UNITED STATES


SECURITIES AND EXCHANGE COMMISSION


WASHINGTON, D.C. 20549


FORM 10-Q





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





For the quarterly period ended September 30, 2010





OR





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





For the transition period from to





Commission File number 000-51358











Kenexa Corporation


(Exact Name of Registrant as Specified in Its Charter)





Pennsylvania

(State or other jurisdiction of incorporation or organization)
23-3024013

(I.R.S. Employer Identification Number)





650 East Swedesford Road, Wayne, PA

(Address of Principal Executive Offices)
19087

(Zip Code)





Registrant’s Telephone Number, Including Area Code: (610) 971-9171








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  x  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 definition 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 x                                           Non-accelerated Filer  ̈                                           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   ̈   No  x





On November 5, 2010, 22,779,496 shares of the registrant’s Common Stock, $0.01 par value, were outstanding.





,


1


Kenexa Corporation and Subsidiaries


FORM 10-Q


Quarter Ended September 30, 2010


Table of Contents








PART I: FINANCIAL INFORMATION

PageItem I: Financial StatementsConsolidated Balance Sheets as of September 30, 2010 (unaudited) and December 31, 2009

3Consolidated Statements of Operations for the three and nine months ended September 30, 2010 and 2009 (unaudited)

4Consolidated Statements of Shareholders’ Equity for the nine months ended September 30, 2010 (unaudited) and the year ended December 31, 2009

5Consolidated Statements of Cash Flows for the nine months ended September 30, 2010 and 2009 (unaudited)

6Notes to Consolidated Financial Statements (unaudited)

7Item 2: Management’s Discussion and Analysis of Financial Condition and Results of Operations

32Item 3: Quantitative and Qualitative Disclosures about Market Risk

49Item 4: Controls and Procedures

49PART II: OTHER INFORMATIONItem 1: Legal Proceedings

50Item 1A: Risk Factors

51Item 2: Unregistered Sales of Equity Securities and Use of Proceeds

51Item 3: Defaults Upon Senior Securities

51Item 4: Removed and Reserved

51Item 5: Other Information

51Item 6: Exhibits

51Signatures

52Exhibit Index

53





2


Table of Contents


PART I FINANCIAL INFORMATION


Item 1: Financial Statements


Kenexa Corporation and Subsidiaries


Consolidated Balance Sheets


(In thousands, except share data)





September 30,

2010


December 31,

2010(unaudited)AssetsCurrent AssetsCash and cash equivalents

$
90,430


$
29,221Short-term investments


—



29,570Accounts receivable, net of allowance for doubtful accounts of $1,896 and $2,090, respectively


34,918



26,782Unbilled receivables


5,128



4,457Income tax receivable


273



1,704Deferred income taxes


6,319



8,685Prepaid expenses and other current assets


10,813



8,428Total Current Assets


147,881



108,847Property and equipment, net of accumulated depreciation


18,542



19,530Software, net of accumulated amortization


21,060



17,337Goodwill


5,997



3,204Intangible assets, net of accumulated amortization


8,602



9,143Deferred income taxes, non-current


36,686



34,879Deferred financing costs, net of accumulated amortization


81



—Other long-term assets


9,975



9,403Total assets

$
248,824


$
202,343Liabilities and Shareholders’ EquityCurrent liabilitiesAccounts payable

$
9,352


$
5,727Notes payable, current


5



16Commissions payable


2,047



671Accrued compensation and benefits


6,387



4,820Other accrued liabilities


7,042



6,376Deferred revenue


58,708



49,964Capital lease obligations


229



211Total current liabilities


83,770



67,785Capital lease obligations, less current portion


107



259Revolving credit loan


25,000



—Deferred income taxes


530



850Other non-current liabilities


1,892



1,981Total liabilities


111,299



70,875Commitments and ContingenciesTemporary EquityNoncontrolling interest


2,546



1,330Shareholders’ EquityPreferred stock, par value $0.01; 10,000,000 shares authorized; no shares issued or outstanding


—



—Common stock, par value $0.01; 100,000,000 shares authorized;  22,708,829 and 22,561,883 shares issued and outstanding, respectively


227



226Additional paid-in-capital


278,656



275,127Accumulated deficit


(139,795
)


(141,712
)Accumulated other comprehensive loss


(4,109
)


(3,503
)Total shareholders’ equity


134,979



130,138Total liabilities and shareholders’ equity

$
248,824


$
202,343








See notes to consolidated financial statements.


3


Kenexa Corporation and Subsidiaries


Consolidated Statements of Operations


(In thousands, except share and per share data)


(Unaudited)





Three Months Ended

September 30,


Nine Months Ended

September 30,2010


2009


2010


2009Revenues:Subscription

$
39,764


$
33,221


$
109,136


$
100,527Other


11,020



7,093



26,177



18,083Total revenues


50,784



40,314



135,313



118,610Cost of revenues


17,957



13,129



46,828



40,462Gross profit


32,827



27,185



88,485



78,148Operating expenses:Sales and marketing


11,642



9,083



32,540



26,029General and administrative


12,084



10,182



32,542



30,972Research and development


3,277



2,453



7,693



7,557Depreciation and amortization


4,341



3,582



12,457



10,084Goodwill impairment charge


—



—



—



33,329Total operating expenses


31,344



25,300



85,232



107,971Income (loss) from operations


1,483



1,885



3,253



(29,823
)Interest income (expense)


72



(28
)


355



(186
)(Loss) income on change in fair market value of investments including ARS and put option, net and sale of municipal bonds


(382
)


102



(379
)


54Income (loss) before income tax


1,173



1,959



3,229



(29,955
)Income tax expense


26



361



906



1,418Net income (loss)

$
1,147


$
1,598


$
2,323


$
(31,373
)Income allocated to noncontrolling interests


(188
)


—



(406
)


—Accretion associated with variable interest entity


(809
)


—



(809
)


—Net income (loss) allocable to common shareholders

$
150


$
1,598


$
1,108


$
(31,373
)Basic net income (loss) per share

$
0.01


$
0.07


$
0.05


$
(1.39
)Weighted average shares used to compute net income (loss) allocable to common shareholders per share – basic


22,629,050



22,539,717



22,603,323



22,525,144Diluted net income (loss) per share

$
0.01


$
0.07


$
0.05


$
(1.39
)Weighted average shares used to compute net income (loss) allocable to common shareholders per share – diluted


23,168,553



22,920,935



23,098,070



22,525,144











See notes to consolidated financial statements.





4


Kenexa Corporation and Subsidiaries


Consolidated Statements of Shareholders’ Equity


(In thousands)





Common

stock


Additional paid-in capital


Accumulated deficit


Accumulated other comprehensive

loss


Total

Shareholders’

equity


Comprehensive (loss) incomeBalance, December 31, 2008

$
225


$
269,365


$
(110,633
)

$
(2,421
)

$
156,536


$
(108,520
)Loss on currency translation adjustments


—



—



—



(925
)


(925
)


(925
)Unrealized loss on short-term investments


—



—



—



(157
)


(157
)


(157
)Share-based compensation expense


—



5,364



—



—



5,364



—Option exercises


—



70



—



—



70



—Employee stock purchase plan


1



328



—



—



329



—Income allocated to noncontrolling interest


—



—



(61
)


—



(61
)


(61
)Net loss


—



—



(31,018
)


—



(31,018
)


(31,018
)Balance, December 31, 2009

$
226


$
275,127


$
(141,712
)

$
(3,503
)

$
130,138


$
(32,161
)Loss on currency translation adjustments


—



—



—



(834
)


(834
)


(834
)Unrealized gain on short-term investments


—



—



—



228



228



228Share-based compensation expense


—



3,578



—



—



3,578



—Option exercises


1



457



—



—



458



—Employee stock purchase plan


—



303



—



—



303



—Income allocated to noncontrolling interest


—



—



(406
)


—



(406
)


(406
)Accretion associated with variable interest entity


—



(809
)


—



—



(809
)


(809
)Net income


—



—



2,323



—



2,323



2,323Balance, September 30, 2010 (unaudited)

$
227


$
278,656


$
(139,795
)

$
(4,109
)

$
134,979


$
502





See notes to consolidated financial statements.





5


Kenexa Corporation and Subsidiaries


Consolidated Statements of Cash Flows


(In thousands)


(Unaudited)





Nine months ended

September 30,2010


2009Cash flows from operating activitiesNet income (loss)

$
2,323


$
(31,373
)Adjustments to reconcile net income(loss) to net cash provided by operating activities:Depreciation and amortization


12,457



10,084Loss on disposal of property and equipment


48



—Realized loss on available-for-sale securities


483



—Gain (loss) on change in fair market value of ARS and put option, net


(3
)


9Goodwill impairment charge


—



33,329Share-based compensation expense


3,578



4,080Amortization of deferred financing costs


2



364Bad debt net of recoveries


(23
)


(471
)Deferred income tax benefit


(387
)


(1,118
)Changes in assets and liabilitiesAccounts and unbilled receivables


(6,896
)


4,272Prepaid expenses and other current assets


(3,522
)


(1,907
)Income taxes receivable


1,432



83Other long-term assets


(778
)


(903
)Accounts payable


1,994



336Accrued compensation and other accrued liabilities


2,259



180Commissions payable


1,380



149Deferred revenue


8,501



5,433Other liabilities


(279
)


(34
)Net cash provided by operating activities


22,569



22,513Cash flows from investing activitiesCapitalized software and purchases of property and equipment


(12,121
)


(10,923
)Purchases of available-for-sale securities


(7,653
)


(4,765
)Sales of available-for-sale securities


23,054



2,572Sales of trading securities


15,291



1,650Acquisitions and variable interest entity, net of cash acquired


(5,736
)


(4,795
)Cash released from escrow for acquisitions


250



—Net cash provided by (used in) investing activities


13,085



(16,261
)Cash flows from financing activitiesBorrowings from revolving credit loan


25,000



—Net repayments of notes payable


(9
)


(73
)Repayments of capital lease obligations


(160
)


(237
)Deferred financing costs


(83
)


—Proceeds from common stock issued through Employee Stock Purchase Plan


303



244Net proceeds from option exercises


458



70Net cash provided by financing activities


25,509



4Effect of exchange rate changes on cash and cash equivalents


46



226Net increase in cash and cash equivalents


61,209



6,482Cash and cash equivalents at beginning of period


29,221



21,742Cash and cash equivalents at end of period

$
90,430


$
28,224Supplemental disclosures of cash flow informationCash paid (received) during the period for:Interest expense

$
30


$
190Income taxes paid

$
909


$
4,634Income taxes refunded

$
(1,725
)

$
—Non-cash investing and financing activities:Capital leases

$
—


$
513Common stock issuance for earn out

$
—


$
1,050





See notes to consolidated financial statements


6


Table of Contents


Kenexa Corporation and Subsidiaries


Notes to Consolidated Financial Statements - Unaudited


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








1. Organization





Kenexa Corporation and its subsidiaries (collectively the “Company” or “Kenexa”) commenced operations in 1987 as a provider of recruiting services to a wide variety of industries.  In 1993, the Company offered its first automated talent management system.  Between 1994 and September 30, 2010, the Company acquired 29 businesses that enabled it to offer comprehensive human capital management, or HCM, services integrated with web-based technology.  The Company’s business solutions include a comprehensive suite of on-demand software applications and complementary services, including outsourcing services and consulting, to help global organizations recruit high performing individuals and to foster optimal work environments to increase employee productivity and retention.





The Company began its operations in 1987 under its predecessor companies, Insurance Services, Inc., or ISI, and International Holding Company, Inc., or IHC. In December 1999, the Company reorganized its corporate structure by merging ISI and IHC with and into Raymond Karsan Associates, Inc., or RKA, a Pennsylvania corporation and a wholly owned subsidiary of Raymond Karsan Holdings, Inc., or RKH, a Pennsylvania corporation. Each of RKA and RKH were newly created to consolidate the businesses of ISI and IHC. In April 2000, the Company changed its name to TalentPoint, Inc. and changed the name of RKA to TalentPoint Technologies, Inc. In November 2000, the Company changed its name to Kenexa Corporation, and changed the name of TalentPoint Technologies, Inc. to Kenexa Technology, Inc., or Kenexa Technology. Currently, Kenexa transacts business primarily through Kenexa Technology. Although the Company has several product lines, our chief decision makers determine resource allocation decisions and assess and evaluate periodic performance under one operating segment.








2. Summary of Significant Accounting Policies





In June 2009, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Codification 2009-01, “Amendments based on Statement of Financial Accounting Standards No. 168 - The FASB Accounting Standards CodificationTM and the Hierarchy of Generally Accepted Accounting Principles,” to codify in ASC 105, “Generally Accepted Accounting Principles,” FASB Statement 168, “The FASB Accounting Standards CodificationTM and the Hierarchy of Generally Accepted Accounting Principles,” which was issued to establish the Codification as the sole source of authoritative U.S. GAAP recognized by the FASB, excluding SEC guidance, to be applied by nongovernmental entities.  The guidance in ASC 105 is effective for financial statements issued for interim and annual periods ending after September 15, 2009. The Company has revised its references to pre-Codification GAAP and noted there was no impact on the financial condition or results of operations of the Company.





The accompanying consolidated financial statements as of September 30, 2010 and for the three and nine months ended September 30, 2010 and 2009 have been prepared by the Company without audit.  In the opinion of management, all adjustments (which include only normal recurring adjustments) necessary to present fairly the financial position and the results of operations and cash flows for the three and nine months ended September 30, 2010 and 2009 have been made.  The results for the three and nine months ended September 30, 2010 are not necessarily indicative of the results to be expected for the year ended December 31, 2010 or for any other interim period.  Certain information and footnote disclosures normally included in the Company’s annual consolidated financial statements have been condensed or omitted and, accordingly, the accompanying financial information should be read in conjunction with the consolidated financial statements and notes thereto contained in the Company’s Annual Report on Form 10-K, filed with the United States Securities and Exchange Commission for the year ended December 31, 2009.








Principles of Consolidation





The consolidated financial statements of the Company include the accounts of Kenexa Corporation and its subsidiaries and variable interest entity as described in Footnote 5 – Variable Interest Entity in the Notes to Consolidated Financial Statements.  All significant intercompany accounts and transactions have been eliminated in consolidation.








7




Kenexa Corporation and Subsidiaries


Notes to Consolidated Financial Statements – Unaudited (Continued)


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








2. Summary of Significant Accounting Policies (continued)





Use of Estimates





The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates, and such differences may be material to the Company’s consolidated financial statements.








Fair Value of Financial Instruments





The carrying amounts of the Company’s financial assets and liabilities, including cash and cash equivalents, accounts receivable, short-term investments and  put option, if presented,  and accounts payable at September 30, 2010 and December 31, 2009 approximate fair value of these instruments.








Concentration of Credit Risk





Financial instruments which potentially expose the Company to concentration of credit risk consist primarily of accounts receivable.  Credit risk arising from receivables is mitigated by the large number of customers comprising the Company's customer base and their dispersion across various industries.  The Company does not require collateral.  The customers are concentrated primarily in the Company’s U.S. market area.  At September 30, 2010 and December 31, 2009, there were no customers that represented more than 10% of the net accounts receivable balance.





For the three and nine months ended September 30, 2010 and 2009, no one customer individually exceeded 10% of the Company's revenues.  The Company’s top 3 customers represented approximately 13.9% and 13.0% for the three and nine months ended September 30, 2010 and 16.1% and 14.9% for the three and nine months ended September 30, 2009, respectively, of the Company’s total revenues.





As discussed in Footnote 3 – Investments of the Notes to the Consolidated Financial Statements, the Company sold its auction rate securities back to UBS AG in July 2010.








Foreign Currency Translation





The financial position and operating results of the Company’s foreign operations are consolidated using the local currency as the functional currency.  Local currency assets and liabilities are translated at the rate of exchange to the U.S. dollar on the balance sheet date, and the local currency revenues and expenses are translated at average rates of exchange to the U.S. dollar during the period. The operations of the variable interest entity in China are translated from Chinese renminbis, for which the current exchange rate is approximately 6.8 renminbis to one U.S. dollar. The related translation adjustments are reported in the shareholders’ equity section of the balance sheet and resulted in a net reduction in shareholders’ equity of $834 and $925 for the periods ended September 30, 2010 and December 31, 2009, respectively.  The foreign currency translation adjustment is not adjusted for income taxes as it relates to an indefinite investment in a non-U.S. subsidiary.








Comprehensive income (loss)





Comprehensive income (loss) consists of net gains and losses on foreign currency translations, net unrealized gains and losses on short-term investments, net income allocated to noncontrolling interests, accretion associated with variable interest entity and net income or loss and is reported on the accompanying consolidated statements of shareholders’ equity.  For the nine months ended September 30, 2010 and 2009 comprehensive income was $502 and comprehensive loss was $32,045, respectively.





8





Kenexa Corporation and Subsidiaries


Notes to Consolidated Financial Statements – Unaudited (Continued)


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








2. Summary of Significant Accounting Policies (continued)





Cash and Cash Equivalents





Cash and cash equivalents consist of highly liquid investments with remaining maturities of three months or less at the time of purchase.  Cash which is restricted for lease deposits is included in other assets.  Cash balances are maintained at several banks. Accounts located in the United States are insured by the Federal Deposit Insurance Corporation ("FDIC") up to $100 (which has been temporarily increased to $250 through December 31, 2013). Certain operating cash accounts may periodically exceed the FDIC limits.





Cash and cash equivalents in foreign denominated currencies which are held in foreign banks totaled $6,337 and $7,994 and represented 7.0% and 27.4% of our total cash and cash equivalents balance at September 30, 2010 and December 31, 2009, respectively.








Investments





Investments as of December 31, 2009 include floating rate letter of credit backed securities, municipal bonds and auction rate securities.  The maturities of these securities may range from 1 day to approximately 1 year and are rated A, AA and AAA by various rating agencies.  Certain investments are recorded at fair value based on current market rates and are classified as available-for-sale.  Changes in the fair value are included in accumulated other comprehensive income (loss) in the accompanying consolidated financial statements.  At December 31, 2009, other investments, including auction rate securities, are recorded at fair value and are classified as trading securities.  Changes in the fair value are included in the statement of operations in the accompanying consolidated financial statements.  Both the cost and realized gains and losses of these securities are calculated using the specific identification method.








Investment income





Investment income includes changes in the fair value of auction rate securities, put option related to the UBS Settlement Agreement and changes in the fair value of municipal bond securities.  See Footnote 3 – Investments of the Notes to Consolidated Financial Statements for further details.








Software Developed for Internal Use





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





The Company capitalized internal-use software costs for the nine month period ended September 30, 2010 and the year ended December 31, 2009 of $9,156 and $9,665, respectively. Amortization of capitalized internal-use software costs was $1,878 and $5,032 for the three and nine months ended September 30, 2010, respectively and $572 and $2,283 for the three and nine months ended September 30, 2009, respectively.


9





Kenexa Corporation and Subsidiaries


Notes to Consolidated Financial Statements – Unaudited (Continued)


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








2. Summary of Significant Accounting Policies (continued)





Prepaid Expenses and Other Current Assets





Prepaid expenses and other current assets as of September 30, 2010 and December 31, 2009 are as follows:





September 30, 2010


December 31,

2009Prepaid expenses

$
6,814


$
4,845Deferred implementation costs


3,207



2,096UBS Settlement Agreement


—



1,374Other current assets


792



113Total prepaid expenses and other current assets

$
10,813


$
8,428





Deferred implementation costs represent internal payroll and other costs incurred in connection with the configuration of the sites associated with our internet hosting arrangements.  Prior to our adoption of ASU 2009-13 on January 1, 2010 (see revenue recognition accounting policy for implementation service revenue), these costs were deferred over the implementation period which precedes the hosting period, typically three to four months, and were expensed ratably when the hosting period commences, typically four to five years.  The remaining deferred costs at September 30, 2010 relate to implementations which commenced prior to the adoption of ASU 2009-13 and will continue to be deferred until such time as the hosting or license period for those specific contracts commences, at which time these costs will be expensed over the hosting period in accordance with our previous accounting policy.  Implementation costs related to contracts signed or modified after January 1, 2010, our date of adoption of ASU 2009-13, will be expensed as incurred to be consistent with our new accounting policy related to implementation service revenue.  During the nine months ended September 30, 2010, approximately $481 of previously deferred costs were expensed because the implementation revenue related to a certain contract is now being recognized in accordance with our new revenue recognition policy in connection with a material modification of that contract during the quarter ended March 31, 2010.








Other Long-Term Assets





Other long-term assets as of September 30, 2010 and December 31, 2009 are as follows:





September 30, 2010


December 31,

2009Acquisition related escrow balances (1)

$
1,096


$
1,397Security deposits


1,422



1,529Deferred implementation costs


5,107



6,263Other long-term assets


2,350



214Total other long-term assets

$
9,975


$
9,403





(1)
For acquisitions that occurred prior to January 1, 2009 and upon completion of the escrow term and settlement of any outstanding claims, all remaining escrow balances are reclassified to additional purchase price consideration for the respective acquisition.











10





Kenexa Corporation and Subsidiaries


Notes to Consolidated Financial Statements – Unaudited (Continued)


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








2. Summary of Significant Accounting Policies (continued)





Goodwill





Since 2002, the Company has recorded goodwill in accordance with the provisions of FASB ASC, 350, “Intangibles-Goodwill and Other,” which discontinued the amortization of existing goodwill and instead requires the Company to annually review the carrying value of goodwill for impairment. Prior to 2007, the Company evaluated the carrying value of its goodwill under two reporting units within its single reporting segment.  During 2007, the Company combined those two reporting units into a single reporting unit to be in alignment with its organizational and management structure, which was evaluated and restructured as part of the integration of our acquired businesses.  As a result, in 2007 and 2008, goodwill was evaluated at the enterprise or Company level.  Following its investment in the variable interest entity in China in 2009, the Company reverted to evaluating the carrying value of goodwill under two reporting units within a single segment.  The Company conducted its 2009 annual evaluation of goodwill for impairment and determined that there was no impairment at October 1, 2009.  The Company determined there was no triggering event at December 31, 2009 and September 30, 2010 which could require an interim impairment analysis.





The changes in the carrying amount of goodwill, which include adjustments for earnouts, taxes and escrow adjustments, acquisitions and impairment charges, for the period ended September 30, 2010 and the year ended December 31, 2009 are as follows:





Balance as of December 31, 2008

$
32,366Acquisitions or adjustments:Impairment charge


(33,329
)StraightSource


125HRC Human Resources Consulting GmbH


215Quorum International Holdings Limited


2,315Shanghai Runjie Management Consulting Company (variable interest equity)


1,512Balance as of December 31, 2009

$
3,204StraightSource


250Quorum International Holdings Limited


459Centre for High Performance Development


2,080Other


4Balance as of September 30, 2010

$
5,997














11


Kenexa Corporation and Subsidiaries


Notes to Consolidated Financial Statements – Unaudited (Continued)


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








2. Summary of Significant Accounting Policies (continued)





Self-Insurance





The Company is self-insured for the majority of its health insurance costs, including claims filed and claims incurred but not reported subject to certain stop loss provisions. The Company estimates the liability based upon management’s judgment and historical experience.  At September 30, 2010 and December 31, 2009, self-insurance accruals totaled $474 and $556, respectively.  Management continuously reviews the adequacy of the Company’s stop loss insurance coverage. Material differences may result in the amount and timing of health insurance expense if actual experience differs significantly from management’s estimates.








Guarantees





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








Share-based Compensation Expense





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





The fair value of market based, performance vesting share awards granted is calculated using a Monte Carlo valuation model that results in a factor applied to the fair market value of the Company's common stock on the date of the grant (measurement date), and is recognized over a four year explicit service period using the straight-line method.  Since the award requires both the completion of four years of service and the share price reaching predetermined levels as defined in the option agreement, compensation cost will be recognized over the four year explicit service period.  If the employee terminates prior to the four-year requisite service period, compensation cost will be reversed even if the market condition has been satisfied by that time.





12




Kenexa Corporation and Subsidiaries


Notes to Consolidated Financial Statements – Unaudited (Continued)


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








2. Summary of Significant Accounting Policies (continued)





Revenue Recognition





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





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





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





Prior to its adoption of Accounting Standards Update 2009-13 (“ASU 2009-13”), “Multiple Deliverable Revenue Arrangements,” the Company separated certain arrangements only if the professional services, provided at the outset of the engagement, had value to the customer on a stand-alone basis and there was objective and reliable evidence of fair value of the undelivered service elements.  All other multi-element arrangements were treated as one unit of accounting, since the undelivered element lacked objective and reliable evidence of fair value.  In such instances both the initial professional services and subsequent subscription services were recognized ratably over the term of the license and estimated customer relationship period.  When offered by itself, professional services are recognized based upon proportional performance as value is delivered to the customer.





Prior to its adoption of ASU 2009-13, in determining whether revenues from professional services could be accounted for separately from subscription revenue, the Company considered the following factors for each agreement: availability from other vendors, whether objective and reliable evidence of fair value exists of the undelivered elements, the nature and the timing of when the agreement was signed in comparison to the subscription agreement start date and the contractual dependence of the subscription service on the customer's satisfaction with the other services.





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





The Company records expenses billed to customers in accordance with FASB ASC 605-45, “Revenue Recognition-Principal Agent Considerations,” which requires that reimbursements received for out-of-pocket expenses be classified as revenues and not as cost reductions.  These items primarily include travel, meals and certain telecommunication costs. Reimbursed expenses totaled $671 and $2,150 for the three and nine months ended September 30, 2010, respectively and $526 and $1,593 for the three and nine months ended September 30, 2009, respectively.





13





Kenexa Corporation and Subsidiaries


Notes to Consolidated Financial Statements – Unaudited (Continued)


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








2. Summary of Significant Accounting Policies (continued)





Revenue Recognition (continued)





Pursuant to the transition rules contained in ASU 2009-13, the company elected to early adopt the provisions included in the amendment effective January 1, 2010.





Based upon a review of its applicant tracking system (“ATS”) arrangements the Company determined that professional services, previously combined with hosting fees as one unit of accounting, now qualify as a separate unit of accounting.  This new approach is supported by existence of the Company’s estimated selling prices for all of its deliverables within an ATS arrangement and the assertion that the delivered items within these arrangements, i.e. the services, have standalone value.  Under these arrangements, contract consideration will be allocated to each deliverable using the relative selling price method.  As a result of this adoption, consulting revenue previously recognized over the license term will be recognized in the period the service is provided which corresponds to value delivered to the customer.  The adoption had no impact on contracts executed prior to January 2010.





In addition to modifying revenue recognition for ATS arrangements, the new guidance contained in ASU 2009-13 permits the Company to unbundle multiple products within an arrangement using the relative selling price method.   Previously, these deliverables were treated as one unit of accounting with revenue under these arrangements being deferred until all products, for which the Company lacked objective evidence of fair value, were delivered.  Under the new guidance, total consideration will be allocated to each product based upon the availability of vendor specific objective evidence (“VSOE”), third party evidence and the relative selling price method and recognized as each product is delivered to the customer.  In addition, the new guidance prohibits the use of the residual method for determining the value of the delivered element.





Based upon a preliminary analysis the Company has determined that the adoption of ASU 2009-13 will not have a material impact on the financial statements after the initial adoption.  This conclusion is based in part on the following facts:





•
Revenue that would have been recognized if the related arrangements entered into or materially modified after the effective date were subject to the measurement requirements of FASB ASC 605-25, “Multiple Element Arrangements,” would have been $27 and $1,990 or 0.1% and 1.5% less than currently reported revenue of $50,784 and $135,313, for the three and nine months ended September 30, 2010.•
Revenue that would have been recognized in the year before the year of adoption if the arrangements accounted for under ASC 605-25 were subject to the new measurement requirements of ASU 2009-13 would have been $229 and $331 or 0.6% and 0.3% more than the reported revenue of $40,314 and $118,610, for the three and nine months ended September 30, 2009.•
Revenue recognized and deferred revenue as of and for the period ended September 30, 2010 from applying ASC 605-25 and ASU 2009-13:





Revenue recognized

for the nine months ended

September 30, 2010


Deferred revenue for the period ended

September 30, 2010ASC 605-25

$
133,323


$
51,512ASU 2009-13


1,990



7,196Total

$
135,313


$
58,708








14





Kenexa Corporation and Subsidiaries


Notes to Consolidated Financial Statements – Unaudited (Continued)


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








2. Summary of Significant Accounting Policies (continued)





Revenue Recognition (continued)





The new revenue guidance contained in ASU 2009-13 modifies the way the Company accounts for its ATS arrangements, by allowing the Company to separate its professional services and corresponding license fees into two separate units of accounting.  These two deliverables represent the primary elements in an ATS arrangement and are recognized upon performance or delivery of each service or product, respectively to the end customer.  The implementation services are typically earned over a three to six month period, while the license fees are recognized over a two to five year period.  These arrangements usually do not contain cancellation or refund-type provisions and may include termination for convenience clauses following a stated period of time or performance level commitments.





Multiple element arrangements consisting of multiple products are also impacted by the new revenue guidance.  Under ASU 2009-13, total consideration for an arrangement is allocated to each product using the hierarchy of VSOE, third party evidence and the relative selling price method and recognized as each product is delivered to the customer.  Consistent with current practice, revenue may be deferred if the arrangement includes any unusual terms including extended payment terms, specified acceptance terms, or hold backs payable upon final acceptance of the product.





The Company utilizes a pricing model for its products which considers market factors such as customer demand for its products, and the geographic regions where the products are sold.   In addition, the model considers entity-specific factors such as volume based pricing, discounts for bundled products and total contract commitment.  Management approval of the model ensures that all of the Company’s selling prices are consistent and within an acceptable range for use with the relative selling price method.





While the pricing model currently in use captures all critical variables, unforeseen changes due to external market forces may result in the Company revising some of its inputs.  These modifications may result in the consideration allocation differing from the one presently in use.  Absent a significant change in the pricing inputs or the way in which the industry structures its deals, future changes in the pricing model are not expected to materially affect the Company’s allocation of arrangement consideration.








15





Kenexa Corporation and Subsidiaries


Notes to Consolidated Financial Statements – Unaudited (Continued)


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








2. Summary of Significant Accounting Policies (continued)








Earnings (Loss) Per Share





The Company follows FASB ASC 260, “Earnings Per Share,”which requires companies that are publicly held or have complex capital structures to present basic and diluted earnings per share on the face of the statement of operations.  Earnings (loss) per share is based on the weighted average number of shares and common stock equivalents outstanding during the period.  In the calculation of diluted earnings per share, shares outstanding are adjusted to assume conversion of the exercise of options if they are dilutive.  In the calculation of basic earnings per share, weighted average numbers of shares outstanding are used as the denominator. Certain common stock equivalents of stock options and restricted stock issued and outstanding other than the options included in the table below were excluded in the computation of diluted earnings per share for the periods ended September 30, 2010 and 2009 since their effect was antidilutive.  A summary of the computation is presented in the table below.






Basic and diluted earnings (loss) per share are computed as follows:





Three months ended

September 30,


Nine months ended

September 30,2010


2009


2010


2009Numerator:Net income (loss) allocable to common shareholders

$
150


$
1,598


$
1,108


$
(31,373
)Denominator:Weighted average shares used to compute net income (loss) allocable to common shareholders per common share - basic


22,629,050



22,539,717



22,603,323



22,525,144Effect of dilutive stock options and restricted stock


539,503



381,218



494,747



—Weighted average shares used to compute net income (loss) allocable to common shareholders per common share – dilutive


23,168,553



22,920,935



23,098,070



22,525,144Basic net income (loss) per share

$
0.01


$
0.07


$
0.05


$
(1.39
)Diluted net income (loss) per share

$
0.01


$
0.07


$
0.05


$
(1.39
)Total antidilutive stock options and restricted stock issued and outstanding


1,814,198



1,894,956



1,814,198



1,966,056








16





Kenexa Corporation and Subsidiaries


Notes to Consolidated Financial Statements – Unaudited (Continued)


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








2. Summary of Significant Accounting Policies (continued)








Adoption of new accounting pronouncements





In June 2009, the FASB issued new accounting guidance for variable interest entities. This guidance was codified under ASU 2009-17 in December 2009 and includes: (1) the elimination of the exemption from consolidation for qualifying special purpose entities, (2) a new approach for determining the primary beneficiary of a variable interest entity (“VIE”), which requires that the primary beneficiary have both (i) the power to control the most significant activities of the VIE and (ii) either the obligation to absorb losses or the right to receive benefits that could potentially be significant to the VIE, and (3) the requirement to continually reassess who should consolidate a VIE.  The new guidance is effective for annual reporting periods that begin after November 15, 2009 and applies to all existing and new VIEs. The Company adopted ASU 2009-17 on January 1, 2010 and the adoption did not have a material impact on the Company’s financial statements.





We adopted in January 2010, the Accounting Standards Update (“ASU”) No. 2009-13, “Revenue Recognition: Multiple-Deliverable Revenue Arrangements - a consensus of the FASB Emerging Issues Task Force,” which eliminates the use of the residual method for allocating consideration, as well as the criteria that requires objective and reliable evidence of fair value of undelivered elements in order to separate the elements in amultiple-element arrangement. By removing the criterion requiring the use of objective and reliable evidence of fair value in separately accounting for deliverables, the recognition of revenue will more closely align with certain revenue arrangements. The standard also will replace the term "fair value" in the revenue allocation guidance with "selling price" to clarify that the allocation of revenue is based on entity-specific assumptions rather than assumptions of a marketplace participant. ASU No. 2009-13 is effective for revenue arrangements entered or materially modified in fiscal years beginning on or after June 15, 2010.  The adoption did not have a material impact on the Company’s financial statements.   See “Revenue Recognition” above for further details, including financial impact.





Effective July 1, 2009, we adopted “The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles.” This standard establishes only two levels of GAAP, authoritative and non-authoritative. The FASB Accounting Standards Codification (the “Codification”) became the source of authoritative, non-governmental GAAP, except for rules and interpretive releases of the SEC, which are sources of authoritative GAAP for SEC registrants. All other non-grandfathered, non-SEC accounting literature not included in the Codification became non-authoritative. We began using the new guidelines and numbering system prescribed by the Codification when referring to GAAP in the third quarter of fiscal 2009. As the Codification was not intended to change or alter existing GAAP, it did not have any impact on our consolidated financial statements.





In May 2009, the FASB adopted Codification Topic 855, “Subsequent Events,” which codifies the guidance regarding the disclosure of events subsequent to the balance sheet date. The statement established 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. ASC 855 is effective for interim or annual financial periods ending after June 15, 2009, and shall be applied prospectively. The adoption ASC 855 did not have a material impact on the Company’s financial statements.





In April 2009, the FASB amended ASC 805 “Business Combinations,” which established a model to account for certain pre-acquisition contingencies. Under ASC 805, an acquirer is required to recognize at fair value an asset acquired or a liability assumed in a business combination that arises from a contingency if the acquisition-date fair value of that asset or liability can be determined during the measurement period. If the acquisition-date fair value cannot be determined, then the acquirer should follow the recognition criteria in ASC 450, “Contingencies”. In the first quarter of 2009, we adopted ASC 805 and will apply its provisions when applicable.





In December 2007, the FASB issued ASC 810-10, “Consolidation-Overall,” and ASC 805, “Business Combinations.”  Changes for business combination transactions pursuant to ASC 805 include, among others, expensing of acquisition-related transaction costs as incurred, the recognition of contingent consideration arrangements at their acquisition date fair value and capitalization of in-process research and development assets acquired at their acquisition date fair value. Changes in accounting for noncontrolling (minority) interests pursuant to ASC 810-10 include, among others, the classification of noncontrolling interest as a component of consolidated shareholders’ equity and the elimination of "minority interest" accounting in results of operations. ASC 805 is required to be adopted and was effective for fiscal years beginning on or after December 15, 2008. The adoption of ASC 805 and ASC 810-10 impacted the Company’s accounting related to the consolidation of its variable interest entity in 2009 and impacted the accounting for the Company's current acquisition.





17





Kenexa Corporation and Subsidiaries


Notes to Consolidated Financial Statements – Unaudited (Continued)


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








2. Summary of Significant Accounting Policies (continued)








New Accounting Pronouncements





In March 2010 the EITF Task Force reached a consensus on ASU No. 2010-17, “Milestone Method of Revenue Recognition,” which permits the use of the milestone method as a valid application of the proportional performance model for revenue recognition if the milestones are substantive and there is substantive uncertainty about whether the milestones will be achieved.    The milestone method is mainly used in research and development arrangements involving contingent payments for achieving specified performance measures, which are commonly found in the pharmaceutical and biotechnology industries.  Those arrangements often include incentive payments that are linked to milestones in the clinical-development process.  In order to meet the definition of substantive, the milestone would have to 1) be commensurate  with either the level of effort required to achieve the milestone or the enhancement in the value of the item delivered, 2) relate solely to past performance, and 3) should be reasonable relative to all deliverables and payment terms in the arrangement.  The new guidance is effective for interim and annual periods beginning on or after June 15, 2010 with early adoption permitted.  The Company does not believe this pronouncement will have a material impact on the presentation of its financial statements.


In January 2010, the FASB issued ASU No. 2010-06, “Improving Disclosures about Fair Value Measurements (Topic 820) - Fair Value Measurements and Disclosures (ASU2010-06),” to add additional disclosures about the different classes of assets and liabilities measured at fair value, the valuation techniques and inputs used, the activity in Level 3 fair value measurements, and the transfers between Levels 1, 2, and 3 (as defined in Footnote 3 – Investments of the Notes to the Consolidated Financial Statements). Certain provisions of this update will be effective for us during the first quarter of 2011 and we are currently evaluating the impact of the pending adoption of this standards update on our consolidated financial statements.








3.  Investments





The following is a summary of our short-term investments at December 31, 2009:








Cost


Unrealized (loss) /gain


Accrued interest


Fair market valueAvailable for Sale securitiesMunicipal bond securities

$
15,627


$
(89
)

$
118


$
15,656Trading SecuritiesAuction rate securities


13,737



177



—



13,914Total short-term investments as of December 31, 2009

$
29,364


$
88


$
118


$
29,570








18





Kenexa Corporation and Subsidiaries


Notes to Consolidated Financial Statements – Unaudited (Continued)


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








3.  Investments (continued)





During the six months ended June 30, 2010 the Company liquidated $8,700 of its auction rate securities through periodic redemptions, which included $1,377 of realized gains.  For the three months ended September 30, 2010 the Company exercised its right to sell the remaining auction rate securities back to UBS at par value realizing $6,591 in proceeds, effectively liquidating its $13,914 investment at December 31, 2009.   For the three months ended September 30, 2010, in anticipation of the Salary.com acquisition (as discussed in Footnote 15 – Subsequent Events of the Notes to the Consolidated Financial Statements)  the Company liquidated the remaining balance of its municipal bonds, which totaled $15,656 at December 31, 2009.





Due to the failure of the auction rate market in early 2008, UBS AG and other major banks entered into discussions with government agencies to provide liquidity to owners of auction rate securities. In November 2008, the Company entered into an agreement (the “UBS Settlement Agreement”) with UBS AG which provided (1) the Company with a “no net cost” loan up to the par value of Eligible auction rate securities until June 30, 2010, and  (2) the Company, the right to sell these auction rate securities back to UBS AG at par, at the Company’s sole discretion, anytime during the period from June 30, 2010 through July 2, 2012, and (3) UBS AG the right to purchase these auction rate securities or sell them on the Company’s behalf at par anytime through July 2, 2012.  Following the execution of the UBS Settlement Agreement, the Company determined that it no longer had the intent to hold the auction rate securities until either the maturity or recovery of the auction rate security market. Based upon this unusual circumstance related to the execution of the UBS Settlement Agreement, the Company transferred these investments from available-for-sale to trading securities and began recording the change in fair value of the auction rate securities as gains or losses in current statements of operations.





Contemporaneous with the determination to transfer the auction rate securities to trading securities, the Company elected to measure the value of its option to put the securities (“put option”) to UBS AG under the fair value option of ASC 825, “Financial Instruments”.  As a result, the Company recorded at December 31, 2008 a non-operating gain representing the estimated fair value of the put option and a corresponding long-term asset of approximately $2,219.  At December 31, 2009, the put option’s estimated fair value decreased to $1,374 and by June 30, 2010, the put option’s estimated fair value decreased to zero.





Based upon the results of the discounted cash flow analysis, the Company determined that the fair value of its investment in auction rate securities should be discounted approximately $2,219 to $16,513 at December 31, 2008, with any other-than temporary impairment in the fair value of the auction rate securities offset substantially by the fair value recognized for the rights provided in the settlement agreement.  As a result of the transfer of the auction rate securities from available-for-sale to trading investment securities noted above, the Company also recorded a non-operating gain for the nine months ended September 30, 2010 and the twelve months ended December 31, 2009 of approximately $1,377 and $833, respectively.   The recording of the loss relating to the decrease in the fair value of the put option and the corresponding recognition of the gain in the auction rate securities resulted in an overall net gain of approximately $3 for the nine months ended September 30, 2010.





Realized gains and losses from fixed-income, available for sale securities are primarily attributable to changes in interest rates.   During the quarter ended September 30, 2010, the Company liquidated its municipal bond securities, resulting in a realized loss of $382.   At December 31, 2009, contractual maturities of our short-term investments were one year or less.








19





Kenexa Corporation and Subsidiaries


Notes to Consolidated Financial Statements – Unaudited (Continued)


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








3.  Investments (continued)





The Company had investments that were valued in accordance with the provisions of ASC 820, “Fair Value Measurements and Disclosure.” Under this standard, fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.  ASC 820, Fair Value Measurements and Disclosure establishes a hierarchy for inputs used in measuring fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that the most observable inputs be used when available. The hierarchy is broken down into three levels based on the reliability of inputs as follows:





•
Level 1 - Valuations based on quoted prices in active markets for identical assets that the Company has the ability to access.


•
Level 2 - Valuations based inputs on other than quoted prices included within level 1, for which all significant inputs are observable, either directly or indirectly.


•
Level 3 - Valuations based on inputs that are unobservable and significant to the overall fair value measurement.








The estimated fair value of the Company’s municipal bond securities on December 31, 2009 of $15,656 was determined based upon quoted prices in active markets for identical assets or Level 1 inputs.  The estimated fair value of the Company’s auction rate securities on December 31, 2009 of $13,914 and was determined based upon significant unobservable inputs or Level 3 inputs.





A reconciliation of the beginning and ending balances for the auction rate securities using significant unobservable inputs (Level 3) for the period ended September 30, 2009 is presented below:





Auction rate securitiesBalance at December 31, 2008

$
16,513Net realized gains included in earnings


656Settlements


(1,807
)Balance at September 30, 2009

$
15,362





A reconciliation of the beginning and ending balances for the auction rate securities using significant unobservable inputs (Level 3) for the period ended September 30, 2010 is presented below:





Auction rate securitiesBalance at December 31, 2009

$
13,914Net realized gains included in earnings


1,377Settlements


(15,291
)Balance at September 30, 2010

$
—





20


Kenexa Corporation and Subsidiaries


Notes to Consolidated Financial Statements – Unaudited (Continued)


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





4. Acquisitions





Quorum International Holdings Limited





On April 2, 2008, the Company acquired all of the outstanding stock of Quorum International Holdings Limited (“Quorum”), a provider of recruitment process outsourcing services based in London, England, for a purchase price of approximately $27,950, in cash, of which $19,753 was paid in April 2008 and $8,197 was paid in July 2008.  The total cost of the acquisition, including legal, accounting, other professional fees and additional consideration of $2,873, was approximately $30,823, including acquired intangibles of $8,633, with estimated useful lives between 3 and 10 years.  In addition, the acquisition agreement contains an earnout provision which provides for the payment of additional consideration by the Company based upon the gross profit of Quorum for the twelve month period ending June 30, 2009 and June 30, 2010.  Formulaically, the earnout is 3.86 times Quorum’s gross profit less the amount of base consideration, as defined in the agreement.  Pursuant to FASB ASC 805, “Business Combinations,” the Company accrues contingent purchase consideration when the outcome of the contingency is determinable beyond a reasonable doubt.  Based upon the results for the twelve month period through June 30, 2009, it was determined that an earnout payment was due to the former shareholders of Quorum and as such, the additional consideration of $1,167 was accrued for in the financial statements at December 31, 2009.  During the first quarter of 2010 additional consideration of $468 was determined payable.  The total consideration of $1,635 was paid in cash during the first quarter of 2010.  In addition, based upon the results for the twelve month period through June 30, 2010 no earnout payment was determined to be earned.  The Company evaluates the earnout provisions contained in the acquisition agreement at each financial statement reporting date.  In connection with the acquisition, €500 or approximately $687, of the purchase price was deposited into an escrow account and recorded in other long-term assets, to cover any claims for indemnification made by the Company against Quorum under the acquisition agreement.  Although, the escrow agreement expired approximately two years from the acquisition date, the Company is currently evaluating the status of any claims and the amounts to be withheld from the escrow account.  The Company expects that the acquisition of Quorum will broaden its presence in the global recruitment market.  The purchase price has been allocated to the assets acquired and liabilities assumed based upon management’s best estimate of fair value with any excess over the net tangible and intangible assets acquired allocated to goodwill.   Quorum’s results of operations were included in the Company’s consolidated financial statements beginning on April 2, 2008.








The Centre for High Performance Development (Holdings) Limited




On July 26, 2010, the Company acquired all of the outstanding stock of which operates as a leadership development and management training company based in London, England for a purchase price of approximately $4,233 in cash.  The Company deposited €314 or approximately $428 into escrow to cover any claims for indemnification made by the Company or CHPD.The Company used its cash to acquire all the outstanding stock of CHPD.  The Company expects the acquisition of CHPD will enhance its existing research and content portfolio.  The purchase price has been allocated on a preliminary basis to the assets acquired and liabilities assumed based upon management’s best estimate of fair value with any excess over the net tangible and intangible assets acquired allocated to goodwill.  CHPD’s results of operations were included in the Company’s consolidated financial statements beginning on July 26, 2010.








21





Kenexa Corporation and Subsidiaries


Notes to Consolidated Financial Statements – Unaudited (Continued)


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








5. Variable Interest Entity





On January 20, 2009, the Company entered into an ownership interest transfer agreement (“the agreement”) with Shanghai Runjie Management Consulting Company, (“R and J”) in Shanghai, China.   In conjunction with the agreement, the Company paid $1,337 to provide an initial equity contribution and to compensate the former owners of R and J, who transferred their existing business into a new entity, Shanghai Kenexa Human Resources Consulting Co., Ltd., (the “variable interest entity”).  The initial payment provided the Company with a 46% ownership in the variable interest entity, and a presence in China’s human capital management market.   The former owners of R and J are required to transfer 1% additional ownership interests (in 1% increments up to 49% over a two year period), with consideration to be paid by the Company based upon adjusted EBITDA, as defined in the agreement.  In the fourth quarter of 2009, based upon the 2008 operating results for R and J, the Company paid an additional $206 for an additional 1% ownership interest in the variable interest entity.  At December 31, 2009 and September 30, 2010, the Company had a 47% ownership interest in the variable interest entity.





Consideration for the ownership interest transfer in the third quarter of 2009 was determined as the greater of 1) the amount of registered capital attributable to a 1% ownership interest or 2) an amount denominated in Chinese Yuan Renminbi (“RMB¥”) equal to the result of 47% times four and one half times the Adjusted EBITDA of the variable interest entity for the calendar year ended December 31, 2008, plus 1% of the variable interest entity’s free cash flow as of March 31, 2008, minus the amount of the initial investment or RMB¥ 8,145 or $1,224. The additional transfers of ownership interests for 2010 and 2011 will be determined formulaically the same as above and will be adjusted only for any increase in actual ownership percentage by the Company.





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





In accordance with ASC 810, “Variable Interest Entities,” the new entity qualified for consolidation as it was determined to be a variable interest entity and the Company as its primary beneficiary.   The determination of the primary beneficiary was based, in part, upon a qualitative assessment which included the Company’s commitment to finance the variable interest entity’s ongoing operations, the level of involvement in the variable interest entity’s operations, the use of the Company’s brand by the variable interest entity, and the lack of equity “at risk” by R and J given its put rights.  The variable interest entity is consolidated in the Company’s financial statements because of the Company’s implicit guarantee to provide financing as well as its significant involvement in the day-to-day operations.   The equity interests of R and J not owned by the Company are reported as a noncontrolling interest in the Company’s December 31, 2009 and September 30, 2010 accompanying consolidated balance sheets.  All inter-company transactions are eliminated.  See Footnote 2 – Summary of Significant Accounting Policies Principles of Consolidation for additional details.





The noncontrolling interest related to the variable interest entity is subject to periodic adjustments in its carrying amount based on the put rights contained in the agreement.  For the three months ended September 30, 2010, the Company accreted $809 based upon a calculation of the actual operating results of the variable interest entity for the twelve month period ended September 30, 2010.





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





Pursuant to ASC 480 “Distinguishing Liabilities from Equity,” (formerly Emerging Issues Task Force Abstracts Topic No. D-98, “Classification and Measurement of Redeemable Securities,”)due to the put rights included in the agreement, the Company has presented the estimated fair value of R and J’s 53% initial ownership interest and the calculated value of the put right in the variable interest entity amounting to $2,546 at September 30, 2010 in noncontrolling interest and classified the amount as temporary equity on the consolidated balance sheet.


22





Kenexa Corporation and Subsidiaries


Notes to Consolidated Financial Statements – Unaudited (Continued)


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








6. Property, Equipment and Software





A summary of property, equipment and software and related accumulated depreciation and amortization as of September 30, 2010 and December 31, 2009 is as follows:





September 30, 2010


December 31, 2009Equipment

$
19,255


$
17,748Software


34,600



28,397Office furniture and fixtures


2,443



2,455Leasehold improvements


2,805



2,735Land


745



714Building


8,653



7,828Software in development


6,596



3,083Total property, equipment and software

$
75,097


$
62,960Less accumulated depreciation and amortization


35,495



26,093Total property, equipment and software, net of accumulated depreciation and amortization

$
39,602


$
36,867








Depreciation and amortization expense is excluded from cost of revenues.  Equipment and office furniture and fixtures included assets under capital leases totaling $2,524 and $2,621 at September 30, 2010 and December 31, 2009, respectively. Depreciation and amortization expense, including amortization of assets under capital leases, was $3,563 and $9,947 for the three and nine months ended September 30, 2010, respectively and $2,542 and $6,902 for the three and nine months ended September 30, 2009, respectively.





Pursuant to FASB ASC 360, “Property, Plant and Equipment,” the Company determined that there were no events that caused the fair value to exceed the carrying value, and therefore did not record a fixed asset impairment for the nine months ended September 30, 2010.








7. Other Accrued Liabilities





Other accrued liabilities consist of the following:





September 30, 2010


December 31, 2009Accrued professional fees

$
410


$
1,031Straight line rent accrual


1,279



2,084Other taxes payable


913



118Income taxes payable


3,075



837Other liabilities


1,365



1,139Contingent purchase price


—



1,167Total other accrued liabilities

$
7,042


$
6,376











23


Kenexa Corporation and Subsidiaries


Notes to Consolidated Financial Statements (Continued)


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








8. Line of Credit







On August 31, 2010, the Company entered into a secured credit agreement with PNC Bank, N.A. (the “Credit Agreement”), as administrative agent, in connection with its acquisition of Salary.com, as discussed in Footnote 15 – Subsequent Events of the Notes to the Consolidated Financial Statements.  The secured Credit Agreement includes a maximum amount available under the credit facility of $25,000 including a sublimit of up to $2,000 for letters of credit. Borrowings under the new credit facility are secured by substantially all of the Company’s assets and the assets of its subsidiaries. As of September 30, 2010 the Company borrowed $25.0 million under the Credit Agreement in connection with the acquisition of Salary.com.




The Company’s borrowings under the Credit Agreement bear interest at the Company’s option at LIBOR plus 225 basis points or the Base Rate, as defined, plus 125 basis points. Interest on LIBOR borrowings is calculated on an actual/360 day basis and is payable the earlier of quarterly or on the last day of each interest period.  LIBOR advances are available for periods of 1, 2, 3 or 6 months. LIBOR pricing is adjusted for any statutory reserves.  The base interest rate at September 30, 2010 was 4.5%.




Borrowings under the Credit Agreement are cross collateralized by a first priority perfected lien on the Company’s assets including, but not limited to, receivables, inventory, equipment, furniture, general intangibles, fixtures, real property and improvements.  The Credit Agreement contains various terms and covenants that provide for restrictions on payment of dividends, dispositions of assets, investments and acquisitions and require the Company, among other things, to maintain minimum levels of tangible net worth, net income and fixed charge coverage. The Company was compliant with its covenants at September 30, 2010.





9.  Income Taxes





The Company’s tax provision for interim periods is determined using an estimate of its annual effective tax rate.  The 2010 effective tax rate is lower than the 35% statutory U.S. Federal rate primarily due to an increase in foreign sourced income.





On January 1, 2007, we adopted the FASB ASC 740, “Income Taxes,” which clarifies the accounting for uncertain income tax positions recognized in financial statements and requires the impact of a tax position to be recognized in the financial statements if that position is more likely than not of being sustained by the taxing authority.  The Company does not expect that the amount of unrecognized tax benefits will significantly increase or decrease within the next twelve months.  Our policy is to recognize interest and penalties on unrecognized tax benefits in the provision for income taxes in the consolidated statements of operations.  Tax years beginning in 2005 are subject to examination by taxing authorities, although net operating loss and credit carryforwards from all years are subject to examinations and adjustments for at least three years following the year in which the attributes are used.





During the nine months ended September 30, 2010, the valuation allowance increased from $7,460 at December 31, 2009 by approximately $886 and $2,310 of acquired valuation allowance from CHPD to $10,656 as management continues to believe based on the weight of available evidence; it is more likely than not that some of the deferred tax asset will not be realized.


24





Kenexa Corporation and Subsidiaries


Notes to Consolidated Financial Statements (Continued)


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








10. Commitments and Contingencies





Litigation





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





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





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





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





On June 11, 2009 and July 16, 2009, two putative class actions were filed against Kenexa Corporation and our Chief Executive Officer and Chief Financial Officer in the United States District Court for the Eastern District of Pennsylvania, purportedly on behalf of a class of our investors who purchased our publicly traded securities between May 8, 2007 and November 7, 2007. The complaint filed on July 16, 2009 has since been voluntarily dismissed.  On September 28, 2010, the court granted Kenexa’s motion to dismiss the complaint filed on June 11, 2009 in its entirety.  The plaintiffs filed a motion for reconsideration of the court’s decision on October 12, 2010.





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





On October 1, 2010, Kenexa completed its acquisition of Salary.com, Inc. which included responsibility for the suit filed on August 13, 2010 by former shareholders and option holders of Genesys Software Systems, Inc. (Genesys) against Salary.com, Inc. and Silicon Valley Bank –Trustee Process Defendant in Massachusetts Superior Court.  Genesys asserts claims for breach of contract, breach of implied covenant of good faith and fair dealing, violation of the Massachusetts Unfair Business Practices Act, and declaratory judgment seeking damages of $2.0 million in contingent consideration related to the purchase of Genesys by Salary.com, plus other monetary damages and fees.  On September 7, 2010 Salary.com filed an answer and counterclaim against the Genesys parties, and certain former shareholders of Genesys, asserting breach of contract, breach of implied covenants of good faith and fair dealing, fraud, violation of the Massachusetts Unfair Business Practices Act, civil conspiracy, negligent misrepresentation, and declaratory judgment seeking to dismiss the original complaint and unspecified monetary damages.





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








25





Kenexa Corporation and Subsidiaries


Notes to Consolidated Financial Statements (Continued)


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








11. Equity





Rollforward of Shares





The Company’s common shares issued for the nine months ended September 30, 2010 and the year ended December 31, 2009 are as follows:





Class A

Common SharesDecember 31, 2008 ending balance


22,504,924Stock option exercises


14,747Employee stock purchase plan


42,212December 31, 2009 ending balance


22,561,883Stock option exercises


105,486Restricted stock awards


13,758Employee stock purchase plan


27,702September 30, 2010 ending balance


22,708,829





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








Stock and Voting Rights





Undesignated Preferred Stock





The Company has 10,000,000 shares of $0.01 par value undesignated preferred stock authorized, with no shares issued or outstanding at September 30, 2010 or December 31, 2009. These shares have preferential rights in the event of liquidation and payment of dividends.








Common Stock





At September 30, 2010 and December 31, 2009, the Company had 100,000,000 authorized shares of common stock.  At September 30, 2010 and December 31, 2009, shares of common stock outstanding were 22,708,829 and 22,561,883, respectively.  Each share of common stock has one-for-one voting rights.








Authorized but not issued shares





On February 20, 2008, our board of directors authorized a stock repurchase plan providing for the repurchase of up to 3,000,000 shares of the Company’s common stock, of which 1,125,651 shares were repurchased at an aggregate cost of $20,429 as of December 31, 2008.  These shares were restored to original status prior to December 31, 2008 and accordingly are presented as authorized but not issued.  The timing, price and volume of repurchases were based on market conditions, relevant securities laws and other factors.  As of December 31, 2008 the amount of shares available for repurchase under the stock repurchase plan was 1,874,349.  No repurchases were or have been made under the stock repurchase plan from January 1, 2009 to September 30, 2010.


26





Kenexa Corporation and Subsidiaries


Notes to Consolidated Financial Statements (Continued)


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








12. Stock Plans





Equity Incentive Plan





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





As of September 30, 2010, there were options to purchase and restricted stock of 3,549,623 and 98,758, respectively, shares of common stock outstanding under the 2000 and 2005 Option Plan.  The Company is authorized to issue up to an aggregate of 4,842,910 shares of its common stock pursuant to stock options and restricted stock granted under the 2005 Option Plan.  As of September 30, 2010, there were a total of 451,546 shares of common stock not subject to outstanding options and restricted stock and available for issuance under the 2005 Option Plan.





FASB ASC 718, “Compensation-Stock Compensation,” requires companies to estimate the fair value of share-based payment awards on the date of grant using an option-pricing model.  In 2010 and 2009, the fair value of each grant was estimated using the Black-Scholes valuation model.  Expected volatility was based upon a weighted average of peer companies and the Company’s stock volatility.  The expected life was determined based upon an average of the contractual life and vesting period of the options.  The estimated forfeiture rate was based upon an analysis of historical data.  The risk-free rate was based on U.S. Treasury zero coupon bond yields for periods commensurate with the expected term at the time of grant.





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








No options were granted during the three months ended September 30, 2010.  The following table provides the assumptions used in determining the fair value of service based awards as follows:





Quarter ended

June 30, 2010

Service based awards


Quarter ended

March 31, 2010

Service based awards


Year ended

December 31, 2009

Service based awardsExpected volatility


63.30-65.91
%


63.38
%


62.70 – 69.38
%Expected dividends


0



0



0Expected term (in years)


3-6.25



6.25



3 - 6.25Risk-free rate


0.98-2.36
%


3.27
%


1.36 - 3.09
%








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


27




Kenexa Corporation and Subsidiaries


Notes to Consolidated Financial Statements (Continued)


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








12. Stock Plans (continued)





A summary of the status of the Company’s stock options and restricted stock as of September 30, 2010 and December 31, 2009 and changes during the period then ended is as follows:





Options & Restricted Stock Outstanding


Options ExercisableShares Available for Grant


Shares


Wtd. Avg.

ExercisePrice


Shares


Wtd. Avg. Exercise PriceBalance at December 31, 2008

1,732,506


2,487,654


$
17.33


447,854


$
14.01Granted – options

(756,000
)

756,000



6.12


—



—Exercised

—


(14,747
)


4.72


—



—Forfeited or expired

55,000


(55,000
)


22.76


—



—Balance at December 31, 2009

1,031,506


3,173,907


$
14.63


696,407


$
17.68Granted – options

(547,822
)

547,822



11.24


—



—Granted – restricted stock

(98,758
)

98,758



—


—



—Exercised

—


(105,486
)


11.41


—



—Forfeited or expired

66,620


(66,620
)


17.55


—



—Balance at September 30, 2010

451,546


3,648,381


$
13.76


1,781,051


$
19.42





The total intrinsic value of options and restricted stock outstanding, exercisable and exercised for and during the nine months ended September 30, 2010 was $23,624 and $6,191 and $398, respectively.  The weighted average fair value for options and restricted stock granted during the nine months ended September 30, 2010 and the year ended December 31, 2009 was $7.29 and $3.50, respectively.  The weighted average remaining contractual term of options and restricted stock outstanding and exercisable at September 30, 2010 was 5.6 and 3.27 years, respectively.





Between January 1, 2010 and September 30, 2010, the Company granted to certain employees, officers and non-employee directors options to purchase an aggregate of 547,822 shares of the Company's common stock at prevailing market price of $10.50 to $14.39 per share.





On February 17, 2010, the Company granted to certain executive officers shares of restricted stock units in aggregate of 85,000 shares, which will vest 25% per year on each of February 17, 2011, February 17, 2012, February 17, 2013 and February 17, 2014.  In the event the certain executive officer ceases to be an employee before these shares are fully vested, the unvested restricted shares units will be forfeited to the Company. The grant date fair value of the restricted stock was $10.50 per share.





On May 19, 2010, the Company granted to certain non-employee directors shares of restricted stock awards in aggregate of 13,758 shares, which will vest 100% on the day preceding the Company’s 2011 annual meeting of Shareholders.  In the event the certain non-employee director ceases to be a director for the Company before these shares are fully vested, the unvested restricted shares units will be forfeited to the Company. The grant date fair value of the restricted stock was $14.39 per share.





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





28


Kenexa Corporation and Subsidiaries


Notes to Consolidated Financial Statements (Continued)


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








12. Stock Plans (continued)





A summary of the status of the Company’s unvested stock options and restricted stock for the periods ended September 30, 2010 and December 31, 2009 is presented below:





Shares


Wtd. Avg.

Grant Date Fair ValueNonvested at December 31, 2008


2,039,800


$
8.24Granted – options


756,000



3.50Vested


(279,000
)


9.21Forfeited or expired


(39,300
)


11.11Nonvested at December 31, 2009


2,477,500


$
6.34Granted – options


547,822



6.61Granted – restricted stock


98,758



11.04Vested


(1,213,750
)


9.18Forfeited or expired


(43,000
)


5.21Nonvested at September 30, 2010


1,867,330


$
4.85








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








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





Three months ended

September 30,


Nine months ended

September 30,2010


2009


2010


2009Cost of revenue

$
40


$
59


$
195


$
281Sales and marketing


226



286



776



838General and administrative


631



902



2,253



2,595Research and development


113



137



354



365Pre-tax share-based compensation

$
1,010


$
1,384


$
3,578


$
4,079Income tax benefit


—



355



—



1,084Share-based compensation expense, net

$
1,010


$
1,029


$
3,578


$
2,995














29





Kenexa Corporation and Subsidiaries


Notes to Consolidated Financial Statements (Continued)


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








12. Stock Plans (continued)





Employee Stock Purchase Plan





The Employee Stock Purchase Plan, which was approved in May 2006, enables substantially all U.S. and foreign employees to purchase shares of our common stock at a 5% discounted offering price off the closing market price of our common stock on the Nasdaq National Market, LLC on the offering date.  We have granted rights to purchase up to 500,000 common shares to our employees under the Plan. The Plan is not considered a compensatory plan in accordance with FASB ASC 718 and requires no compensation expense to be recognized.  Shares of our common stock purchased under the employee stock purchase plan were 27,702 and 42,212 for the periods ended September 30, 2010 and December 31, 2009, respectively.  As of September 30, 2010 the shares of common stock available to purchase under the employee stock purchase plan were 392,793.








13. Geographic Information





The following table summarizes the distribution of revenue by geographic region as determined by billing address for the three and nine months ended September 30, 2010 and 2009.











For the three months ended September 30,


For the nine months ended September 30,2010


2009


2010


2009Country

Amount


Percent of

Revenues


Amount


Percent of

Revenues


Amount


Percent of

Revenues


Amount


Percent of

RevenuesUnited States

$
36,835



72.5
%

$
30,918



76.7
%

$
100,401



74.2
%

$
94,343



79.5
%United Kingdom


4,615



9.1
%


2,912



7.2
%


10,825



8.0
%


8,287



7.0
%Germany


1,704



3.3
%


1,363



3.4
%


4,424



3.3
%


3,261



2.7
%The Netherlands


954



1.9
%


425



1.1
%


2,060



1.5
%


1,314



1.1
%Other European Countries


2,753



5.4
%


1,774



4.4
%


6,480



4.8
%


5,428



4.6
%Canada


947



1.9
%


1,085



2.7
%


2,587



1.9
%


1,815



1.5
%China


1,553



3.1
%


—



—
%


3,766



2.8
%


—



—
%Other


1,423



2.8
%


1,837



4.6
%


4,770



3.5
%


4,162



3.5
%Total

$
50,784



100.0
%


40,314



100.0
%

$
135,313



100.0
%

$
118,610



100.0
%











The following table summarizes the distribution of assets by geographic region as of September 30, 2010 and December 31, 2009.





September 30, 2010


December 31, 2009Country

Assets


Assets as a percentage of total assets


Assets


Assets as a percentage of total assetsUnited States

$
203,199



78.2
%

$
161,351



79.7
%United Kingdom


18,711



8.2
%


14,125



7.0
%India


10,641



5.3
%


9,943



4.9
%Ireland


2,278



2.1
%


4,182



2.1
%China


3,406



1.6
%


2,962



1.5
%Germany


2,792



2.0
%


4,381



2.2
%Canada


553



1.1
%


2,574



1.3
%Other


7,244



1.5
%


2,825



1.3
%Total

$
248,824



100.0
%

$
202,343



100.0
%





30





Kenexa Corporation and Subsidiaries


Notes to Consolidated Financial Statements (Continued)


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








14.  Related Party Transactions





One of the Company's directors, Barry M. Abelson, is a partner in the law firm of Pepper Hamilton LLP. This firm has represented the Company since 1997.  The Company paid Pepper Hamilton LLP, net of insurance coverage, $42 and $515 for the three and nine months ended September 30, 2010, respectively, and $42 and $231 for the three and nine months ended September 30, 2009, respectively, for general legal matters.   The increase in payments to Pepper Hamilton LLP for the three and nine months ended September 30, 2010 as compared to the previous year, resulted from an increase in activity from our class action shareholder lawsuits, our recent acquisitions of CHPD and Salary.com and credit facility.  The amount payable to Pepper Hamilton as of September 30, 2010 and December 31, 2009, was $640 and $202, respectively.








15. Subsequent Events





On October 1, 2010, the Company acquired all of the outstanding stock of Salary.com, which provides on-demand compensation software that helps businesses and individuals manage pay and performance, for a purchase price of approximately $80,000 in cash.  The fees incurred in connection with the acquisition were approximately $2,250.  The Company used its cash and borrowings against the credit facility to fund the acquisition of Salary.com.  The Company believes there is a significant opportunity to expand Salary.com’s adoption in large organizations and on a global basis because its compensation analysis software is highly synergistic with our current suite of talent acquisition and retention solutions.





On, October 20, 2010, the Company paid all outstanding amounts and terminated its secured Credit Agreement, dated August 31, 2010, with PNC Bank, N.A.  The material terms of the Original Credit Agreement are disclosed in Kenexa’s current report on Form 8-K filed with the Securities and Exchange Commission on September 1, 2010, the contents of which are incorporated by reference herein.





On October 20, 2010, the Company entered into a credit agreement (the “Credit Agreement”) with PNC Bank, National Association, as administrative agent (“Agent”), and the lenders party thereto.  The maximum amount available under the senior secured credit facility is $60,000, comprised of a $35,000 revolving facility, including a sublimit of up to $5,000 for letters of credit and a sublimit of up to $2,500 for swing loans (the “Revolving Facility”), and a $25,000 term facility (the “Term Facility”).  The Company may request to increase the maximum amount available under the Revolving Facility to $50,000.  The Credit Agreement will terminate, and all borrowings will become due and payable, on October 19, 2013. Kenexa and each of its U.S. subsidiaries are guarantors of the obligations under the Credit Agreement. Borrowings under the Credit Agreement are secured by substantially all of the Company’s and the Guarantors’ assets.





The Company’s borrowings under the Revolving Facility and Term Facility bear interest at either (i) the adjusted London Interbank Offered Rate for U.S. Dollar deposits, or LIBOR Rate, plus the applicable margin or (ii) the Base Rate—the greater of the Agent’s prime rate, the Federal Funds Open Rate plus 1⁄2 of 1.0%, and the LIBOR rate plus 100 basis points—plus the applicable margin. The applicable margin, ranging from 275 to 325 basis points for LIBOR Rate loans and from 175 to 225 basis points for Base Rate loans, depends on the fixed coverage ratio of the Company.













31


Table of Contents




Item 2: Management's Discussion and Analysis of Financial Condition and Results of Operations





This Quarterly Report on Form 10-Q, including the following Management’s Discussion and Analysis of Financial Condition and Results of Operations, contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, Section 21E of the Securities Exchange Act of 1934, as amended, and the Private Securities Litigation Reform Act of 1995, that involve a number of risks and uncertainties. These forward-looking statements include, but are not limited to, plans, objectives, expectations and intentions and other statements contained herein that are not historical facts and statements identified by words such as “expects,” “anticipates,” “will,” “intends,” “plans,” “believes,” “seeks,” “estimates” or words of similar meaning. These statements may contain, among other things, guidance as to future revenue and earnings, operations, prospects of the business generally, intellectual property and the development of products.  These statements are based on our current beliefs or expectations and are inherently subject to various risks and uncertainties, including those set forth under the caption “Risk Factors” in our most recent Annual Report on Form 10-K as filed with the Securities and Exchange Commission, as amended and supplemented under the caption “Risk Factors” in our subsequent Quarterly Reports on Form 10-Q filed with the Securities and Exchange Commission.  Actual results may differ materially from these expectations due to changes in global political, economic, business, competitive, market and regulatory factors, our ability to implement business and acquisition strategies or to complete or integrate acquisitions.  We do not undertake any obligation to update any forward-looking statements contained herein as a result of new information, future events or otherwise. References herein to “Kenexa,” “we,” “our,” and “us” collectively refer to Kenexa Corporation, a Pennsylvania corporation, and all of its direct and indirect U.S., U.K., Canada, India, and other foreign subsidiaries.





1. Overview





We provide software, proprietary content and services that enable organizations to more effectively recruit and retain employees. Our solutions are built around a suite of easily configurable software applications that automate talent acquisition and employee performance management best practices. We offer the software applications that form the core of our on-demand solutions, which materially reduces the costs and risks associated with deploying traditional enterprise applications. We complement our software applications with tailored combinations of outsourcing services, proprietary content and consulting services based on our 23 years of experience assisting customers in addressing their Human Resource (HR) requirements.  Together, our software applications and services form complete and highly effective solutions available from a single vendor. We believe that these solutions enable our customers to improve the effectiveness of their talent acquisition programs, increase employee productivity and retention, measure key HR metrics and make their talent acquisition and employee performance management programs more efficient.





We sell our solutions to large and medium-sized organizations through our direct sales force. As of December 31, 2009, we had a customer base of approximately 4,900 companies, including approximately 170 companies on the Fortune 500 list published in May 2009. Our customer base includes companies that we billed for services during the 12 months ended December 31, 2009 and does not necessarily indicate an ongoing relationship with each such customer. Our top 80 customers contributed approximately $75.4 million or 55.7% of our total revenue for the nine months ended September 30, 2010.





Our customers typically purchase multi-year subscriptions which provide us with a recurring revenue stream.  During the nine months ended September 30, 2010 and year ended December 31, 2009, our customers renewed over 80% of the aggregate value of multi-year subscriptions for our on-demand talent acquisition and performance management solution contracts subject to renewal.  This renewal rate provides us with a strong base of recurring revenue. We believe that our strong customer relationships provide us with a meaningful opportunity to cross-sell additional solutions to our existing customers and to achieve greater penetration within an organization. As the business environment improves we expect renewal rates to improve to our historical renewal rate in excess of approximately 90%.





During the nine months ended September 2010 the unemployment rate dropped slightly from the prior year and with the drop we have witnessed a slow but steady improvement in business conditions.  While we expect the pace of the economic recovery to be erratic over the balance of this year and into 2011, we remain optimistic in the intermediate to longer term about our prospects for continued growth.





In May 2010, we launched a major upgrade to our product line.  Our 2x platform includes applications such as 2x Recruit, 2x BrassRing, 2x Onboard and our first-to-market 2x Mobile solution.  Future modules to the 2x platform include 2x Perform, 2x Assess, 2x Analytics and 2x Survey.  We believe that Kenexa 2x enables customers to improve productivity, increase cost savings, ensure compliance with corporate and legal mandates, and raise employee engagement.


32





2. Recent Events





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





On May 21, 2009, we terminated our secured credit agreement with PNC Bank.





On June 11, 2009 and July 16, 2009, two putative class actions were filed against Kenexa Corporation and our Chief Executive Officer and Chief Financial Officer in the United States District Court for the Eastern District of Pennsylvania, purportedly on behalf of a class of our investors who purchased our publicly traded securities between May 8, 2007 and November 7, 2007. The complaint filed on July 16, 2009 has since been voluntarily dismissed.  On September 28, 2010, the court granted Kenexa’s motion to dismiss the complaint filed on June 11, 2009 in its entirety.  The plaintiffs filed a motion for reconsideration of the court’s decision on October 12, 2010.




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





At June 30, 2010 the fair value of our auction rate securities portfolio and our put option approximated par value.  In July 2010, in accordance with the UBS AG agreement, we exercised our right to sell our auction rate securities back to UBS and liquidated the auction rate security portfolio in its entirety.





On July 26, 2010, we  acquired all of the outstanding stock of The Centre for High Performance Development (Holdings) Limited (“CHPD”) which operates as a leadership development and management training company based in London, England for a purchase price of approximately $4.2 million in cash.  The total cost of the acquisition including estimated legal, accounting, and other professional fees was approximately $4.3 million. We deposited $0.4 million into escrow to cover any claims for indemnification. Weacquired all assets and liabilities of CHPD using our existing cash and expect the acquisition of CHPD will enhance our existing research and content portfolio.





On August 31, 2010, we entered into a secured credit agreement with PNC Bank, N.A. (the “Credit Agreement”), as administrative agent, in connection with our acquisition of Salary.com.   The secured Credit Agreement includes a maximum amount available under the credit facility of $25.0 million including a sublimit of up to $2.0 million for letters of credit. Borrowings under the new credit facility are secured by substantially all of the Company’s assets and the assets of its subsidiaries.  As of September 30, 2010 the Company borrowed $25.0 million under the Credit Agreement in connection with the acquisition of Salary.com.





On October 1, 2010, we acquired all of the outstanding stock of Salary.com, which provides on-demand compensation software that helps businesses and individuals manage pay and performance, for a purchase price of approximately $80.0 million in cash.  The total cost of the acquisition including estimated legal, accounting, and other professional fees was approximately $82.2 million.  We used cash and borrowings against the credit facility to fund the acquisition.  We believe there is a significant opportunity to expand Salary.com’s adoption in large organizations and on a global basis because its compensation analysis software is highly synergistic with our current suite of talent acquisition and retention solutions.





On October 20, 2010, we terminated our August 31, 2010 credit agreement and entered into a senior secured credit facility with PNC Bank, N.A. with a maximum amount available of $60.0 million, comprised of a $35.0 million revolving facility, a $25.0 million term facility, and a sublimit for letters of credit and swing loans.  Under the terms of the loan we may request to increase the maximum amount available under the revolving facility to $50.0 million. Borrowings under the senior credit facility are secured by substantially all our and our subsidiaries’ assets.











33





3. Sources of Revenue





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





Our customers primarily purchase renewable subscriptions for our solutions. The typical term is one to three years, with some terms extending up to five years. The majority of our subscription agreements are not cancelable for convenience although our customers have the right to terminate their contracts for cause if we fail to provide the agreed-upon services or otherwise breach the agreement. A customer does not generally have a right to a refund of any advance payments if the contract is cancelled.  Recently as economic conditions have improved, contract renewals have increased.  During the nine months ended September 30, 2010 and year ended December 31, 2009 our customers renewed over 80% of the aggregate value of multi-year subscriptions for our on-demand talent acquisition and performance management solution contracts subject to renewal during the period rather than our historical renewal rate of approximately 90%.  As the business environment improves, we expect renewal rates to improve to the 90% range.





Consistent with our historical practices, revenue derived from subscription fees is recognized ratably over the term of the subscription agreement. We generally invoice our customers in advance in quarterly installments and typical payment terms provide that our customers pay us within 30 days of invoice. Amounts that have been invoiced are recorded in accounts receivable prior to the receipt of payment and in deferred revenue to the extent revenue recognition criteria have not been met.  As of September 30, 2010, deferred revenue increased by $8.7 million, or 17.5%, to $58.7 million from $50.0 million at December 31, 2009.  The increase in deferred revenue is a result of increased sales volume from the prior year.  We generally price our solutions based on the number of software applications and services included and the number of customer employees. Accordingly, subscription fees are generally greater for larger organizations and for those that subscribe for a broader array of software applications and services.





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





For the three months ended September 30, 2010, approximately 72.5% of our total revenue was derived from sales in the United States. Revenue that we generated from customers in the United Kingdom, Germany, China and Canada was approximately 9.1%, 3.3%, 3.1% and 1.9%, respectively, for the three months ended September 30, 2010. Revenue for all other countries amounted to an aggregate of 10.1%. Other than the countries listed, no other country represented more than 2.0% of our total revenue for the nine months ended September 30, 2010.





For the nine months ended September 30, 2010, approximately 74.2% of our total revenue was derived from sales in the United States. Revenue that we generated from customers in the United Kingdom, Germany, China and Canada was approximately 8.0%, 3.3%, 2.8% and 1.9%, respectively, for the nine months ended September 30, 2010. Revenue for all other countries amounted to an aggregate of 9.8%. Other than the countries listed, no other country represented more than 2.0% of our total revenue for the nine months ended September 30, 2010.


34




4. Key Performance Indicators





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








For the three months ended

September 30,


For the nine months ended

September 30,2010


2009


2010


2009(unaudited)


(unaudited)


(unaudited)


(unaudited)Total Revenue

$
50,784


$
40,314


$
135,313


$
118,610Subscription revenue as a percentage of total revenue


78.3
%


82.4
%


80.7
%


84.8
%Non-GAAP income from operations

$
4,215


$
4,310


$
10,286


$
12,611Net cash provided by operating activities

$
6,589


$
6,148


$
22,569


$
22,513








As of December 31,


As of September 30,2009


2010


2009Deferred revenue

$
49,964


$
58,708


$
44,192








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





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





Net cash provided by operating activities. Net cash provided by operating activities is taken from our consolidated statement of cash flows and represents the amount of cash generated by our operations that is available for investing and financing activities. Generally, our net cash provided by operating activities has exceeded our operating income.  It is possible that this trend may vary as business conditions change.








35





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





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





For the

year ended

December 31,


For the

three months ended

September 30,


For the

nine months ended

September 30,2009


2010


2009


2010


2009(unaudited)


(unaudited)


(unaudited)


(unaudited)Deferred revenue at the beginning of the period

$
38,638


$
57,844


$
42,223


$
49,964


$
38,638Total invoiced subscriptions during period


145,180



40,386



35,190



117,638



106,081Deferred revenue from acquisitions


—



242



—



242



—Subscription revenue recognized during period


(133,854
)


(39,764
)


(33,221
)


(109,136
)


(100,527
)Deferred revenue at end of period

$
49,964


$
58,708


$
44,192


$
58,708


$
44,192








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





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





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








For the three months ended

September 30,


For the nine months ended

September 30,2010


2009


2010


2009(unaudited)


(unaudited)


(unaudited)


(unaudited)Income (loss) from operations

$
1,483


$
1,885


$
3,253


$
(29,823
)Share-based compensation expense


1,010



1,384



3,578



4,079Amortization of intangibles associated with acquisitions


777



1,041



2,510



3,183Acquisition-related fees


945



—



945



—Severance expense


—



—



—



1,156Goodwill impairment charge


—



—



—



33,329Professional fees associated with variable interest entity


—



—



—



687Non-GAAP income from operations

$
4,215


$
4,310


$
10,286


$
12,611





36





Our non-GAAP financial measures as set forth in the table above exclude the following:





Share-based compensation expense.  Share-based compensation expense consists of expenses for stock options and stock awards that we began recording in accordance with ASC 718 during the first quarter of 2006. Share-based compensation expenses are excluded in our non-GAAP financial measures because share-based compensation amounts are difficult to forecast. This is due in part to the magnitude of the charges which depends upon the volume and timing of stock option grants, which can vary dramatically from period to period, and external factors such as interest rates and the trading price and volatility of our common stock.  We believe that this exclusion provides meaningful supplemental information regarding our operating results because these non-GAAP financial measures facilitate the comparison of results for future periods with results from past periods. The dilutive effect of all outstanding options is included in the calculation of diluted earnings per share on both a GAAP and a non-GAAP basis.





Amortization of intangibles associated with acquisitions. In accordance with GAAP, operating expenses include amortization of acquired intangible assets which are amortized over the estimated useful lives of such assets.  Amortization of acquired intangible assets is excluded from our non-GAAP financial measures because we believe that such exclusion facilitates comparisons to its historical operating results and to the results of other companies in the same industry, which have their own unique acquisition histories.





Acquisition-related fees.    In accordance with ASC 805, Business Combinations, acquisition-related fees including advisory, legal, accounting and other professional fees are reported as expense in the periods in which the costs are incurred and the services are received.    Acquisition-related fees of $0.9 million for the three months ended September 30, 2010 include legal, travel, and other fees not expected to recur from the acquisitions of Salary.com and CHPD.  Acquisition-related fees are excluded in the non-GAAP financial measures because we believe that such exclusion facilitates comparisons to its historical operating results and to the results of other companies in the same industry, which have their own unique acquisition histories.





Severance expense. These charges were excluded in computing our non-GAAP income to facilitate a more meaningful comparison to the prior year’s results.





Goodwill impairment charge. We recorded a non-cash goodwill impairment charge as a result of a substantial decrease in our stock price, reflecting the impact of the unprecedented turmoil in world economies and the resultant impact on our operations.





Professional fees associated withvariable interest entity.  These charges are related to our variable interest entity in China.  We believe that such exclusion facilitates comparisons to our historical operating results and to the results of other companies in the same industry, which have their own unique acquisition histories.














37





5. Results of Operations





Three and nine months ended September 30, 2010 compared to three and nine months ended September 30, 2009





The following table sets forth for the periods indicated, the amount and percentage of total revenue represented by certain items reflected in our unaudited consolidated statements of operations:







Kenexa Corporation Consolidated Statements of Operations


(In thousands)


(Unaudited)





For the three months ended September 30,


For the nine months ended September 30,2010


2009


2010


2009Amount


Percent of

Revenues


Amount


Percent of

Revenues


Amount


Percent of

Revenues


Amount


Percent of

RevenuesRevenue:Subscription

$
39,764



78.3
%

$
33,221



82.4
%

$
109,136



80.7
%

$
100,527



84.8
%Other


11,020



21.7
%


7,093



17.6
%


26,177



19.3
%


18,083



15.2
%Total revenue


50,784



100.0
%


40,314



100.0
%


135,313



100.0
%


118,610



100.0
%Cost of revenue


17,957



35.4
%


13,129



32.6
%


46,828



34.6
%


40,462



34.1
%Gross profit


32,827



64.6
%


27,185



67.4
%


88,485



65.4
%


78,148



65.9
%Operating expenses:Sales and marketing


11,642



22.9
%


9,083



22.5
%


32,540



24.0
%


26,029



21.9
%General and administrative


12,084



23.8
%


10,182



25.3
%


32,542



24.0
%


30,972



26.1
%Research and development


3,277



6.5
%


2,453



6.1
%


7,693



5.7
%


7,557



6.4
%Depreciation and amortization


4,341



8.5
%


3,582



8.9
%


12,457



9.2
%


10,084



8.5
%Goodwill impairment charge


—



—
%


—



—
%


—



—
%


33,329



28.1
%Total operating expenses


31,344



61.7
%


25,300



62.8
%


85,232



62.9
%


107,971



91.0
%Income (loss) from operations


1,483



2.9
%


1,885



4.7
%


3,253



2.4
%


(29,823
)


(25.1
) %Interest income (expense)


72



0.1
%


(28
)


(0.1
) %


355



0.3
%


(186
)


(0.2
) %(Loss) income on change in fair market value of ARS and put option, net


(382
)


(0.8
) %


102



0.3
%


(379
)


(0.3
) %


54



0.0
%Income (loss) before income taxes


1,173



2.2
%


1,959



4.9
%


3,229



2.4
%


(29,955
)


(25.3
) %Income tax expense


26



0.1
%


361



0.9
%


906



0.7
%


1,418



1.2
%Net income (loss)

$
1,147



2.1
%

$
1,598



4.0
%

$
2,323



1.7
%

$
(31,373
)


(26.5
) %Income allocated to noncontrolling interests


(188
)


(0.4
) %


—



—
%


(406
)


(0.3
) %


—



—
%Accretion of variable interest entity


(809
)


(1.6
) %


—



—
%


(809
)


(0.6
) %


—



—
%Net income (loss) available to common shareholders'

$
150



0.1
%

$
1,598



4.0
%

$
1,108



0.8
%

$
(31,373
)


(26.5
) %


38





Revenue





Total revenue increased by $10.5 million or 26.0% to $50.8 million, subscription revenue increased by $6.6 million or 19.7% to $39.8 million and other revenue increased by $3.9 million or 55.4% to $11.0 million for the three months ended September 30, 2010, compared to the same period in 2009.  Subscription revenue represented approximately 78.3% of our total revenue for the three months ended September 30, 2010.  Total revenue increased by $16.7 million or 14.1% to $135.3 million, subscription revenue increased by $8.6 million or 8.6% to $109.1 million and other revenue increased by $8.1 million or 44.8% to $26.2 million for the nine months ended September 30, 2010, compared to the same period in 2009. Subscription revenue represented approximately 80.7% of our total revenue for the nine months ended September, 2010.





The increase in total revenue for the three months ended September 30, 2010 is attributable to increased activity in our recruitment process outsourcing and other consulting services, our Chinese variable interest entity, favorable changes in foreign exchange rates, and subscription, which contributed $1.6 million, $1.5 million, $0.8 million and $6.6 million, respectively, compared to the same period in 2009.   The same factors drove the increase in total revenue over the nine months ended September 30, 2010, contributing $3.7 million, $3.6 million, $0.8 million and $6.6 million, respectively, compared to the same period in 2009.  In addition, accounting adjustments relating to the adoption of ASU 2009-13 contributed $2.0 million to the increase.  Based upon the current market conditions, we expect our subscription-based and other revenues to continue to increase in 2010 and into 2011 over the prior year due to stabilization in the unemployment rate, slightly improved business environment and continued acceptance of our talent management solutions on-demand model.








Cost of Revenue





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





Cost of revenue increased by $4.9 million or 36.8% to $18.0 million during the three months ended September 30, 2010, compared to the same period in 2009. The $4.9 million increase was primarily due to an increase in staff related expense of $4.0 million in connection with an increase in headcount in our RPO division and our acquisition of CHPD.  In addition, third party fees contributed $0.9 million to the increase.  As a percentage of revenue, cost of revenue increased by 2.8% to 35.4% for the three months ended September 30, 2010, compared to the same period in 2009.





Cost of revenue increased by $6.4 million or 15.7% to $46.8 million during the nine months ended September 30, 2010, compared to the same period in 2009.  The $6.4 million increase was due to an increase in staff related expense, third party fees and reimbursable expenses of $5.2 million, $1.4 million and $0.5 million, respectively, partially offset by a reduction in severance expense of $0.7 million.  The increase in staff related expense was due to an increase in headcount in our RPO division and our acquisition of CHPD.  As a percentage of revenue, cost of revenue increased by 0.5% to 34.6% for the nine months ended September 30, 2010, compared to the same period in 2009.








39




Sales and Marketing Expense





Sales and marketing expenses primarily consist of personnel and related costs for employees engaged in sales and marketing, including salaries, commissions, and other variable compensation, travel expenses and costs associated with trade shows, advertising and other marketing efforts and allocated overhead. We expense our sales commissions at the time the related revenue is recognized, and we recognize revenue from our subscription agreements ratably over the terms of the agreements.  Consistent with our past practice, we intend to continue to invest in sales and marketing to pursue new customers and expand relationships with existing customers at levels we deem appropriate given our current economic conditions.  We expect our sales and marketing expense to increase from current levels, mainly due to increased staff expense, marketing campaigns and continued emphasis on our rebranding effort.





Sales and marketing expense increased by $2.5 million or 28.2% to $11.6 million during the three months ended September 30, 2010, compared to the same period in 2009.  The $2.5 million increase was due primarily to increased staff and staff related expense of $1.7 million resulting from an increase in internal hires and additional personnel from our acquisition of CHPD.  In addition, increases in marketing and bad debt expense contributed $0.7 million and $0.1 million, respectively, to the overall increase in sales and marketing expense as compared to the same period in 2009.  Bonus expense increased $0.5 million but was offset by a decrease in third party consultants of $0.5 million.  As a percentage of revenue, sales and marketing expense increased by 0.4% to 22.9%, for the three months ended September 30, 2010.





Sales and marketing expense increased by $6.4 million or 25.0% to $32.5 million during the nine months ended September 30, 2010, compared to the same period in 2009.  The $6.4 million increase was due primarily to increased staff and staff related expense of $4.1million resulting from an increase in internal hires and additional personnel from our acquisition of CHPD.  In addition, increased expenses relating to marketing, travel and bad debt reserve contributed $1.4 million, $1.0 million and $0.5 million to the increase as compared to the same period in 2009, partially offset by a decrease of in bonus expense, severance expense and third party consultants of $0.2 million each.  As a percentage of revenue, sales and marketing expense increased by 2.1% to 24.0%, for the nine months ended September 30, 2010.








General and Administrative Expense





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





General and administrative expense increased by $2.0 million or 18.7% to $12.1 million during the three months ended September 30, 2010, compared to the same period in 2009. The $2.0 million increase was due primarily to an increase in bonus expense, professional fees and other expense of $1.6 million, $0.7 million and $0.3 million, respectively, partially offset by a reduction in staff and share-based compensation expense of $0.3 million each.  The increase in professional fees was primarily due to litigation expenses from our patent infringement suits and consulting fees from our recent acquisitions and credit facility.  As a percentage of revenue, general and administrative expense decreased by 1.5% to 23.8% for the three months ended September 30, 2010, compared to the same period in 2009.





General and administrative expense increased by $1.6 million or 5.1% to $32.5 million during the nine months ended September 30, 2010, compared to the same period in 2009.  The $1.6 million increase was due primarily to an increase in bonus expense, professional fees and other expense of $0.9 million, $1.3 million and $0.6 million, respectively, partially offset by a reduction in staff, severance and share-based compensation expense of $0.7 million, $0.2 million and $0.3 million, respectively. The increase in professional fees was primarily due to litigation expenses from our class action and patent infringement suits and consulting fees from our recent acquisitions of approximately $1.9 million, partially offset by a reduction in variable interest entity setup fees of $0.6 million for the nine months ended September 30, 2010, compared to the same period in 2009.  As a percentage of revenue, general and administrative expense decreased by 2.1% to 24.0% for the nine months ended September 30, 2010, compared to the same period in 2009.





40





Research and Development (“R&D”) Expense





Research and development expenses primarily consist of personnel and related costs, including salaries, and employee benefits, for software engineers, quality assurance engineers, product managers, technical sales engineers and management information systems personnel and third-party consultants.  Our research and development efforts have been devoted primarily to new product offerings and enhancements and upgrades to our existing products.  We expect research and development expenses to remain flat or increase slightly as we continue to execute on our strategies which include furthering the common services enterprise architecture, introducing Kenexa 2x modules, and continuing to develop feature enhancements.  As a result of these ongoing development efforts, we have capitalized software costs of $3.2 million and $9.2 million for the three and nine months ended September 30, 2010, respectively and $2.3 million and $7.3 million for the three and nine months ended September 30, 2009, respectively.  The remaining R&D activities have been expensed as incurred.





Research and development expense increased by $0.8 million or 6.5% to $3.3 million during the three months ended September 30, 2010, compared to the same period in 2009, due to an increase in staff expense.  As a percentage of revenue, research and development expense increased by 0.4% to 6.5% for the three months ended September 30, 2010, compared to the same period in 2009.





Research and development expense increased by $0.1 million or 1.8% to $7.7 million during the nine months ended September 30, 2010, compared to the same period in 2009, due to an increase in staff expense of $0.2 million, partially offset by a reduction in severance expense of $0.1 million.  As a percentage of revenue, research and development expense decreased by 0.7% to 5.7% for the nine months ended September 30, 2010, compared to the same period in 2009.




Our total capitalized software costs and research and development expense totaled $6.5 million and $16.8 million or 12.7% and 12.5%, as a percentage of revenue, for the three and nine months ended September 30, 2010.  For the three and nine months ended September 30, 2009, our total capitalized software costs and research and development expense totaled $4.8 million and $14.9 million or 12.0% and 12.6%, as a percentage of revenue.
  41




Depreciation and Amortization





Depreciation and amortization expense increased by $0.7 million and $2.4 million or 21.2% and 23.5% to $4.3 million and $12.5 million during the three and nine months ended September 30, 2010, respectively, compared to the same period in 2009.





The $0.7 million and $2.4 million increase was due primarily to increased depreciation expense associated with our capitalized software and equipment purchases.  In the future, we expect depreciation and amortization expense to increase due to recent capital purchases and as we place our software development costs into service.  The increase in capitalized software development costs is directly attributable to an increase in the software development projects qualifying for capitalization, pursuant to ASC 350-40, “Internal-Use Software.”








Income Tax Expense





Income tax expense decreased by $0.4 million or 92.8% to $26 thousand during the three months ended September 30, 2010 and decreased by $0.6 million or 36.1% to $0.9 million during the nine months ended September 30, 2010, compared to the same period in 2009.





42




6. Liquidity and Capital Resources





Since we were formed in 1987, we have financed our operations primarily through internally generated cash flows, our revolving credit facilities and the issuance of equity. As of September 30, 2010, we had cash and cash equivalents of $90.4 million. We had borrowings of $0.3 million in capital equipment leases and in addition in order to finance our acquisition of Salary.com we borrowed $25.0 million on September 30, 2010. Cash held in foreign denominated currencies was $6.3 million or 7.0% of our total cash balance as of September 30, 2010.  A ten percent change in the exchange rate of the underlying currencies would not have a material impact on our foreign denominated cash balances on our statement of cash flows.





Our cash provided from operations was $22.6 million and $22.5 million for the nine months ended September 30, 2010 and 2009.  Cash provided by and (used in) investing activities was $13.1 million and ($16.3) million for the nine months ended September 30, 2010 and 2009.  Cash provided by financing activities was $25.5 million for the nine months ended September 30, 2010 and less than $0.1 million for the nine months ended September 30, 2009.  Our net increase in cash and cash equivalents was $61.2 million and $6.5 million for the nine months ended September 30, 2010 and 2009, respectively, resulting primarily from our operating and financing activities.  We expect positive cash flow from operations to continue in future periods.







On August 31, 2010, we entered into a secured Credit Agreement with PNC Bank, N.A., as administrative agent, in connection with our acquisition of Salary.com.   The secured Credit Agreement includes a maximum amount available under the credit facility of $25.0 million including a sublimit of up to $2.0 million for letters of credit. Borrowings under the new credit facility are secured by substantially all of our assets and the assets of our subsidiaries.  As of September 30, 2010, the Company borrowed $25.0 million under the Credit Agreement in connection with the acquisition of Salary.com.





On October 20, 2010, we terminated our August 31, 2010 credit agreement and entered into a senior secured credit facility with PNC Bank, N.A. with a maximum amount available of $60.0 million, comprised of a $35.0 million revolving facility, a $25.0 million term facility, and a sublimit for letters of credit and swing loans.  Under the terms of the loan we may request to increase the maximum amount available under the revolving facility to $50.0 million. Borrowings under the senior credit facility are secured by substantially all our assets.






Operating Activities





Historically, our largest source of operating cash flows was cash collections from our customers following the purchase and renewal of their software subscriptions. Payments from customers for subscription agreements are generally received quarterly in advance of providing services. We also generate significant cash from our recruitment process outsourcing services, and to a lesser extent, our consulting services. Our primary uses of cash from operating activities are for personnel related expenditures as well as payments related to taxes and leased facilities.





Net cash provided by operating activities was $22.6 million and $22.5 million for the nine months ended September 30, 2010 and 2009, respectively.  Net cash provided by operating activities for the nine months ended September 30, 2010 resulted primarily from net income of approximately $2.3 million, non-cash charges to net income of $16.2 million, an increase in deferred revenue of $8.5 million, and changes in working capital of $2.5 million offset by an increase in accounts receivables of $6.9 million.





Net cash provided by operating activities for the nine months ended September 30, 2009 resulted primarily from a net loss of approximately $31.4 million, increase in deferred tax benefits of $1.1 million and changes in working capital of $2.1 million offset by non-cash charges to net income of $14.1 million, a non-cash goodwill impairment charge of $33.3 million, an increase in deferred revenue of $5.4 million, and a decrease in accounts receivables of approximately $4.3 million.








43





Investing Activities





Net cash provided by and (used in) investing activities was $13.1 million and ($16.3) million for the nine months ended September 30, 2010 and 2009, respectively.  Cash flows used in investing activities consisted primarily of adjustments for earnouts, taxes, escrow payments, acquisitions and additional capital equipment as follows:





For the nine months ended September 30,

2010


For the nine months ended September 30,

2009StraightSource acquisition

$
—


$
(3.1
)HRC acquisition


—



(0.2
)Quorum acquisition


(1.7
)


(0.4
)CHPD acquisition


(3.8
)


—Capitalized software and purchases of property and equipment


(12.1
)


(10.9
)Purchases of available-for-sale securities


(7.7
)


(4.8
)Sales of available-for-sale securities


23.1



2.6Sales of trading securities


15.3



1.6Investment in variable interest entity


—



(1.1
)Total cash flows provided by (used in) by investing activities

$
13.1


$
(16.3
)








Financing Activities





Net cash provided by financing activities was $25.5 million and less than $0.1 million for the nine months ended September 30, 2010 and 2009, respectively.  For the nine months endedSeptember 30, 2010, net cash provided by financing activities resulted primarily from borrowing from our credit facility of $25.0 million.  In addition, net proceeds from stock option exercises and share issuance from our employee stock purchase plan of $0.5 and $0.3 million, respectively, was partially offset by repayments of capital lease obligations and notes payable of $0.2 million and deferred financing costs of $0.1 million.











44


Critical Accounting Policies and Estimates





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





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





Revenue Recognition





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





•
there is persuasive evidence of an arrangement;




•
the service has been provided to the customer;





•
the collection of the fees is probable; and





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








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





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





Prior to our adoption of ASU 2009-13, in determining whether revenues from professional services could be accounted for separately from subscription revenue, we considered the following factors for each agreement: availability from other vendors, whether objective and reliable evidence of fair value exists of the undelivered elements, the nature and the timing of when the agreement was signed in comparison to the subscription agreement start date and the contractual dependence of the subscription service on the customer's satisfaction with the other services.





In accordance with FASB ASC 605-45, “Principal Agent Considerations,” we record reimbursements received for out-of-pocket expenses as revenue and not netted with the applicable costs.  These items primarily include travel, meals and certain telecommunication costs.  Reimbursed expenses totaled $0.7 million and $2.2 million for the three and nine months ended September 30, 2010, respectively and $0.5 million and $1.6 million for the three and nine months ended September 30, 2009, respectively.








45




Pursuant to the transition rules contained in Accounting Standards Update 2009-13 (“ASU 2009-13”), “Multiple Deliverable Revenue Arrangements,” we elected to adopt early the provisions included in the amendment effective January 1, 2010.





Based upon a review of our applicant tracking system arrangements (“ATS”), we determined that implementation services, previously combined with hosting fees as one unit of accounting now qualify as a separate unit of accounting.  This new approach is supported by the existence of our estimated selling prices for all of our deliverables within an ATS arrangement and the assertion that the delivered items within these arrangements, i.e. the implementation services, have standalone value.  Under these arrangements, contract consideration will be allocated to each deliverable using the relative selling price method.  As a result of this adoption, implementation revenue previously recognized over the license term, will be recognized in the period the service is provided which corresponds to value delivered to the customer.





In addition to modifying revenue recognition for ATS arrangements, the new guidance contained in ASU 2009-13 permits us to unbundle multiple products within an arrangement using the relative selling price method.   Previously, these deliverables were treated as one unit of accounting with revenue under these arrangements being deferred until all products, for which we lacked objective evidence of fair value, were delivered.  Under the new guidance, total consideration is allocated to each product using the relative selling price method and recognized as each product is delivered to the customer.  In addition, the new guidance prohibits the use of the residual method for determining the value of the delivered element.





Based upon a preliminary analysis, we determined that the adoption of ASU 2009-13 did not have a material impact on the financial statements after the initial adoption.  This conclusion is based in part on the following facts:





•
Revenue that would have been recognized if the related arrangements entered into or materially modified after the effective date were subject to the measurement requirements of ASC 605-25 would have been less than $0.1 million and $2.0 million or 0.1% and 1.5% less than currently reported revenue of $50.8 million and $135.3 million, for the three and nine months ended September 30, 2010.•
Revenue that would have been recognized in the year before the year of adoption if the arrangements accounted for under ASC 605-25 were subject to the new measurement requirements of ASU 2009-13 would have been $0.2 million and $0.3 million or 0.6% and 0.3% greater than the reported revenue of $40.3 million and $118.6 million, for the three and nine months ended September 30, 2009.•
Revenue recognized and deferred revenue reported as of and for the quarter ended September 30, 2010 using ASC 605-25  and ASU 2009-13 is presented as follows:





Revenue recognized


Deferred revenueASC 605-25

$
133.3


$
51.5ASU 2009-13


2.0



7.2Total

$
135.3


$
58.7








The new revenue guidance contained in ASU 2009-13 modifies the way we account for our ATS arrangements by allowing us to separate the implementation services and corresponding license fees into two separate units of accounting.  These two deliverables represent the primary elements in an ATS arrangement and are recognized upon performance or delivery of each service or product, respectively, to the end customer.  The implementation services are typically earned over a three to six month period, while the license fees are recognized over a two to five year period.  These arrangements usually do not contain cancellation or refund-type provisions and may include termination for convenience clauses following a stated period of time or performance level commitments.





Multiple element arrangements consisting of multiple products are also impacted by the new revenue guidance.  Under ASU 2009-13 total consideration for an arrangement is allocated to each product using the relative selling price method and revenue is recognized upon delivery of the product or service.  Consistent with current practice, revenue may be deferred if the arrangement includes any unusual terms including extended payment terms, specified acceptance terms, or hold backs payable upon final acceptance of the product.








46





We utilize a pricing model for our products which considers market factors such as customer demand for its products, competitor’s pricing and the geographic regions where the products are sold.  In addition, the model considers entity-specific factors such as volume based pricing, discounts for bundled products, total contract commitment and the number of required languages for the product.  The pricing model for the individual or bundled arrangement includes a price floor amount, which provides for a 15% discount on the bundled price, and an actual quote to determine if the quote is within an acceptable range for management’s approval.  Including this final verification in the model ensures that all of our selling prices are consistent and within an acceptable range for use with the relative selling price method.





While the pricing model, currently in use, captures all critical variables, unforeseen changes due to external market forces may result in a revision of the inputs.  These modifications may result in the consideration allocation differing from the one presently in use.  Absent a significant change in the pricing inputs or the way in which the industry structures its deals, future changes in the pricing model are not expected to materially affect our allocation of arrangement consideration.








Allowance for Doubtful Accounts





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








Capitalized Software Development Costs





In accordance with FASB ASC 985, “Software,” and FASB ASC 350, “Intangibles-Goodwill and Other,” costs incurred in the preliminary stages of a development project are expensed as incurred.  Once an application has reached the development stage, internal and external costs, if direct and incremental, will be capitalized until the software is substantially complete and ready for its intended use. Capitalization ceases upon completion of all substantial testing. We also capitalize costs related to specific upgrades and enhancements when it is probable the expenditures will result in additional functionality. Maintenance and training cost are expensed as incurred.  Internal use software is amortized on a straight-line basis over its estimated useful life, generally three years. Management evaluates the useful lives of these assets on an annual basis and tests for impairments whenever events or changes in circumstances occur that could impact the recoverability of these assets. There were no impairments to internal software in any of the periods covered in this report.  We have capitalized software costs of $9.2 million and $9.7 million for the period ended September 30, 2010 and the year ended December 31, 2009, respectively.


47





Goodwill and Other Identified Intangible Asset Impairment





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





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





During the quarter ended March 31, 2009 we reevaluated our goodwill due to continued adverse changes in the economic climate, a 32.5% decline in our market capitalization from December 31, 2008 through March 31, 2009 and a downward revision in internal projections.  These factors signaled a triggering event, which required us to determine whether and to what extent our goodwill may have been impaired as of March 31, 2009.  The allocation process performed on the test date was only for purposes of determining the implied fair value of goodwill with no assets or liabilities written up or down, nor any additional unrecognized identifiable intangible assets recorded as part of this process.  Based on the analysis, a goodwill impairment charge of $33.3 million was recorded to write off the remaining balance of our goodwill for the quarter ended March 31, 2009. The goodwill impairment charge had no effect on our cash balances.  We conducted the 2009 annual evaluation of goodwill for impairment and determined that there was no impairment at October 1, 2009.  We determined there was no triggering event at December 31, 2009 and September 30, 2010 which required an interim impairment analysis.







Self-Insurance





We are self-insured for the majority of our health insurance costs, including claims filed and claims incurred but not reported subject to certain stop loss provisions. We estimate our liability based upon management’s judgment and historical experience. We also rely on the advice of consulting administrators in determining an adequate liability for self-insurance claims. Self-insurance accruals totaled approximately $0.5 million and $0.6 million as of September 30, 2010 and December 31, 2009, respectively. We continuously review the adequacy of our insurance coverage. Material differences may result in the amount and timing of insurance expense if actual experience differs significantly from management's estimates.





48





Accounting for Share-Based Compensation





Share-based compensation expense recognized during the period is based on the value of the number of awards that are expected to vest multiplied by the fair value.  We use a Black-Scholes option-pricing model to calculate the fair value of our share-based awards. The calculation of the fair value of the awards using the Black-Scholes option-pricing model is affected by our stock price on the date of grant as well as assumptions regarding the following:





•
Volatility is a measure of the amount by which the stock price is expected to fluctuate each year during the expected life of the award and is based on a weighted average of peer companies, comparable indices and our stock volatility. An increase in the volatility would result in an increase in our expense.





•
The expected term represents the period of time that awards granted are expected to be outstanding and is currently based upon an average of the contractual life and the vesting period of the options. With the passage of time actual behavioral patterns surrounding the expected term will replace the current methodology. Changes in the future exercise behavior of employees or in the vesting period of the award could result in a change in the expected term. An increase in the expected term would result in an increase to our expense.





•
The risk-free interest rate is based on the U.S. Treasury yield curve in effect at time of grant. An increase in the risk-free interest rate would result in an increase in our expense.





•
The estimated forfeiture rate is the rate at which awards are expected to expire before they become fully vested and exercisable. An increase in the forfeiture rate would result in a decrease to our expense.





In certain instances where market based, performance share awards are granted, we use the Monte Carlo valuation model to calculate the fair value.  This approach utilizes a two-stage process, which first simulates potential outcomes for our shares using the Monte Carlo simulation.  The first stage of the Monte Carlo simulation requires a variety of assumptions about both the statistical properties of our shares as well as potential reactions to such share price movements by our management.  Such assumptions include the natural logarithm of our stock price, a random log-difference using the Russell 2000 stock index and a random variable using the specific deviations of our returns relative to the returns dictated by the CAPM model.  The second stage employs the Black-Scholes model to value the various outcomes predicted by the Monte Carlo simulation.  The resulting fair value, on the date of the grant (measurement date), is being recognized over the vesting period using the straight-line method.








Accounting for Income Taxes





We are subject to income taxes in the U.S. and various foreign countries.  We record an income tax provision for the anticipated tax consequences of operating results reportable to each taxing jurisdiction in compliance with enacted tax legislation.  We account for income taxes in accordance with FASB ASC 740, “Income Taxes,” which requires that deferred tax assets and liabilities be recognized using enacted tax rates for the effect of temporary differences between the book and tax basis of recorded assets and liabilities.  ASC 740 also requires that deferred tax assets be reduced by a valuation allowance if it is more likely than not that some portion or all of the deferred tax asset will not be realized.





The realization of the deferred tax assets is evaluated quarterly by assessing the valuation allowance and by adjusting the amount of the allowance, if necessary. The factors used to assess the likelihood of realization are the forecast of future taxable income and available tax planning strategies that could be implemented to realize the net deferred tax assets. We have used tax-planning strategies to realize or renew net deferred tax assets in order to avoid the potential loss of future tax benefits.  In addition, we operate within multiple taxing jurisdictions and are subject to audit in each jurisdiction. These audits can involve complex issues that may require an extended period of time to resolve. In our opinion, adequate provisions for income taxes have been made for all periods.





Our determination of the level of valuation allowance at September 30, 2010 is based on an estimated forecast of future taxable income which includes many judgments and assumptions primarily related to revenue, margins, operating expenses, tax planning strategies and tax attributes in multiple taxing jurisdictions.  Accordingly, it is at least reasonably possible that future changes in one or more of these assumptions may lead to a change in judgment regarding the level of valuation allowance required in future periods.





49


Table of Contents




Item 3: Quantitative and Qualitative Disclosures about Market Risk





Market risk represents the risk of loss that may impact our financial position due to adverse changes in financial market prices and rates. Our market risk exposure is primarily a result of fluctuations in interest rates and foreign currency exchange rates. We do not hold or issue financial instruments for trading purposes.








Foreign Currency Exchange Risk





For the nine months ended September 30, 2010, approximately 74.2% of our total revenue was comprised of sales to customers in the United States.  A key component of our business strategy is to expand our international sales efforts, which will expose us to foreign currency exchange rate fluctuations. A 10% change in the value of the U.S. dollar, relative to each of our non-U.S. generated sales would not have resulted in a material change to our operating results for the three and nine months ended September 30, 2010 and 2009.





While we believe we have implemented a strategy, utilizing each country’s operations as a natural hedge, to mitigate foreign currency risk, changes in foreign currency exchange rates in future periods will continue to affect our financial position and results of operations because they are reported in U.S. Dollars.  At September 30, 2010, approximately 7.0% of our cash and cash equivalents were denominated in foreign currencies.  A ten percent change in the exchange rate of the underlying currencies would not have a material impact on our foreign denominated cash balances on our statement of cash flows.  Although we currently do not have a program in place to manage our foreign cash currency cash exposures, we will continue to monitor these balances to determine if a more formal approach is necessitated.





The financial position and operating results of our foreign operations are consolidated using the local currency as the functional currency. Local currency assets and liabilities are translated at the rate of exchange to the U.S. dollar on the balance sheet date, and the local currency revenue and expenses are translated at average rates of exchange to the U.S. dollar during the period. The related translation adjustments to shareholders’ equity were decreases of $0.8 million and $0.9 million during the period ended September 30, 2010 and the year end December 31, 2009, respectively, and are included in other comprehensive loss. The foreign currency translation adjustment is not adjusted for income taxes as it relates to an indefinite investment in a non-U.S. subsidiary.








Interest Rate Risk





The primary objective of our investment activities is to preserve principal while maximizing income without significantly increasing risk. Some of the securities in which we invest may be subject to market risk. This means that a change in prevailing interest rates may cause the principal amount of the investment to fluctuate.  To minimize this risk in the future, we intend to maintain our portfolio of cash equivalents and short-term investments in a variety of securities, including commercial paper, money market funds, government and non-government debt securities and certificates of deposit. Our cash equivalents, which consist solely of money market funds, are not subject to market risk because the interest paid on these funds fluctuates with the prevailing interest rate. We believe that a 10% change in interest rates would not have had a significant effect on our interest income for the three and nine months ended September 30, 2010 and 2009.








Item 4: Controls and Procedures





Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 as of the end of the period covered by this report, or the Evaluation Date.  Based upon the evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures were effective as of the Evaluation Date.  Disclosure controls and procedures are controls and procedures designed to reasonably ensure that information required to be disclosed in our reports filed under the Exchange Act, such as this report, is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms.  Disclosure controls and procedures include controls and procedures designed to reasonably ensure that such information is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate to allow timely decisions regarding required disclosure.





No changes in our internal control over financial reporting occurred during the most recent fiscal quarter that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.








50


PART II: OTHER INFORMATION





Item 1: Legal Proceedings





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





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





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





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





On June 11, 2009 and July 16, 2009, two putative class actions were filed against Kenexa Corporation and our Chief Executive Officer and Chief Financial Officer in the United States District Court for the Eastern District of Pennsylvania, purportedly on behalf of a class of our investors who purchased our publicly traded securities between May 8, 2007 and November 7, 2007. The complaint filed on July 16, 2009 has since been voluntarily dismissed.  On September 28, 2010, the court granted Kenexa’s motion to dismiss the complaint filed on June 11, 2009 in its entirety.  The plaintiffs filed a motion for reconsideration of the court’s decision on October 12, 2010.




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





On October 1, 2010, Kenexa completed its acquisition of Salary.com, Inc. and assumed responsibility for the suit filed on August 13, 2010 by former shareholders and option holders of Genesys Software Systems, Inc. (Genesys ) against Salary.com, Inc. and Silicon Valley Bank –Trustee Process Defendant in Massachusetts Superior Court.  Genesys asserts claims for breach of contract, breach of implied covenant of good faith and fair dealing, violation of the Massachusetts Unfair Business Practices Act, and declaratory judgment seeking damages of $2.0 million in contingent consideration related to the purchase of Genesys by Salary.com, plus other monetary damages and fees.  On September 7, 2010, Salary.com filed an answer and counterclaim against the Genesys parties, and certain former shareholders in particular asserting breach of contract, breach of implied covenants of good faith and fair dealing, fraud, violation of the Massachusetts Unfair Business Practices Act, civil conspiracy, negligent misrepresentation, and declaratory judgment seeking to dismiss the original complaint and unspecified monetary damages.





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








51





Item 1A: Risk Factors





In addition to the other information set forth in this Form 10-Q, you should carefully consider the factors discussed in Part I, Item 1A “Risk Factors” of our Annual Report on Form 10-K for the year ended December 31, 2009 which could materially affect our business, financial condition or future results of operations.  The risks described in our Annual Report on Form 10-K for the year ended December 31, 2009 are not the only risks that we face.  Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial may also materially adversely affect our business, financial condition and future results of operations.  There have been no material changes from the risk factors previously disclosed in Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2009.








Item 2: Unregistered Sales of Equity Securities and Use of Proceeds





Not applicable.








Item 3: Defaults Upon Senior Securities





Not applicable.








Item 4: Removed and Reserved





Removed and Reserved.








Item 5: Other Information





Not applicable.








Item 6: Exhibits





The following exhibits are filed herewith:




2.1
Agreement and Plan of Merger, dated as of August 31, 2010, among Kenexa Corporation, Spirit Merger Sub, Inc. and Salary.com, Inc. (incorporated by reference to Exhibit 2.1 filed with the Company’s Current Report on Form 8-K dated September 1, 2010).10.1
Form of Tender and Support Agreement, dated as of August 31, 2010, by and among Kenexa Corporation, Spirit Merger Sub, Inc., and certain Salary.com stockholders (incorporated by reference to Exhibit 10.1 filed with the Company’s Current Report on Form 8-K dated September 1, 2010).10.2
Credit Agreement, dated as of August 31, 2010, by and among Kenexa Technology, Inc., PNC Bank, National Association, as administrative agent, and the lenders party thereto (incorporated by reference to Exhibit 10.3 filed with the Company’s Current Report on Form 8-K dated September 1, 2010)10.3
Credit Agreement, dated as of August 31, 2010, by and among Kenexa Technology, Inc., PNC Bank, National Association, as administrative agent, and the lenders party thereto (incorporated by reference to Exhibit 10.3 filed with the Company’s Current Report on Form 8-K dated September 1, 2010)




31.1*    Certification by Chief Executive Officer Pursuant to Rule 13a-14(a)/15d-14(a).





31.2*    Certification by Chief Financial Officer Pursuant to Rule 13a-14(a)/15d-14(a).





32.1*    Certification Furnished Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.





____________


* - Filed herewith.








52


Table of Contents


SIGNATURES





Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.





November 9, 2010


Kenexa Corporation





/s/ Nooruddin S. Karsan

----------------------------

Nooruddin S. Karsan

Chairman of the Board and Chief Executive Officer





/s/ Donald F. Volk

-----------------

Donald F. Volk

Chief Financial Officer














53


Table of Contents


EXHIBIT INDEX















2.1
Agreement and Plan of Merger, dated as of August 31, 2010, among Kenexa Corporation, Spirit Merger Sub, Inc. and Salary.com, Inc. (incorporated by reference to Exhibit 2.1 filed with the Company’s Current Report on Form 8-K dated September 1, 2010).10.1
Form of Tender and Support Agreement, dated as of August 31, 2010, by and among Kenexa Corporation, Spirit Merger Sub, Inc., and certain Salary.com stockholders (incorporated by reference to Exhibit 10.1 filed with the Company’s Current Report on Form 8-K dated September 1, 2010).10.2
Credit Agreement, dated as of August 31, 2010, by and among Kenexa Technology, Inc., PNC Bank, National Association, as administrative agent, and the lenders party thereto (incorporated by reference to Exhibit 10.3 filed with the Company’s Current Report on Form 8-K dated September 1, 2010)10.3
Credit Agreement, dated as of August 31, 2010, by and among Kenexa Technology, Inc., PNC Bank, National Association, as administrative agent, and the lenders party thereto (incorporated by reference to Exhibit 10.3 filed with the Company’s Current Report on Form 8-K dated September 1, 2010)
  31.1*    Certification by Chief Executive Officer Pursuant to Rule 13a-14(a)/15d-14(a).
 
 31.2*    Certification by Chief Financial Officer Pursuant to Rule 13a-14(a)/15d-14(a).
 
 32.1*    Certification Furnished Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.





____________


* - Filed herewith.