7.9% of the increase in our total revenue for the year ended December 31, 2008 compared to the prior year. Our other revenue increased by $7.1 million to $40.3 million for the year ended December 31, 2008 from $33.2 million for the year ended December 31, 2007. This increase was mostly due to an increase in demand for our consulting services which resulted from an increase in our subscription-based revenues.

Cost of Revenues

Cost of revenue increased by $10.7 million or 21.0% to $61.6 million for the year ended December 31, 2008 from $50.9 million for the year ended December 31, 2007. As a percentage of revenue, cost of revenue increased 2.2% to 30.2% for the year ended December 31, 2008 compared to 28.0% for the year ended December 31, 2007. The $10.7 million increase in the cost of revenue was primarily due to increased salaries, overhead, direct costs and other expense of $7.1 million, $1.2 million, $1.1 million and $1.3 million, respectively.  Our increased salaries were due in part to the addition of 100 employees from the acquisition of Quorum in 2008.

 

52

---

 

Sales and Marketing

Sales and marketing expense increased by $5.5 million or 15.6% to $40.8 million for the year ended December 31, 2008 compared to $35.3 million for the year ended December 31, 2007. The $5.5 million increase was due in part to an increase of staff related expense of approximately $5.6 million, partially offset by a decrease in performance bonuses, commissions and travel expenses of approximately $3.7 million from the prior year. The net $1.9 million increase in salaries was due partially to the addition of 24 employees from our Quorum acquisition and 39 employees hired for our existing business in 2008.  In addition, reserve for bad debt and advertising and marketing expense contributed approximately $2.4 million and $1.2 million to the increase in sales and marketing expense for the year ended December 31, 2008 over the prior year.  The increase in bad debt was mainly attributed to three customers.  As a percentage of total revenue, S&M expense increased to 20.0% for the year ended December 31, 2008 from 19.4% for the year ended December 31, 2007 due to increased expense.

General and Administrative

General and administrative expense increased by $9.5 million or 24.1% to $48.9 million for the year ended December 31, 2008 compared to $39.4 million for the year ended December 31, 2007. The $9.5 million increase was due in part to an increase in professional fees, rent and utilities expense, and share-based compensation expense which contributed $2.6 million, $1.6 million, and $1.8 million, respectively, to the increase in general and administrative expense for the year ended December 31, 2008 compared to the prior year. In addition increased travel, phone and license expense contributed approximately $0.9 million, $0.8 million and $0.4 million in expense for the year ended December 31, 2008 compared to the prior year.  The remainder of the increase of $1.4 million was attributable to increases in infrastructure expenses such as supplies, insurance and other expenses of $1.0 million and salary and bonus expenses of $0.4 million. As a percentage of total revenue, general and administrative expense increased by 2.4% to 24.0% for the year ended December 31, 2008 compared to 21.6% for the year ended December 31, 2007.

Research and Development

 

Research and development expense decreased by $2.1 million or 11.9% to $15.6 million for the year ended December 31, 2008 from $17.7 million for the year ended December 31, 2007. The $2.1 million decrease in research and development expense was directly attributable to increased capitalized software development costs during 2008.  Capitalized software development costs increased by $5.5 million or 203.7% to $8.2 million for the year ended December 31, 2008 from $2.7 million for the year ended December 31, 2007.  The increase in capitalized software development costs represents 52.6% and 15.3% of research and development expense for the years ended December 31, 2008 and 2007, respectively and was directly attributable to an increase in the software development projects qualifying for capitalization, pursuant to ASC 350-40, “Internal-Use Software”.  This increase was due in part to greater use of third party software developers.  As a percentage of total revenue, research and development expense decreased from 9.7% to 7.6% for the year ended December 31, 2008 compared to the year ended December 31, 2007 due to increased capitalized software development costs.

Depreciation and Amortization

Depreciation and amortization expense increased $4.4 million or 57.9% to $12.0 million for the year ended December 31, 2008 compared to $7.6 million for the year ended December 31, 2007.  The $4.4 million increase was due in part to increased amortization expense associated with our recent acquisitions and increased depreciation expense associated with our capitalized software and our capital purchases including our building in Vizag.

Restructuring expense

During the quarter ended December 31, 2008 in response to the weakness of our macroeconomic environment and widespread deterioration in our business climate we announced a restructuring program involving staff reductions of approximately 200 employees which included severance and outplacement benefit costs totaling approximately $2.0 million.

 

53

---

 

Goodwill Impairment

During the quarter ended December 31, 2008, due to adverse changes in the economic climate, a 49.5% decline in the our  market capitalization from October 1, 2008, and a downward revision in our earnings guidance for the quarter and year ended December 31, 2008, we reevaluated our goodwill impairment analysis.   Pursuant to FASB ASC 350, “Assets-Intangibles-Goodwill and Other”, these factors signaled a triggering event, which required us to determine whether and to what extent our goodwill was impaired as of December 31, 2008.  The first step of this analysis required the estimation of our fair value, as an entity, and is calculated based on the observable market capitalization with a range of estimated control premiums as well as discounted future estimated cash flows. This step yielded an estimated fair value for us which was less than our carrying value including goodwill at December 31, 2008. The next step entailed performing an analysis to determine whether the carrying amount of goodwill on our balance sheet exceeded our implied fair value. The implied fair value of our goodwill, for this step was determined in the same manner as goodwill recognized in a business combination. Our estimated fair value was allocated to our assets and liabilities, including any unrecognized identifiable intangible assets, as if we had been acquired in a business combination with our estimated fair value representing the price paid to acquire it. The allocation process performed on the test date was only for purposes of determining the implied fair value of goodwill with neither the write up or write down of any assets or liabilities, nor recording of any additional unrecognized identifiable intangible assets as part of this process, but did cause us to be out of compliance with the covenants under our credit facility pursuant as of December 31, 2008. Based on the analysis, we determined that the implied fair value of the Kenexa’s goodwill was $32.4 million, resulting in a goodwill impairment charge of $167.0 million. The goodwill impairment charge had no effect on our cash balances.

Interest Income

Interest income decreased $1.7 million or 54.8% for the year ended December 31, 2008 to $1.4 million for the year ended December 31, 2008 from $3.1 million for the year ended December 31, 2007. The $1.7 million decrease was due primarily to lower cash balances and lower rates of interest in 2008.

 

Income Tax Expense

 

An income tax benefit on continuing operations of $38.1 million was recorded for the year ended December 31, 2008 as compared with an income tax expense of $10.6 million for the year ended December 31, 2007. This income tax benefit was primarily attributable to the recognition of a deferred tax asset of $42.3 million relating to a goodwill impairment loss that was deductible for U.S. tax purposes. Changes to deferred income taxes are generally based on management's evaluation of our positive and negative evidence bearing upon the realizability of its deferred tax assets and the determination that it is more likely than not that we will realize a portion of the benefits of federal and state tax assets.

Webhire, which we acquired in January 2006, had a net operating loss carryforward balance of approximately $48.0 million for federal purposes as of September 30, 2005. BrassRing, which we acquired in November 2006, had a net operating loss carryforward balance of approximately $78.0 million for federal purposes as of December 31, 2006. Based upon the uncertainty of our ability to utilize these acquired net operating losses, we recorded a valuation allowance of approximately $12.0 million during the year ended December 31, 2006.

During the year ended December 31, 2007, Webhire and BrassRing made retroactive elections under Section 338(g) of the Internal Revenue Code with the effect of increasing the tax basis of acquired intangible assets to the deemed purchase price of these assets. We will amortize the increased tax basis of acquired intangibles over a 15-year period for federal and state income tax purposes. Separate gains equal to the respective increases in tax basis were included in the pre-acquisition taxable incomes of each acquired company. Webhire and BrassRing each had sufficient net operating loss carryforwards to fully offset the income recognized on the deemed sale of assets for regular federal income tax purposes. However, under the federal alternative minimum tax rules, net operating loss carryforwards may not offset more than 90% of income taxable under this measure. We have therefore paid alternative minimum tax on these gains of approximately $0.5 million. Concurrent with the recognition of these gains, certain of the acquired net operating losses were deemed to expire. Accordingly, we reduced the deferred tax assets associated with these acquired net operating losses and the related valuation allowances by offsetting amounts of approximately $12.0 million.

 

54

---

 

Our largest source of operating cash flows is cash collections from our customers following the purchase and renewal of their software subscriptions. Payments from customers for subscription agreements are generally received near the beginning of the contract term, which can vary from one to three years in length. We also generate significant cash from our recruitment process outsourcing services and to a lesser extent our consulting services. Our primary uses of cash from operating activities are for personnel related expenditures as well as payments related to taxes and leased facilities.

Net cash provided by operating activities for the year ended December 31, 2009 resulted primarily from a net loss of approximately $31.0 million, an increase in deferred tax benefits of $0.4 million and other changes in working capital of $5.0 million, offset by a non-cash charge to goodwill impairment of $33.3 million, other non-cash charges of $19.6 million, accounts and unbilled receivables of $7.8 million and deferred revenue of $11.2 million.

Net cash provided by operating activities for the year ended December 31, 2008 resulted primarily from a net loss of approximately $104.7 million, an increase in deferred tax benefits of $46.5 million and other changes in working capital of $8.4 million, partially offset by a non-cash charge to goodwill impairment of $167.0 million, other non-cash charges of $20.9 million, and deferred revenue of $4.2 million.

Net cash provided by operating activities for the year ended December 31, 2007 resulted primarily from net income of approximately $23.5 million, non-cash charges to net income of $12.3 million, deferred revenue of $3.7 million and other changes in working capital of $0.4 million offset by a $1.3 million reduction in taxes payable resulting from our adoption of FAS 123R in 2006.

During 2008, we completed a restructuring plan to decrease costs by reducing our workforce across our organization and by consolidating facilities where the workforce reductions resulted in excess office space. This restructuring plan was designed to decrease costs by reducing our workforce throughout the company of approximately 200 employees.  We recorded restructuring and other charges and made payments of $2.0 million during fiscal 2008.  As a result of the continued deterioration in the economic environment during the first quarter of 2009, we executed an additional reduction in force resulting in the elimination of approximately 159 employees, as a result we incurred severance and outplacement benefit costs totaling $1.2 million.

Investing Activities

Net cash used in investing activities was $28.2 million, $18.1 million and $86.3 million for the years ended December 31, 2009, 2008 and 2007, respectively. Cash flows used in investing activities consisted primarily of adjustments for earnouts, taxes, escrow payments, acquisitions and additional capital equipment as follows:

 

		Years ended December 31,
		2009				2008				2007
Scottworks acquisition		$	—			$	0.1			$	—
Webhire acquisition			—				—				5.0
Knowledge Workers acquisition			—				0.1				—
Gantz Wiley Research acquisition			—				0.6				0.7
BrassRing acquisition			—				—				11.7
Psychometrics acquisition			—				3.4				0.3
StraightSource acquisition			3.1				2.0				9.9
HRC acquisition			0.2				0.2				2.4
Quorum acquisition			0.6				27.7				—
Investment in variable interest entity			1.1				—				—
Cash held in escrow for acquisitions			—				(1.6	)			(14.9	)
Capitalized software and purchases of computer hardware			15.3				20.8				12.7
Purchases of available-for-sale securities			14.9				20.5				133.7
Sales of available-for-sale securities			(3.7	)			(55.7	)			(75.2	)
Sales of trading securities			(3.3	)			—				—
Total Cash flows from investing activities		$	28.2			$	18.1			$	86.3

 

56

---

 

Financing Activities

Net cash used in financing activities was $0.2 million and $29.7 million for the years ended December 31, 2009 and 2008, respectively.  Net cash provided by financing activities was $42.3 million for the year ended December 31, 2007.

For the year ended December 31, 2009, net cash used in financing activity resulted primarily from our variable interest entity of $0.2 million, repayments of capital lease obligations and notes payable of $0.4 million, partially offset by net proceeds from stock option exercises of $0.1 million, and share issuance from our employee stock purchase plan of $0.3 million.

For the year ended December 31, 2008, net cash used in financing activity resulted primarily from repurchases of our common shares of $30.3 million, repayments of capital lease obligations and notes payable of $0.3 million, partially offset by net proceeds from stock option exercises of $0.4 million, excess tax benefits from share-based payment arrangements of $0.2 million, and share issuance from our employee stock purchase plan of $0.3 million.

For the year ended December 31, 2007, net cash provided by financing activity resulted primarily from net proceeds from our public offering of $130.4 million, net proceeds from stock option exercises of $1.6 million, excess tax benefits from share-based payment arrangements of $1.3 million, share issuance from our employee stock purchase plan of $0.2 million, partially offset by deferred financing costs of $0.1 million, repayments of borrowings under our line of credit of $65.0 million, repurchases of our common shares of $25.5 million, repayments of capital lease obligations of $0.2 million, and net repayments of notes payable of $0.4 million.

 

57

---

 

Unaudited Quarterly Statements of Operations

 

		Consolidated Statements of Operations
		For the Three Months Ended
		December 31, 2009				September 30, 2009				June 30,  2009				March 31, 2009				December 31, 2008				September 30, 2008				June 30, 2008				March 31, 2008
		(unaudited and in thousands, except per share data)
Revenues:
Subscription revenue		$	33,327			$	33,221			$	34,041			$	33,265			$	37,565			$	43,031			$	43,668			$	39,156
Other revenue			5,732				7,093				5,424				5,566				7,493				10,995				12,773				9,051
Total revenues			39,059				40,314				39,465				38,831				45,058				54,026				56,441				48,207
Cost of revenues			12,909				13,129				13,637				13,696				14,854				16,461				17,173				13,105
Gross profit			26,150				27,185				25,828				25,135				30,204				37,565				39,268				35,102
Operating expenses:
Sales and marketing			9,153				9,083				8,241				8,705				9,605				10,298				10,988				9,889
General and administrative			9,829				10,182				9,917				10,873				11,397				12,649				12,845				11,993
Research and development			2,200				2,453				2,536				2,568				2,950				3,756				4,307				4,542
Depreciation and amortization			4,180				3,582				3,274				3,228				3,322				3,337				3,278				2,151
Restructuring charges			—				—				—				—				1,979				—				—				—
Goodwill impairment charge			—				—				—				33,329				167,011				—				—				—
Total operating expenses			25,362				25,300				23,968				58,703				196,264				30,040				31,418				28,575
Income (loss) from operations			788				1,885				1,860				(33,568	)			(166,060	)			7,525				7,850				6,527
Interest income (expense), net			142				(28	)			(221	)			63				179				255				320				641
(Loss) gain on change in fair market value of ARS and put option, net			(66	)			102				247				(295	)			—				—				—				—
Income (loss) before income tax			864				1,959				1,886				(33,800	)			(165,881	)			7,780				8,170				7,168
Income tax expense (benefit)			509				361				575				482				(45,026	)			2,356				2,205				2,394
Net income (loss)		$	355			$	1,598			$	1,311			$	(34,282	)		$	(120,855	)		$	5,424			$	5,965			$	4,774
Income allocated to noncontrolling interests			(61	)			—				—				—				—				—				—				—
Net income (loss) available to common shareholders’			294			$	1,598			$	1,311			$	(34,282	)		$	(120,855	)		$	5,424			$	5,965			$	4,774
Net income (loss) per share - basic		$	0.01			$	0.07			$	0.06			$	(1.52	)		$	(5.36	)		$	0.24			$	0.26			$	0.20
Net income (loss) per share - diluted		$	0.01			$	0.07			$	0.06			$	(1.52	)		$	(5.36	)		$	0.24			$	0.26			$	0.20

 

58

---

 

In accordance with FASB ASC 605, “Revenue Recognition-Multiple Element Arrangements”, the Company applies FASB ASC 350, “Intangibles-Goodwill and Other, Internal-Use Software”.  The costs incurred in the preliminary stages of development are expensed as incurred. Once an application has reached the development stage, internal and external costs, if direct and incremental, are capitalized until the software is substantially complete and ready for its intended use. Capitalization ceases upon completion of all substantial testing. The Company also capitalizes costs related to specific upgrades and enhancements when it is probable the expenditures will result in additional functionality.  Maintenance and training costs are expensed as incurred. Internal use software is amortized on a straight-line basis over its estimated useful life, generally three years.  Management evaluates the useful lives of these assets on an annual basis and tests for impairments whenever events or changes in circumstances occur that could impact the recoverability of these assets. There were no impairments to internal software in any of the periods covered in these consolidated financial statements.

The Company capitalized internal-use software costs for the years ended December 31, 2009, 2008 and 2007 of $9,665, $8,137 and $3,321, respectively. Amortization of capitalized internal-use software costs for the years ended December 31, 2009, 2008 and 2007 was $3,623, $1,629 and $1,163, respectively.

 

74

---

 

 

Kenexa Corporation and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

(All amounts in thousands, except share and per share data, unless noted otherwise)

2. Summary of Significant Accounting Policies (continued)

Goodwill

Since 2002, the Company has recorded goodwill in accordance with the provisions of FASB ASC, 350, “Intangibles-Goodwill and Other”, which discontinued the amortization of existing goodwill and instead requires the Company to annually review the carrying value of goodwill for impairment. Prior to 2007, the Company evaluated the carrying value of its goodwill under two reporting units within its single segment.  During 2007, the Company combined those two reporting units into a single reporting unit to be in alignment with its organizational and management structure which was evaluated and restructured as part of the integration of our acquired businesses.  As a result, in 2007 and 2008 goodwill was evaluated at the enterprise or Company level.  Following its investment in the variable interest entity in China in 2009, the Company reverted back to evaluating the carrying value of goodwill under two reporting units within a single segment.  The Company conducted its 2009 annual evaluation of goodwill for impairment and determined that there was no impairment at October 1, 2009 and December 31, 2009.

Due to a downward revision in internal projections, continued adverse changes in the economic climate, a decline in the Company’s market capitalization of 49.5% from October 1, 2008 (the Company’s annual testing date) through December 31, 2008 and an additional 32.5% from December 31, 2008 through March 31, 2009.  These events signified triggering events and required the determination as to whether, and to what extent, the Company’s goodwill may have been impaired.  As a result, the Company completed in consecutive quarters its goodwill impairment analyses during the year ended December 31, 2008 and the quarter ended March 31, 2009.

The first step of each analysis required the estimation of fair value of the Company and was calculated primarily based on the observable market capitalization with a range of estimated control premiums as well as discounted future estimated cash flows. This step yielded an estimated fair value of the Company which was less than the Company’s carrying value (including goodwill) at each test date, December 31, 2008 and March 31, 2009. The next step entailed performing an analysis to determine whether the carrying amount of goodwill on the Company’s balance sheet exceeded its implied fair value. The implied fair value of the Company’s goodwill for this step was determined in a similar manner as goodwill recognized in a business combination. That is, the estimated fair value of the Company was allocated to its assets and liabilities, including any unrecognized identifiable intangible assets, as if the Company had been acquired in a hypothetical business combination with the estimated fair value of the Company representing the price paid to acquire it. The allocation process performed on each test date was only for purposes of determining the implied fair value of goodwill with no assets or liabilities written up or down, nor any additional unrecognized identifiable intangible assets recorded as part of this process. Based on these analyses, management recorded goodwill impairment charges of $167,011 for the quarter and year ended December 31, 2008 and $33,329 for the quarter ended March 31, 2009. The goodwill impairment charges had no effect on the Company’s cash balances.

 

75

---

 

 

Kenexa Corporation and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

(All amounts in thousands, except share and per share data, unless noted otherwise)

The changes in the carrying amount of goodwill, which include adjustments for earnouts, taxes, escrow adjustments, acquisitions, variable interest entity and impairment charges, for the years ended December 31, 2009, 2008 and 2007 are as follows:

Balance as of December 31, 2006		$	143,371
Acquisitions or adjustments:
Webhire			7,942
Knowledge Workers			(796	)
Gantz Wiley Research			(81	)
BrassRing			13,059
Psychometrics Services Ltd.			516
StraightSource (2007 acquisition)			5,700
HRC Human Resources Consulting GmbH (2007 acquisition)			3,791
Balance as of December 31, 2007		$	173,502
Acquisitions or adjustments:
ScottWorks			85
Webhire			311
Knowledge Workers			100
Gantz Wiley Research			398
BrassRing			(121	)
Psychometrics Services Ltd.			3,383
StraightSource			6,051
HRC Human Resources Consulting GmbH			330
Quorum International Holding Limited (2008 acquisition)			15,338
Impairment charge			(167,011	)
Balance as of December 31, 2008		$	32,366
Acquisitions or adjustments:
Impairment charge			(33,329	)
StraightSource			125
HRC Human Resources Consulting GmbH			215
Quorum International Holding Limited			2,315
Shanghai Runjie Management Consulting Company (variable interest entity)			1,512
Balance as of December 31, 2009		$	3,204

Long Lived Assets

 

In connection with the Company’s goodwill impairment analysis for each of the periods ended December 31, 2009 and 2008, the Company evaluated its long-lived assets, including certain identifiable intangible assets, for potential impairment by comparing the carrying amount of any asset to future net cash flows expected to be generated by the asset, pursuant to FASB ASC 360-10-35, “Impairment or Disposal of Long-Lived Assets,” and determined that no such assets were impaired.  Given the general current economic climate, it is possible that the estimated future cash flows of the asset groupings will be reduced, which may result in an impairment in future periods.  If such assets are considered to be impaired, the impairment is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets.

 

76

---

 

 

Kenexa Corporation and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

(All amounts in thousands, except share and per share data, unless noted otherwise)

2. Summary of Significant Accounting Policies (continued)

Intangible Assets

Intangible assets consist of intellectual property, non-compete agreements, customer lists and trademarks.  Intellectual property, non-compete agreements and trademarks are amortized on a straight-line basis over their estimated useful lives or contract periods, generally ranging from 3 to 20 years. Customer lists are amortized based on the attrition rate of our customers. The amounts were based, in part, on an analysis of the incremental cash flows expected to be derived from the customer lists using historic retention rates and an appropriate discount rate. Accumulated amortization of intangible assets was $13,713, $9,443 and $4,091 as of December 31, 2009, 2008 and 2007, respectively. Amortization expense related to these intangible assets was $4,475, $5,168 and $2,412 for 2009, 2008 and 2007, respectively.

Intangible Assets subject to amortization at December 31, 2009 and 2008 consist of the following:

		Gross Carrying Value								Accumulated Amortization								Weighted Average Amortization Period (in years)
		2009				2008				2009				2008
Description
Customer lists		$	18,700			$	18,911			$	10,067			$	6,500				5.8
Intellectual property and non-compete			2,413				2,204				1,957				1,264				0.2
Trademarks			91				91				37				27				11.9
Fully amortized intangibles			1,652				1,652				1,652				1,652
Total		$	22,856			$	22,858			$	13,713			$	9,443				6.1

Intangible Assets estimated amortization expense for each of the next five years is as follows:

Year Ending December 31,		Amortization Expense
2010		$	2,897
2011			1,988
2012			1,322
2013			963
2014			671

Guarantees

The Company’s software license agreements typically provide for indemnifications of customers for intellectual property infringement claims.  The Company also warrants to customers, when requested, that the Company’s software products operate substantially in accordance with standard specifications for a limited period of time.  The Company has not incurred significant obligations under customer indemnification or warranty provisions historically, and does not expect to incur significant obligations in the future.  Accordingly, the Company does not maintain accruals for potential customer indemnification or warranty-related obligations.

 

77

---

 

 

Kenexa Corporation and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

(All amounts in thousands, except share and per share data, unless noted otherwise)

2. Summary of Significant Accounting Policies (continued)

Revenue Recognition

The Company derives its revenue from two sources: (1) subscription revenue for solutions, which is comprised of subscription fees from customers accessing the Company’s on-demand software, consulting services, outsourcing services and proprietary content, and from customers purchasing additional support beyond the standard support that is included in the basic subscription fee; and (2) other fees for discrete professional services. Because the Company provides its solutions as a service, the Company follows the provisions of FASB ASC 605-10, “Revenue Recognition” and FASB ASC 605-25 “Multiple Elements Arrangements”. We recognize revenue when all of the following conditions are met:

	•	There is persuasive evidence of an arrangement;
	•	The service has been provided to the customer;
	•	The collection of the fees is probable; and
	•	The amount of fees to be paid by the customer is fixed or determinable.

Subscription fees and support revenues are recognized on a monthly basis over the lives of the contracts. Amounts that have been invoiced are recorded in accounts receivable and in deferred revenue or revenue, depending on whether the revenue recognition criteria have been met.

Discrete professional services and other revenues, when sold with subscription and support offerings, are accounted for separately since these services have value to the customer on a stand-alone basis and there is objective and reliable evidence of fair value of the undelivered elements. The Company's arrangements do not contain general rights of return.  Additionally, when professional services are sold with other elements, the consideration from the revenue arrangement is allocated among the separate elements based upon the relative fair value.  Professional services and other revenues are recorded as follows: Consulting revenues are recognized based upon proportional performance as value is delivered to the customer.

In determining whether revenues from professional services can be accounted for separately from subscription revenue, the Company considers the following factors for each agreement: availability from other vendors, whether objective and reliable evidence of fair value exists of the undelivered elements, the nature and the timing of when the agreement was signed in comparison to the subscription agreement start date and the contractual dependence of the subscription service on the customer's satisfaction with the other services. If the professional service does not qualify for separate accounting, the Company recognizes the revenue ratably over the remaining term of the subscription contract. In these situations the Company defers the direct and incremental costs of the professional service over the same period as the revenue is recognized.

Deferred revenue represents payments received or accounts receivable from the Company's customers for amounts billed in advance of subscription services being provided.

The Company records expenses billed to customers in accordance with FASB ASC 605-45, “Revenue Recognition-Principal Agent Considerations,” which requires that reimbursements received for out-of-pocket expenses be classified as revenues and not as cost reductions.  These items primarily include travel, meals and certain telecommunication costs. For the years ended December 31, 2009, 2008 and 2007 reimbursed expenses totaled $2,218, $4,700 and $3,469, respectively.

 

78

---

 

Kenexa Corporation and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

(All amounts in thousands, except share and per share data, unless noted otherwise)

2. Summary of Significant Accounting Policies (continued)

Allowance for Doubtful Accounts

The Company records an allowance for doubtful accounts based on specifically identified amounts that management believes to be uncollectible. The Company also records an additional allowance based on certain percentages of aged receivables, which is determined based on historical experience and management's assessment of the general financial conditions affecting the Company's customer base. If actual collections experience changes, revisions to the allowance may be required. Activity in the allowance for doubtful accounts is as follows:

Year		Balance at January 1,				Bad debt expense (recoveries)				Acquired reserves				Recoveries /  (Write offs)				Balance at December 31,
2009		$	3,755			$	(400	)		$	—			$	(1,265	)		$	2,090
2008			1,158				2,702				—				(105	)			3,755
2007			975				329				—				(146	)			1,158

Share-based Compensation Expense

On January 1, 2006, the Company adopted FASB ASC 718, “Compensation-Stock Compensation using the Modified Prospective Approach” (“MPA”). The MPA requires that compensation expense be recorded for restricted stock and all unvested stock options as of January 1, 2006.  Following the adoption, the Company recognized the cost of previously granted share-based awards on a straight-line basis over the remaining vesting period.  The compensation expense for new share-based awards with a service condition that cliff vest, is recognized on a straight-line basis over the award’s requisite service period.  For those awards with a service condition that have graded vesting, compensation expense is calculated using the graded-vesting attribution method.   This method entails recognizing expense on a straight-line basis over the requisite service period for each separately vesting portion as if the grant consisted of multiple awards, each with the same service inception date but different requisite service periods.  This method accelerates the recognition of compensation expense.  In accordance with FASB ASC 718, the pool of excess tax benefits available to absorb tax deficiencies was determined using the alternative transition method.

 

Kenexa Corporation and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

(All amounts in thousands, except share and per share data, unless noted otherwise)

 

5. Variable Interest Entity

On January 20, 2009, the Company entered into an ownership interest transfer agreement (“the agreement”) with Shanghai Runjie Management Consulting Company, (“R and J”) in Shanghai, China.   In conjunction with the agreement, the Company paid $1,337 to provide an initial equity contribution and to compensate the former owners of R and J, who transferred their existing business into a new entity, Shanghai Kenexa Human Resources Consulting Co., Ltd., (the “variable interest entity”).   The initial payment provided the Company with a 46% ownership in the variable interest entity, and a presence in China’s human capital management market.   The former owners of R and J are required to transfer 1% additional ownership interests (in 1% increments up to 49% over a two year period), with consideration to be paid by the Company based upon adjusted EBITDA, as defined.  In the fourth quarter of 2009, based upon the 2008 operating results for R and J, the Company paid an additional $206 for an additional 1% ownership interest in the variable interest entity.   At December 31, 2009, the Company had a 47% ownership interest in the variable interest entity.

Consideration for the ownership interest transfer  in the third quarter was determined as the greater of 1) the amount of registered capital attributable to a 1% ownership interest or 2) an amount denominated in Chinese Yuan Renminbi (“RMB¥”) equal to the result of 47% times four and one half times the Adjusted EBITDA of the variable interest entity for the calendar year ended December 31, 2008, plus 1% of the variable interest entity’s free cash flow as of March 31, 2008, minus the amount of the initial investment or RMB¥ 8,145 or $1,224. The additional transfers of ownership interests for 2010 and 2011 will be determined formulaically the same as above and will be adjusted only for any increase in actual ownership percentage by the Company.

Under the terms of the variable interest entity agreement, the Company has the right to acquire R and J’s remaining interest in the variable interest entity at any time after the earlier of the termination of the general manager’s employment by the variable interest entity or during the first three months of any calendar year beginning on or after January 1, 2013 (call rights).  The purchase price for the remaining ownership interest is based upon the outstanding ownership interest multiplied by the sum of the amount of free cash flow plus four and one half times the Adjusted EBITDA, as defined. R and J may also require the Company to purchase its interest in the variable interest entity at any time after the earlier of the Company’s acquisition of more than fifty percent of the variable interest entity or January 1, 2011 (put rights).

In accordance with ASC 810, “Variable Interest Entities”, the new entity qualified for consolidation as it was determined to be a variable interest entity and the Company as its primary beneficiary.   The determination of the primary beneficiary was based, in part, upon a qualitative assessment which included the Company’s commitment to finance the variable interest entity’s ongoing operations, the level of involvement in the variable interest entity’s operations, the use of the Company’s brand by the variable interest entity, and the lack of equity “at risk” by R and J given its put rights.  The variable interest entity is consolidated in the Company’s financial statements because of the Company’s implicit guarantee to provide financing and as well as its significant involvement in the day-to-day operations.   The equity interests of R and J not owned by the Company are reported as a noncontrolling interest in the Company’s December 31, 2009 accompanying consolidated balance sheet.  All inter-company transactions are eliminated (see Note 2 – Summary of Significant Accounting Policies.)

The variable interest entity was financed with $307 in initial equity contributions from the Company and R and J, and has no borrowings for which its assets would be used as collateral.  Following the formation of the variable interest entity, the Company completed a valuation of the concern, which resulted in the recording of net tangible assets, intangible assets and goodwill of $314, $1,100 and $1,512, respectively in the consolidated balance sheet.   On September 30, 2009, the Company provided $160 of financing for the variable interest entity in the form of an intercompany loan.   The creditors of the variable interest entity do not have recourse to other assets of the Company.

Pursuant to ASC 480 “Distinguishing Liabilities from Equity” (formerly Emerging Issues Task Force Abstracts Topic No. D-98, “Classification and Measurement of Redeemable Securities”, due to the put rights included in the agreement, the Company has presented the estimated fair value of R and J’s 53% ownership interest in the variable interest entity amounting to $1,330 at December 31, 2009 in noncontrolling interest and classified the amount as mezzanine equity (temporary equity) on the consolidated balance sheet.

 

87

---

 

Kenexa Corporation and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

(All amounts in thousands, except share and per share data, unless noted otherwise)

6. Property, Equipment and Software

A summary of property, equipment and capitalized software and related accumulated depreciation and amortization as of December 31, 2009 and 2008 is as follows:

		December 31,
		2009				2008
Equipment		$	17,748			$	15,112
Software			28,397				13,999
Office furniture and fixtures			2,455				2,370
Leasehold improvements			2,735				2,744
Land			714				643
Building			7,828				6,771
Software in development			3,083				7,185
			62,960				48,824
Less accumulated depreciation and amortization			26,093				17,624
		$	36,867			$	31,200

Depreciation and amortization expense is excluded from cost of revenues.

Equipment and office furniture and fixtures included assets under capital leases totaling $2,621 and $2,612 at December 31, 2009 and 2008, respectively. Depreciation and amortization expense, including amortization of assets under capital leases, was $9,789, $6,920 and $5,172 for the years ended December 31, 2009, 2008 and 2007, respectively.

 

Pursuant to FASB ASC 360, “Property, Plant and Equipment,” the Company reviewed its fixed assets and determined that the fair value exceeded the carrying value, and therefore did not record any fixed asset impairment as of December 31, 2009.

 

88

---

 

Kenexa Corporation and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

(All amounts in thousands, except share and per share data, unless noted otherwise)

7. Other Accrued Liabilities

Other accrued liabilities consist of the following:

		December 31,
		2009				2008
Accrued professional fees		$	1,031			$	131
Straight line rent accrual			2,084				1,904
Other taxes payable			118				450
Income taxes payable			837				2,293
Other liabilities			1,139				1,056
Contingent purchase price			1,167				3,000
Total other accrued liabilities		$	6,376			$	8,834

8. Line of Credit

On May 21, 2009, based upon its current liquidity needs, the Company elected not to renew its secured credit agreement with PNC Bank, as administrative agent, and several other lenders named therein (the “Credit Agreement”). The Credit Agreement, which became effective November 13, 2006, provided (i) a $50 million revolving credit facility, including a sublimit of up to $2 million for letters of credit and (ii) a $50 million term loan.  The Company and each of its U.S. subsidiaries guaranteed the obligations of the Company under the Credit Agreement.  The Credit Agreement also required the Company to pay a monthly commitment fee based on the unused portion of the revolving credit facility.  At May 21, 2009, the Company had no outstanding balance on the Credit Agreement. Unless renewed, the Credit Agreement would have expired on its own terms on March 26, 2010.  No early termination penalties were incurred in connection with the termination of the Credit Agreement.  In connection with the termination of the Credit Agreement, the Company wrote off $289 of deferred financing fees during the quarter ended June 30, 2009.  As a result of the termination of the Credit Agreement, the Company does not have a revolving credit facility or other debt financing arrangement.

  

89

---

 

Kenexa Corporation and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

(All amounts in thousands, except share and per share data, unless noted otherwise)

9.    Income Taxes

		For the years ended December 31,
		2009				2008				2007
Current
Federal		$	417			$	4,542			$	4,866
Foreign			1,080				2,777				308
State and local			853				616				422
Total current		$	2,350			$	7,935			$	5,596
Deferred
Federal		$	378			$	(39,325	)		$	3,517
Foreign			(811	)			(696	)			836
State and local			10				(5,985	)			630
Total deferred			(423	)			(46,006	)			4,983
Total income tax (benefit) provision		$	1,927			$	(38,071	)		$	10,579

A reconciliation of the Company’s effective income tax rate to the U.S. statutory federal income tax rate of 35% is as follows:

		For the years ended December 31,
		2009				2008				2007
U.S. statutory federal tax rate			(35.0	)%			(35.0	)%			35.0	%
Foreign tax differential			0.8	%			(1.9	)%			(1.5	)%
Domestic production deduction			—	%			—	%			(0.5	)%
Nondeductible goodwill impairment			15.8	%			12.1	%			—	%
State income taxes			(1.6	)%			(2.4	)%			2.0	%
Officer’s life insurance			—	%			—	%			0.1	%
Other nondeductible expenses			0.5	%			0.1	%			0.7	%
Change in valuation allowance			23.9	%			0.5	%			—	%
Research and development credit			(0.9	)%			(0.4	)%			(2.7	)%
Non-taxable interest			(0.5	)%			(0.3	)%			(3.2	)%
Provision to return true-up			3.7	%			0.6	%			1.1	%
Income tax (benefit) expense			6.7	%			(26.7	)%			31.0	%

 

90

---

 

Kenexa Corporation and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

(All amounts in thousands, except share and per share data, unless noted otherwise)

9.    Income Taxes (continued)

		December 31,
		2009				2008
Deferred tax assets
Foreign net operating loss carryforwards		$	2,129			$	2,209
Accrued expenses			879				43
Federal and state net operating loss carryforwards			1,397				877
AMT tax carryforward			166				166
Deferred revenue			6,616				3,178
Accounts receivable allowance			514				799
Stock options			5,927				4,092
Depreciation and amortization			—				1,636
Goodwill			38,379				36,309
Capitalized R&D tax credits			314				262
Section 481(a) adjustment			549				361
Other			60				121
Total deferred tax assets		$	56,930			$	50,053
Deferred tax liabilities
Capitalized R&D			(3,648	)			(423	)
Other accrued expenses			(333	)			(481	)
Depreciation and amortization			(1,493	)			—
Amortization of intangibles and goodwill			(1,282	)			(5,529	)
Total deferred tax liabilities			(6,756	)			(6,433	)
Net deferred tax asset			50,174				43,620
Valuation allowance			(7,460	)			(1,329	)
Net deferred tax asset (liability)		$	42,714			$	42,291

 

 

91

---

 

 

Kenexa Corporation and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

(All amounts in thousands, except share and per share data, unless noted otherwise)

9.    Income Taxes (continued)

 

At December 2009, the Company has remaining Federal net operating loss carryforwards from acquisitions of $2,021 with an expiration date of 2025. These acquired operating loss carryovers are subject to Internal Revenue Code section 382 loss limitations. The Company also has $11,342 of state net operating loss carryovers available from domestic affiliates and $8,546 of net operating loss carryovers available from foreign affiliates.  These state losses have various expiration dates not in excess of 20 years while the foreign losses have no expiration date.  Based on the uncertainty of fully utilizing these NOLs the Company has recorded valuation allowances as of December 31, 2009 of $4,567, $1,561 and $1,332 for Federal, state and foreign purposes, respectively.  In 2009, the Company released $838 of its foreign valuation allowance and simultaneously wrote off a fully reserved acquired foreign net operating loss that was determined to be nondeductible.

 

At December 2008, the Company has remaining Federal net operating loss carryforwards from acquisitions of $2,253 with an expiration date of 2025. The Company also has net operating loss carryforwards available from foreign acquisitions of $7,731.  These losses have no expiration date.  Based on the uncertainty of fully utilizing these NOLs the Company has recorded a valuation allowance as of December 31, 2008 of $4,417.  The Company also has state NOL carryforwards of $2,266.

 

Activity in the valuation allowance account for the years ended December 31, 2009, 2008 and 2007 is presented in the table below:

		Beginning Balance				Increase in valuation allowance				Acquired valuation allowance				Release of valuation allowance				338g election				Ending Balance
2009		$	(1,329	)		$	(6,969	)		$	—			$	838			$	—			$	(7,460	)
2008			(653	)			—				(676	)			—				—				(1,329	)
2007			(12,634	)			—				(653	)			796				11,838				(653	)

 

The determination of the level of valuation allowance at December 31, 2009 is based on an estimated forecast of future taxable income which includes many judgments and assumptions primarily related to revenue, margins, operating expenses, tax planning strategies and tax attributes in multiple taxing jurisdictions.  Accordingly, it is at least reasonably possible that future changes in one or more of these assumptions may lead to a change in judgment regarding the level of valuation allowance required in future periods.

 

In 2005, the Company was granted a tax holiday from the government of India for its development center located in Hyderabad, India.  This tax holiday was granted for a five year period, was subsequently extended via statute for an additional year and is scheduled to expire in 2010.  The income tax benefit on this holiday is $83, $65 and $362 in 2009, 2008 and 2007, respectively. In 2008, the Company was granted a separate tax holiday from the Indian government covering the activities of its new development center in Vizag, India.  This tax holiday was granted for a period of 10 years and will expire in 2018.  The income tax benefit on this holiday is $236 and $309 in 2009 and 2008, respectively.

 

92

---

 

 

Kenexa Corporation and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

(All amounts in thousands, except share and per share data, unless noted otherwise)

9.    Income Taxes (continued)

 

The Company does not provide for U.S. deferred income taxes or tax benefits on the undistributed earnings or losses of its non-U.S. subsidiaries because earnings are permanently reinvested and, in the opinion of management, will continue to be reinvested indefinitely. At December 31, 2009, the Company had not provided for deferred income tax expense for cumulative income of individual international subsidiaries of $18,202.  Should these earnings be distributed in the form of dividends or otherwise, the Company would be subject to both U.S. income taxes and withholding taxes in various international jurisdictions. Determination of the related amount of unrecognized deferred U.S. income tax liability is not practicable because of the complexities associated with its hypothetical calculation.  In the event of the repatriation of foreign earnings, the Company believes that it would be in a position to claim sufficient foreign tax credits for U.S. federal income taxes purposes to offset a significant amount of potential tax liability.

During the third quarter of 2009, the Internal Revenue Service completed its examination of the Company’s federal income tax returns for the years 2006 and 2007 and issued a final Revenue Agent’s Report (RAR.)  The Company agreed with all of the adjustments contained in the RAR and during the fourth quarter of 2009, received written notification from the IRS that the final examination report had been accepted.  The resolution of the examination resulted in the disallowance of tax credits previously claimed by the Company, the loss of which did not have a material impact on the financial condition of the Company.

During 2007, the Company filed separate elections under Section 338(g) of the Internal Revenue Code to treat the acquisitions of Webhire and BrassRing as the purchase of assets for tax purposes. These elections allow the tax basis in acquired assets to be valued at their relative fair market values on the respective dates of purchase.  As a result of these elections, certain deferred tax assets of Webhire and BrassRing totaling $2,942 and $342, respectively were reduced and reclassified to goodwill following the elimination of certain tax attributes, including previously recorded net operating loss carryforwards.

The amount of unrecognized tax benefits as of December 31, 2009, determined in accordance with the provisions of ACS 740 increased by $634.  A reconciliation of the beginning and ending amounts of unrecognized tax benefits is as follows:

Beginning Balance December 31, 2007		$	—
Additions for tax positions			1,256
Ending balance December 31, 2008		$	1,256
Additions based on tax positions related to the current year			844
Reductions for positions of prior years, including impacts due to a lapse in statute			(11	)
Settlements			(199	)
Ending balance December 31, 2009		$	1,890

 

The additions to the unrecognized tax benefits related to the current and prior years are primarily attributable to various transfer pricing and related valuation matters, certain tax incentives and credits, acquisition matters, apportionment of state taxable income and other foreign matters.  The settlements and reductions to the unrecognized tax benefits for tax positions of prior years are primarily attributable to the conclusion of the IRS examination.  The liability of $1,890 can be reduced by $195 of offsetting tax benefits associated with the correlative effects of potential transfer pricing adjustments, state income taxes and timing adjustments.  The net amount of $1,695, if recognized, would have a favorable impact on the Company’s effective tax rate.

Our policy is to recognize interest and penalties on unrecognized tax benefits in the provision for income taxes in the consolidated statements of operations.  During the year ended December 31, 2009, the Company recognized $69 in interest and penalties, and in 2008, the Company recognized $101 in interest and penalties.

With certain limited exceptions, the Company is no longer subject to U.S. federal income tax audits for tax years through 2007 and state and local or non-U.S. income tax audits by taxing authorities for tax years through 2004.  However, net operating loss and tax credit carryovers from all years continue to be subject to examinations and adjustments for at least three years following the year in which the attributes are used.  The Company is currently under examination by certain state taxing authorities for tax years 2005 and 2006.  Although the outcome of tax audits is difficult to predict with certainty, the Company believes that adequate amounts of tax and interest have been provided for any adjustments that may result from tax examinations.

 

93

---

 

 

Kenexa Corporation and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

(All amounts in thousands, except share and per share data, unless noted otherwise)

10. Commitments and Contingencies

Leasing Arrangements

The Company leases certain of its facilities and equipment under various operating and capital leases. Equipment under capital leases consists primarily of computer equipment and furniture and fixtures. These leases generally have terms of three to five years, bear interest up to 13.0% per annum and are collateralized by the underlying equipment. Operating leases primarily consist of leases for office space and equipment. Future minimum lease payments for each of the following five years are:

		Capital Leases				Operating Leases
2010		$	215			$	7,532
2011			204				5,164
2012			57				3,789
2013			—				2,624
2014			—				1,687
Total minimum lease payments		$	476			$	20,796
Less amount representing interest			6
Present value of minimum payments under capital leases			470
Less current portion			211
		$	259

Rent expense was $7,496, $7,174 and $5,824 for the years ended December 31, 2009, 2008 and 2007, respectively.  Most of the Company’s capital and operating leases contain automatic renewal terms, bargain purchase options or escalation clauses but the leases are expensed on a straight-line basis.

Severance arrangement

On November 26, 2006, the Company entered into a separation agreement and general release with its former Chief Operating Officer who resigned from his positions as an officer and a director of the Company and each of its subsidiaries, effective on the close of business on November 30, 2006.  The separation agreement provided that the Company continue to pay the former officer his base salary of $250 per year through November 29, 2008.  In addition, until May 29, 2010, the Company will provide the former officer with continued participation in the medical insurance coverage plans of the Company, or the economic equivalent of the employer portion of the premium for such plans.  Pursuant to the separation agreement, the former officer received $397 under the Company’s 2006 bonus plan.  In addition, previously unvested options to purchase 28,333 shares of the Company’s common stock held by the former officer became immediately exercisable, and all other unvested stock options granted to the former officer by the Company were forfeited on the separation date.

Also, pursuant to the separation agreement, the former officer provided the Company and its subsidiaries and affiliates with a general release, and the former officer agreed to certain restrictive covenants, including confidentiality and non-disparagement, and non-competition and non-solicitation for a period of two years after the separation date, as such, the company recognized the severance expense over the non compete term.

 

94

---

 

 

Kenexa Corporation and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

(All amounts in thousands, except share and per share data, unless noted otherwise)

10. Commitments and Contingencies (continued)

Litigation

On August 27, 2007, a complaint was filed and served by Kenexa BrassRing, Inc. against Taleo Corporation in the United States District Court for the District of Delaware.  Kenexa alleges that Taleo infringed Patent Nos. 5,999,939 and 6,996,561, and seeks monetary damages and an order enjoining Taleo from further infringement.

On May 9, 2008, Kenexa BrassRing, Inc. filed a similar lawsuit against Vurv Technology, Inc. in the United States District Court for the District of Delaware, alleging that Vurv has infringed Patent Nos. 5,999,939 and 6,996,561, and seeks monetary damages and an order enjoining further infringement.  This lawsuit has been consolidated with the Kenexa BrassRing, Inc. versus Taleo Corporation lawsuit.

On June 25, 2008, Kenexa Technology, Inc. filed suit in the United States District Court of Delaware against Taleo Corporation for tortious interference with contract, unfair competition, unfair trade practices and unjust enrichment. On August 28, 2009, Taleo filed an amended answer and counterclaim against Kenexa BrassRing, Inc. asserting copyright infringement against Kenexa by the users accessing the Taleo system on behalf of Kenexa’s recruitment process outsourcing customers. Kenexa seeks monetary damages and to enjoin the actions of Taleo.  Taleo seeks monetary damages and to enjoin the actions of Kenexa.

On November 7, 2008, Vurv Technology LLC, sued Kenexa Corporation, Kenexa Technology, Inc., and two former employees of Vurv, who now work for Kenexa , in the United States District Court for the Northern District of Georgia.  In this action, Vurv asserts claims for breach of contract, computer trespass and theft, misappropriation of trade secrets, interference with contract and civil conspiracy.   Vurv seeks unspecified monetary damages and injunctive relief.

On June 11, 2009 and July 16, 2009, two putative class actions were filed against Kenexa Corporation and our Chief Executive Officer and Chief Financial Officer in the United States District Court for the Eastern District of Pennsylvania, purportedly on behalf of a class of our investors who purchased our publicly traded securities between May 8, 2007 and November 7, 2007. The complaint filed on July 16, 2009 has since been voluntarily dismissed.  In the pending action, Building Trades United Pension Trust Fund, individually and on behalf of all others similarly situated alleges violations of Section 10(b) of the Securities Exchange Act of 1934 ("Exchange Act"), Rule 10b-5 promulgated thereunder and Section 20(a) of the Exchange Act in connection with various public statements made by Kenexa.  This action seeks unspecified damages, attorneys’ fees and expenses.

On July 17, 2009, Kenexa BrassRing, Inc. and Kenexa Recruiter, Inc. filed suit against Taleo Corporation, a current Taleo employee and a former Taleo employee in Massachusetts Superior Court.   Kenexa amended the complaint on August 27, 2009 and added Vurv Technology LLC, two former employees of Taleo and two current employees of Taleo.   Kenexa asserts claims for breach of contract and the implied covenant of good faith and fair dealing, unfair trade practices, computer theft, misappropriation of trade secrets, tortious interference, unfair competition, and unjust enrichment.  Kenexa seeks monetary damages and injunctive relief.

The Company is involved in claims, including those identified above, which arise in the ordinary course of business. In the opinion of management, the Company has made adequate provision for potential liabilities, if any, arising from any such matters.  However, litigation is inherently unpredictable, and the costs and other effects of pending or future litigation, governmental investigations, legal and administrative cases and proceedings (whether civil or criminal), settlements, judgments and investigations, claims and changes in any such matters, could have a material adverse effect on the Company’s business, financial condition and operating results.

 

95

---

 

 

Kenexa Corporation and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

(All amounts in thousands, except share and per share data, unless noted otherwise)

Rollforward of Shares

The Company’s common shares issued and repurchased during the years ended December 31, 2009, 2008 and 2007 are as follows:

		Common Shares
		Class A
December 31, 2006 ending balance			20,897,777
Repurchase of shares			(1,448,091	)
Shares issued in public offering			4,312,500
Stock option exercises			136,673
Employee Stock Purchase Plan			10,152
Restricted shares issued			16,200
Shares issued for acquisition			107,235
December 31, 2007 ending balance			24,032,446
Repurchase of shares			(1,677,560	)
Stock option exercises			67,021
Employee Stock Purchase Plan			27,141
Shares issued for earnout			55,876
December 31, 2008 ending balance			22,504,924
Stock option exercises			14,747
Employee Stock Purchase Plan			42,212
December 31, 2009 ending balance			22,561,883

Refer to the accompanying consolidated statements of shareholders’ equity and this note for further discussion.

 

96

---

 

 

Kenexa Corporation and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

(All amounts in thousands, except share and per share data, unless noted otherwise)

11. Equity (continued)

Stock and Voting Rights

Undesignated Preferred Stock

The Company has 10,000,000 shares of $0.01 par value undesignated preferred stock authorized, with no shares issued or outstanding at December 31, 2009 or 2008. These shares have preferential rights in the event of liquidation and payment of dividends.

Common Stock

At December 31, 2009 and 2008, the Company had 100,000,000 authorized shares of common stock.  At December 31, 2009 and 2008 22,561,883 and 22,504,924 shares of common stock respectively, were outstanding.  Each share of common stock has one-for-one voting rights.

Authorized but not issued shares

On November 8, 2007, our board of directors authorized a stock repurchase plan providing for the repurchase of up to 2,000,000 shares of our common stock, of which 1,448,091 shares were repurchased at an aggregate cost of $25,482 as of December 31, 2007.  These shares were restored to original status prior to December 31, 2007 and accordingly are presented as authorized but not issued.  The timing, price and volume of repurchases were based on market conditions, relevant securities laws and other factors.  As of December 31, 2007 the amount of shares available for repurchase under the stock repurchase plan was 551,909.  Through January 24, 2008, the remaining 551,909 shares available for repurchase under the stock repurchase plan were repurchased at an aggregate cost of $9,848.

On February 20, 2008, our board of directors authorized a stock repurchase plan providing for the repurchase of up to 3,000,000 shares of the Company’s common stock, of which 1,125,651 shares were repurchased at an aggregate cost of $20,429 as of December 31, 2008.  These shares were restored to original status prior to December 31, 2008 and accordingly are presented as authorized but not issued.  The timing, price and volume of repurchases were based on market conditions, relevant securities laws and other factors.  As of December 31, 2008 the amount of shares available for repurchase under the stock repurchase plan was 1,874,349.  For the year ended, December 31, 2009 no repurchases were made under the stock repurchase plan.

 

97

---

 

 

Kenexa Corporation and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

(All amounts in thousands, except share and per share data, unless noted otherwise)

12. Stock Plans

Stock Option Plan

The Company’s 2005 Equity Incentive Plan (the “2005 Option Plan”), which was adopted by the Company’s Board of Directors (the “Board”) in March 2005 and was approved by the Company’s shareholders in June 2005, provides for the granting of stock options to employees and directors at the discretion of the Board or a committee of the Board.  The 2005 Option Plan replaced the Company’s 2000 Stock Option Plan (the “2000 Option Plan”).  The purpose of stock options is to recognize past services rendered and to provide additional incentive in furthering the continued success of the Company.  Stock options granted under both the 2005 Option Plan and the 2000 Stock Option Plan expires between the fifth and tenth anniversary of the date of grant and generally vest on the third anniversary of the date of grant.  Unexercised stock options may expire up to 90 days after an employee's termination for options granted under the 2000 Option Plan.

As of December 31, 2009, there were options to purchase 3,173,907 shares of common stock outstanding under the 2005 Option Plan.  The Company is authorized to issue up to an aggregate of 4,842,910 shares of its common stock pursuant to stock options granted under the 2005 Option Plan. As of December 31, 2009, there were a total of 1,031,506 shares of common stock not subject to outstanding options and available for issuance under the 2005 Option Plan.

FASB ASC 718, “Compensation-Stock Compensation”, requires companies to estimate the fair value of share-based payment awards on the date of grant using an option-pricing model.  In 2009 and 2008, the fair value of each grant was estimated using the Black-Scholes valuation model.  Expected volatility was based upon a weighted average of peer companies and the Company’s stock volatility.  The expected life was determined based upon an average of the contractual life and vesting period of the options.  The estimated forfeiture rate was based upon an analysis of historical data.   The risk-free rate was based on U.S. Treasury zero coupon bond yields for periods commensurate with the expected term at the time of grant.

Compensation expense, for awards with a service condition that cliff vest, is recognized on a straight-line basis over the award’s requisite service period.   For those awards with a service condition that have a graded vest, compensation expense is calculated using the graded-vesting attribution method.   This method entails recognizing expense on a straight-line basis over the requisite service period for each separately vesting portion as if the grant consisted of multiple awards, each with the same service inception date but different requisite service periods.  This method accelerates the recognition of compensation expense.

The fair value of market based, performance vesting share awards granted is calculated using a Monte Carlo valuation model that simulates various potential outcomes of the option grant and values each outcome using the Black-Scholes valuation model which yields a fair market value of the Company's common stock on the date of the grant (measurement date).  This amount is recognized over the vesting period, using the straight-line method. Since the award requires both the completion of 4 years of service and the share price reaching predetermined levels as defined in the option agreement, compensation cost will be recognized over the 4 year explicit service period.  If the employee terminates prior to the four-year requisite service period, compensation cost will be reversed even if the market condition has been satisfied by that time. The total grant date fair value of the options granted during 2008 using the Monte Carlo valuation model was $1,026.

98

---

 

Kenexa Corporation and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

(All amounts in thousands, except share and per share data, unless noted otherwise)

12. Stock Plans (continued)

The following table provides the assumptions used in determining the fair value of the market and service based awards for the year ended December 31, 2009, 2008 and 2007, respectively.

		Years ended December 31,
		2009				2008				2008				2007
		Service based awards				Service based awards				Market based awards				Service based awards
Expected volatility			62.70 – 69.38	%			56.23 – 57.52	%			60.98	%			47.26 – 54.95	%
Expected dividends			0				0				0				0
Expected term (in years)			3 - 6.25				3.75				10				4 – 5
Risk-free rate			1.36 - 3.09	%			1.87 – 2.77	%			3.45	%			2.5 – 4.6	%

A summary of the status of the Company’s stock options as of December 31, 2009 and 2008 and changes during the period then ended is as follows:

		Options & Restricted Stock Outstanding												Options Exercisable
		Shares available for Grant				Shares				Wtd. Avg. Exercise Price				Shares				Wtd. Avg. Exercise Price
Balance at December 31, 2007			2,702,346				1,601,035			$	21.18				241,335			$	14.96
Granted – options			(1,084,600	)			1,084,600				11.87				—				—
Exercised options and vested restricted stock			—				(83,221	)			4.41				—				—
Forfeited or expired			114,760				(114,760	)			29.28				—				—
Balance at December 31, 2008			1,732,506				2,487,654			$	17.33				447,854			$	14.01
Granted – options			(756,000	)			756,000				6.12				—				—
Exercised options			—				(14,747	)			4.72				—				—
Forfeited or expired			55,000				(55,000	)			22.76				—				—
Balance at December 31, 2009			1,031,506				3,173,907			$	14.63				696,407			$	17.68

The total intrinsic value of options outstanding, exercisable and exercised as of and for the period ended December 31, 2009 was $10,758, $750 and $116, respectively.  The weighted average fair value for options granted during the period ended December 31, 2009, 2008 and 2007 was $3.50, $5.67 and $14.91, respectively.  The weighted-average remaining contractual term of options outstanding and exercisable at December 31, 2009 was 5.53 and 2.97, respectively.

Between January 1, 2009 and December 31, 2009, the Company granted options to certain employees to purchase an aggregate of 756,000 shares of the Company's common stock at a weighted exercise price of $6.12 per share. The Company granted the options at prevailing market prices ranging from $4.74 to $13.38 per share.

Between January 1, 2008 and December 31, 2008, the Company granted options to certain employees to purchase an aggregate of 1,084,600 shares of the Company's common stock at a weighted exercise price of $11.87 per share. The Company granted the options at prevailing market prices ranging from $5.11 to $21.80 per share.

Between January 1, 2007 and December 31, 2007, the Company granted options to certain employees to purchase an aggregate of 539,400 shares of the Company's common stock at a weighted exercise price of $35.40 per share. The Company granted the options at prevailing market prices ranging from $29.94 to $36.87 per share.

On August 14, 2007, the Company granted to each non-employee member of the Board of Directors 2,700 shares of restricted stock, or, an aggregate of 16,200 shares of restricted stock, which vested on May 19, 2008.  The grant date fair value of the restricted stock was $31.46.

 

99

---

 

 

Kenexa Corporation and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

(All amounts in thousands, except share and per share data, unless noted otherwise)

12. Stock Plans (continued)

The following table summarizes information about stock options outstanding at December 31, 2009:

		Options Outstanding												Options Exercisable
Range of Exercise Prices		Number Outstanding				Weighted Average Remaining Contract Life (Years)				Weighted Average Exercise Price				Number Exercisable				Weighted Average Exercise Price
$3.68 - $7.37			1,194,051				8.65			$	4.91				81,051			$	4.62
$7.38 - $11.06			152,000				5.44			$	9.38				—			$	—
$11.07 - $14.74			640,856				5.12			$	12.51				197,856			$	13.52
$14.75 - $18.43			102,000				1.41			$	17.51				102,000			$	17.51
$18.44 - $22.12			527,000				2.99			$	19.27				201,500			$	19.66
$25.80 - $29.49			32,000				1.45			$	27.25				32,000			$	27.25
$29.50 - $33.18			103,000				3.92			$	31.99				82,000			$	32.22
$33.19 - $36.87			423,000				2.25			$	35.50				—			$	—
$3.68 - $36.87			3,173,907				5.53			$	14.63				696,407			$	17.68

As of December 31, 2009, there was $3,941 of total unrecognized compensation cost related to unvested share-based compensation arrangements granted under the 2005 Option Plan.  That cost is expected to be recognized over a weighted-average period of 1.47 years.

A summary of the status of the Company’s unvested share options and restricted stock as of December 31, 2009 and 2008 is presented below:

Unvested Shares		Shares				Wtd. Avg.  Grant Date  Fair Value
Unvested at December 31, 2007			1,359,700			$	10.73
Granted - options			1,084,600				5.67
Vested			(293,000	)			8.98
Forfeited or expired			(111,500	)			12.31
Unvested at December 31, 2008			2,039,800			$	8.24
Granted - options			756,000				3.50
Vested			(279,000	)			9.21
Forfeited or expired			(39,300	)			11.11
Unvested at December 31, 2009			2,477,500			$	6.34

In accordance with FASB ASC 718, “Compensation-Stock Compensation,” excess tax benefits, associated with the expense recognized for financial reporting purposes, realized upon the exercise of stock options are presented as a financing cash inflow rather than as a reduction of income taxes paid in our consolidated statement of cash flows.  In addition, the Company classifies share-based compensation within cost of revenues, sales and marketing, general and administrative expenses and research and development corresponding to the same line as the cash compensation paid to respective employees, officers and non-employee directors.

 

100

---

 

 

Kenexa Corporation and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

(All amounts in thousands, except share and per share data, unless noted otherwise)

12. Stock Plans (continued)

The following table shows total share-based compensation expense included in the accompanying Consolidated Statement of Operations:

		Year ended December 31,
		2009				2008				2007
Cost of revenues		$	369			$	341			$	391
Sales and marketing			1,092				961				1,006
General and administrative			3,456				4,032				2,204
Research and development			447				427				192
Pre-tax share-based compensation		$	5,364			$	5,761			$	3,793
Income tax benefit			1,391				1,813				1,407
Share-based compensation expense, net		$	3,973			$	3,948			$	2,386

Employee Stock Purchase Plan