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 March 31, 2011





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.YesRNo*





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
R

Non-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 April 29, 2011, there were 18,697,210 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 March 31, 2011 and December 31, 2010


1Condensed Consolidated Statements of Income for the Three Months Ended March 31, 2011 and 2010


2Condensed Consolidated Statement of Shareholders’ Equity for the Three Months Ended March 31, 2011


3Condensed Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2011 and 2010


4Notes to Condensed Consolidated Financial Statements


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


13Item 3.
Quantitative and Qualitative Disclosures About Market Risk.


21Item 4.
Controls and Procedures.


21PART II. OTHER INFORMATIONItem 1.
Legal Proceedings.


22Item 1A.
Risk Factors.


22Item 6.
Exhibits.


22SIGNATURE


23








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 March 31, 2011 and December 31, 2010


(In thousands, except share and per share amounts)





March 31,


December 31,2011


2010(unaudited)AssetsCurrent assets:Cash and cash equivalents

$
51,870


$
48,300Short-term investments


34,439



37,582Accounts receivable, net of allowance for doubtful accounts of $1,365 at March 31, 2011 and $1,148 at December 31, 2010


37,295



36,130Deferred tax assets, net


5,112



5,499Prepaid expenses


9,054



7,456Other current assets


4,773



4,989Total current assets


142,543



139,956Long-term investments


5,566



--Property and equipment, net


11,877



10,336Deferred tax assets, net


2,494



2,765Goodwill


14,567



11,371Intangible assets, net


12,068



11,001Other assets, net


931



803Total assets

$
190,046


$
176,232Liabilities and Shareholders’ EquityCurrent liabilities:Accounts payable and accrued liabilities

$
15,139


$
16,364Accrued compensation and related expenses


5,303



6,553Deferred product revenues


4,989



3,350Deferred services revenues


47,109



43,281Total current liabilities


72,540



69,548Deferred revenue


8,935



7,420Total liabilities


81,475



76,968Commitments and contingencies


--



--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; 18,638,444 issued and outstanding at March 31, 2011, 18,157,789 issued and outstanding at December 31, 2010


186



182Additional paid-in capital


109,990



103,837Accumulated other comprehensive loss


(235
)


(290
)Accumulated deficit


(1,370
)


(4,465
)Total shareholders’ equity


108,571



99,264Total liabilities and shareholders’ equity

$
190,046


$
176,232





See Accompanying Notes to Condensed Consolidated Financial Statements


1


Interactive Intelligence, Inc.


Condensed Consolidated Statements of Income (unaudited)


For the Three Months Ended March 31, 2011 and 2010


(In thousands, except per share amounts)





Three Months Ended

March 31,2011


2010Revenues:Product

$
20,766


$
15,786Recurring


20,746



15,925Services


6,218



3,312Total revenues


47,730



35,023Cost of revenues:Product


6,196



4,799Recurring


5,282



3,423Services


3,712



2,174Amortization of intangible assets


35



16Total cost of revenues


15,225



10,412Gross profit


32,505



24,611Operating expenses:Sales and marketing


14,157



10,352Research and development


8,147



6,425General and administrative


5,095



3,836Amortization of intangible assets


184



9Total operating expenses


27,583



20,622Operating income


4,922



3,989Other income (expense):Interest income, net


43



42Other expense, net


(166
)


(775
)Total other expense, net


(123
)


(733
)Income before income taxes


4,799



3,256Income tax expense


1,704



1,388Net income

$
3,095


$
1,868Net income per share:Basic

$
0.17


$
0.11Diluted


0.16



0.10Shares used to compute net income per share:Basic


18,417



17,320Diluted


19,780



18,708








See Accompanying Notes to Condensed Consolidated Financial Statements





2


Interactive Intelligence, Inc.


Condensed Consolidated Statement of Shareholders’ Equity (unaudited)


For the Three Months Ended March 31, 2011


(In thousands)





Common Stock


Additional

Paid-in


Accumulated Other Comprehensive Gain


AccumulatedShares


Amount


Capital


(Loss)


Deficit


TotalBalances, December 31, 2010


18,158


$
182


$
103,837


$
(290
)

$
(4,465
)

$
99,264Stock-based compensation


--



--



1,318



--



--



1,318Exercise of stock options


476



4



3,877



--



--



3,881Issuances of common stock


4



--



96



--



--



96Tax benefits from stock-based payment arrangements


--



--



862



--



--



862Comprehensive income:Net income


--



--



--



--



3,095



3,095Net unrealized investment gain


--



--



--



55



--



55Total comprehensive income


--



--



--



55



3,095



3,150Balances, March 31, 2011


18,638


$
186


$
109,990


$
(235
)

$
(1,370
)

$
108,571








See Accompanying Notes to Condensed Consolidated Financial Statements


3


Interactive Intelligence, Inc.


Condensed Consolidated Statements of Cash Flows (unaudited)


For the Three Months Ended March 31, 2011 and 2010


(In thousands)





Three Months Ended

March 31,2011


2010Operating activities:Net income

$
3,095


$
1,868Adjustments to reconcile net income to net cash provided by operating activities:Depreciation, amortization and other non-cash items


1,481



1,059Stock-based compensation expense


1,318



1,012Tax benefits from stock-based payment arrangements


(862
)


(1,251
)Deferred income tax


258



(150
)Accretion of investment income


(682
)


27Changes in operating assets and liabilities:Accounts receivable


(49
)


5,110Prepaid expenses


(1,311
)


(346
)Other current assets


372



(47
)Other assets


(128
)


53Accounts payable and accrued liabilities


(1,922
)


143Accrued compensation and related expenses


(1,585
)


(1,304
)Deferred product revenues


1,793



(615
)Deferred services revenues


4,889



(214
)Net cash provided by operating activities


6,667



5,345Investing activities:Sales of available-for-sale investments


21,028



2,550Purchases of available-for-sale investments


(22,740
)


(7,828
)Purchases of property and equipment


(2,139
)


(985
)Acquisition, net of cash


(4,111
)


--Unrealized gain on investment


26



--Net cash used in investing activities


(7,936
)


(6,263
)Financing activities:Proceeds from stock options exercised


3,881



691Proceeds from issuance of common stock


96



158Tax benefits from stock-based payment arrangements


862



1,251Net cash provided by financing activities


4,839



2,100Net increase in cash and cash equivalents


3,570



1,182Cash and cash equivalents, beginning of period


48,300



48,497Cash and cash equivalents, end of period

$
51,870


$
49,679Cash paid during the year for:Interest

$
--


$
1Income taxes


842



318Other non-cash item:Purchase of property and equipment payable at end of period

$
746


$
57





See Accompanying Notes to Condensed Consolidated Financial Statements


4


Interactive Intelligence, Inc.


Notes to Condensed Consolidated Financial Statements


March 31, 2011 and 2010 (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 (“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 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, 2010 have been derived from the Company’s audited consolidated financial statements at that date but do not include all of the information and notes required by 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, 2010, included in the Company’s most recent Annual Report on Form 10-K as filed with the SEC on March 16, 2011. 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 condensed consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries after elimination of all significant intercompany accounts and transactions.





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, 2010.





During the three months ended March 31, 2011, there were no material changes to the Company’s significant accounting policies or critical accounting estimates.





In September 2009, the Financial Accounting Standards Board (“FASB”) issued FASB Accounting Standards Update (“ASU”) 2009-13, Multiple-Deliverable Revenue Arrangements, which addresses criteria for separating consideration in multiple-element arrangements. The guidance requires companies allocating the overall consideration to each deliverable to use an estimated selling price of individual deliverables in the arrangement in the absence of vendor-specific objective evidence or other third-party evidence of the selling price for the deliverables. This guidance is effective for fiscal years beginning on or after June 15, 2010 and early adoption was permitted. The Company adopted this guidance on January 1, 2011 and there was no material impact on its consolidated financial statements.
 
 In September 2009, the FASB issued FASB ASU 2009-14, Certain Revenue Arrangements that Include Software Elements, which excludes from the scope of the FASB’s software revenue guidance tangible products that contain both software and non-software components that function together to deliver a product’s essential functionality. This guidance is effective prospectively for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010 with early adoption permitted. The Company adopted this guidance on January 1, 2011 and there was no material impact on its consolidated financial statements.
 
 In December 2010, the FASB issued FASB ASU 2010-29, Disclosure of Supplementary Pro Forma Information for Business Combinations,which amends FASB Accounting Standards Codification (“ASC”) Topic 805, Business Combinations(“FASB ASC 805”). The updated guidance requires that if a public entity presents comparative financial statements, the acquirer should disclose revenue and earnings of the combined entity as though the business combination that occurred during the current year had occurred as of the beginning of the comparable prior annual reporting period only. This updated guidance also expands the supplemental pro forma disclosures to require a company to include a description of the nature and amount of material, nonrecurring pro forma adjustments directly attributable to the business combination included in the reported pro forma revenue and earnings. The guidance is effective prospectively for business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2010. Early adoption was permitted. The Company adopted this guidance on January 1, 2011 and there was no material impact on its consolidated financial statements.


5


3.
FAIR VALUE MEASUREMENTS
 
 FASB ASC Topic 820, Fair Value Measurements and Disclosures (“FASB ASC 820”), 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. FASB ASC 820 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 short-term investments all mature in less than one year and its long-term investments all mature within three years. Both short-term and long-term investments are considered available for sale. The Company’s assets that are measured at fair value on a recurring basis are 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 money market securities. Such instruments are 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, agency bonds, T-bills and  commercial paper. Such instruments are 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, short-term investments and long-term investments on its condensed consolidated balance sheet, measured at fair value as of March 31, 2011 (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

$
9,490


$
9,490


$
--


$
--Cash


9,112



9,112Commercial paper


2,999



2,999Agency bonds


1,650



1,650



--



--Total

$
23,251


$
23,251


$
--


$
--Short-term investments:Corporate notes

$
22,328


$
--


$
22,328


$
--Agency bonds


6,415



--



6,415



--Commercial paper


5,696



--



5,696



--Total

$
34,439


$
--


$
34,439


$
--Long-term investments:Corporate notes

$
3,971


$
--


$
3,971


$
--Agency bonds


1,595



--



1,595



--Total

$
5,566


$
--


$
5,566


$
--




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 FASB ASC Topic 260, 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):





6




Three Months Ended

March 31,2011


2010Net income, as reported (A)

$
3,095


$
1,868Weighted average shares of common stock outstanding (B)


18,417



17,320Dilutive effect of employee stock options


1,363



1,388Common stock and common stock equivalents (C)


19,780



18,708Net income per share:Basic (A/B)

$
0.17


$
0.11Diluted (A/C)


0.16



0.10




The Company’s calculation of diluted net income per share for the three months ended March 31, 2011 and 2010 excludes stock options to purchase approximately 239,000 and 796,000 shares of the Company’s common stock, respectively, as their effect would be anti-dilutive.





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 (“RSUs”), 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 7,050,933 shares are available for delivery under the 2006 Plan, which consists of (i) 3,350,000 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 Select Market, on the business day immediately preceding the date of grant.
 The Company grants four types of equity compensation awards, including three types of stock options and RSUs. The first type of stock option granted by the Company to new employees and newly-elected non-employee directors is non-performance-based 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.
 
 The second type of stock option granted by the Company is performance-based subject to cancellation if the specified performance targets 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 third type of stock option granted by the Company is director options granted to non-employee directors annually. These options are similar to the non-performance-based options described above except that 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 over one year. The director options are generally granted at the Company’s Annual Meeting of Shareholders during the second quarter of a fiscal year.
 
 The fourth type of equity compensation awards granted to employees by the Company is RSUs. Commencing in January 2011, the Company began granting RSUs to certain key employees. The fair value of the RSUs is determined on the date of grant and the RSUs vest in four equal annual installments beginning one year after the grant date. RSUs are not included in issued and outstanding common stock until the shares are vested and settlement has occurred.


The plans may be terminated by the Company’s Board of Directors at any time.
 
 Stock-Based Compensation Expense Information
 
 The following table summarizes the allocation of stock-based compensation expense related to employee and director stock options and RSUs under FASB ASC Topic 718, Compensation – Stock Compensation for the three months ended March 31, 2011 and 2010 (in thousands):


Three Months Ended

March 31,2011


2010Stock-based compensation expense by category:Cost of recurring revenues

$
105


$
31Cost of services revenues


25



48Sales and marketing


392



324Research and development


408



298General and administrative


388



311Total stock-based compensation expense

$
1,318


$
1,012





7





Stock Option and Restricted Stock Unit Valuation





The Company estimated the fair value of stock options using the Black-Scholes valuation model. 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, 2010. The weighted-average estimated per option value of non-performance-based and performance-based options granted during the three months ended March 31, 2011 and 2010 used the following assumptions:




Three Months Ended

March 31,Valuation assumptions for non-performance-based options:

2011


2010Dividend yield


--
%


--
%Expected volatility


63.10
%


69.10
%Risk-free interest rate


1.74
%


2.06
%Expected life of option (in years)


4.25



4.25





Three Months Ended

March 31,Valuation assumptions for performance-based options:

2011


2010Dividend yield


--
%


--
%Expected volatility


65.55
%


67..81
%Risk-free interest rate


1.97
%


2.30
%Expected life of option (in years)


4.75



4.75





RSUs are valued using the fair market value of the Company’s stock on the date of grant on a straight line basis taking into account an estimated forfeiture rate.


Stock Option and RSU Activity


The following table sets forth a summary of stock option activity for the three months ended March 31, 2011:


As of March 31, 2011Options


Weighted-

Average

Exercise

PriceBalances, beginning of year


3,129,373


$
11.58Options granted


293,500



32.33Options exercised


(476,792
)


8.14Options cancelled, forfeited or expired


(8,500
)


23.33Options outstanding


2,937,581



14.17Option price range

$
2.55 – 32.33Weighted-average fair value of options granted

$
16.40Options exercisable


1,743,848


$
10.47




The following table sets forth a summary of RSU activity for the three months ended March 31, 2011:


As of March 31, 2011AwardsBalances, beginning of year


--RSUs granted


117,007RSUs released


--RSUs forfeited


(667
)RSUs outstanding


116,340


As of March 31, 2011, there were 1,316,047 shares of stock available for issuance for equity compensation awards under the 2006 Plan, including the three types of stock options and RSUs.


8




6.
CONCENTRATION OF CREDIT RISK





No customer or partner accounted for more than 10% of the Company’s accounts receivable as of March 31, 2011 and December 31, 2010. No customer or partner accounted for 10% or more of the Company’s revenues for the three months ended March 31, 2011 and 2010. The United States and Canada accounted for 61% and 11%, respectively, of the Company’s revenues in the three months ended March 31, 2011. No other country accounted for more than 10% of the Company’s revenues in the three months ended March 31, 2011. No country other than the United States accounted for more than 10% of the Company's revenues in the three months ended March 31, 2010.




7.
COMMITMENTS AND CONTINGENCIES




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 assure you 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.





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.





Guarantees




The Company provides indemnifications of varying scope and amount to certain customers against claims of intellectual property infringement made by third parties arising from the use of its products.The Company’s direct software license agreements, in accordance with FASB ASC Topic 460, Guarantees, include certain provisions for indemnifying customers, in material compliance with their license agreement, against liabilities if the Company’s 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, the Company may at any time and at its option and expense:  (i) procure the right of the customer to continue to use the Company’s software that may infringe a third party’s rights; (ii) modify its software so as to avoid infringement; or (iii) require the customer to return its software and refund the customer the fee actually paid by the customer for its 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 the Company of its obligations under this indemnification to the extent that it has been actually and materially prejudiced by such failure. To date, the Company has not incurred, nor does it expect to incur, any material related costs and, therefore, has not reserved for such liabilities.




The Company’s software license agreements also include a warranty that its software products will substantially conform to its software user documentation for a period of one year, provided the customer is in material compliance with the software license agreement. To date, the Company has not incurred any material costs associated with these product warranties, and as such, has not reserved for any such warranty liabilities in its operating results.




Lease Commitments




The Company leases space for its world headquarters in Indianapolis, Indiana under an operating lease agreement and amendments which expire on March 31, 2018. The Company also has multiple leases for offices and other space throughout the world. The office space for sales, services, development and international offices are rented under operating leases and expire at various times through 2016. In accordance with FASB ASC Topic 840, Leases, rental expense is recognized ratably over the lease period, including those leases containing escalation clauses.





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 sets forth the items accounting for the difference between expected income tax expense at the 35% federal statutory rate compared to actual income tax expense recorded in the Company’s condensed consolidated financial statements (in thousands):





Three Months Ended

March 31,2011


2010Expected income tax expense at 35% tax rate

$
1,680


$
1,139State taxes, net of federal benefit


191



237Stock-based compensation expense related to non-deductible stock option expense


35



99Disqualifying dispositions of stock options


(223
)


(80
)Research tax credit


(138
)


--Other


159



(7
)Income tax expense

$
1,704


$
1,388





9





FASB ASC Topic 740, Income Taxes, prescribes a recognition threshold and measurement attributes for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return.  The Company has 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. Prior to the fourth quarter of 2007, this uncertain tax position had not been recognized because the Company had a full valuation allowance established.  The balance of the reserve was approximately $1.1 million at December 31, 2010. As of March 31, 2011, the reserve 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 2006 and forward remain open for examination for federal tax purposes and tax years 2005 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, 2010 will remain subject to examination until the respective tax year is closed.





During the third quarter of 2010, the Company utilized its remaining net operating losses generated from the exercise of stock options in prior years and began utilizing deferred tax assets generated from foreign withholding credits. At March 31, 2011, the Company had approximately $4.0 million of alternative minimum tax, federal and state research tax credit carryforwards and foreign tax credits available to offset taxes payable.





9.
ACQUISITIONS





Agori Acquisition


The Company entered into a stock purchase agreement, dated as of February 28, 2011, with Agori Communications, GmbH (“Agori”), a Frankfurt, Germany-based reseller of the Company’s solutions. Pursuant to the terms of the stock purchase agreement, the Company purchased 100% of Agori’s outstanding capital stock for an aggregate purchase price of $4.9 million, including $687,000 related to the working capital of Agori, funded with cash-on-hand. The Company deposited $493,000 of the purchase price into an escrow account to ensure funds are available to pay indemnification claims, if any. The Company acquired Agori as part of its growth strategy of accelerating business in key international markets, including Germany, which is currently the fourth largest economy in the world and the Company’s largest market in Europe, the Middle East and Africa. The acquisition was accounted for using the acquisition method of accounting in accordance with FASB ASC 805, and the results of Agori’s operations were included in the Company’s condensed consolidated financial statements commencing on March 1, 2011.
 The purchase price allocations for the Company’s acquisition of Agori are based on a third-party valuation report which was prepared in accordance with the provisions of FASB ASC 805 and are considered preliminary and are subject to finalization. The Company is in the process of finalizing the valuation of Agori, which may affect the assigned values. Adjustments to the current values will result in a corresponding adjustment to recorded goodwill. 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):
 February 28, 2011Cash and cash equivalents

$
815Accounts receivable


1,116Prepaid expenses


287Property and equipment, net


123Other assets, net


156Intangible assets, net


1,280Goodwill


3,196Total assets acquired


6,973Accounts payable and accrued liabilities


(1,012
)Accrued compensation and related expenses


(335
)Deferred tax liability


(400
)Deferred services revenues


(300
)Net assets acquired

$
4,926
 The fair value of financial assets acquired includes accounts receivable with a fair value and a contractual value of $1.1 million. The receivables consist of amounts due from customers for products sold and/or services rendered.
 The Company has recorded a deferred tax liability of $400,000 associated with the intangible asset recorded in connection with the Agori acquisition. This resulted in a corresponding adjustment recorded to goodwill.
 
 Acquisition-related professional fees recognized during the first quarter of 2011 totaled approximately $168,000 and included transaction costs such as legal, accounting, valuation and other professional services, which were expensed as incurred. These costs are included within general and administrative expenses on the condensed consolidated statements of income.
 
 The premium paid over the fair value of the net assets acquired in the purchase, or goodwill, was primarily attributed to Agori’s existing client base. Included within goodwill is the assembled workforce, comprised of 16 employees, 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 historical 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 sets forth the customer relationships acquired and their economic useful live at the date of acquisition (dollars in thousands):
 
 As of March 31, 2011Gross Amount


Accumulated Amortization


Net Amount


Economic Useful Life

(in years)Customer relationships

$
1,280



--


$
1,280



8


10





Pro Forma Results


The following table shows unaudited pro forma results of operations as if we had acquired Agori on January 1, 2010 (in thousands, except per share amounts):
 
 Three Months EndedMarch 31,2011


2010Revenue

$
48,180


$
35,810Net Income


3,119



1,903EPS – Basic


0.17



0.11EPS - Diluted


0.16



0.10
 
 The unaudited pro forma results of operations are not necessarily indicative of the actual results that would have occurred had the transaction actually taken place at the beginning of the periods indicated.
 Latitude Acquisition
 
 The Company entered into a stock purchase agreement, dated as of October 5, 2010, with Global Software Services, Inc., doing business as Latitude Software (“Latitude”), a privately-held provider of accounts receivable management software and services. Pursuant to the terms of the stock purchase agreement, the Company purchased 100% of Latitude’s outstanding capital stock for an aggregate purchase price of $15.6 million, including $1.6 million related to the working capital of Latitude, funded with cash-on-hand. The Company deposited $1.1 million of the purchase price into an escrow account to ensure funds are available to pay indemnification claims, if any. Latitude is operating as a subsidiary of the Company. The Company acquired Latitude as part of its growth strategy of adding industry-specific applications and expertise. With a broader focus on Latitude, the Company intends to create tighter integration between Latitude’s applications and its core Interaction Center Platform® technology, enhance Latitude solutions for first-party debt collections, incorporate Latitude’s solutions in the Company’s cloud-based offerings, and internationalize Latitude’s solutions for sale around the world. The acquisition was accounted for using the acquisition method of accounting in accordance with FASB ASC 805, and the results of Latitude’s operations were included in the Company’s consolidated financial statements commencing on October 1, 2010.


The preliminary purchase price allocations for the Company’s acquisition of Latitude are based on a third-party valuation report which was prepared in accordance with the provisions of FASB ASC 805. 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):





October 1, 2010Cash

$
338Accounts receivable, net


1,998Prepaids


57Property, plant and equipment, net


697Accounts payable


(448
)Accrued compensation


(237
)Intangible assets


10,000Goodwill


8,519Total assets acquired


20,924Deferred services revenue


(967
)Deferred tax liability


(4,294
)Net assets acquired

$
15,663





The fair value of financial assets acquired includes accounts receivable with a fair and contractual value of $2.0 million. The receivables consist of amounts due from customers for products sold and/or services rendered.





The Company has recorded a deferred tax liability of $4.3 million associated with the intangible assets recorded in connection with the Latitude acquisition. This resulted in a corresponding adjustment recorded to goodwill. The Company plans to complete a research and development study for Latitude for 2010 and the fourth quarter of 2009, 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.





Acquisition-related professional fees recognized as of March 31, 2011 for the Latitude acquisition totaled approximately $122,000, with approximately $33,000 recognized during the first quarter of 2011. Acquisition-related professional fees include transaction costs such as legal, accounting, valuation and other professional services, which were expensed as incurred. These costs are included within general and administrative expenses on the condensed consolidated statements of income.


The premium paid over the fair value of the net assets acquired in the purchase, or goodwill, was primarily attributed to expected synergies from Latitude’s debt collection software, experienced staff and existing client base. Included within goodwill is the assembled workforce, comprised of 40 employees, which does not qualify for separate recognition. None of the goodwill is expected to be deductible for tax purposes.





11





Customer relationships, core technology and non-competition agreements are amortized based upon historical 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 respective economic useful lives at the date of acquisition (dollars in thousands):




As of March 31, 2011Gross Amount


Accumulated Amortization


Net Amount


Economic Useful Life

(in years)Trade name

$
1,670


$
--


$
1,670


IndefiniteCustomer relationships


6,270



261



6,009



12Core technology


980



38



942



13Non-competition agreements


1,080



90



990



6Total

$
10,000


$
389


$
9,611
 
 Pro Forma Results
 
 The following table shows unaudited pro forma results of operations as if we had acquired Latitude on January 1, 2010 (in thousands, except per share amounts):
 
 Three Months EndedMarch 31,2011


2010Revenue

$
47,730


$
37,099Net Income


3,095



2,557EPS – Basic


0.17



0.15EPS - Diluted


0.16



0.14
 
 The unaudited pro forma results of operations are not necessarily indicative of the actual results that would have occurred had the transaction actually taken place at the beginning of the periods indicated.
 
 10.
SUBSEQUENT EVENT
 The Company will ask its shareholders at its 2011 annual shareholder meeting to vote on a proposal to reorganize the Company as a holding company incorporated in Indiana.
 
 If the reorganization is approved by shareholders at the annual meeting, in the reorganization:
 ●Each outstanding share of the Company’s common stock will automatically convert into one share of common stock of a new Indiana corporation
 named Interactive Intelligence Group, Inc. (“ININ Group”), and the current shareholders of the Company will become shareholders of ININ Group on
 a one-for-one basis, holding the same number of shares and the same ownership percentage after the reorganization as they held prior to the
 reorganization.
 
 ●The Company will become a wholly owned subsidiary of ININ Group.
 
 ●All current subsidiaries of the Company will become direct or indirect subsidiaries of ININ Group.
 
 ●Each of the outstanding options to acquire shares of the Company’s common stock will become options to acquire an identical number of shares of
 ININ Group common stock with the same terms and conditions as before the reorganization.
 
 ●Each outstanding RSU will become an RSU for an identical number of shares of ININ Group common stock.
 
 ●It is expected that the Company’s board of directors and executive officers will hold the same positions with ININ Group.
 
 ●ININ Group is expected to be listed on Nasdaq under “ININ,” the Company’s current symbol.
 Upon completion of the reorganization, ININ Group would replace the Company as the publicly held corporation. The reorganization would generally be tax-free for the Company’s shareholders. The reorganization is more fully described in the proxy statement/prospectus relating to the annual meeting of shareholders filed with the SEC on April 29, 2011.
  The primary objectives of the reorganization are to provide the Company with enhanced strategic, operational, and financing flexibility, improve its ability to determine financial results and profitability of different lines of business, and better manage tax expenses and exposure to liabilities.
 12


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, 2010. The following will be discussed and analyzed:





●Forward-Looking Information


●Overview
 
 ●Financial Highlights
 
 ●Historical Results of Operations
 
 ●Comparison of Three Months Ended March 31, 2011 and 2010
  ●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 the 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, to successfully integrate acquired businesses and other factors set forth in our Securities and Exchange Commission (“SEC”) filings.





Overview





Interactive Intelligence, Inc. (“Interactive Intelligence”, “we”, “us”, or “our”) is a leading provider of software applications. Our principal product is a suite of applications that provides customers with a software-based multi-channel communications platform. We are a recognized leader in the worldwide contact center market, where our software applications provide a range of pre-integrated functionality.  We use this same platform to offer our solutions for business communications, including business process automation. Our solutions are delivered both on-premise and through “cloud-based” models using hosted data centers. Our solutions are used by businesses and organizations in industries such as teleservices, financial services, higher education, utilities, healthcare, retail, technology, government and business services.





Our strategy is to expand our reach in three ways: through continued penetration of our unified Internet Protocol business communication solutions, through business process automation, and through the acquisition of complementary applications and distribution channels. In addition, we plan to invest in current partners to drive deeper penetration into existing accounts and existing markets, leverage our multi-national partners to expand global markets in which we operate and cultivate new strategic partners to grow our global presence.
 
 We will seek shareholder approval of a proposal to reorganize our company as a holding company incorporated in Indiana at our 2011 annual shareholder meeting. If approved by our shareholders, upon completion of the reorganization, Interactive Intelligence Group, Inc. would replace Interactive Intelligence as the publicly held corporation. The reorganization would generally be tax-free for our shareholders. The reorganization is more fully described in the proxy statement/prospectus relating to the annual meeting of shareholders filed with the SEC on April 29, 2011. The primary objectives of the reorganization are to provide us with enhanced strategic, operational, and financing flexibility, improve our ability to determine financial results and profitability of different lines of business, and better manage tax expenses and exposure to liabilities. For further information, see Note 10 of Notes to Condensed Consolidated Financial Statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q.
 
 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, 2010.
 
 Our management monitors certain key measures to assess our financial results. In particular, we track trends on product orders, contracted professional services, and cloud-based orders from quarter to quarter and in comparison to the prior year actual results and current year projected amounts. We also review leading market indicators to look for trends in economic conditions. In addition to orders and revenues, management reviews costs of revenue and operating expenses and staffing levels to ensure we are managing new expenditures and controlling costs. For additional discussions regarding trends and our expectations for 2011, see “Financial Highlights” on page 15.


13


In addition to the above, our management monitors diluted earnings per share (“EPS”), a key measure of performance also used by analysts and investors, based on accounting principles generally accepted in the United States of America (“GAAP”) and on a non-GAAP basis. Management uses non-GAAP EPS, net income and operating income to analyze our business. These non-GAAP measures include revenue which was not recognized on a GAAP basis due to purchase accounting adjustments and exclude non-cash stock-based compensation expense, non-cash purchase accounting adjustments and non-cash income tax expense. During the fourth quarter of 2010, we began including purchase accounting adjustments in our GAAP to non-GAAP reconciliation and historical amounts shown below are presented using the revised format. These measures are not in accordance with, or an alternative for, GAAP, and may be different from non-GAAP measures used by other companies. Stock-based compensation expense and purchase accounting adjustments are non-cash and income tax expense is primarily non-cash. We believe that the presentation of non-GAAP results, when shown in conjunction with corresponding GAAP measures, provides useful information to our management and investors regarding financial and business trends related to our results of operations. Further, our management believes that these non-GAAP measures improve management’s and investors’ ability to compare our financial performance with other companies in the technology industry. Because stock-based compensation expense, purchase accounting adjustments and non-cash income tax expense amounts can vary significantly between companies, it is useful to compare results excluding these amounts. Our management also uses financial statements that exclude stock-based compensation expense related to stock options, purchase accounting adjustments and non-cash income tax expense for our internal budgets.
 
 Reconciliations of these non-GAAP measures to the most directly comparable GAAP measures are included below (in thousands, except per share amounts):


Three Months Ended

March 31,2011


2010Net income, as reported

$
3,095


$
1,868Purchase accounting adjustments:Increase to revenues:Recurring


59



7Services


31



2Reduction of operating expenses:Customer relationships


139



9Technology


35



16Non-compete agreements


45



-Acquisition costs


201



-Total


510



34Non-cash stock-based compensation expense:Cost of recurring revenues


105



31Cost of services


25



48Sales and marketing


392



324Research and development


408



298General and administrative


388



311Total


1,318



1,012Non-cash income tax expense


549



1,241Non-GAAP net income

$
5,472


$
4,155Operating income, as reported

$
4,922


$
3,989Purchase accounting adjustments


510



34Non-cash stock-based compensation expense


1,318



1,012Non-GAAP operating income

$
6,750


$
5,035Diluted EPS, as reported

$
0.16


$
0.10Purchase accounting adjustments


0.03



0.00Non-cash stock-based compensation expense


0.07



0.05Non-cash income tax expense


0.02



0.07Non-GAAP diluted EPS

$
0.28


$
0.22





14





Financial Highlights





The table below shows our total revenues (in millions) for the most recent five quarters and the years ended December 31, 2010, 2009 and 2008 and the percentage change over the previous period.





Period

Revenues


Sequential

Growth %Three Months Ended:March 31, 2011

$
47.7



(6
)%December 31, 2010


50.7



21
%September 30, 2010


41.8



8
%June 30, 2010


38.8



11
%March 31, 2010


35.0



(3
)%Year Ended December 31:2010

$
166.3



27
%2009


131.4



8
%2008


121.4



10
%





During the three months ended March 31, 2011, product revenues increased 32% compared to the same period in 2010. The increase was primarily due to a 28% increase in the dollar amount of orders received from new and existing customers as we continued to license our software to larger organizations. We received 21 product orders over $250,000 during the three months ended March 31, 2011 compared to 12 product orders over $250,000 during the three months ended March 31, 2010.


Our recurring revenues increased 30% during the first quarter of 2011 compared to the first quarter of 2010. Recurring revenues include maintenance and support and cloud-based revenues. Cloud-based orders received during the first quarter of 2011 increased $6.3 million compared to the same period in 2010. We have continued to see interest for our cloud-based solutions grow among prospective customers as cloud computing is becoming an accepted alternative to premise-based solutions.
 
 As our cloud-based business has grown, the associated costs have also increased as we have expanded our cloud-based infrastructure and staffing both domestically and internationally. We have two data centers in the United States, and one in each of the United Kingdom, Japan, Australia and Germany.
 
 Services revenues increased 88% during the three months ended March 31, 2011 compared to the same period in 2010. This increase was attributable to the large contracts from both premise-based and cloud-based customers. Consistent with an increase in services revenue, the cost of services revenue also increased during the same period due to increased professional services and education staffing.
 
 During the three months ended March 31, 2011, we continued to invest in our operations by increasing our staffing company-wide by 34% compared to the prior year period, which resulted in increased compensation expenses year-over-year. We anticipate our staffing levels will continue to increase during 2011.
 
 On February 28, 2011, we entered into a stock purchase agreement with Agori Communications, GmbH (“Agori”), a Frankfurt, Germany-based reseller of our solutions. Pursuant to the terms of the stock purchase agreement, we purchased 100% of Agori’s outstanding capital stock for an aggregate purchase price of $4.9 million, including $687,000 related to the working capital of Agori, funded with cash-on-hand. We acquired Agori as part of our growth strategy of accelerating business in key international markets, including Germany, which is currently the fourth largest economy in the world and our largest market in Europe, the Middle East and Africa.


15





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 months ended March 31, 2011 and 2010 are not necessarily indicative of the results that may be expected for the full year or for any future period.





Three Months Ended

March 31,2011


2010Revenues:Product


44
%


45
%Recurring


43



45Services


13



10Total revenues


100



100Cost of revenues:Product


13



14Recurring


11



10Services


8



6Amortization of intangible assets


--



--Total cost of revenues


32



30Gross profit


68



70Operating expenses:Sales and marketing


29



30Research and development


17



18General and administrative


11



11Amortization of intangible assets


--



--Total operating expenses


57



59Operating income


11



11Other income:Interest income, net


--



--Other expense


--



(2
)Total other income


--



(2
)Income before income taxes


11



9Income tax expense


4



4Net income


7
%


5
%




Comparison of Three Months Ended March 31, 2011 and 2010





Revenues





Primary Sources of Revenues





We generate revenues from: (i) product revenues, which include licensing the right to use our software applications and selling hardware as a part of our solutions; (ii) recurring revenues, which include support fees from perpetual license agreements, renewal fees from annually renewable license agreements, and fees from our cloud-based offerings; and (iii) services revenues, which include professional services fees and educational services fees. Prior to the fourth quarter of 2010, revenues were reported as two types, product and services. Historical amounts have been reclassified based on this new, three-revenue presentation. Our revenues are generated by direct sales to customers and through our partner channels.





Product Revenues

Three Months Ended March 31,2011


2010($ in thousands)Product revenues

$
20,766


$
15,786Change from prior year period


32
%


21
%Percentage of total revenues


44
%


45
%





16





Product revenues increased $5.0 million, or 32%, during the three months ended March 31, 2011 compared to the three months ended March 31, 2010, primarily due to a 28% increase in the dollar amount of orders received from both new and existing customers. During the first quarter of 2011, we received 21 product orders over $250,000, compared to 12 product orders over $250,000 during the first quarter of 2010. Those product orders included two orders over $1.0 million received in each of the first quarter of 2011 and the first quarter of 2010. Additionally, the dollar amount of hardware orders received increased 49% during the first quarter of 2011 compared to a year ago as there were more sales of our handsets. As the dollar amount of hardware orders received increased, the associated cost of product also increased.
 Not all software and hardware product orders are recognized as revenues when they are received because of certain contractual terms or the collection history with particular customers or partners. Consequently, product revenues for any particular period not only reflect the orders received in the current period but also include certain orders received but deferred in previous periods and recognized in the current period. In addition, a portion of product orders are related to maintenance and support, and they are recognized over the maintenance and support period as recurring revenues.


Recurring Revenues

Three Months Ended March 31,2011


2010($ in thousands)Recurring revenues

$
20,746


$
15,925Change from prior year period


30
%


19
%Percentage of total revenues


43
%


45
%





Recurring revenues include the portion of license arrangements allocated to maintenance and support from perpetual and annually renewable contracts, renewals of annually renewable licenses and maintenance contracts, and revenues from our cloud-based applications. Revenues related to our renewal and support fees represented approximately 88% and 91% of our total recurring revenues for the three months ended March 31, 2011 and 2010, respectively. The mix of annually renewable and perpetual licensing arrangements in the future is not expected to impact our future recurring revenues.
 
 Recurring revenues increased $4.8 million, or 30%, during the three months ended March 31, 2011 compared to the same period in 2010, primarily due to an increase in renewal and support fees of $3.7 million in 2011 resulting from continued growth in the number and size of our installed base of customers. In addition, cloud-based revenues increased $1.1 million year-over-year as more customers selected our cloud-based solutions.
 
 Renewal rates for license and support fees in the three months ended March 31, 2011 were consistent with the renewal rates in the three months ended March 31, 2010.
 
 Revenues from cloud-based contracts are recognized ratably over the life of the contract, which is typically three to four years. Our unrecognized cloud-based revenues were $19.6 million and $7.0 million as of March 31, 2011 and 2010, respectively. These amounts are not included in deferred revenues on our balance sheet.
 
 We believe recurring revenues will continue to grow with further expansion of our installed base of customers and continued increase in our cloud-based contracts as more customers utilize hosted delivery of software for their information technology needs.


Services Revenues

Three Months Ended March 31,2011


2010($ in thousands)Services revenues

$
6,218


$
3,312Change from prior year period


88
%


11
%Percentage of total revenues


13
%


10
%





Services revenues primarily include revenues related to professional services and education.





Services revenues increased $2.9 million, or 88%, in the first three months of 2011 compared to the first three months of 2010. The increase was primarily due to an increase in professional services related to increases in both the number and size of our customer installations as we signed larger direct contracts with both premise-based and cloud-based customers.
 
 Services revenues have and will continue to fluctuate based on the number of attendees at our educational classes and the amount of assistance our customers and partners need for implementation. We believe services revenues will continue to grow as product revenues increase, order sizes increase and direct sales grow.


17




Cost of Revenues

Three Months Ended March 31,2011


2010($ in thousands)Cost of revenues:Product

$
6,196


$
4,799Recurring


5,282



3,423Services


3,712



2,174Total cost of revenues

$
15,190


$
10,396Change from prior year period


46
%


15
%Product cost as a % of product gross revenues


30
%


30
%Recurring cost as a % of recurring gross revenues


25
%


24
%Services cost as a % of services gross revenues


60
%


66
%





Cost of product revenues consists of hardware costs (including media servers and Interaction Gateway® appliances that we develop, as well as 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 product distribution facility costs. Cost of product revenues 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.
 
 Cost of product revenues increased $1.4 million during the first quarter of 2011 compared to the same quarter in 2010 primarily because more customers chose to implement our solutions with our hardware offerings. In addition, royalty expense increased period-over-period principally due to a contractual license for intellectual property.
 
 Cost of Recurring Revenues
 
 Cost of recurring revenues consists primarily of compensation expenses for technical support personnel and costs associated with our cloud-based offering. Cost of recurring revenues increased $1.9 million during the three months ended March 31, 2011 compared to the three months ended March 31, 2010, primarily due to an increase in compensation and travel related expenses of $1.2 million resulting from an increase in the number of maintenance staff, support staff and staff associated with the delivery of our cloud-based solutions, as well as staff added as a result of recent acquisitions. Expenses related to revenue growth in our cloud-based offering increased $614,000 during the first quarter of 2011 compared to the first quarter of 2010 primarily due to data center, hosting and personnel costs. Although some costs related to our cloud-based offerings are fixed, others are variable based on usage and call volume and, therefore, we would expect our recurring expenses to increase as the revenues from these orders are recognized.
 
 Cost of Services Revenues
 
 Cost of services revenues consists primarily of compensation expenses for professional services and educational personnel. Cost of services revenues increased by $1.5 million during the first quarter of 2011 compared to the same period in 2010 primarily due to a $1.3 million increase in compensation and travel related expenses resulting from an increase in professional services and education staffing, as well as staff added as a result of recent acquisitions.
 Cost of services revenues as a percentage of services revenues decreased during the three months ended March 31, 2011 compared to the three months ended March 31, 2010 even though the actual costs increased primarily due to the significant increase in professional services revenues year-over-year.


Gross Profit

Three Months Ended March 31,2011


2010($ in thousands)Gross profit

$
32,505


$
24,611Change from prior year period


32
%


20
%Percentage of total revenues


68
%


70
%





Gross profit as a percentage of total revenues in any particular period reflects the amount of product, recurring and services revenues recognized and the cost of product, recurring and services incurred.





Gross profit increased by $7.9 million during the three months ended March 31, 2011 compared to the same period in 2010 as a result of the impact of the factors discussed above.





Operating Expenses





Sales and Marketing

Three Months Ended March 31,2011


2010($ in thousands)Sales and marketing expenses

$
14,157


$
10,352Change from prior year period


37
%


12
%Percentage of total revenues


30
%


30
%Percentage of net product and cloud-based revenues


96
%


94
%





18





Sales and marketing expenses primarily include compensation, travel, and promotional costs related to our sales, marketing and channel management operations. These expenses increased by $3.8 million during the first quarter of 2011 compared to the first quarter of 2010 primarily due to an increase in compensation and travel related expenses of $2.6 million as sales and marketing staffing increased 24%, as well as staff added as a result of recent acquisitions. Additionally, corporate marketing expenses increased $812,000 year-over-year due to increased spending on promotional events and advertising.
 We expect sales and marketing expenses will increase in future periods as we continue to expand our promotional and branding initiatives.  We believe that the investment in sales and marketing is a critical piece to our future growth.


Research and Development

Three Months Ended March 31,2011


2010($ in thousands)Research and development expenses

$
8,147


$
6,425Change from prior year period


27
%


14
%Percentage of total revenues


17
%


18
%





Research and development expenses are comprised primarily of compensation and depreciation expenses. These expenses increased by $1.7 million during the three months ended March 31, 2011 compared to the three months ended March 31, 2010 primarily due to an increase in compensation expense of $1.4 million resulting from a 29% increase in research and development staffing, as well as staff added as a result of recent acquisitions.
 We believe that investment in research and development is critical to our future growth, particularly because our competitive position in the marketplace is directly related to the timely development of new and enhanced solutions. As a result, we expect research and development expenses will continue to increase in future periods.
 
 General and Administrative

Three Months Ended March 31,2011


2010($ in thousands)General and administrative expenses

$
5,095


$
3,836Change from prior year period


33
%


20
%Percentage of total revenues


11
%


11
%
 
 General and administrative expenses include 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. These expenses increased $1.3 million during the first quarter of 2011 compared to the same period in 2010 primarily due to an increase in compensation expense of $566,000 as a result of an increase in staffing of 28%, as well as staff added as a result of recent acquisitions. Additionally, expenses related to outside legal services increased $304,000 year-over-year due to our proposed reorganization into a holding company structure, recent acquisitions and various other legal matters within the normal course of business.


Other Income (Expense)




Interest Income, Net

Three Months Ended March 31,2011


2010($ in thousands)Cash, cash equivalents, short-term and long-term investments (average)

$
88,879


$
68,190Interest income, gross


43



42Return on investments


0.19
%


0.25
%





Interest income, net, primarily consists of interest earned from investments and interest-bearing cash accounts. Interest expense and fees, which were not material in any years reported, are also included in this category.





Interest earned on investments remained unchanged during the first quarter of 2011 compared to the same period in 2010 as a result of decreasing yields on investments offset by increasing investment balances.





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. Beginning in the first quarter of 2011, we purchased investments with maturities of up to three years to increase investment income. We do not have any investments in subprime assets.




Other Expense, Net

Three Months Ended March 31,2011


2010($ in thousands)Other expense, net

$
123


$
733





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Other expense, net includes foreign currency transaction gains and losses. These gains and losses can fluctuate based on the amount of receivables that are generated in certain international currencies (particularly the Euro), the exchange gain or loss that results from foreign currency disbursements and receipts, and the cash balances and exchange rates at the end of a reporting period. Other expense included $166,000 and $775,000 of foreign currency losses during the three months ended March 31, 2011 and 2010, respectively. The expense in 2010 was related to an overall weakening of the Euro and British Pound in relation to the U.S. dollar. During February 2010, we transferred the majority of our Euro cash balances to a U.S. dollar account and in May 2010, we instituted a currency hedging program to help mitigate future effects of fluctuations in the foreign exchange rates on cash and receivables. As a result of these changes, other expense decreased year-over-year. We continue to explore ways to mitigate the impact of currency fluctuations in the future.
 
 Income Tax Expense

Three Months Ended March 31,2011


2010($ in thousands)Income tax expense

$
1,704


$
1,388
 
 Our effective tax rate for the three months ended March 31, 2011 was 35.5%. This tax rate was determined by considering the annual expected federal tax rate, rates in various states and international jurisdictions in which we have operations, and a portion of the amount of stock-based compensation that is not deductible for income tax purposes. For the three months ended March 31, 2011, we expect to pay $1.2 million in taxes, with the remaining amounts offset by various credits and deductions for tax reporting purposes.
 
 Liquidity and Capital Resources
 
 We generate cash from the collection of payments related to licensing our products as well as from selling hardware, renewals of annual licenses and maintenance and support agreements, and the delivery of other services.  During the three months ended March 31, 2011, we also received $3.9 million in cash from the exercise of stock options and $96,000 from purchases of common stock under our 2000 Employee Stock Purchase Plan. We use cash primarily for paying our employees (including salaries, commissions and benefits), leasing office space, paying travel expenses, marketing activities, paying vendors for hardware, other services and supplies, purchasing property and equipment, research and development costs and funding acquisitions. For example, we acquired Agori for $4.9 million in cash during the first quarter of 2011. We continue to be debt free.


We determine liquidity by combining cash and cash equivalents, short-term investments and long-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.





March 31,

2011


December 31,

2010($ in thousands)Cash and cash equivalents

$
51,870


$
48,300Short-term and long-term investments


40,005



37,582Total liquidity

$
91,875


$
85,882





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 are reported as a use of cash and the related receipt of proceeds upon maturity of investments is reported as a source of cash.





The following table shows cash flows from operating activities, investing activities and financing activities for the stated periods:





Three Months Ended

March 31,2011


2010Beginning cash and cash equivalents

$
48,300


$
48,497Cash provided by operating activities


6,667



5,345Cash used in investing activities


(7,936
)


(6,263
)Cash provided by financing activities


4,839



2,100Ending cash and cash equivalents

$
51,870


$
49,679





Cash provided by operating activities during both periods was generated primarily by our net income adjusted for routine fluctuations in our operating assets and liabilities. The cash used in investing activities during the three months ended March 31, 2011 increased compared to the same period in 2010 due to the continued transferring of a portion of our cash to short-term and long-term investments as well as the purchase of Agori during the first quarter of 2011. Cash provided by financing activities during both periods was primarily due to tax benefits from stock-based payment arrangements and proceeds from stock options exercised.




20





Contractual Obligations
 
 As of March 31, 2011, we had additional purchase obligations totaling $848,000 to be paid out over the next year for marketing related contracts. There have been no other material changes to 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, 2010.


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, 2010, 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 March 31, 2011.




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 software license agreements, in accordance with FASB ASC Topic 460, Guarantees, 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. We are not able to estimate the potential exposure related to the indemnification provisions of our license agreements but have not incurred expenses under these indemnification provisions. 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 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, revenues 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, 2010 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, 2010. 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. During 2010, we began hedging both our accounts receivable and cash that are held in Euros due to the effects of the fluctuations in the foreign currency exchange rates. Prior to 2010, we had 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 continue 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. For the three months ended March 31, 2011, our foreign currency transaction losses amounted to $166,000.
 
 As of March 31, 2011 and December 31, 2010, we had accounts with Euro balances of approximately $2.7 million and $5.6 million, respectively, British pound balances of $122,000 and $207,000, respectively, and balances of seven other foreign currencies totaling $545,000 and $332,000, 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.





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 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 March 31, 2011, pursuant to Rule 13a-15 of the Exchange Act. Based on that evaluation, our President and Chief Executive Officer and our Chief Financial Officer concluded that our disclosure controls and procedures were effective as of March 31, 2011.





21





There have been no changes in our internal control over financial reporting that occurred during the quarter ended March 31, 2011 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, 2010. 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, 2010.





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





22


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:   May 9, 2011



By:

/s/     Stephen R. HeadStephen R. Head

Chief Financial Officer,

Senior Vice President of Finance and Administration,

Secretary and Treasurer

(Principal Financial Officer and Principal Accounting Officer)


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