UNITED STATES
 SECURITIES AND EXCHANGE COMMISSION
 Washington, D.C.  20549
 
 ____________
 
 FORM 10-Q
 
 (Mark One)
 
 R
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
 For the quarterly period ended June 30, 2009
 
 Or
 
 o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
 For the transition period from ____________to____________
 
 Commission File Number: 000-27385
 
 
 INTERACTIVE INTELLIGENCE, INC.
 (Exact name of registrant as specified in its charter)
 
 Indiana
(State or other jurisdiction
of incorporation or organization)

35-1933097
(I.R.S. Employer
Identification No.)7601 Interactive Way
Indianapolis, IN 46278
(Address of principal executive offices, including zip code)(317) 872-3000
(Registrant’s telephone number, including area code)Not Applicable(Former name, former address and former fiscal year, if changed since last report)
 
  
  Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject
to such filing requirements for the past 90 days.
  Yes     R
No       ̈
  Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required
to submit and post such files).
 
 
 Yes      ̈
No       ̈
 
 Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check One):
 
 Large accelerated filer
*


Accelerated filer
RNon-accelerated filer
*(Do not check if a smaller reporting company)
Smaller reporting company
*
 
 Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).Yes*NoR
 
 As of July 31, 2009, there were 17,134,744 shares outstanding of the registrant’s common stock, $0.01 par value.
  
 
  
 TABLE OF CONTENTS
 
 PART I. FINANCIAL INFORMATION

PageItem 1.
Financial Statements.Condensed Consolidated Balance Sheets as of June 30, 2009 and December 31, 2008


1Condensed Consolidated Statements of Income for the Three and Six Months Ended June 30, 2009 and 2008


2Condensed Consolidated Statement of Shareholders’ Equity for the Six Months Ended June 30, 2009


3Condensed Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2009 and 2008


4Notes to Condensed Consolidated Financial Statements


5Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations.


12Item 3.
Quantitative and Qualitative Disclosures About Market Risk.


19Item 4.
Controls and Procedures.


20PART II. OTHER INFORMATIONItem 1.
Legal Proceedings.


20Item 1A.
Risk Factors.


20Item 4.
Submission of Matters to a Vote of Security Holders.


20Item 6.
Exhibits.


21SIGNATURE


22
  
  PART I. FINANCIAL INFORMATION
 
 Item 1. Condensed Consolidated Financial Statements and Notes to Condensed Consolidated Financial Statements.
 
 Interactive Intelligence, Inc.
 Condensed Consolidated Balance Sheets
 As of June 30, 2009 and December 31, 2008
 (In thousands, except share and per share amounts)
 
 June 30,
2009


December 31,
2008(unaudited)AssetsCurrent assets:Cash and cash equivalents

$
48,062


$
34,705Short-term investments


5,989



10,805Accounts receivable, net of allowance for doubtful accounts of
$1,014 at June 30, 2009 and $1,004 at December 31, 2008


24,626



27,533Deferred tax assets, net


6,139



6,017Prepaid expenses


4,915



5,507Other current assets


3,308



1,995Total current assets


93,039



86,562Property and equipment, net


9,546



10,762Deferred tax assets, net


4,476



5,136Other assets, net


4,837



2,723Total assets

$
111,898


$
105,183Liabilities and Shareholders’ EquityCurrent liabilities:Accounts payable and accrued liabilities


11,934


$
11,361Accrued compensation and related expenses


3,854



3,486Deferred product revenues


4,835



4,754Deferred services revenues


30,679



31,457Total current liabilities


51,302



51,058Deferred revenue


6,323



6,878Total liabilities


57,625



57,936Commitments and contingencies (Note 7)


--



--Shareholders’ equity:Preferred stock, no par value: 10,000,000 shares authorized; no shares issued and outstanding


--



--Common stock, $0.01 par value: 100,000,000 shares authorized;17,073,727 issued and outstanding at June 30, 2009
and 16,928,089issued and outstanding at December 31, 2008


171



169Treasury Stock


(8,470
)


(9,714
)Additional paid-in capital


86,577



83,604Accumulated deficit


(24,005
)


(26,812
)Total shareholders’ equity


54,273



47,247Total liabilities and shareholders’ equity

$
111,898


$
105,183
 
 See Accompanying Notes to Condensed Consolidated Financial Statements
  1
  Interactive Intelligence, Inc.
 Condensed Consolidated Statements of Income (unaudited)
 For the Three and Six Months Ended June 30, 2009 and 2008
 (In thousands, except per share amounts)
 
 Three Months Ended
June 30,


Six Months Ended
June 30,2009


2008


2009


2008(Note 1)





(Note 1)Revenues:Product

$
16,494


$
15,321


$
29,543


$
30,166Services


16,401



15,289



32,828



29,927Total revenues


32,895



30,610



62,371



60,093Cost of revenues:Product


4,841



3,909



8,369



7,039Services


5,708



6,088



11,210



11,985Total cost of revenues


10,549



9,997



19,579



19,024Gross profit


22,346



20,613



42,792



41,069Operating expenses:Sales and marketing


9,965



10,138



19,179



20,322Research and development


5,986



5,336



11,613



10,301General and administrative


3,416



3,848



6,604



7,786Total operating expenses


19,367



19,322



37,396



38,409Operating income


2,979



1,291



5,396



2,660Other income (expense):Interest income


73



344



181



803Other income (expense), net


649



(90
)


225



124Total other income, net


722



254



406



927Income before income taxes


3,701



1,545



5,802



3,587Income tax expense


1,604



700



2,482



1,625Net income

$
2,097


$
845


$
3,320


$
1,962Net income per share:Basic

$
0.12


$
0.05


$
0.20


$
0.11Diluted


0.12



0.04



0.19



0.10Shares used to compute net income per share:Basic


17,015



17,972



16,981



17,956Diluted


18,070



19,077



17,859



19,149
 
 
 See Accompanying Notes to Condensed Consolidated Financial Statements
 
 
  2
  Interactive Intelligence, Inc.
 Condensed Consolidated Statement of Shareholders’ Equity (unaudited)
 For the Six Months Ended June 30, 2009
 (In thousands)
 
 Common Stock


Treasury


Additional
Paid-in


AccumulatedShares


Amount


Stock


Capital


Deficit


TotalBalances, December 31, 2008


16,928


$
169


$
(9,714
)

$
83,604


$
(26,812
)

$
47,247Stock-based compensation


--



--



--



1,572



--



1,572Exercise of stock options


127



2



1,244



(1
)


(513
)


732Issuances of common stock


19



--



--



132



--



132Tax benefits from stock-based compensation


--



--



--



1,278



--



1,278Comprehensive income:Net income


--



--



--



--



3,320



3,320Net unrealized investment loss


--



--



--



(8
)


--



(8
)Total comprehensive income


--



--



--



(8
)


3,320



3,312Balances, June 30, 2009


17,074


$
171


$
(8,470
)

$
86,577


$
(24,005
)

$
54,273
 
 See Accompanying Notes to Condensed Consolidated Financial Statements
  3
  Interactive Intelligence, Inc.
 Condensed Consolidated Statements of Cash Flows (unaudited)
 For Six Months Ended June 30, 2009 and 2008
 (In thousands)
 
 
 Six Months Ended
June 30,2009


2008Operating activities:Net income

$
3,320


$
1,962Adjustments to reconcile net income to net cash provided by operating activities:Depreciation


2,094



1,690Stock-based compensation expense


1,572



1,876Tax benefits from stock-based compensation


(1,278
)


--Deferred income tax


538



1,477Accretion of investment income


(142
)


(89
)Changes in operating assets and liabilities:Accounts receivable


2,969



1,763Prepaid expenses


622



74Other current assets


(1,312
)


(392
)Other assets


308



(149
)Accounts payable and accrued liabilities


1,824



1,438Accrued compensation and related expenses


368



(1,118
)Deferred product revenues


168



(1,407
)Deferred services revenues


(1,704
)


(363
)Net cash provided by operating activities


9,347



6,762Investing activities:Sales of available-for-sale investments


10,800



17,650Purchases of available-for-sale investments


(5,850
)


(14,613
)Purchases of property and equipment


(833
)


(4,047
)Acquisition of intangible and other assets, net of cash and cash equivalents


(2,249
)


--Net cash provided by (used in) investing activities


1,868



(1,010
)Financing activities:Proceeds from stock options exercised


732



442Procees from issuance of common stock


132



131Tax benefits from stock-based compensation


1,278



--Net cash provided by financing activities


2,142



573Net increase in cash and cash equivalents


13,357



6,325Cash and cash equivalents, beginning of period


34,705



29,359Cash and cash equivalents, end of period


48,062


$
35,684Cash paid during the period for:Income taxes

$
199


$
170Other non-cash item:Purchases of property and equipment payable at end of period

$
(78
)

$
(72
)
 
 See Accompanying Notes to Condensed Consolidated Financial Statements
  4
  Interactive Intelligence, Inc.
 Notes to Condensed Consolidated Financial Statements
 June 30, 2009 and 2008 (unaudited)
 
 1.
FINANCIAL STATEMENT PRESENTATION
 
 The accompanying unaudited condensed consolidated financial statements of Interactive Intelligence, Inc. (the “Company”) have been prepared in conformity with accounting principles generally accepted in the United States of America (“US GAAP”) and with the instructions for Form 10-Q and Article 10 of Regulation S-X
for interim financial information. Accordingly, certain information and note disclosures normally included in the Company’s financial statements prepared in accordance with US GAAP have been condensed, or omitted, pursuant to the rules and regulations of the United States Securities and Exchange Commission (the “SEC”).
 
 The preparation of the Company’s condensed consolidated financial statements requires management to make estimates and assumptions that affect reported amounts of assets and liabilities, at the respective balance sheet dates, and the reported amounts of revenues and expenses during the respective reporting periods. Despite management’s
best effort to establish good faith estimates and assumptions, actual results could differ from these estimates. In management’s opinion, the Company’s accompanying condensed consolidated financial statements include all adjustments necessary (which are of a normal and recurring nature, except as otherwise noted) for the fair presentation of the results of the interim periods presented.
 
 The Company’s accompanying condensed consolidated financial statements as of December 31, 2008 have been derived from the Company’s audited consolidated financial statements at that date but does not include all of the information and notes required by US GAAP for complete financial statements. These accompanying condensed consolidated
financial statements should be read in conjunction with the Company’s audited consolidated financial statements for the year ended December 31, 2008, included in the Company’s most recent Annual Report on Form 10-K as filed with the SEC on March 9, 2009. The Company’s results of operations for any interim period are not necessarily indicative of the results of operations for any other interim period or for a full fiscal year.
 
 Principles of Consolidation
 
 The accompanying consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries after elimination of all significant intercompany accounts and transactions.
 
 Reclassifications
 
 Effective April 1, 2009, the Company began presenting gains and losses resulting from foreign currency fluctuations within other income, net. Previously, the Company included a portion of these gains and losses within operating expense. The Company changed its presentation as such gains and losses arising from the adjustment of foreign
currency fluctuations are incidental to its operations. The Company reclassified $126,000 of foreign currency losses for the three months ended March 31, 2009, $117,000 of foreign currency gains for the three months ended March 31, 2008, and $38,000 of foreign currency losses for the three months ended June 30, 2008 from operating expense to other income, net on the accompanying condensed consolidated statements of income. This reclassification did not have any impact on the overall results previously reported.
 
 2.
SUMMARY OF CERTAIN ACCOUNTING POLICIES AND RECENT ACCOUNTING PRONOUNCEMENTS
 
 The Company’s interim critical accounting policies and estimates include the recognition of income taxes using an estimated annual effective tax rate.  For a complete summary of the Company’s other significant accounting policies and other critical accounting estimates, refer to Note 2 of Notes to Consolidated Financial
Statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2008.
 
 During the six months ended June 30, 2009, there were no material changes to the Company’s significant accounting policies or critical accounting estimates.
 
 In December 2007, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”)  No. 141 (revised 2007), Business Combinations(“SFAS 141R”) and SFAS No. 160, Noncontrolling
Interests in Consolidated Financial Statements– an amendment to ARB No. 51(“SFAS 160”). SFAS 141R and SFAS 160 require most identifiable assets, liabilities, noncontrolling interests, and goodwill acquired in a business combination to be recorded at “full fair value” and require noncontrolling interests (previously referred to as minority interests) to be reported as a component of equity, which changes the accounting for transactions with noncontrolling interest holders.
Both SFAS 141R and SFAS 160 became effective for periods beginning on or after December 15, 2008, and earlier adoption was prohibited. SFAS 141R applies to business combinations occurring after the effective date. SFAS 160 applies prospectively to all noncontrolling interests, including any that arose before the effective date. Upon adoption of SFAS 141R and SFAS 160, there was no material impact on the Company’s condensed consolidated financial statements.
 
 In April 2009, the FASB issued FASB Staff Position (“FSP”) No. 157-4, Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly (“FSP 157-4”), which provides
guidance on determining fair values for assets or liabilities when there is no active market or where the price inputs being used represent distressed sales. The guidance reaffirms the need to use judgment to ascertain if a formerly active market has become inactive and determining fair values when markets have become inactive. FSP 157-4 became effective for interim and annual reporting periods ending after June 15, 2009. Upon adoption of FSP 157-4 during the second quarter of 2009, there was no
material impact on the Company’s condensed consolidated financial statements.
 
 In April 2009, the FASB issued FSP No. 115-2 and No. 124-2, Recognition and Presentation of Other-Than-Temporary Impairments (“FSP 115-2 and FSP 124-2”), which amends the other-than-temporary impairment guidance in U.S. GAAP for debt securities to make the guidance more
operational and to improve the presentation and disclosure of other-than-temporary impairments on debt and equity securities in the financial statements. FSP 115-2 and FSP 124-2 became effective for interim and annual reporting periods ending after June 15, 2009 with early adoption permitted for periods ending after March 15, 2009. Upon adoption of FSP 115-2 and FSP 124-2 during the second quarter of 2009, there was no material impact on the Company’s condensed consolidated financial statements.
 5
 In April 2009, the FASB issued FSP No. 107-1, which amends FSP No. 107, Disclosures about Fair Value of Financial Instruments, and Accounting
Principles Board Opinion (“APB”) No. 28-1, which amends APB No. 28, Interim Financial Reporting (“FSP 107-1 and APB 28-1”). FSP 107-1 and APB 28-1 require the disclosures of FSP No. 107 and APB No. 28 in summarized financial information at interim reporting periods for publicly traded companies as well as in annual financial statements. FSP 107-1 and APB 28-1 became effective for interim and annual reporting periods
ending after June 15, 2009. Upon adoption of FSP 107-1 and APB 28-1 during the seond quarter of 2009, there was no material impact on the Company’s condensed consolidated financial statements.
 
 In May 2009, the FASB issued SFAS No. 165, Subsequent Events(“SFAS 165”), which establishes general standards of accounting for and disclosure of events that occur after the balance sheet date
but before financial statements are issued or are available to be issued.SFAS 165 became effective for interim and annual reporting periods ending after June 15, 2009. We performed an evaluation of subsequent events through August 7, 2009, and we issued our financial statements on August 10, 2009.
 
 In June 2009, the FASB issued SFAS No. 166,Accounting for Transfers of Financial Assets(“SFAS 166”), whichwillimprove
the relevance, representational faithfulness, and comparability of the information that a reporting entity provides in its financial statements about a transfer of financial assets; the effects of a transfer on its financial position, financial performance, and cash flows; and a transferor’s continuing involvement, if any, in transferred financial assets.SFAS 166 will be effective for annual
reporting periods beginning after November 15, 2009. The Company does not expect that the adoption of SFAS 166 will have a material impact on its condensed consolidated financial statements.
 
 In June 2009, the FASB issued SFAS No. 168,The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles(“SFAS 168”),
which is thesource of authoritative US GAAP recognized by the FASB to be applied by nongovernmental entities (the “Codification”).SFAS 168 will be effective for interim and annual reporting periods ending after September 15, 2009. Therefore, beginning with the third quarter of 2009, all references made by the Company in its condensed consolidated financial statements will have
the new Codification numbering system. The Codification does not change or alter existing US GAAP and, therefore, is not expected to have a material impact on the Company’s condensed consolidated financial statements.
 
 3.
FAIR VALUE MEASUREMENTS
 
 SFAS 157, as amended, defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. SFAS 157 also establishes a fair value hierarchy
which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes the following three levels of inputs that may be used to measure fair value:
 
 ·
Level 1 - Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities.
 
 ·
Level 2 - Observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.
 
 ·
Level 3 - Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.
 
 The Company’s assets that are measured at fair value on a recurring basis are generally classified within Level 1 or Level 2 of the fair value hierarchy.  The types of instruments valued based on quoted market prices in active markets include mostly money market securities and equity investments.  Such instruments
are generally classified within Level 1 of the fair value hierarchy.  The Company invests in money market funds that are traded daily and does not adjust the quoted price for such instruments.  The types of instruments valued based on quoted prices in less active markets, broker or dealer quotations, or alternative pricing sources with reasonable levels of price transparency include corporate notes, commercial paper and certificates of deposits.  Such instruments are generally classified
within Level 2 of the fair value hierarchy.  The Company uses consensus pricing, which is based on multiple pricing sources, to value its fixed income investments.
 
 The following table sets forth a summary of the Company’s financial assets, classified as cash and cash equivalents and short-term investments on its condensed consolidated balance sheet, measured at fair value on a recurring basis as of June 30, 2009 (in thousands):
  Fair Value Measurements at
Reporting Date UsingDescription

Total


Quoted Prices in
Active Markets
for
Identical Assets
(Level 1)


Significant
Other Observable
Inputs
(Level 2)


Significant
Unobservable
Inputs
(Level 3)Cash & cash equivalents:Money Market Funds

$
19,906


$
19,906


$
--


$
--Commercial Paper


900



--



900



--Total

$
20,806


$
19,906


$
900


$
--Short-term investments:Corporate Notes

$
4,189


$
--


$
4,189


$
--Commercial Paper


1,800



--



1,800



--Total

$
5,989


$
--


$
5,989


$
--
 
 6
 4.
NET INCOME PER SHARE
 
 Basic net income per share is calculated based on the weighted-average number of common shares outstanding in accordance with SFAS No. 128, Earnings per Share. Diluted net income per share is calculated based on the weighted-average number of common shares outstanding plus the effect
of dilutive potential common shares. When the Company reports net income, the calculation of diluted net income per share excludes shares underlying stock options outstanding that would be anti-dilutive. Potential common shares are composed of shares of common stock issuable upon the exercise of stock options. The following table sets forth the calculation of basic and diluted net income per share (in thousands, except per share amounts):
  Three Months Ended
June 30,


Six Months Ended
June 30,2009


2008


2009


2008Net income, as reported (A)

$
2,097


$
845


$
3,320


$
1,962Weighted average shares of common stock outstanding (B)


17,015



17,972



16,981



17,956Dilutive effect of employee stock options


1,055



1,105



878



1,193Common stock and common stock equivalents (C)


18,070



19,077



17,859



19,149Net income per share:Basic (A/B)

$
0.12


$
0.05


$
0.20


$
0.11Diluted (A/C)


0.12



0.04



0.19



0.10
 
 The Company’s calculation of diluted net income per share for the three months ended June 30, 2009 and 2008 excludes stock options to purchase approximately 1.2 million and 1.4 million shares of the Company’s common stock, respectively, as their effect would be anti-dilutive. The diluted net income per share for the six months
ended June 30, 2009 and 2008 excludes stock options to purchase approximately 1.8 million and 1.2 million shares of the Company’s common stock, respectively.
 
 5.
STOCK-BASED COMPENSATION
 
 Stock Option Plans
 
 The Company’s Stock Option Plans, adopted in 1995, 1999 and 2006, authorize the Board of Directors or the Compensation Committee, as applicable, to grant incentive and nonqualified stock options, and, in the case of the 2006 Equity Incentive Plan, as amended (the “2006 Plan”), stock appreciation rights, restricted stock,
restricted stock units, performance shares, performance units and other stock-based awards. After adoption of the 2006 Plan by the Company’s shareholders in May 2006, the Company may no longer make any grants under previous plans, but any shares subject to awards under the 1999 Stock Option and Incentive Plan and the Outside Directors Stock Option Plan (collectively, the “1999 Plans”) that are cancelled are added to shares available under the 2006 Plan. A maximum of 5,850,933 shares are available
for delivery under the 2006 Plan, which consists of (i) 2,150,000 shares, plus (ii) 320,000 shares available for issuance under the 1999 Plans, but not underlying any outstanding stock options or other awards under the 1999 Plans, plus (iii) up to 3,380,933 shares subject to outstanding stock options or other awards under the 1999 Plans that expire, are forfeited or otherwise terminate unexercised on or after May 18, 2006. The number of shares available under the 2006 Plan is subject to adjustment for certain
changes in the Company’s capital structure. The exercise price of options granted under the 2006 Plan is equal to the closing price of the Company’s common stock, as reported by The NASDAQ Global Market, on the business day immediately preceding the date of grant. Non-qualified stock options granted under the 2006 Plan have a term of six years.
 
 Stock options granted by the Company are categorized into three types.  The first type is performance-based stock options that are subject to cancellation if the specified performance targets, as approved by the Company's Compensation Committee, are not met.  If the applicable performance targets have been achieved, the
options will vest in four equal annual installments beginning one year after the performance-related period has ended.  The fair value of these stock option grants is determined on the date of grant and the related compensation expense is recognized over the requisite service period, including the initial period for which the specified performance targets must be met.
 
 The second type of stock options granted by the Company is non-performance-based stock options that are subject only to time-based vesting.  These stock options vest in four equal annual installments beginning one year after the grant date.  The fair value of these option grants is determined on the date of grant and the
related compensation expense is recognized for the entire award on a straight-line basis over the vesting period.
 
 Commencing in May 2009 the Company began granting a third type of stock options to its non-employee directors. These options are similar to the non-performance-based options described above except the director options vest one year after the grant date. The fair value of these option grants is determined on the date of the grant and the related
compensation expense is recognized for the entire award one year after the grant date. Prior to May 2009 non-employee directors received non-performance-based stock options that vested over four years.
 
 The plans may be terminated by the Company’s Board of Directors at any time.
 
 7
 
 Stock-Based Compensation Expense Information
 
 The following table summarizes the allocation of stock-based compensation expense related to employee and director stock options under SFAS No. 123 (revised 2004), Share-Based Payment, and the guidance of Staff Accounting Bulletin No. 107, as amended by Staff Accounting Bulletin No.
110,  for the three and six months ended June 30, 2009 and 2008 (in thousands):
 
 Three Months Ended
June 30,


Six Months Ended
June 30,2009


2008


2009


2008Stock-based compensation expense by category:Cost of services

$
50


$
69



114


$
141Sales and marketing


230



382



538



744Research and development


227



224



472



432General and administrative


218



269



447



559Total stock-based compensation expense

$
725


$
944


$
1,571


$
1,876
 
 Valuation Assumptions
 
 The Company estimated the fair value of stock options using the Black-Scholes valuation model. Except as disclosed above, there were no material changes in the way the assumptions were calculated as previously disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2008.  The weighted-average
estimated per option value of performance-based, non-performance-based and director options granted during the six months ended June 30, 2009 and June 30, 2008 used the following assumptions:
 
 Six Months Ended June 30,


Six Months Ended June 30,Valuation assumptions for performance-based options:

2009


2008Dividend yield


--



--Expected volatility


67.35



63.66Risk-free interest rate


1.77
%


2.39
%Expected life of option (in years)


4.75



4.75
  Six Months Ended June 30,


Six Months Ended June 30,Valuation assumptions for non-performance-based options:

2009


2008Dividend yield


--



--Expected volatility


67.88 - 68.51



63.21- 64.12Risk-free interest rate


1.64 - 2.36
%


2.22 - 3.34
%Expected life of option (in years)


4.25



4.25
  Six Months Ended June 30,


Six Months Ended June 30,Valuation assumptions for director options:

2009


2008Dividend yield


--



--Expected volatility


71.48



--Risk-free interest rate


2.01
%


--Expected life of option (in years)


3.50



--
  There were no performance-based options granted during the three months ended June 30, 2009 and June 30, 2008. Performance-based options were granted during the three months ended March 31, 2009 and March 31, 2008.
 
 8
 
 Stock Option Activity
 
 The following table sets forth a summary of option activity for the six months ended June 30, 2009:
  As of June 30, 2009Options


Weighted-
Average
Exercise
PriceBalances, beginning of year


3,300,565


$
9.46Options granted


546,375



7.16Options exercised


(126,914
)


5.76Options cancelled


(35,779
)


10.95Options outstanding


3,684,247



9.24Option price range

$
2.51 - 50.50Weighted-average fair value of options granted

$
3.83Options exercisable


2,362,545



8.10Options available for grant


859,994
  6.
CONCENTRATION OF CREDIT RISK
 
 Two partners individually accounted for 10% or more of the Company’s accounts receivable as of June 30, 2009. There were no customers or partners who accounted for more than 10% of the Company’s accounts receivable as of December 31, 2008. In addition, no customer or partner accounted for 10% or more of the Company’s
revenues for the three and six months ended June 30, 2009 and 2008.
 
 7.
COMMITMENTS AND CONTIGENCIES
 
 Legal Proceedings
 
 From time to time, the Company has received notification from competitors and other technology providers claiming that the Company’s technology infringes their proprietary rights. The Company cannot provide assurance that these matters can be resolved amicably without litigation, or that the Company will be able to enter into licensing
arrangements on terms and conditions that would not have a material adverse effect on its business, financial condition or results of operations.
 
 During the fourth quarter of 2008, the Company reached a settlement with the French Taxing Authority (“FTA”) as a result of a tax audit that had been conducted encompassing the years 1998 through 2004.Subsequent to the settlement, the Company received a letter from another
division within the FTA that claimed Interactive Intelligence France SARL owes $702,000 in penalties and interest as of June 30, 2009. The Company has submitted an appeal for this amount, as it believes that these penalties and interest were agreed to and paid for in the previous settlement. The Company does not believe it will have to pay any money related to this claim; therefore, no amount has been accrued as of June 30, 2009. Although the Company is appealing this claim, it cannot provide assurance that
these matters will be resolved without further litigation or that the Company will not have to pay some or all of this amount.
 
 From time to time, the Company is also involved in certain legal proceedings in the ordinary course of conducting its business. While the ultimate liability pursuant to these actions cannot currently be determined, the Company believes these legal proceedings will not have a material adverse effect on its financial position or results of
operations. Litigation in general, and intellectual property litigation in particular, can be expensive and disruptive to normal business operations. Moreover, the results of complex legal proceedings are difficult to predict.
 
 Lease Commitments
 
 The Company’s world headquarters are located in a 200,000 square foot space in two office buildings in Indianapolis, Indiana. The Company leases the space under an operating lease agreement and amendments which expire on March 31, 2018. In addition to the Company’s world headquarters, it occupies two regional offices in the United
States, one in Herndon, Virginia that it opened in October 2006, and one in Irvine, California that it opened in September 2006. The Company also leases offices for each of its Europe, the Middle East and Africa (“EMEA”) and Asia-Pacific (“APAC”) operations in Berkshire, United Kingdom and Kuala Lumpur, Malaysia, respectively, and has several other office leases throughout the United States and in 11 other countries. The Company rents office space for sales, services, development and international
offices under month-to-month leases. In accordance with SFAS No. 13, Accounting for Leases, rental expense is recognized ratably over the lease period, including those leases containing escalation clauses.
 
 9
  Other Contingencies
 
 The Company has received and may continue to receive certain payroll tax credits and real estate tax abatements that were granted to the Company based upon certain growth projections.  If the Company’s actual results are less than those projections, the Company may be subject to repayment of some or all of the tax credits or payment
of additional real estate taxes in the case of the abatements.  The Company does not believe that it will be subject to payment of any money related to these taxes; however, the Company cannot provide assurance as to the outcome.
 
 8.
INCOME TAXES
 
 The following table is a reconciliation of the difference between the actual provision for income taxes and the provision computed by applying the federal statutory rate, 35%, on income before income taxes (in thousands):
 
 Three Months Ended
June 30,


Six Months Ended
June 30,2009


2008


2009


2008Expected income tax expense at 35% tax rate


1,296


$
541



2,031


$
1,255State taxes, net of federal benefit


198



77



314



179Non-deductible stock-based compensation expense


107



154



248



344Other


3



(72
)


(111
)


(153
)Income tax expense

$
1,604


$
700


$
2,482


$
1,625
  Upon adoption of FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes an interpretation of FASB Statement No. 109 in 2007, the Company identified an uncertain tax position related to certain tax credits that the Company currently believes meets the “more likely
than not” recognition threshold to be sustained upon examination. The balance of the unrecognized tax benefit was approximately $750,000 at December 31, 2008 and, if recognized, would impact the effective tax rate. As of June 30, 2009, the unrecognized tax benefit had not changed.
 
 The Company and its subsidiaries file federal income tax returns and income tax returns in various states and foreign jurisdictions.  Tax years 2005 and forward remain open for examination for federal tax purposes and tax years 2004 and forward remain open for examination for the Company’s more significant state tax jurisdictions.  To
the extent utilized in future years’ tax returns, net operating loss and capital loss carryforwards at December 31, 2008 will remain subject to examination until the respective tax year is closed.
 
 During the second quarter of 2009, the Company utilized its remaining net operating loss deferred tax asset generated in prior years and began utilizing operating losses generated from the tax benefits related to the issuance and exercise of non-qualified stock options. The Company does not have a deferred tax asset on its balance sheet for
the operating losses generated from these deductions; therefore, the reduction in taxes payable related to the use of these operating losses increases additional paid-in capital. At June 30, 2009, the Company had approximately $20 million in stock-based compensation deductions available to offset taxable income and $4.7 million of alternative minimum tax, federal and state research tax credit carryforwards and foreign tax credits available to offset taxes payable.
 
 9.
Acquisition
 
 Stock Purchase Agreement
 
 On May 15, 2009, the Company entered into a stock purchase agreement with AcroSoft Corp. (“AcroSoft”), a provider of insurance content management solutions, pursuant to which the Company purchased 100% of AcroSoft’s issued and outstanding shares of capital stock for an aggregate purchase price of $2.4 million with cash available
from operations. Ten percent of the purchase price, or $240,000, was deposited into an escrow account to ensure funds are available to pay indemnification claims, if any. The Company acquired AcroSoft to integrate their document management and workflow functionality into the Company’s Interaction Center Platform, including its Interaction Process Automation application.  Over time, the Company also anticipates extending the integrated solution to other document-intensive industry vertical and horizontal
processes. The acquisition was accounted for using the acquisition method of accounting in accordance with SFAS 141R, and the results of AcroSoft’s operations were included in the Company’s condensed consolidated financial statements commencing on the acquisition date.
  10
 
 The preliminary purchase price allocations for the Company’s acquisition of AcroSoft are based on a third-party valuation report which was prepared in accordance with the provisions of SFAS 141R, and are subject to adjustment. The following table summarizes the fair value of the intangible and other assets acquired and liabilities assumed
at the date of the acquisition (in thousands):
 
 May 15, 2009Cash

$
149Investments


2Accounts receivable


62Prepaid royalties


30Other current assets


1Property, plant and equipment


26Current tax asset


122Deferred tax asset


287Accounts payable


(8
)Deferred tax liability


(212
)Intangible assets


530Goodwill


1,695Total assets acquired

$
2,684Deferred services revenue


(284
)Net assets acquired

$
2,400
  The fair value of financial assets acquired includes accounts receivable with a fair and contractual value of $62,000. The receivables consist of amounts due from customers for products sold and/or services rendered.
 
 Acquisition-related costs recognized as of June 30, 2009 include transaction costs such as legal, accounting, valuation and other professional services, which were expensed as incurred. Acquisition-related costs totaled $52,000 as of June 30, 2009 and were included within general and administrative expenses on the condensed consolidated statements
of income for the three and six months ended June 30, 2009.
 
 The premium paid over the fair value of the net assets acquired in the purchase, or goodwill, was primarily attributed to expected synergies from AcroSoft's document management software, experienced document management staff and an existing client base. Included within goodwill is the assembled workforce, comprised of 12 employees, acquired
with the acquisition, which does not qualify for separate recognition. None of the goodwill is expected to be deductible for tax purposes.
 
 Customer relationships are amortized based upon patterns in which the economic benefits are expected to be realized. Other finite-lived identifiable intangible assets are amortized on a straight-line basis. The following are the identifiable intangible assets acquired and their remaining economic useful  lives:
 
 Amount


Remaining Economic
Useful Life
(in years)Customer relationships

$
210,000



6Core technology


320,000



5Total

$
530,000
 
 Goodwill
 
 Goodwill is reviewed for impairment at least annually in accordance with the provisions of SFAS No. 142, Goodwill and Other Intangible Assets. The goodwill impairment test is a two-step test. Under the first step, the fair value of the reporting unit is compared with its carrying
value (including goodwill). Fair value of the reporting unit is determined using a discounted cash flow analysis. If the fair value of the reporting unit exceeds its carrying value, step two does not need to be performed. If the fair value of the reporting unit is less than its carrying value, an indication of goodwill impairment exists for the reporting unit and the enterprise must perform step two of the impairment test (measurement). Under step two, an impairment charge is recognized for any excess of the
carrying amount of the reporting unit’s goodwill over the implied fair value of that goodwill. The implied fair value of goodwill is determined by allocating the fair value of the reporting unit in a manner similar to a purchase price allocation, in accordance with SFAS 141R. The residual fair value after this allocation is the implied fair value of the reporting unit goodwill. The following table presents a rollforward of goodwill, which is included within other assets, net on the accompanying condensed
consolidated balance sheets, as of June 30, 2009 (in thousands):
 
 Balance as of January 1, 2009

$
995AcroSoft goodwill


1,695Balance as of June 30, 2009

$
2,690
 
 11
 
 The amount of AcroSoft's revenues included in the Company's condensed consolidated statements of income from the acquisition date through June 30, 2009 was approximately $100,000, with almost all being included in services revenues. AcroSoft's operating costs and related charges totaled approximately $160,000, resulting in a decrease
in operating income of $60,000 attributable to AcroSoft.
 
 The following table presents the pro forma statements of income obtained by combining the historical consolidated statements of income for the Company and AcroSoft for the six months ended June 30, 2009 and 2008, giving effect to the acquisition as if it had occurred January 1, 2009 and 2008, respectively (in thousands):
 Six Months Ended June 30,2009


2008Total Revenue

$
62,875


$
60,826Operating Income


3,470



1,830
 The allocation of the purchase price is preliminary and is subject to finalization. The Company is in the process of finalizing AcroSoft's tax return related to the period beginning January 1, 2009 and ending May 15, 2009, which may affect the net operating losses and related deferred tax assets. In addition, the Company plans to complete
a research and development study for AcroSoft, which may result in a related research and development credit recorded as a deferred tax asset. Adjustments for these tax matters will result in a corresponding adjustment to recorded goodwill.
 
 Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations.
 
 The following Management’s Discussion and Analysis of Financial Condition and Results of Operations is intended to provide our investors with an understanding of our past performance, our financial condition and our prospects and should be read in conjunction with other sections of this Quarterly Report on Form 10-Q. Investors should
carefully review the information contained in this report under Part II, Item 1A “Risk Factors” and in the Part I, Item 1A “Risk Factors” section of our Annual Report on Form 10-K for the fiscal year ended December 31, 2008. The following will be discussed and analyzed:
 
 ·     Forward-Looking Information
 
 ·     Overview
 
 ·     Financial Highlights
 
 ·     Historical Results of Operations
 
 ·     Liquidity and Capital Resources
 
 ·     Critical Accounting Policies and Estimates
 
 Forward-Looking Information
 
 Certain statements in this Quarterly Report on Form 10-Q contain “forward-looking” information (as defined in the Private Securities Litigation Reform Act of 1995,Section 27A of the Securities Act of 1933, as amended and Section 21E of the Securities Exchange
Act of 1934, as amended (the “Exchange Act”)) that involves risks and uncertainties which may cause actual results to differ materially from those predicted in the forward-looking statements. Forward-looking statements can often be identified by their use of such verbs as “expects”, “anticipates”, “believes”, “intend”, “plan”, “may”, “should”, “will”,
“would”, “will be”, “will continue”, “will likely result”, or similar verbs or conjugations of such verbs. If any of our assumptions on which the statements are based prove incorrect or should unanticipated circumstances arise, our actual results could materially differ from those anticipated by such forward-looking statements. The differences could be caused by a number of factors or combination of factors, including, but not limited to, unstable economic conditions,
rapid technological changes in the industry, our ability to maintain profitability, to manage successfully our growth, to manage successfully our increasingly complex third-party relationships resulting from the software and hardware components being licensed or sold with our solutions, to maintain successful relationships with certain suppliers which may be impacted by competition in the technology industry, to maintain successful relationships with our current and any new partners, to maintain and improve our
current products, to develop new products, to protect our proprietary rights adequately, and other factors set forth in our Securities and Exchange Commission (“SEC”) filings.
 
 Overview
 
 Interactive Intelligence, Inc. (“Interactive Intelligence”, “we”, “us” or “our”) was formed in 1994 as an Indiana corporation and maintains its world headquarters and executive offices at 7601 Interactive Way, Indianapolis, IN 46278. Our telephone number is (317) 872-3000. We are located on
the web at http://www.inin.com. We file annual, quarterly and current reports, proxy statements and other documents with the SEC under the Exchange Act. These periodic and current reports and all amendments to those reports are available free of charge on the investor relations page of our website at http://investors.inin.com.
 
 We are a leading provider of software application suites for Voice over Internet Protocol (“VoIP”) business communications, and are increasingly leveraging our leadership position in the worldwide contact center market to offer our solutions for a broad range of business operations. In addition to contact centers, our solutions
are used in various industries including, but not limited to, teleservices, financial services, insurance, higher education, healthcare, retail, technology, government and business services, particularly in organizations that employ remote and mobile workers. For enterprises that rely on the Microsoft® Corporation (“Microsoft”) platform, we offer a pre-integrated all-software Internet Protocol Private Branch Exchange phone and communications system that enables straightforward integration to
Microsoft compatible applications for data management. In all, our innovative software products and services are designed expressly for multichannel contact management, business communications and messaging using the Session Initiation Protocol (“SIP”) global communications standard that supports VoIP. To supplement our software solutions, we also offer a media server, media gateways and SIP proxy for IP-based communications networks and infrastructures. Our customers can deploy our solutions as an
on-premise system at their site or as Communications as a Service (“CaaS”).
 
 12
 
 Our application-based solutions are integrated on a single software platform. Overall, our platform has been developed to deliver security, broaden integration to business systems and end-user devices, enhance mobility for today’s workforce, scale to thousands of users, and comprehensively address various business communications and
interaction management needs in markets for:
  ·
The Contact Center
  ·
Enterprise IP Telephony
  ·
Enterprise Messaging
  By implementing our all-in-one solutions, businesses are able to unify multichannel communications media (phone, fax, e-mail and web chat); improve workforce performance, effectiveness and productivity; and more readily adapt to changing market and customer requirements. Organizations in the industries we serve are further able to reduce
equipment and maintenance costs over traditional “multi-point” communications hardware, and additionally reduce the complexity of such non-integrated systems.
 
 For further information on our business and the products and services we offer, refer to the Part I, Item 1 “Business” section of our Annual Report on Form 10-K for the year ended December 31, 2008.
 
 Our management monitors certain key measures to assess our financial results. In particular, we track trends on product orders, contracted professional services, and CaaS orders from quarter to quarter and in comparison to the prior year and budget.  We
also regularly monitor staffing levels because salaries are our largest expense, as well as macroeconomic conditions, which, as noted below, have materially affected the orders we received in recent quarters. In addition to orders and revenues, management reviews costs of revenue and operating expenses to ensure we are managing new expenditures and controlling costs. Finally, management monitors diluted earnings per share, which is a key measure of performance that is also used by analysts and investors.
 
 The table below shows our total revenues (in millions) for the most recent five quarters and the years ended December 31, 2008, 2007 and 2006 and the percentage change over the previous period (including the impact of reclassifications and adjustments for 2006 and 2007 as discussed in Note 2 of Notes to Condensed Consolidated Financial Statements
in the Annual Report on Form 10-K for the year ended December 31, 2008).
 
 Period

Revenues


Sequential
Growth %Three Months Ended:June 30, 2009

$
32.9



12
%March 31, 2009


29.5



(6
)%December 31, 2008


31.3



4
%September 30, 2008


30.1



(2
)%June 30, 2008


30.6



4
%Year Ended December 31:2008

$
121.4



10
%2007


109.9



32
%2006


83.0



32
%
 
 As shown in the 2008 annual growth rate and the quarterly growth rates in 2008 and for the first quarter of 2009, our revenue growth trend has generally slowed, although we did experience increased growth in the second quarter of 2009.  We believe that this was primarily due to the instability in the economy worldwide, which has
resulted in longer sales cycles, as potential customers are hesitant to commit to capital purchases.  This has also had a negative effect on our existing customers licensing additional software and purchasing hardware, in part because many customers are experiencing minimal growth in revenues or revenue reductions with some customers reducing their staffing.
 
 We will continue to focus on maintaining profitability by continuing to increase the efficiency of our sales and marketing efforts and by management of our operating expenses. As our profitability allows, we will position the company for future growth through our research and development initiatives which may increase expenses in the
future as we focus on these efforts.
  13
 
 Financial Highlights
 
 Product revenues increased $1.2 million during the three months ended June 30, 2009 compared to the same quarter in 2008, reflecting a 9% increase in the dollar amount of orders received year-over-year. For the six months ended June 30, 2009, product revenues decreased $623,000 compared to the same period in 2008, reflecting a 6% decrease
in the dollar amount of orders received.
 
 Services revenues increased $1.1 million and $2.9 million during the three and six months ended June 30, 2009, respectively, compared to the same periods last year, primarily due to higher support fees as well as increased revenues from CaaS and managed services.
 
 Costs of product increased during the three and six months ended June 30, 2009 compared to the same periods in 2008 primarily as a result of an increase of $932,000 and $1.3 million, respectively, in hardware and appliances delivered by us during those periods. The increase in costs of product was partially offset by a decrease in costs of
services for the three and six months ended June 30, 2009 compared to the same periods in 2008 of $380,000 and $775,000, respectively, primarily related to a decrease in compensation, travel and communications related expenses.
 
 Our total operating expenses remained consistent for the three months ended June 30, 2009 and decreased $1.0 million for the six months ended June 30, 2009, compared to the same periods in 2008. Sales and marketing expenses and general and administrative expenses decreased for the three and six months ended June 30, 2009 compared to the same
periods 2008 due to decreases in compensation and travel expenses. Compensation expense decreased due to reductions in staffing and travel expenses decreased due to our cost management programs. These decreases were partially offset by an increase in research and development expenses for the three and six months ended June 30, 2009 compared to the same periods in 2008 due to increases in research and development staffing, which also increased certain allocable expenses such as rent and depreciation. We believe
that investment in research and development is critical to our future growth and competitive position in the marketplace and is directly related to timely development of new and enhanced solutions that are central to our business.
 
 On May 15, 2009, we entered into a stock purchase agreement with AcroSoft, a provider of insurance content management solutions, pursuant to which we purchased 100% of AcroSoft’s issued and outstanding shares of capital stock for an aggregate purchase price of $2.4 million with cash available from operations. Ten percent of the purchase
price, or $240,000, was deposited into an escrow account to ensure funds are available to pay indemnification claims, if any. We acquired AcroSoft to integrate their document management and workflow functionality into our Interaction Center Platform, including our Interaction Process Automation application.  Over time, we also anticipate extending the integrated solution to other document-intensive industry vertical and horizontal processes. AcroSoft's results of operations were included in our condensed
consolidated financial statements for the three and six months ended June 30, 2009 and accounted for $100,000 in revenues, almost all of which was included in services revenues. AcroSoft's operating costs and related charges totaled approximately $160,000, resulting in a decrease in operating income of $60,000.
 Historical Results of Operations
 
 The following table presents certain financial data, derived from our unaudited statements of income, as a percentage of total revenues for the periods indicated. The operating results for the three and six months ended June 30, 2009 and 2008 are not necessarily indicative of the results that may be expected for the full year or for any future
period.
 
 Three Months Ended
June 30,


Six Months Ended
June 30,2009


2008


2009


2008Revenues:Product


50
%


50
%


47
%


50
%Services


50
%


50
%


53
%


50
%Total revenues


100
%


100
%


100
%


100
%Cost of revenues:Product


15
%


13
%


13
%


12
%Services


17
%


20
%


18
%


20
%Total cost of revenues


32
%


33
%


31
%


32
%Gross profit


68
%


67
%


69
%


68
%Operating expenses:Sales and marketing


30
%


33
%


31
%


34
%Research and development


18
%


17
%


19
%


17
%General and administrative


11
%


13
%


11
%


13
%Total operating expenses


59
%


63
%


60
%


64
%Operating income


9
%


4
%


9
%


4
%Other income (expense):Interest income, net


--
%


1
%


--
%


1
%Other income (expense), net


2
%


--
%


--
%


1
%Total other income


2
%


1
%


--
%


2
%Income before income taxes


11
%


5
%


9
%


6
%Income tax expense


(5
)%


(2
)%


(4
)%


(3
)%Net income


6
%


3
%


5
%


3
%
 14
  Comparison of Three and Six Months Ended June 30, 2009 and 2008
 
 Revenues
 
 Product Revenues

Three Months Ended
June 30,


Six Months Ended
June 30,2009


2008


2009


2008($ in thousands)Product revenues

$
16,494


$
15,321


$
29,543


$
30,166Change from prior year period


8
%


5
%


(2
)%


12
%Percentage of total revenues


50
%


50
%


47
%


50
%
 
 Product revenues, which include software, hardware and appliance revenues, increased $1.2 million during the three months ended June 30, 2009 compared to the same quarter in 2008. This increase was primarily due to a 16% increase in the dollar amount of follow-on orders, mainly in North America and Europe, as well as a 9% increase in total
orders. We received three orders over $1 million and 11 orders between $250,000 and $1 million during the three months ended June 30, 2009, compared to two orders over $1 million and nine orders between $250,000 and $1 million in the same period in 2008, resulting in an increase in the average new customer order value. We believe that our improved performance during the second quarter of 2009 was primarily related to existing customers making purchasing decisions they had delayed in previous quarters. We do not
know if this improved performance will continue in future quarters.
  Product revenues decreased $623,000 during the six months ended June 30, 2009 compared to the six months ended June 30, 2008. This decrease was primarily due to a 6% reduction in the dollar amount of orders received during the first half of 2009 compared to the same period last year as
economic uncertainties caused customers to delay purchasing decisions primarily in the first quarter of 2009.
 
 Product revenues can fluctuate from period to period depending on the mix of perpetual and annually renewable licenses. The majority of our product licenses are perpetual but we do also have certain customers with renewable term licenses. Orders for perpetual licenses are recognized when received if specific recognition criteria are satisfied,
while renewable term licenses are recognized ratably over the term of the agreement, generally one year. The impact of the mix of contracts on our product revenues occurs only in the year of a product order since fees from the subsequent renewal of annually renewable licenses and renewal of support fees for perpetual contracts are allocated entirely to services revenues.
 
 Services Revenues

Three Months Ended
June 30,


Six Months Ended
June 30,2009


2008


2009


2008($ in thousands)Services revenues

$
16,401


$
15,289


$
32,828


$
29,927Change from prior year period


7
%


22
%


10
%


22
%Percentage of total revenues


50
%


50
%


53
%


50
%
 
 Services revenues include the portion of license arrangements allocated to maintenance and support from annually renewable and perpetual contracts, renewals of annually renewable licenses and maintenance contracts, as well as revenues from professional services, CaaS and education.
  Services revenues increased in the three and six months ended June 30, 2009 compared to the same periods in 2008 primarily due to growth in the number and size of our installed base of customers. Annual license renewal fees and support fees for perpetual licenses, which comprise 76% of total services revenues, increased by $550,000, or 5%,
and $1.8 million, or 8%, during the three months and six months ended June 30, 2009, respectively, compared to the same periods in 2008. We believe services revenues will continue to grow as we continue to license and install our solutions to new customers and expand existing customer implementations. The actual percentage fee charged for the renewal of annually renewable licenses and perpetual support agreements as compared to the initial annually renewable license fee and perpetual license, respectively, is
comparable on a relative percentage basis, and therefore, the mix of these types of contracts in the future is not expected to impact our future services revenues. Renewal rates for license and support fees have not materially changed in 2009.
 
 Professional services revenues also increased $189,000, or 13%, and $67,000 or 2%, during the three and six months ended June 30, 2009, respectively, compared to the same periods in 2008 primarily due to an increase in demand for our installation services, principally in the second quarter of 2009.  In addition, revenues from
CaaS and managed services increased $271,000, or 30%, and $801,000, or 50%, during the three and six months ended June 30, 2009, respectively, compared to the same periods in 2008, as the number of customers preferring these licensing and implementation alternatives continued to increase.  We believe this growth in CaaS and managed services revenues will continue as more customers utilize outsourced services for their information technology needs instead of purchasing software or hiring additional technical
employees.
 15
 Cost of Revenues

Three Months Ended
June 30,


Six Months Ended
June 30,2009


2008


2009


2008($ in thousands)Cost of revenues:Product

$
4,841


$
3,909


$
8,369


$
7,039Services


5,708



6,088



11,210



11,985Total cost of revenues

$
10,549


$
9,997



19,579


$
19,024Change from prior year period


6
%


16
%


3
%


20
%Product costs as a % of product revenues


29
%


26
%


28
%


23
%Services costs as a % of services revenues


35
%


40
%


34
%


40
%
 
 Costs of product consist of hardware costs (including media servers and Interaction Gateway appliances that we develop and servers, telephone handsets and gateways that we purchase and resell), royalties for third party software and other technologies included in our solutions, personnel costs, and software packaging costs (including product
media and documentation duplication).  Costs of product can fluctuate depending on which software applications are licensed to our customers and partners, the third party software that is licensed by the end user from us as part of our software applications and the dollar amount of orders for hardware and appliances.Costs of product increased $932,000 and $1.3 million, respectively, during the three and six months ended June 30, 2009 compared
to the same periods in 2008, as more customers included our hardware offerings in their implementations of our solutions.
 
 Costs of services consist primarily of compensation expenses for technical support, professional services and educational personnel and costs associated with our CaaS offering. These expenses decreased primarily due to a decrease in compensation expense of $331,000 and $691,000, respectively, during the three and six months ended June
30, 2009 compared to the same periods in 2008 resulting from a 12% reduction in services staff at June 30, 2009 compared to June 30, 2008. During the three and six months ended June 30, 2009 compared to the same periods in 2008, travel related expenses also decreased as a result of the decreased services staffing by $287,000 and $468,000, respectively, which was partially offset by an increase of $125,000 and $153,000, respectively, in CaaS data expenses primarily due to higher costs to provide the contracted
services.  We believe CaaS expenses will continue to increase as our CaaS business grows.
 
 Gross Profit

Three Months Ended
June 30,


Six Months Ended
June 30,2009


2008


2009


2008($ in thousands)Gross profit

$
22,346


$
20,613


$
42,792


$
41,069Change from prior year period


8
%


11
%


4
%


16
%Percentage of total revenues


68
%


67
%


69
%


68
%
 
 Gross profit increased during the three and six months ended June 30, 2009 compared to the same periods in 2008 primarily due to an increase in total revenues during those periods, partially offset by a smaller increase in cost of revenues.
 
 Gross profit as a percentage of total revenues in any particular quarter is dependent upon product and services revenues recognized versus costs of product and costs of services incurred and is expected to vary.
 
 Operating Expenses
 Sales and Marketing

Three Months Ended
June 30,


Six Months Ended
June 30,2009


2008


2009


2008($ in thousands)Sales and marketing expenses

$
9,965


$
10,138


$
19,179


$
20,322Change from prior year period


(2
)%


15
%


(6
)%


16
%Percentage of total revenues


30
%


33
%


31
%


34
%Percentage of net product revenues


86
%


89
%


91
%


88
%
 
 Sales and marketing expenses primarily include compensation, travel, and promotional costs related to our sales, marketing and channel management operations. These expenses decreased $173,000 in the three months ended June 30, 2009 compared to the same quarter last year due to decreases in travel expenses of $346,000, third party referral
fees of $241,000 and stock option compensation expense of $153,000. The decrease in stock option compensation expense was due to some stock options becoming fully vested in 2008 while stock options with a lower compensation cost than in previous years were granted in 2008. Partially offsetting these decreases was an increase in salary and incentive compensation expenses due to a 9% increase in orders and an overall increase in sales incentive awards compared to the previous year.
 
 During the six months ended June 30, 2009 compared to the six months ended June 30, 2008, sales and marketing expenses decreased by $1.1 million as our cost management programs reduced travel expenses by $585,000, corporate marketing costs by $223,000, charges for outsourced services by $253,000 and recruiting costs by $137,000.  We
expect marketing costs to increase in future quarters as our profitability allows and as we begin to resume targeted marketing programs.
 
 16
 Research and Development

Three Months Ended
June 30,


Six Months Ended
June 30,2009


2008


2009


2008($ in thousands)Research and development expenses

$
5,986


$
5,336


$
11,613


$
10,301Change from prior year period


12
%


26
%


13
%


27
%Percentage of total revenues


18
%


17
%


19
%


17
%
 
 Research and development expenses are comprised primarily of compensation and depreciation expenses. Research and development expenses increased during the three months ended June 30, 2009 compared to the same period in 2008 primarily due to an increase in compensation expense of $378,000, resulting from a 12% staffing increase in the
research and development department at June 30, 2009 compared to June 30, 2008. The staffing increase was the result of the AcroSoft acquisition and general research and development staffing increases. In addition, the rent, internal depreciation and corporate insurance allocated to research and development increased by $159,000 due to the staffing additions in the research and development department. Finally, outsourced services increased by $117,000 due to an increased use of outsourced services
for localization efforts of our product.
 
 During the six months ended June 30, 2009 compared to the same period in 2008, research and development compensation expense increased $849,000, primarily due to the increase in staffing at June 30, 2009 compared to June 30, 2008. In addition, the rent and internal depreciation allocated to research and development increased by
$403,000 due to the staffing additions in the research and development department.
 
 We believe that investment in research and development is critical to our future growth and competitive position in the marketplace and is directly related to timely development of new and enhanced solutions that are central to our business. As a result, we expect research and development expenses will continue to increase in future periods
as our profitability allows.
 
 General and Administrative

Three Months Ended
June 30,


Six Months Ended
June 30,2009


2008


2009


2008($ in thousands)General and administrative expenses

$
3,416


$
3,848


$
6,604


$
7,786Change from prior year period


(11
)%


17
%


(15
)%


23
%Percentage of total revenues


11
%


13
%


11
%


13
%
  General and administrative expenses include salary and incentive compensation expense as well as general corporate expenses that are not allocable to other departments, such as legal and other professional fees and bad debt expense.
 
 During the three months ended June 30, 2009, these expenses decreased by $432,000 compared to the same quarter last year. A 7% reduction in general and administrative staff resulted in a $165,000 decrease in compensation expense and an associated decrease of $117,000 in allocated shipping, office supplies and depreciation.
 
 During the six months ended June 30, 2009, general and administrative expenses decreased by $1.2 million compared to the six months ended June 30, 2008. This decrease was primarily due to lower compensation expense of $337,000 resulting from staff reductions and an associated decrease of $417,000 due to decreased travel, professional development
expenses and allocated depreciation. Stock option compensation expense decreased $110,000 as some stock options fully vested in 2008 while stock options with a lower compensation cost than in previous years were granted in 2008. These lower compensation expenses were partially offset by an increase in incentive compensation of $253,000.
  Other Income (Expense)
 
 Interest Income

Three Months Ended
June 30,


Six Months Ended
June 30,2009


2008


2009


2008($ in thousands)Cash, cash equivalents and short-term investments (average)

$
51,941


$
49,544


$
49,781


$
47,989Interest income


73



344



181



803Return on investment (annualized)


0.56
%


2.8
%


0.73
%


3.4
%
 
 Interest earned on investments decreased $271,000 and $622,000, respectively, during the three and six months ended June 30, 2009, compared to the same periods in 2008, due to lower interest rates. We continue to monitor the allocation of funds in which we have invested to maximize our return on investment while utilizing safe investment
alternatives within our established investment policy.
 
 17
 Other Income (Expense), Net

Three Months Ended
June 30,


Six Months Ended
June 30,2009


2008


2009


2008($ in thousands)Other income (expense), net

$
649


$
(90
)

$
225


$
124
 
 Other income (expense), net includes foreign currency transaction gains and losses. Effective April 1, 2009, we changed our reporting to present gains and losses resulting from foreign currency fluctuations in this category rather than within operating expense because such gains and losses are incidental to our operations. Foreign currency
transaction gains and losses can fluctuate based on the amount of revenue that is generated in certain international currencies, particularly the Euro, and the exchange gain or loss that results from foreign currency disbursements and receipts. In 2008, these amounts included foreign withholding expenses that were later reclassified in the third quarter of 2008 as a result of a study of our foreign tax withholdings, which determined that we had sufficient and appropriate foreign source income to record our foreign
withholdings as a tax credit instead of a deduction to net income.
 
 During the three months ended June 30, 2008, we recorded a gain from foreign currency transactions of $13,000 and expense of $102,000 related to foreign tax withholding. For the first six months of 2008, we recorded a gain from foreign currency transactions of $338,000 and expense of $214,000 related to foreign tax withholdings.
 
 Income tax expense

Three Months Ended
June 30,


Six Months Ended
June 30,2009


2008


2009


2008($ in thousands)Income tax expense

$
1,604


$
700


$
2,482


$
1,625
 
 We incurred $1.6 million and $2.5 million of income tax expense during the three and six months ended June 30, 2009, respectively, compared to $700,000 and $1.6 million of income tax expense recorded during the three and six months ended June 30, 2008, respectively.  For the three
and six months ended June 30, 2009, $60,000 and $139,000, respectively, is expected to result in cash payments and the remaining amount was offset by the utilization of our deferred tax assets and stock-based compensation deductions. We have significant remaining credits and deductions to offset taxable income and taxes payable as described in Note 8 of Notes to Condensed Consolidated Financial Statements in Part I, Item 1 of this Quarterly Report on Form 10-Q. Our effective tax rate was 43% as of June 30, 2009.
The tax rate is determined by considering the federal tax rate, rates in various states and international jurisdictions in which we have operations, and the amount of the stock-based compensation that is not deductible for income tax purposes.
 
 Liquidity and Capital Resources
 
 We generate cash from the collections related to licensing our products and from annual license renewals, maintenance and support and other services revenues. We use cash primarily for paying our employees (including salaries, commissions and benefits), leasing office space, paying travel expenses and marketing activities, paying vendors
for hardware, other services and supplies, purchasing property and equipment, repurchasing $10.0 million of our common stock during the third and fourth quarters of 2008 and, during the second quarter of 2009, acquiring AcroSoft for $2.4 million. We continue to be debt free.
 
 We determine liquidity by combining cash and cash equivalents and short-term investments as shown in the table below. Based on our recent performance and current expectations, we believe that our current liquidity position, when combined with our anticipated cash flows from operations, will be sufficient to satisfy our working capital needs
and current or expected obligations associated with our operations over the next 12 months. Our future requirements will depend on many factors, including cash flows from operations, territory expansion and product development decisions and potential acquisitions. If our liquidity is not sufficient to cover our needs, we may be forced to raise additional capital, either through the capital markets or debt financings, and may not be able to do so on favorable terms or at all.
 
 Our liquidity position at June 30, 2009 and December 31, 2008 was as follows:
 
 June 30,


December 31,2009


2008($ in thousands)Cash and cash equivalents

$
48,062


$
34,705Short-term investments


5,989



10,805Liquidity, net

$
54,051


$
45,510
  The amount that we report as cash and cash equivalents or as short-term investments fluctuates depending on investing decisions in each period. Purchases of short-term investments and property and equipment are reported as a use of cash and the related receipt of proceeds upon maturity of investment is reported as a source of cash.
 
 The following table shows the total increase from cash and cash equivalents from operating activities, investing activities and financing activities for the stated periods:
 
 Six Months Ended June 30,2009


2008($ in thousands)Cash provided by operating activities

$
9,347


$
6,762Cash provided by (used in) investing activities


1,868



(1,010
)Cash provided by financing activities


2,142



573Total increase in cash and cash equivalents

$
13,357


$
6,325
  18
 
 Operating cash was generated by our net income and a decrease in accounts receivable and depreciation. The increase in net cash provided by investing activities was due primarily to the maturity of investments which are now being held as cash and cash equivalents.
 
 As of June 30, 2009, there have been no material changes in our contractual obligations as set forth in the Contractual Obligations table disclosed in our Annual Report on Form 10-K for the year ended December 31, 2008.
  Off-Balance Sheet Arrangements
 
 Except as set forth in the Contractual Obligations table disclosed in our Annual Report on Form 10-K for the year ended December 31, 2008, we have no off-balance sheet arrangements that have or are reasonably likely to have a current or future material impact on our financial condition, changes in financial condition, revenues or expenses,
results of operations, liquidity, capital expenditures or capital resources as of June 30, 2009.
  We provide indemnifications of varying scope and amount to certain customers against claims of intellectual property infringement made by third parties arising from the use of our products. Our direct software license agreements, in accordance with FASB Interpretation No. 45, Guarantor’s
Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others - an interpretation of FASB Statement No. 5, No. 57 and No. 107, include certain provisions for indemnifying customers, in material compliance with their license agreement, against liabilities if our software products infringe upon a third party's intellectual property rights, over the life of the agreement. There is no maximum potential amount of future payments set under the guarantee. However,
we may at any time and at our option and expense:  (i) procure the right of the customer to continue to use our software that may infringe a third party’s rights; (ii) modify our software so as to avoid infringement; or (iii) require the customer to return our software and refund the customer the fee actually paid by the customer for our software less depreciation based on a five-year straight-line depreciation schedule. The customer’s failure to provide timely notice or reasonable assistance
will relieve us of our obligations under this indemnification to the extent that we have been actually and materially prejudiced by such failure. To date, we have not incurred, nor do we expect to incur, any material related costs and therefore, have not reserved for such liabilities.
  Our direct software license agreements also include a warranty that our software products will substantially conform to our software user documentation for a period of one year, provided the customer is in material compliance with the software license agreement. To date, we have not incurred any material costs associated with these product
warranties, and as such, we have not reserved for any such warranty liabilities in our operating results.
  Critical Accounting Policies and Estimates
 
 The preparation of our condensed consolidated financial statements requires us to make estimates and judgments that affect the reported amount of assets, liabilities, revenue and expenses. Actual results may differ from those estimates and judgments under different assumptions or conditions. We have discussed the critical accounting policies
that we believe affect our more significant estimates and judgments used in the preparation of our consolidated financial statements in the “Management’s Discussion and Analysis of Financial Condition and Results of the Operations—Critical Accounting Policies and Estimates” section of our Annual Report on Form 10-K for the year ended December 31, 2008 and in Note 2 of Notes to Consolidated Financial Statements included in our Annual Report on Form 10-K for the year ended December 31, 2008.
For a further summary of certain accounting policies, see Note 2 of Notes to Condensed Consolidated Financial Statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q.
 
 Item 3.
Quantitative and Qualitative Disclosures about Market Risk.
 
 We develop software application products in the United States and license our products worldwide. As a result, our financial results could be affected by market risks, including changes in foreign currency exchange rates, interest rates or weak economic conditions in certain markets. Market risk is the potential of loss arising from unfavorable
changes in market rates and prices.
 
 Foreign Currency Exchange Rates
 
 We transact business in certain foreign currencies including the British pound and the Euro. However, as a majority of the orders we receive are denominated in United States dollars, a strengthening of the dollar could make our products more expensive and less competitive in foreign markets. We have not historically used foreign currency
options or forward contracts to hedge our currency exposures because of variability in the timing of cash flows associated with our larger contracts. We did not have any such hedge instruments in place at June 30, 2009. Rather, we attempt to mitigate our foreign currency risk by generally transacting business and paying salaries in the functional currency of each of the major countries in which we do business, thus creating natural hedges. Additionally, as our business matures in foreign markets, we may offer
our products and services in certain other local currencies. If this were to occur, foreign currency fluctuations would have a greater impact on us and may have an adverse effect on our results of operations. Historically, our gains or losses on foreign currency exchange transactions have been immaterial to our consolidated financial statements. For the three and six months ended June 30, 2009, our foreign currency exchange transaction
gains amounted to $655,000 and $231,000, respectively.
  Interest Rate Risk
 
 We invest cash balances in excess of operating requirements in securities that have maturities of one year or less. The carrying value of these securities approximates market value, and there is no long-term interest rate risk associated with these investments.
 
 19
 Item 4.
Controls and Procedures.
 
 We maintain a set of disclosure controls and procedures that are designed to ensure that information required to be disclosed by us in the reports filed by us under the Securities Exchange Act of 1934, as amended (the “Exchange Act”) is (a) recorded, processed, summarized and reported within the time periods specified in the SEC’s
rules and forms; and (b) accumulated and communicated to our management, including our principal executive and principal financial officers, to allow timely decisions regarding required disclosures. We carried out an evaluation, under the supervision and with the participation of our management, including our President and Chief Executive Officer (principal executive officer) and our Chief Financial Officer (principal financial officer), of the effectiveness of the design and operation of our disclosure controls
and procedures as of June 30, 2009 pursuant to Rule 13a-15 of the Exchange Act. Based on that evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures were effective as of June 30, 2009.
 
 There have been no changes in our internal control over financial reporting that occurred during the three months ended June 30, 2009 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
 
 PART II. OTHER INFORMATION
 
 Item 1.
Legal Proceedings.
 
 The information set forth under “Legal Proceedings” in Note 7 of Notes to Condensed Consolidated Financial Statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q is incorporated herein by reference.
 
 Item 1A.
Risk Factors.
 
 In addition to the information set forth in this Quarterly Report on Form 10-Q and before deciding to invest in, or retain, shares of our common stock, you also should carefully review and consider the information contained in our other reports and periodic filings that we make with the SEC, including, without limitation, the information
contained under the caption Part I, Item 1A “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2008. Those risk factors could materially affect our business, financial condition and results of operations.
 
 The risks that we describe in our public filings are not the only risks that we face. Additional risks and uncertainties not currently known to us, or that we presently deem to be immaterial, also may materially adversely affect our business, financial condition and results of operations. There have been no material changes from the risk
factors previously disclosed in our Annual Report on Form 10-K for the year ended December 31, 2008.
 
 Item 4.
Submission of Matters to a Vote of Security Holders.
 
 We held our Annual Meeting of Shareholders on May 28, 2009. At that meeting, our shareholders:
 
 ·
reelected Edward L. Hamburg, Ph.D. as our Director for a three-year term or until his successor is elected and has qualified; and
 
 ·
consented to the appointment of KPMG LLP as our independent registered public accounting firm for 2009.
 
 The final results of the votes taken at the annual meeting were as follows:
 Votes
FOR


Votes
WITHHELDElection of Director:Edward L. Hamburg, Ph.D.


14,328,641



690,597Votes
FOR


Votes
AGAINST

Votes
ABSTAINEDVote on Proposal:To consent to the appointment of KPMG LLP as our independent registered public accounting firm for 2009


14,901,294



30,288

87,656
 
 
 
 In addition, the following Directors also have terms in office that continue until the annual meeting of shareholders in the year indicated:
 
 Director
YearMichael C. Heim
2010Mark E. Hill
2010Donald E. Brown, M.D.
2011Richard A. Reck
2011
  20
  
 Item 6.
Exhibits.
 
 (a)
Exhibits
 
 Incorporated by ReferenceExhibit Number

Exhibit Description

Form

Exhibit

Filing Date

Filed Herewith3.1

Restated Articles of Incorporation of the Company, as currently in effect
S-1
(Registration No. 333-79509)

3.1

5/28/19993.2

Amended By-Laws of the Company, as currently in effect

8-K

3.2

7/28/200931.1

Certification of the Chief Executive Officer pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002






X31.2

Certification of the Chief Financial Officer pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002






X32.1

Certification of the Chief Executive Officer, pursuant to 18 U. S. C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002






X32.2

Certification of the Chief Financial Officer, pursuant to 18 U. S. C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002






X
  21
  SIGNATURE
 
 Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned hereunto duly authorized.
 
 Interactive Intelligence, Inc.
(Registrant)Date:   August 10, 2009



By:

/s/     Stephen R. HeadStephen R. Head
Chief Financial Officer,
Vice President of Finance and Administration,
Secretary and Treasurer
(Principal Financial Officer and Principal Accounting Officer)