** **

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

**FORM 10-Q**

**xQUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIESEXCHANGE ACT OF 1934**

**Forthe quarterly period ended September 30, 2006**

**oTRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIESEXCHANGE ACT OF 1934**

**Forthe transition period from                   to                   **

**CommissionFile number 000-51358**

**Kenexa Corporation**

(Exact Name ofRegistrant as Specified in Its Charter)

| **Pennsylvania**                          |   | **23-3024013**          |
|-------------------------------------------|--------|-------------------------|
| (State or other  jurisdiction of          |   | (I.R.S. Employer        |
| incorporation or  organization)           |   | Identification  Number) |
| ** **                                |   | ** **              |
| **650  East Swedesford Road**             |   |                    |
| **Wayne,  PA**                            |   | **19087**               |
| (Address of  Principal Executive Offices) |   | (Zip Code)              |

 

Registrant’sTelephone Number, Including Area Code:**(610) 971-9171**

Indicate by check mark whether the registrant: (1) hasfiled all reports required to be filed by Section 13 or 15 (d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter 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  o

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, or a non-accelerated filer.  See definition of “accelerated filer andlarge accelerated filer” in Rule 12b in Rule 12b-2 of the Exchange Act.
| Large accelerated filer o | Accelerated filer o | Non-accelerated filer x |
|--------------------------------|--------------------------|------------------------------|

 

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act).Yes  o    No  x

On November 8, 2006, 20,632,273 shares of theregistrant’s Common Stock, $0.01 par value, were outstanding.

 

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**KenexaCorporation and SubsidiariesFORM 10-QQuarter Ended September 30, 2006Table of Contents**
|  PART I: FINANCIAL INFORMATION |                                                                                                   |                                          |
|-------------------------------------|--------------------------------------------------------------------------------------------------------|-----------------------------------------------|
|                                | Item  1: Financial Statements (unaudited)                                                              |                                          |   |
|                                | Consolidated  Balance sheets as of September 30, 2006 and December 31, 2005                            |                                          | 3 |
|                                | Consolidated Statements of Operations for the three  and nine months ended September 30, 2006 and 2005 |                                          | 4 |
|                                | Consolidated Statements of Shareholders’ Equity as of  September 30, 2006 and December 31, 2005   |                                          | 5 |
|                                | Consolidated Statements of Cash Flows for the nine  months ended September 30, 2006 and 2005           |                                          | 6 |
|                                | Notes to Consolidated Financial Statements                                                             |                                          |   |
|                                |                                                                                                   | 1. Organization                               |   | 8 |
|                                |                                                                                                   | 2. Summary of Significant Accounting Policies |   | 8 |
|                                |                                                                                                   | 3. Property, Equipment and Software           |   | 14 |
|                                |                                                                                                   | 4.  Other Accrued Liabilities                 |   | 14 |
|                                |                                                                                                   | 5. Line of Credit                             |   | 15 |
|                                |                                                                                                   | 6. Commitments and Contingencies              |   | 15 |
|                                |                                                                                                   | 7. Equity                                     |   | 15 |
|                                |                                                                                                   | 8. Related Party                              |   | 15 |
|                                |                                                                                                   | 9. Acquisitions                               |   | 16 |
|                                |                                                                                                   | 10. Subsequent Events                         |   | 16 |
|                                | Item 2: Management’s Discussion and Analysis of  Financial Concern and Risks of Operations        |                                          |   |
|                                |                                                                                                   | 1.Overview                                    |   | 18 |
|                                |                                                                                                   | 2. Recent Events                              |   | 19 |
|                                |                                                                                                   | 3. Sources of Revenue                         |   | 19 |
|                                |                                                                                                   | 4. Key Performance Indicators                 |   | 20 |
|                                |                                                                                                   | 5.  Results of Operations:                    |   |   |
|                                |                                                                                                   |                                          | Three and nine months ended September 30, 2006  compared to three and nine months ended September 30, 2005 |   | 21 |
|                                |                                                                                                   | 6. Liquidity and Capital Resources            |   | 24 |
|                                | Item 3: Quantitative and Qualitative Disclosures about  Market Research                                |                                          | 28 |
|                                | Item  4: Controls and Procedures                                                                       |                                          | 28 |
| PART  2: OTHER INFORMATION          |                                                                                                   |                                          |
|                                | Item 1: Legal Proceedings                                                                              |                                          | 29 |
|                                | Item 1A: Risk Factors                                                                                  |                                          | 29 |
|                                | Item 2: Unregistered Sales of Equity Securities and  Use of proceeds                                   |                                          | 29 |
|                                | Item 3: Defaults upon senior Securities                                                                |                                          | 29 |
|                                | Item 4: Submission of matters to a vote of security  holders                                           |                                          | 30 |
|                                | Item 5: Other Information                                                                              |                                          | 30 |
|                                | Item 6: Exhibits                                                                                       |                                          | 30 |
| Signatures                          |                                                                                                   | 31                                            |
| Exhibit Index                       |                                                                                                   | 32                                            |
|                                     |                                                                                                        |                                               |  |  |  |

 

2

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**PART I FINANCIALINFORMATION**

**Item1: Financial Statements**

**Kenexa Corporationand SubsidiariesCONSOLIDATED BALANCE SHEETS**(Inthousands, except share and per share data)(Unaudited)
| ** **                                                                                                            | ** ** | **September 30,  2006**                                                       | ** ** | **December 31,  2005**                                                                   | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------|------------|
| **Assets**                                                                                                            | ** ** | ** **                                                                         | ** ** | ** **                                                                                    | ** ** |
| Current assets                                                                                                        |       |                                                                               |       |                                                                                          |       |
| Cash and cash  equivalents                                                                                            |       | $        83,109                            |       | $        43,499                                       |       |
| Accounts  receivable, net of allowance for doubtful accounts of $590 and $447                                         |       | 16,237                                                                             |       | 10,306                                                                                        |       |
| Unbilled  receivables                                                                                                 |       | 1,945                                                                              |       | 312                                                                                           |       |
| Deferred income  taxes                                                                                                |       | 6,628                                                                              |       | 2,519                                                                                         |       |
| Prepaid expenses  and other current assets                                                                            |       | 2,459                                                                              |       | 2,134                                                                                         |       |
| **Total current assets**                                                                                              |       | 110,378                                                                            |       | 58,770                                                                                        |       |
| Property and  equipment, net of accumulated depreciation                                                              |       | 5,900                                                                              |       | 4,737                                                                                         |       |
| Software, net of  accumulated depreciation                                                                            |       | 2,324                                                                              |       | 850                                                                                           |       |
| Goodwill                                                                                                              |       | 48,826                                                                             |       | 8,815                                                                                         |       |
| Intangible  assets, net of accumulated amortization                                                                   |       | 1,973                                                                              |       | 125                                                                                           |       |
| Deferred  financing costs, net of accumulated amortization                                                            |       | 98                                                                                 |       | 50                                                                                            |       |
| Other assets                                                                                                          |       | 932                                                                                |       | 552                                                                                           |       |
| **Total assets**                                                                                                      |       | $      170,431                                       |       | $        73,899                                       |       |
| ** **                                                                                                            | ** ** | ** **                                                                         | ** ** | ** **                                                                                    | ** ** |
| **Liabilities and Shareholders’  Equity**                                                                        |       |                                                                               |       |                                                                                          |       |
| Current liabilities                                                                                                   |       |                                                                               |       |                                                                                          |       |
| Notes payable,  current                                                                                               |       | $             479 |       | $               95 |       |
| Accounts payable                                                                                                      |       | 3,520                                                                              |       | 2,306                                                                                         |       |
| Commissions  payable                                                                                                  |       | 1,137                                                                              |       | 834                                                                                           |       |
| Accrued  compensation and benefits                                                                                    |       | 6,224                                                                              |       | 4,590                                                                                         |       |
| Other accrued  liabilities                                                                                            |       | 3,543                                                                              |       | 2,177                                                                                         |       |
| Deferred revenue                                                                                                      |       | 18,759                                                                             |       | 12,588                                                                                        |       |
| Capital lease  obligations                                                                                            |       | 228                                                                                |       | 219                                                                                           |       |
| **Total current liabilities**                                                                                         |       | 33,890                                                                             |       | 22,809                                                                                        |       |
| Notes payable,  less current portion                                                                                  |       | 153                                                                                |       | 108                                                                                           |       |
| Capital lease  obligations, less current portion                                                                      |       | 103                                                                                |       | 185                                                                                           |       |
| Deferred taxes                                                                                                        |       | 606                                                                                |       | —                                                                                        |       |
| Other  liabilities                                                                                                    |       | 19                                                                                 |       | 55                                                                                            |       |
| **Total liabilities**                                                                                                 |       | 34,771                                                                             |       | 23,157                                                                                        |       |
| ** **                                                                                                            | ** ** | ** **                                                                         | ** ** | ** **                                                                                    | ** ** |
| **Shareholders’ equity**                                                                                         | ** ** | ** **                                                                         | ** ** | ** **                                                                                    | ** ** |
| Preferred stock,  par value $0.01; 100,000 shares authorized; no shares issued or outstanding                         |       | —                                                                             |       | —                                                                                        |       |
| Common stock,  $0.01 par value; 100,000,000 shares authorized; 20,596,873 and 17,459,044  shares issued, respectively |       | 206                                                                                |       | 174                                                                                           |       |
| Additional  paid-in capital                                                                                           |       | 170,376                                                                            |       | 97,140                                                                                        |       |
| Deferred  compensation                                                                                                |       | —                                                                             |       | (1,040                                                                                        | )          |
| Notes receivable  for common stock                                                                                    |       | —                                                                             |       | (120                                                                                          | )          |
| Accumulated  other comprehensive loss                                                                                 |       | (257                                                                               | )          | (30                                                                                           | )          |
| Accumulated  deficit                                                                                                  |       | (34,665                                                                            | )          | (45,382                                                                                       | )          |
| **Total shareholders’ equity**                                                                                   |       | 135,660                                                                            |       | 50,742                                                                                        |       |
| **Total liabilities and shareholders’ equity**                                                                   |       | $      170,431                                       |       | $        73,899                                       |       |

 

*See accompanying notes to consolidated financial statements.*

3

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**Kenexa Corporationand SubsidiariesCONSOLIDATED STATEMENTS OF OPERATIONS**(Inthousands, except share and per share data)(Unaudited)
| ** **                                                                                                       | ** ** | **Three months ended  September 30,**                                                  | ** ** | **Nine months ended  September 30,**                                                   | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------|------------|
| ** **                                                                                                       | ** ** | **2006**                                                                                              | ** ** | **2005**                                                                                              | ** ** | **2006** | ** ** | **2005** | ** ** |
| Revenue                                                                                                          |       |                                                                                                  |       |                                                                                                  |       |   |   |   |   |
| Subscription revenue                                                                                             |       | $            23,185                       |       | $            13,377                       |       | $            60,725 |   | $            36,370 |   |
| Other revenue                                                                                                    |       | 4,827                                                                                                 |       | 3,857                                                                                                 |       | 15,010 |   | 11,201 |   |
| Total revenue                                                                                                    |       | 28,012                                                                                                |       | 17,234                                                                                                |       | 75,735 |   | 47,571 |   |
| Cost of revenue  (exclusive of depreciation, shown separately below)                                             |       | 8,392                                                                                                 |       | 4,935                                                                                                 |       | 21,419 |   | 13,592 |   |
| Gross profit                                                                                                     |       | 19,620                                                                                                |       | 12,299                                                                                                |       | 54,316 |   | 33,979 |   |
| Operating  expenses:                                                                                             |       |                                                                                                  |       |                                                                                                  |       |   |   |   |   |
| Sales and marketing                                                                                              |       | 5,991                                                                                                 |       | 4,218                                                                                                 |       | 17,436 |   | 11,748 |   |
| General and administrative                                                                                       |       | 5,771                                                                                                 |       | 4,036                                                                                                 |       | 16,972 |   | 10,912 |   |
| Research and development                                                                                         |       | 2,218                                                                                                 |       | 961                                                                                                   |       | 5,570 |   | 3,038 |   |
| Depreciation and amortization                                                                                    |       | 872                                                                                                   |       | 498                                                                                                   |       | 2,362 |   | 1,555 |   |
| Total operating  expenses                                                                                        |       | 14,852                                                                                                |       | 9,713                                                                                                 |       | 42,340 |   | 27,253 |   |
|                                                                                                             |       |                                                                                                  |       |                                                                                                  |       |   |   |   |   |
| Income from  operations before income taxes and interest expense                                                 |       | 4,768                                                                                                 |       | 2,586                                                                                                 |       | 11,976 |   | 6,726 |   |
| Interest income                                                                                                  |       | 764                                                                                                   |       | 220                                                                                                   |       | 1,566 |   | 222 |   |
| Interest on  mandatory redeemable shares                                                                         |       | —                                                                                                |       | —                                                                                                |       | — |   | 3,396 |   |
| Income from  operations before income tax                                                                        |       | 5,532                                                                                                 |       | 2,806                                                                                                 |       | 13,542 |   | 3,552 |   |
| Income tax  expense on operations                                                                                |       | 1,373                                                                                                 |       | 219                                                                                                   |       | 2,825 |   | 477 |   |
| Net income                                                                                                       |       | $              4,159            |       | $              2,587            |       | $            10,717 |   | $              3,075 |   |
| Accretion of  redeemable class B common shares and class C common shares                                         |       | —                                                                                                |       | —                                                                                                |       | — |   | 41,488 |   |
| Net income  (loss) available to common shareholders                                                              |       | $              4,159            |       | 2,587                                                                                                 |       | 10,717 |   | (38,413 | ) |
|                                                                                                             |       |                                                                                                  |       |                                                                                                  |       |   |   |   |   |
| Basic net income  (loss) per share to common shareholders                                                        |       | $                0.20 |       | $                0.15 |       | $                0.55 |   | $               (4.02 | ) |
| Weighted average  shares used to compute net income (loss) to common shareholders per common  share – basic |       | 20,407,856                                                                                            |       | 17,436,026                                                                                            |       | 19,626,010 |   | 9,558,486 |   |
|                                                                                                             |       |                                                                                                  |       |                                                                                                  |       |   |   |   |   |
| Diluted net  income (loss) per share to common shareholders                                                      |       | $                0.20 |       | $                0.15 |       | $                0.53 |   | $               (4.02 | ) |
| Weighted average shares  used to compute net loss available to common shareholders per common share -  diluted   |       | 20,922,015                                                                                            |       | 17,851,098                                                                                            |       | 20,183,995 |   | 9,558,486 |   |

 

*See accompanying notes to consolidated financial statement**s*.

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**Kenexa Corporationand SubsidiariesConsolidated Statements of Shareholders’ Equity (Deficiency)**(in thousands)(Unaudited)
| ** **                                                                                        | ** ** | ** **                                        | ** ** | ** **                                              | ** ** | **Stockholders’ Equity (Deficiency)**          | ** ** |
|---------------------------------------------------------------------------------------------------|------------|---------------------------------------------------|------------|---------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                                                                        | ** ** | **Common Stock  Redeemable**                 | ** ** | **Redeemable  Participating  Preferred Stock**     | ** ** | **Common**                                                    | ** ** | **Additional  Paid-In** | ** ** | **Accumulated** | ** ** | **Accumulated  Other  Comprehensive** | ** ** | **Treasury** | ** ** | **Deferred** | ** ** | **Note  Receivable  Common** | ** ** | **Total  Stockholders’  Equity** | ** ** | **Comprehensive** | ** ** |
| ** **                                                                                        | ** ** | **Class B**                                  | ** ** | **Class C**                                        | ** ** | **Series A**                                             | ** ** | **Series B** | ** ** | **Stock** | ** ** | **Capital** | ** ** | **(Deficit)** | ** ** | **(Loss) Income** | ** ** | **Stock** | ** ** | **Compensation** | ** ** | **Stock** | ** ** | **(Deficiency** | ** ** | **(Loss) Income** | ** ** |
| Balance, December 31,  2004                                                                       |       | $  5,291                                |       | $   4,571                                |       | $  41,727                                           |       | $ 17,178 |   | $          80 |   | $        4,363 |   | $         (44,368 | ) | $                      94 |   | $    (8,772 | ) | $                (454 | ) | $          (519 | ) | $          (49,576 | ) | $               (3,998 | ) |
| Stock repurchase                                                                                  |       | —                                            |       | —                                                  |       | —                                                        |       | — |   | — |   | — |   | — |   | — |   | (515 | ) | — |   | — |   | (515 | ) | — |   |
| Retirement of Treasury  Stock                                                                     |       | —                                            |       | —                                                  |       | —                                                        |       | — |   | (28 | ) | (2,154 | ) | (7,105 | ) | — |   | 9,287 |   | — |   | — |   | — |   | — |   |
| Payments received on  notes receivable for class A common stock                              |       | —                                            |       | —                                                  |       | —                                                        |       | — |   | — |   | — |   | — |   | — |   | — |   | — |   | 399 |   | 399 |   | — |   |
| Accretion of common  stock to redemption values                                                   |       | 20,859                                            |       | 20,630                                                  |       | (664                                                          | )          | 2,243 |   | — |   | (41,488 | ) | — |   | — |   | — |   | — |   | — |   | (41,488 | ) | — |   |
| Accrued dividends                                                                                 |       | —                                            |       | —                                                  |       | 1,147                                                         |       | 670 |   | — |   | — |   | — |   | — |   | — |   | — |   | — |   | — |   | — |   |
| Loss on currency  exchange                                                                        |       | —                                            |       | —                                                  |       | —                                                        |       | — |   | — |   | — |   | — |   | (124 | ) | — |   | — |   | — |   | (124 | ) | (124 | ) |
| Deferred stock  compensation related to stock options                                             |       | —                                            |       | —                                                  |       | —                                                        |       | — |   | — |   | 1,220 |   | — |   | — |   | — |   | (1,220 | ) | — |   | — |   | — |   |
| Amortization of deferred  stock compensation                                                      |       | —                                            |       | —                                                  |       | —                                                        |       | — |   | — |   | — |   | — |   | — |   | — |   | 634 |   | — |   | 634 |   |   |   |
| Option exercises                                                                                  |       | —                                            |       | —                                                  |       | —                                                        |       | — |   | — |   | 147 |   | — |   | — |   | — |   | — |   | — |   | 147 |   | — |   |
| Warrant exercises                                                                                 |       | —                                            |       | —                                                  |       | —                                                        |       | — |   | 4 |   | (4 | ) | — |   | — |   | — |   | — |   | — |   | — |   | — |   |
| Initial public stock  offering, net                                                               |       | —                                            |       | —                                                  |       | (28,600                                                       | )          | (11,400 | ) | 57 |   | 61,466 |   | — |   | — |   | — |   | — |   | — |   | 61,523 |   | — |   |
| Conversion of preferred  stock to common stock upon public offering                               |       | —                                            |       | —                                                  |       | (13,610                                                       | )          | (8,691 | ) | 18 |   | 22,282 |   | — |   | — |   | — |   | — |   | — |   | 22,300 |   | — |   |
| Conversion of class B  and class C redeemable common stock to class A common upon public offering |       | (26,150                                           | )          | (25,201                                                 | )          | —                                                        |       | — |   | 43 |   | 51,308 |   | — |   | — |   | — |   | — |   | — |   | 51,351 |   | — |   |
| Net income                                                                                        |       | —                                            |       | —                                                  |       | —                                                        |       | — |   | — |   | — |   | 6,091 |   | — |   | — |   | — |   | — |   | 6,091 |   | 6,091 |   |
| Balance, December 31,  2005                                                                       |       | $       — |       | $        — |       | $         — |       | $        — |   | $        174 |   | $      97,140 |   | $         (45,382 | ) | $                    (30 | ) | $          — |   | $             (1,040 | ) | $          (120 | ) | $            50,742 |   | $                 5,967 |   |
| Payments received on  notes receivable for class A common stock                              |       | —                                            |       | —                                                  |       | —                                                        |       | — |   | — |   | — |   | — |   | — |   | — |   | — |   | 120 |   | 120 |   | — |   |
| Loss on currency  exchange                                                                        |       | —                                            |       | —                                                  |       | —                                                        |       | — |   | — |   | — |   | — |   | (227 | ) | — |   | — |   | — |   | (227 | ) | (227 | ) |
| Adoption of SFAS 123R                                                                             |       | —                                            |       | —                                                  |       | —                                                        |       | — |   | — |   | (1,040 | ) | — |   | — |   | — |   | 1,040 |   | — |   | — |   | — |   |
| Option exercises                                                                                  |       | —                                            |       | —                                                  |       | —                                                        |       | — |   | 2 |   | 1,760 |   | — |   | — |   | — |   | — |   | — |   | 1,762 |   | — |   |
| Warrant exercises                                                                                 |       | —                                            |       | —                                                  |       | —                                                        |       | — |   | 2 |   | (2 | ) | — |   | — |   | — |   | — |   | — |   | — |   | — |   |
| Stock Compensation  Expense                                                                       |       | —                                            |       | —                                                  |       | —                                                        |       | — |   | — |   | 1,946 |   | — |   | — |   | — |   | — |   | — |   | 1,946 |   | — |   |
| APIC Tax Pool                                                                                     |       | —                                            |       | —                                                  |       | —                                                        |       | — |   | — |   | 1,149 |   | — |   | — |   | — |   | — |   | — |   | 1,149 |   | — |   |
| Follow-on stock  offering, net                                                                    |       | —                                            |       | —                                                  |       | —                                                        |       | — |   | 27 |   | 66,255 |   | — |   | — |   | — |   | — |   | — |   | 66,282 |   | — |   |
| Issuance of common stock  for Gantz Wiley Research                                                |       | —                                            |       | —                                                  |       | —                                                        |       | — |   | 1 |   | 3,168 |   | — |   | — |   | — |   | — |   | — |   | 3,169 |   | — |   |
| Net income                                                                                        |       | —                                            |       | —                                                  |       | —                                                        |       | — |   | — |   | — |   | 10,717 |   | — |   | — |   | — |   | — |   | 10,717 |   | 10,717 |   |
| Balance, September 30, 2006                                                                       |       | $       — |       | $        — |       | $         — |       | $        — |   | $        206 |   | $    170,376 |   | $         (34,665 | ) | $                  (257 | ) | $          — |   | $                    — |   | $             — |   | $          135,660 |   | $               10,490 |   |

 

*See accompanying independent auditors’ report and notes toconsolidated financial statements.*

5

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**Kenexa Corporationand SubsidiariesCONSOLIDATED STATEMENTS OF CASH FLOWS**(Inthousands)(Unaudited)
| ** **                                                                        | ** ** | **Nine months ended  September 30,**     | ** ** |
|-----------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                        | ** ** | **2006**                                                | ** ** | **2005** | ** ** |
|                                                                              |       |                                                    |       |   |   |
| **Cash  flows from operating activities**                                         | ** ** | ** **                                              | ** ** | ** ** | ** ** |
| Net income from  continuing operations                                            |       | $        10,717 |       | $          3,075 |   |
| Adjustments to reconcile net income to net cash  provided by operating activities |       |                                                    |       |   |   |
| Depreciation and amortization                                                     |       | 2,362                                                   |       | 1,555 |   |
| Non-cash interest expense                                                         |       | 72                                                      |       | — |   |
| Share-based compensation                                                          |       | 1,946                                                   |       | 475 |   |
| Excess tax benefits from share-based payment  arrangements                        |       | (1,149                                                  | )          | — |   |
| Amortization of deferred financing fees                                           |       | 79                                                      |       | 69 |   |
| Bad debt expense                                                                  |       | (69                                                     | )          | 154 |   |
| Accrued interest on mandatory redeemable preferred  stock                         |       | —                                                  |       | 3,396 |   |
| Deferred taxes                                                                    |       | (1,834                                                  | )          | (993 | ) |
| Changes in assets and liabilities                                                 |       |                                                    |       |   |   |
| Accounts and unbilled receivables                                                 |       | (4,548                                                  | )          | (2,994 | ) |
| Prepaid expenses and other current assets                                         |       | 276                                                     |       | (896 | ) |
| Other assets                                                                      |       | (112                                                    | )          | 87 |   |
| Accounts payable                                                                  |       | 561                                                     |       | 1,107 |   |
| Accrued compensation and other accrued liabilities                                |       | 1,957                                                   |       | 1,804 |   |
| Commissions payable                                                               |       | 249                                                     |       | 237 |   |
| Deferred revenue                                                                  |       | 673                                                     |       | 4,331 |   |
| Other liabilities                                                                 |       | (35                                                     | )          | (35 | ) |
| **Net  cash provided by operating activities**                                    |       | 11,145                                                  |       | 11,372 |   |
| ** **                                                                        |       |                                                    |       |   |   |
| **Cash  flows from investing activities**                                         | ** ** | ** **                                              | ** ** | ** ** | ** ** |
| Purchases of  property and equipment                                              |       | (3,024                                                  | )          | (2,840 | ) |
| Acquisitions,  net of cash acquired                                               |       | (37,129                                                 | )          | (164 | ) |
| **Net  cash used in investing activities**                                        |       | (40,153                                                 | )          | (3,004 | ) |
| ** **                                                                        |       |                                                    |       |   |   |
| **Cash  flows from financing activities**                                         | ** ** | ** **                                              | ** ** | ** ** | ** ** |
|                                                                              |       |                                                    |       |   |   |
| Repayments of  notes payable                                                      |       | (44                                                     | )          | (16 | ) |
| Repurchase of  common shares                                                      |       | —                                                  |       | (515 | ) |
| Collections of  notes receivable                                                  |       | 120                                                     |       | 160 |   |
| Excess tax  benefits from share-based payment arrangements                        |       | 1,149                                                   |       | — |   |
| Net proceeds  from initial public offering of common stock                        |       | —                                                  |       | 61,840 |   |
| Redemption of  series A and B preferred stock                                     |       | —                                                  |       | (40,000 | ) |
| Net proceeds  from follow-on offering of common stock                             |       | 66,282                                                  |       | — |   |
| Deferred  financing costs                                                         |       | (128                                                    | )          | (16 | ) |
| Net proceeds  from option exercises                                               |       | 1,762                                                   |       | — |   |
| Repayments of  capital lease obligations                                          |       | (302                                                    | )          | (171 | ) |
| **Net  cash provided by financing activities**                                    |       | 68,839                                                  |       | 21,282 |   |
|                                                                              |       |                                                    |       |   |   |
| Effect of  exchange rate changes on cash and cash equivalents                     |       | (221                                                    | )          | (51 | ) |
| Net increase in  cash and cash equivalents                                        |       | 39,610                                                  |       | 29,599 |   |
| Cash and cash equivalents  at beginning of year                                   |       | 43,499                                                  |       | 9,494 |   |
|                                                                              |       |                                                    |       |   |   |
| **Cash  and cash equivalents at end of period**                                   |       | $        83,109 |       | $        39,093 |   |

 

*See accompanying notes to consolidated financial statements.*

6

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| **Supplemental  disclosures of cash flow information**                          |   |                                                                                              |       |                                                                                          |   |
|---------------------------------------------------------------------------------|--------|---------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------|--------|
|                                                                            |   |                                                                                              |       |                                                                                          |   |
| Cash paid during  the year for:                                                 |   |                                                                                              |       |                                                                                          |   |
| Interest expense                                                                |   | $             401                |       | $             181            |   |
| Income taxes                                                                    |   | $          2,059                                |       | $             360            |   |
|                                                                            |   |                                                                                              |       |                                                                                          |   |
| **Non-cash  investing and financing activities**                                |   | ** **                                                                                        | ** ** | ** **                                                                                    |   |
| Capital lease  obligations                                                      |   | $             114                |       | $               92 |   |
| Notes receivable  applied to accrued bonus                                      |   | —                                                                                            |       | $             151            |   |
| Accretion of  class B common stock and class C common stock to redemption value |   | $               — |       | $        41,448                                       |   |
| Redemption and  conversion of class B and class C common stock to common stock  |   | $               — |       | $        51,351                                       |   |

 

*See accompanying notes to consolidated financial statements.*

7

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**KenexaCorporation and Subsidiaries**

**NOTES TO THECONSOLIDATED FINANCIAL STATEMENTS (unaudited)**

All amounts are inthousands, except share and per share amounts, and unless noted otherwise.

**1. Organization**

Kenexa Corporationand its subsidiaries (collectively, the “Company”) commenced operations in 1987as a provider of recruiting services to a wide variety of industries.  In 1993, the Company offered its firstautomated talent management system. Between 1994 and 1998, the Company acquired15 businesses that enabled it to offer comprehensive human capital management,or HCM, services integrated with web-based technology.

The Company began itsoperations in 1987 under its predecessor companies, InsuranceServices, Inc., or ISI, and International Holding Company, Inc., or IHC.In December 1999, the Company reorganized its corporate structure bymerging ISI and IHC with and into Raymond Karsan Associates, Inc., or RKA,a Pennsylvania corporation and a wholly owned subsidiary of Raymond KarsanHoldings, Inc., or RKH, a Pennsylvania corporation. Each of RKA and RKHwere newly created to consolidate the businesses of ISI and IHC. InApril 2000, the Company changed its name to TalentPoint, Inc. andchanged the name of RKA to TalentPoint Technologies, Inc. In November 2000,the Company changed its name to Kenexa Corporation, and changed the name ofTalentPoint Technologies, Inc. to Kenexa Technology, Inc., or KenexaTechnology. Currently, Kenexa transacts business primarily through KenexaTechnology. The Company operates in one segment.

**2. Summary ofSignificant Accounting Policies**

The accompanying financial statements for the threeand nine months ended September 30, 2006 and 2005 have been prepared by theCompany without audit.  In the opinion ofmanagement, all adjustments (which include only normal recurring adjustments)necessary to present fairly the financial position and the results ofoperations and cash flows for the three and nine months ended September 30,2006 and 2005 have been made.  Certaininformation and footnote disclosures normally included in financial statementsprepared in accordance with accounting principles generally accepted in theUnited States have been condensed or eliminated.  The results for the three and nine monthsended September 30, 2006 are not necessarily indicative of the results to beexpected for the year ending December 31, 2006 or for any other interim period.

**Principlesof Consolidation**

Theconsolidated financial statements of the Company include the accounts of KenexaCorporation and its subsidiaries.  Allsignificant intercompany accounts and transactions have been eliminated inconsolidation.

**Cash andCash Equivalents**

Cashand cash equivalents consist of highly liquid investments with remainingmaturities of six months or less at the time of purchase.

**PrepaidExpenses and Other Assets**

Prepaidexpenses and other current assets consist primarily of prepaid softwaremaintenance agreements, deferred implementation costs, insurance, taxes andother current assets. Deferred implementation costs represent internal payrolland other costs incurred in connection with the customization of the sitesassociated with the internet hosting arrangements. These costs are deferredover the implementation period, typically three to four months, and are expensedratably over the subscription period, typically one to three years.  These amounts aggregated $858 and $1,089 atSeptember 30, 2006 and December 31, 2005, respectively. The current portion ofthese deferred costs of $675 and $979 at September 30, 2006 and December 31,2005, respectively, are included in other current assets.  The noncurrent portion of these deferredcosts of $183 and $110 at September 30, 2006 and December 31, 2005,respectively, are included in other assets in the accompanying consolidatedbalance sheets.

8

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**SoftwareDeveloped for Service Transactions**

Inaccordance with EITF 00-3, “Application of AICPA Statement of Position 97-2 toArrangements That Include the Right to Use Software Stored on Another Entity’sHardware”, the Company applies AICPA Statement of Position No. 98-1,*Accounting for the Costs of Computer SoftwareDeveloped or Obtained for Internal Use*. The costs incurred in thepreliminary stages of development are expensed as incurred. Once an applicationhas reached the development stage, internal and external costs, if direct andincremental, will be capitalized until the software is substantially completeand ready for its intended use. Capitalization ceases upon completion of allsubstantial testing. The Company also capitalizes costs related to specificupgrades and enhancements when it is probable the expenditures will result inadditional functionality. Maintenance and training cost are expensed asincurred. Internal use software is amortized on a straight-line basis over itsestimated useful life, generally three years. Management evaluates the usefullives of these assets on an annual basis and tests for impairments wheneverevents or changes in circumstances occur that could impact the recoverabilityof these assets. There were no impairments to internal software in any of theperiods covered in this report.

TheCompany capitalized software costs for the nine months ended September 30, 2006of $1,839.  Amortization of capitalizedinternal-use software costs for the nine months ended September 30, 2006 was$934.

**RevenueRecognition**

TheCompany derives its revenue from two sources: (1) subscription revenue forsolutions, which is comprised of subscription fees from clients accessing ouron-demand software, consulting services, outsourcing services and proprietarycontent, and from clients purchasing additional support beyond the standardsupport that is included in the basic subscription fee; and (2) other fees fordiscrete professional services. Because the Company provides its solutions as aservice, the Company follows the provisions of Securities and ExchangeCommission Staff Accounting Bulletin No. 101,*Revenue Recognition in Financial Statements,* as amended by StaffAccounting Bulletin No. 104,*RevenueRecognition.* On August 1, 2003, the Company adopted Emerging IssuesTask Force Issue No. 00-21,*RevenueArrangements with Multiple Deliverables.* The Company recognizesrevenue when all of the following conditions are met:

·                  Thereis persuasive evidence of an arrangement;

·                  Theservice has been provided to the client;

·                  Thecollection of the fees is probable; and

·                  Theamount of fees to be paid by the client is fixed or determinable.

Subscriptionfees and support revenues are recognized on a monthly basis over the terms ofthe contracts. Amounts that have been invoiced are recorded in accountsreceivable and in deferred revenue or revenue, depending on whether the revenuerecognition criteria have been met.

Discreteprofessional services and other revenues, when sold with subscription andsupport offerings, are accounted for separately since these services have valueto the customer on a stand-alone basis and there is objective and reliableevidence of fair value of the delivered elements. The Company’s arrangements donot contain general rights of return. Additionally, when professional servicesare sold with other elements, the consideration from the revenue arrangement isallocated among the separate elements based upon the relative fair value.Professional services and other revenues are recorded as follows: Consultingrevenues are recognized upon completion of the contracts that are of shortduration (generally less than 60 days) and as the services are rendered forcontracts of longer duration.

Indetermining whether revenues from professional services can be accounted forseparately from subscription revenue, the Company considers the followingfactors for each agreement: availability from other vendors, whether objectiveand reliable evidence of fair value exists of the undelivered elements, thenature and the timing of when the agreement was signed in comparison to thesubscription agreement start date and the contractual dependence of thesubscription service on the client’s satisfaction with the other services. Ifthe professional service does not qualify for separate accounting, the Companyrecognizes the revenue ratably over the remaining term of the subscriptioncontract. In these situations, the Company defers the direct and incrementalcosts of the professional service over the same period as the revenue isrecognized.

Deferredrevenue represents payments received or accounts receivable from the Company’sclients for amounts billed in advance of subscription services being provided.

9

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TheCompany reimburses out-of-pocket expenses incurred in accordance with EITFissue 01-14, “Income Statement Characterization of Reimbursements Received for ‘Out-of-Pocket’ Expenses Incurred”,which requires that reimbursements received for out-of-pocket expenses beclassified as revenues and not as cost reductions.  Before the December 15, 2001 effective dateof EITF 01-14, out-of-pocket reimbursements from clients were netted with theapplicable costs. These items primarily include travel, meals and certaintelecommunication costs.  For the ninemonths ended September 30, 2006, reimbursed expenses totaled $1,087.

**Self-Insurance**

TheCompany is self-insured for the majority of its health insurance costs,including claims filed and claims incurred but not reported subject to certainstop loss provisions. The Company estimated the liability based upon management’sjudgment and historical experience. Self-insurance accruals totaled $322 and $190 at September 30, 2006 andDecember 31, 2005, respectively. Management continuously reviews the adequacy ofthe Company’s stop loss insurance coverage. Material differences may result inthe amount and timing of insurance expense if actual experience differssignificantly from management’s estimates.

**Concentrationof Credit Risk**

Financial instrumentswhich potentially expose the Company to concentration of credit risk consistprimarily of accounts receivable.  Creditrisk arising from receivables is mitigated due to the large number of clientscomprising the Company’s client base and their dispersion across variousindustries.  The clients are concentratedprimarily in the Company’s U.S. market area. At September 30, 2006, there were no clients that represented more than10% of the net accounts receivable balance. There were no clients that individually exceeded 10% of the Company’srevenues.

Cash balances aremaintained at several banks.  Accountslocated in the United States are insured by the Federal Deposit InsuranceCorporation (“FDIC”) up to $100. Certain operating cash accounts may exceed theFDIC limits.

**RecentAccounting Pronouncements**

In July 2006, the Financial Accounting Standards Board(FASB) issued FASB Interpretation No. 48, Accounting for Uncertainty in IncomeTaxes—an interpretation of FASB Statement No. 109 (FIN 48), whichclarifies the accounting for uncertainty in tax positions. This Interpretationrequires that we recognize in our financial statements, the impact of a taxposition, if that position is more likely than not of being sustained on audit,based on the technical merits of the position. The provisions of FIN 48 areeffective as of the beginning of our 2007 fiscal year, with the cumulativeeffect of the change in accounting principle recorded as an adjustment toopening retained earnings. We are currently evaluating the impact of adoptingFIN 48 on our financial statements.

In May 2005, FASB issued SFAS 154, “Accounting Changesand Error Corrections—a replacement of APB Opinion No. 20 and FASB StatementNo. 3”. SFAS 154 changes the requirements for the accounting for and reportingof a change in accounting principle, and applies to all voluntary changes inaccounting principle. It also applies to changes required by an accountingpronouncement in the unusual instance that the pronouncement does not includespecific transition provisions. This statement requires retrospectiveapplication to prior periods’ financial statements of changes in accountingprinciple, unless it is impracticable to determine either the period-specificeffects or the cumulative effect of the change. SFAS 154 is effective foraccounting changes made in fiscal years beginning after December 15, 2005. Wedo not expect that adoption of this statement will have a material impact onour results of operations or financial condition

In March 2005, the Financial Accounting StandardsBoard (the FASB) issued Interpretation No. 47, *Accountingfor Conditional Asset Retirement Obligations*, an interpretation ofSFAS No. 143, *Accounting for AssetRetirement Obligations.* ThisInterpretation clarifies that an entity is required to recognize a liabilityfor the fair value of a conditional asset retirement obligation when incurredif the liability’s fair value can be reasonably estimated. The provisions ofthis pronouncement are effective for fiscal years ending after December 15, 2005.The Company does not expect the adoption of Interpretation No. 47 to have anymaterial financial statement impact.

In December 2004, the FASB issued Statement ofFinancial Accounting Standards No. 123 (revised 2004), “Share-Based Payment”(SFAS 123R). SFAS 123R requires that the cost resulting from all share-basedpayment transactions be recognized in the financial statements. SFAS 123R alsoestablishes fair value as the measurement method in accounting for share-basedpayments. The FASB required the provisions of SFAS 123R be adopted for interimor annual periods beginning after June 15, 2005. In April 2005, the SEC adopteda new rule amending the compliance dates for SFAS 123R for public companies. Inaccordance with this rule, we adopted SFAS 123R effective January 1, 2006 usingthe modified prospective transition method. We did not modify the terms of anypreviously granted options in anticipation of the adoption of SFAS 123R.

We expect the application of the expensing provisionsof SFAS 123R will result in a pretax expense of approximately $2,510 in 2006.Based on the same assumptions used to value our 2006 compensation expense, weestimate our pretax expense associated with our stock-based compensation planswill approximate $2,124 in 2007 and $1,550 in 2008.

10

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In November 2005, the FASB issued FSP FAS123(R)-3, Transition Election Related to Accounting for the Tax Effects ofShare-Based Payment Awards, to provide an alternative approach of accountingfor the tax effects of employee share-based awards. We have elected to adoptthe alternative transition method provided in FSP FAS 123(R)-3 for calculatingthe tax effects of stock-based compensation pursuant to SFAS 123(R). Thealternative transition method includes simplified methods to establish the beginningbalance of the additional paid-in capital pool (APIC pool) related to the taxeffects of employee stock-based compensation, and to determine the subsequentimpact on the APIC pool and consolidated statements of cash flows of the taxeffects of employee stock-based compensation awards that are outstanding uponthe adoption of SFAS 123(R).

**Earnings(Loss) Per Share**

The Company followsSFAS 128, “Earnings Per Share.” Under SFAS 128, companies that arepublicly held or have complex capital structures are required to present basicand diluted earnings per share on the face of the statement of operations.  Earnings (loss) per share are based on theweighted average number of shares and common stock equivalents outstandingduring the period.  In the calculation ofdiluted earnings per share, shares outstanding are adjusted to assumeconversion of the Company’s non-interest bearing convertible stock and theexercise of options and warrants if they are dilutive.  In the calculation of basic earnings pershare, weighted average numbers of shares outstanding are used as thedenominator.  The Company had net incomeavailable to common shareholders for the three month period ended September 30,2006 and 2005 and the nine month period ended September 30, 2006 and a net lossavailable to common shareholders for the nine month period ended September 30,2005.  As a result, the common stockequivalents of stock options, warrants and convertible securities issued andoutstanding at September 30, 2005 were not included in the computation ofdiluted earnings per share for the period then ended as they wereantidilutive.  Income (loss) per share iscomputed as follows:
|                                                                                                                              | ** ** | **Three months ended  September 30,**                                      | ** ** | **Nine months ended  September 30,**                                       | ** ** |
|------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------|------------|
| ** **                                                                                                                   | ** ** | **2006**                                                                                  | ** ** | **2005**                                                                                  | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                                                                                   | ** ** | ** **                                                                                | ** ** | ** **                                                                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income                                                                                                                   |       | $            4,159            |       | $            2,587            |       | $          10,717 |   | $            3,075 |   |
| Accretion of  redeemable class B common stock and redeemable class C common stock                                            |       | —                                                                                    |       | —                                                                                    |       | — |   | 41,488 |   |
|                                                                                                                         |       |                                                                                      |       |                                                                                      |       |   |   |   |   |
| Net income  (loss) available to common shareholders                                                                          |       | $            4,159            |       | $            2,587            |       | $          10,717 |   | $        (38,413 | ) |
|                                                                                                                         |       |                                                                                      |       |                                                                                      |       |   |   |   |   |
| Weighted average  shares used to compute net income (loss) available to common shareholders per  common share - basic        |       | 20,407,856                                                                                |       | 17,436,026                                                                                |       | 19,626,010 |   | 9,558,486 |   |
|                                                                                                                         |       |                                                                                      |       |                                                                                      |       |   |   |   |   |
| Effect of  dilutive stock options and warrants                                                                               |       | 514,159                                                                                   |       | 415,072                                                                                   |       | 557,985 |   | — |   |
|                                                                                                                         |       |                                                                                      |       |                                                                                      |       |   |   |   |   |
| Weighted average  shares used to compute net income (loss) available to common shareholders per  common share – diluted |       | 20,922,015                                                                                |       | 17,851,098                                                                                |       | 20,183,995 |   | 9,558,486 |   |
|                                                                                                                         |       |                                                                                      |       |                                                                                      |       |   |   |   |   |
| Basic net income  (loss) per share to common shareholder                                                                     |       | $              0.20 |       | $              0.15 |       | $              0.55 |   | $            (4.02 | ) |
|                                                                                                                         |       |                                                                                      |       |                                                                                      |       |   |   |   |   |
| Diluted net income  (loss) per share to common shareholder                                                                   |       | $              0.20 |       | $              0.15 |       | $              0.53 |   | $            (4.02 | ) |

 

11

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**Stock-Based Compensation**

The Company’s 2005 Equity Incentive Plan (the “2005Option Plan”), which was adopted by the Company’s Board of Directors (the “Board”)in March 2005 and was approved by the Company’s shareholders in June 2005,provides for the granting of stock options to employees and directors at thediscretion of the Board or a committee of the Board.  The 2005 Option Plan replaced the Company’s2000 Stock Option Plan (the “2000 Option Plan”).  As of September 30, 2006, there were optionsto purchase 1,518,458 shares of common stock outstanding under the 2005 OptionPlan.  The Company is authorized to issueup to an aggregate of 4,842,910 shares of its common stock pursuant to stockoptions granted under the 2005 Option Plan. As of September 30, 2006, therewere a total of 3,142,479 shares of common stock not subject to outstandingoptions and available for issuance under the 2005 Option Plan.  The purpose of stock options is to recognizepast services rendered and to provide additional incentive in furthering thecontinued success of the Company.  Stockoptions granted under both the 2005 Option Plan and the 2000 Stock Option Planexpire between the fifth and tenth anniversary of the date of grant andgenerally vest on the third anniversary of the date of grant.  Unexercised stock options may expire up to90 days after an employee’s termination.

On January 1, 2006, we adopted SFAS No. 123Rusing the Modified Prospective Approach (“MPA”). The MPA requires thatcompensation expense be recorded for restricted stock and all unvested stockoptions as of January 1, 2006. Upon adoption we will continue to recognizethe cost of previously granted share-based awards under the straight-line basisand anticipate that we will recognize the cost for new share-based awards on astraight-line basis over the requisite service period.

SFAS 123R requires companies to estimate the fairvalue of share-based payment awards on the date of grant using anoption-pricing model.  In 2005 and 2006,the fair value of each grant was estimated using the Black-Scholes valuationmodel.  Expected volatility was basedupon a weighted average of peer companies, comparable indices, and the Company’sstock volatility.  The expected life wasdetermined based upon an average of the contractual life and vesting period ofthe options.  The estimated forfeiturerate was based upon an analysis of historical data.   The risk-free rate was based on U.S.Treasury zero coupon bond yields at the time of grant.  The following table provides the assumptionsused in determining the fair value of the stock-based awards for each of thequarters during the year ended December 31, 2005 and for the quarters endedMarch 31, 2006 and June 30, 2006, respectively. No options were granted during the quarter ended September 30, 2006.

|                           | ** ** | **March 31,  2005** | ** ** | **June 30,  2005** | ** ** | **September 30,  2005** | ** ** | **December 31,  2005** | ** ** | **March 31,  2006** | ** ** | **June 30,  2006** | ** ** |
|---------------------------|------------|--------------------------|------------|-------------------------|------------|------------------------------|------------|-----------------------------|------------|--------------------------|------------|-------------------------|------------|
| Expected  volatility      |       | 51.3                     | %          | 51.3                    | %          | 51.3                         | %          | 51.3                        | %          | 39.5                     | %          | 40.8                    | %          |
| Expected  dividends       |       | 0                        |       | 0                       |       | 0                            |       | 0                           |       | 0                        |       | 0                       |       |
| Expected term  (in years) |       | 4 – 6.5             |       | 4 – 6.5            |       | 4 – 6.5                 |       | 4 – 6.5                |       | 4                        |       | 4 - 5                   |       |
| Risk-free rate            |       | 4.5                      | %          | 4.5                     | %          | 4.5                          | %          | 4.5                         | %          | 4.7                      | %          | 5.1                     | %          |

 

Asummary of the status of the Company’s stock options as of December 31, 2005and September 30, 2006 and changes during the period then ended is as follows:
|                                | ** ** | **Options Outstanding**          | ** ** | **Options Exercisable** | ** ** |
|--------------------------------|------------|---------------------------------------|------------|------------------------------|------------|
| ** **                     | ** ** | **Shares  available for  Grant** | ** ** | **Shares**                   | ** ** | **Wtd. Avg.  Exercise  Price** | ** ** | **Shares** | ** ** | **Wtd. Avg.  Exercise  Price** | ** ** |
| Balance at  December 31, 2005  |       | 3,265,859                             |       | 1,562,181                    |       | $       11.74 |   | 638,781 |   | $       12.08 |   |
| Granted                        |       | (203,000                              | )          | 203,000                      |       | $       24.03 |   | — |   | — |   |
| Exercised                      |       | —                                |       | (167,103                     | )          | $       10.54 |   | — |   | — |   |
| Forfeited or  expired          |       | 79,620                                |       | (79,620                      | )          | $       19.39 |   | — |   | — |   |
| Balance at September  30, 2006 |       | 3,142,479                             |       | 1,518,458                    |       | $       13.11 |   | 503,758 |   | $       12.96 |   |

 

The total intrinsic value of options exercised duringthe quarter ended September 30, 2006 was $955. No options were exercised during the quarter ended September 30, 2005.

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Asummary of the status of the Company’s nonvested share options as of December31, 2005 and September 30, 2006 and changes during the period then ended ispresented below:

| Nonvested Shares           | ** ** | **Shares** | ** ** | **Wtd. Avg.  Grant Date  Fair Value** | ** ** |
|---------------------------------|------------|------------|------------|------------------------------------------------------|------------|
| Nonvested at December  31, 2005 |       | 923,400    |       | $                                                    | 8.10       |   |
| Granted                         |       | 203,000    |       | $                                                    | 9.27       |   |
| Vested                          |       | (38,000    | )          | $                                                    | 8.76       |   |
| Forfeited or expired            |       | (73,700    | )          | $                                                    | 7.77       |   |
| Nonvested at September 30, 2006 |       | 1,014,700  |       | $                                                    | 8.16       |   |

 

As of September 30, 2006, there was $5,344 of total unrecognizedcompensation cost related to nonvested share-based compensation arrangementsgranted under the 2005 Option Plan and the 2000 Option Plan.  That cost is expected to be recognized over aweighted-average period of 4.0 years.

SFAS No. 123R also requires us to change theclassification of any tax benefits realized upon exercise of stock options inexcess of that which is associated with the expense recognized for financialreporting purposes. These amounts are presented as a financing cash inflow ratherthan as a reduction of income taxes paid in our consolidated statement of cashflows.

In accordance with Staff Accounting Bulletin No. 107,we classified stock-based compensation within cost of goods sold, selling,general and administrative expenses and research and development correspondingto the same line as the cash compensation paid to respective employees,officers and non-employee directors.

Priorto January 1, 2006 the Company accounted for stock options under AccountingPrinciples Board (“APB”) Opinion 25.  Hadcompensation expense for stock options granted been determined based on thefair value at the grant dates under the provisions of SFAS 123, theCompany’s pro forma net income for the three and nine months ended September30, 2005 would have been as follows: 
|                                                                                                                             | ** ** | **For the three  months ended  September 30,  2005** | ** ** | **For the nine  months ended  September 30,  2005** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|
|                                                                                                                        |       |                                                                     |       |                                                                    |       |
| Net income as reported                                                                                                      |       | $                                                                        | 2,587      |                                                                    | $          | 3,075 |   |
| Add: stock based  employee compensation expense included in reported net income, net of tax                            |       | 119                                                                      |       | 514                                                                     |       |
| Deduct: total  stock-based compensation expense determined under fair value based method for  all awards, net of tax   |       | 608                                                                      |       | 756                                                                     |       |
|                                                                                                                        |       |                                                                     |       |                                                                    |       |
| Pro forma net income                                                                                                        |       | $                                                                        | 2,098      |                                                                    | $          | 2,833 |   |
|                                                                                                                        |       |                                                                     |       |                                                                    |       |
| Accretion of redeemable  class B common stock, class C common stock, series A preferred stock and  series B preferred stock |       | $                                                                        | —     |                                                                    | $          | (41,488 | ) |
|                                                                                                                        |       |                                                                     |       |                                                                    |       |
| Pro forma net income  (loss) available to common shareholders                                                               |       | $                                                                        | 2,098      |                                                                    | $          | (38,655 | ) |
|                                                                                                                        |       |                                                                     |       |                                                                    |       |
| Basic and diluted net  income (loss) per share to common shareholder, as reported:                                          |       | $                                                                        | 0.15       |                                                                    | $          | (4.02 | ) |
| Basic and diluted net income (loss) per share to common shareholder,  pro forma:                                            |       | $                                                                        | 0.12       |                                                                    | $          | (4.04 | ) |

 

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**Use ofEstimates**

Thepreparation of financial statements in conformity with accounting principlesgenerally accepted in the United States of America requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities, disclosure of contingent assets and liabilities at the date of thefinancial statements and the reported amounts of revenues and expenses duringthe reporting period. Actual results could differ from those estimates.

**FairValue of Financial Instruments**

The carrying amounts of the Company’s financial assetsand liabilities, including cash, accounts receivable and accounts payable atSeptember 30, 2006 and 2005 approximate fair value of these instruments.

**3. Property,Equipment and Software**

A summary ofproperty, equipment and software and related accumulated depreciation as ofSeptember 30, 2006 and December 31, 2005 is as follows:

|                                | ** ** | **September 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|--------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| Equipment                      |       | $                            | 7,411      |                        | $          | 7,338 |   |
| Software                       |       | 9,194                        |       | 6,583                       |       |
| Office furniture and  fixtures |       | 1,292                        |       | 1,175                       |       |
| Leasehold improvements         |       | 1,094                        |       | 645                         |       |
| Land                           |       | 708                          |       | 578                         |       |
| Software in development        |       | 276                          |       | 846                         |       |
|                           |       |                         |       |                        |       |
|  Total                    |       | 19,975                       |       | 17,165                      |       |
| Less accumulated  depreciation |       | 11,751                       |       | 11,578                      |       |
|                           |       |                         |       |                        |       |
|  Net                      |       | $                            | 8,224      |                        | $          | 5,587 |   |

 

Equipment, officefurniture and fixtures included capital leases totaling $2,397 and $2,241 atSeptember 30, 2006 and December 31, 2005, respectively. Depreciation expense,including assets under capital leases, was $2,362 and $2,074 for the ninemonths ended September 30, 2006 and year ended December 31, 2005, respectively.

**4. Other AccruedLiabilities**

Other accrued liabilitiesconsist of the following:
|                                       | ** ** | **September 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|---------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| Accrual for  discontinued operations  |       | $                            | —     |                        | $          | 71 |   |
| Accrued  professional fees            |       | 107                          |       | 260                         |       |
| Straight line  rent accrual           |       | 342                          |       | 199                         |       |
| Other taxes  payable (non-income tax) |       | 197                          |       | 220                         |       |
| Income taxes  payable                 |       | 2,206                        |       | 1,084                       |       |
| Other  liabilities                    |       | 692                          |       | 343                         |       |
|                                  |       |                         |       |                        |       |
| Total other accrued  liabilities      |       | $                            | 3,543      |                        | $          | 2,177 |   |

 

14

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**5. Line of Credit**

OnDecember 29, 2005, the Company entered into an amendment (the “2005Amendment”) to its revolving credit facility with PNC Bank, N.A. Under theterms of the 2005 Amendment, the Company’s maximum borrowings under therevolving credit facility increased from $10,000 to $25,000, includingavailability of up to $2,000 for letters of credit. No amounts were outstandingon the line on September 30, 2006.  OnJanuary 13, 2006, the Company borrowed $25,000 from the revolving creditfacility for working capital purposes. On March 14, 2006, the Company repaid the balance due on the revolving creditfacility.

TheCompany’s borrowings under the revolving credit facility bear interest attiered rates based upon the ratio of Net Funded Debt to EBITDA, as defined inthe 2005 Amendment. The Company may also elect interest rates on its borrowingscalculated by reference to LIBOR plus a margin based upon the ratio of its NetFunded Debt to EBITDA ratio. Interest on LIBOR borrowings is calculated on anactual/360 day basis and is paid on the last day of each interest period.LIBOR advances are available for periods of 1, 2, 3 or 6 months. LIBORpricing is adjusted for any statutory reserves. The revolving credit facilitywill terminate on December 31, 2008, at which time all outstandingborrowings must be repaid, and all outstanding letters of credit, if any, mustbe collateralized by cash.

Borrowingsunder the revolving credit facility are collateralized generally by all of theCompany’s assets, including a pledge of the capital stock of itssubsidiaries.  Repayment of amountsoutstanding under certain notes payable and all issued or issuable shares ofcommon and preferred stock are subordinated to the rights of the lender underterms of the revolving credit facility. The revolving credit facility containsvarious terms and covenants that provide for restrictions on capitalexpenditures, payment of dividends, dispositions of assets, investments andacquisitions and require the Company, among other things, to maintain minimumlevels of tangible net worth, net income and fixed charge coverage.

**6. Commitments andContingencies**

**Litigation**

On January 27, 2006,the Company and Gallup settled an outstanding claim and entered into aconfidential settlement agreement. On January 30, 2006, the Court entereda consent order relating to the settlement. The terms of the settlement did nothave a material adverse effect on the results of operations or financialposition.

The Company is a party tocertain legal actions arising in the ordinary course of business. While it isnot possible to determine with certainty the outcome of these matters, in theopinion of management the eventual resolution of these claims and actionsoutstanding will not have a material adverse effect on the Company’sconsolidated financial position, results of operations or liquidity.

**7. Equity**

On March 8, 2006, the Company completed a follow-onoffering of 2,425,000 shares of its common stock at $27.00 per share.  The Company also sold an additional 216,800shares of its common stock to cover over-allotments of shares.  The aggregate net proceeds to the Companyfrom the offering, after payment of all offering expenses and commissions, wereapproximately $66,282.  In addition, 3,510,700 shares, which includedan over-allotment of 585,700 shares, of its common stock were sold in theoffering by selling shareholders.  TheCompany received no proceeds from common stock sold by the selling shareholdersin the offering.

**8. Related Party**

Oneof the Company’s directors, Barry M. Abelson, is a partner in the law firm ofPepper Hamilton LLP. This firm has represented the Company since 1997. TheCompany paid Pepper Hamilton LLP, net of insurance coverage, $1,446 and $1,010for the nine months ended September 30, 2006 and 2005, respectively, for costsassociated with the Company’s follow-on offering, initial public offering andother general legal matters.

15

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**9. Acquisitions**

Gantz Wiley Research 

On August 14, 2006, the Company, through itswholly-owned subsidiary, Kenexa Technology, Inc., acquired all of theoutstanding stock of Gantz Wiley Research, an employee and customer researchfirm based in Minneapolis, Minnesota, for a purchase price of approximately$2,652 in cash and $3,170 in stock consideration.  The total cost of the acquisition, includingestimated legal, accounting, and other professional fees, was approximately$5,851.  In connection with theacquisition $600 of the cash portion of the purchase price was deposited intoan escrow account to cover any claims for indemnification made by the Companyagainst Gantz Wiley Research under the acquisition agreement.  The escrow agreement will remain in place forone year from the acquisition date, and any funds remaining in the escrowaccount at the end of the one year period will be distributed to thestockholder of Gantz Wiley Research.  Inaddition, the acquisition agreement with Gantz Wiley Research contains anearnout provision which provides for the payment of additional consideration bythe Company based upon the annual revenues of Gantz Wiley Research throughDecember 31, 2006.  Depending upon theresults, contingent consideration ranging from $300 to $1,300 may be due andpayable in cash and equity during the first quarter of 2007 to the formershareholder of Gantz Wiley Research.

KnowledgeWorkers

 On April 10,2006, the Company, through its wholly-owned subsidiary, KenexaTechnology, Inc., and Kenexa Acquisition Corp., a wholly-owned subsidiaryof Kenexa Technology, acquired all of the outstanding stock of KnowledgeWorkers, Inc., a human capital consulting and technology firm based in Denver,Colorado, for a purchase price of approximately $2,476 in cash.  The total cost of the acquisition, includingestimated legal, accounting, and other professional fees, was approximately$2,570.  In connection with theacquisition the Company deposited $100 into an escrow account to cover anyclaims for indemnification made by the Company against Knowledge Workers, Inc.under the acquisition agreement.  Theescrow agreement will remain in place for two years from the acquisition date. 

Webhire

On January 13, 2006, the Company, through itswholly-owned subsidiary, Kenexa Technology, Inc., and Kenexa AcquisitionCorp., a wholly-owned subsidiary of Kenexa Technology, completed itsacquisition of Webhire, Inc. (“Webhire”) for approximately $34,395 incash. The total cost of the acquisition, including legal, accounting, and otherprofessional fees of $636, was approximately $35,031. 

Approximately $5,000, or14.5% of the aggregate purchase price, remains deposited in an escrow accountto cover any claims for indemnification made by the Company against Webhireunder the acquisition agreement. Assuming there are no indemnification claims, this amount will bereleased to the former stockholders of Webhire on or about January 13,2007. 

Webhire’s results of operations were included in theCompany’s consolidated financial statements beginning on January 1, 2006.

The purchase price wasallocated as follows: 
| Description                                          | ** ** | **Amount** | ** ** | **Amortization  period** | ** ** |
|------------------------------------------------------|------------|------------|------------|--------------------------|------------|
| Assets acquired                                      |       |       |       |                     |       |
| Cash and short-term investments                      |       | $          | 2,793      |                     |       |   |
| Accounts receivable, net of allowance of $187        |       | 2,005      |       |                     |       |
| Prepaid expenses and other current assets            |       | 461        |       |                     |       |
| Property & equipment                             |       | 623        |       |                     |       |
| Other assets                                         |       | 209        |       |                     |       |
| Trademark/tradename, service marks & domain name |       | 20         |       | Indeterminable           |       |
| Customer Lists                                       |       | 1,031      |       | 22  years                |       |
| Internally developed software                        |       | 877        |       | 3  years                 |       |
| Goodwill                                             |       | 32,925     |       | Indeterminable           |       |
| Deferred income taxes                                |       | 1,525      |       | 15  years                |       |
|                                                 |       |       |       |                     |       |
| Less:  Liabilities assumed                           |       |       |       |                     |       |
| Notes payable                                        |       | 26         |       |                     |       |
| Capital lease obligations                            |       | 102        |       |                     |       |
| Accounts payable                                     |       | 294        |       |                     |       |
| Accrued expenses                                     |       | 1,549      |       |                     |       |
| Other liabilities                                    |       | 226        |       |                     |       |
| Deferred revenue                                     |       | 5,313      |       |                     |       |
| Total Cash  Purchase Price                           |       | $          | 34,959     |                     |       |   |

 

16

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The purchase price was allocated to the tangible andidentified intangible assets and the excess of the total purchase price overthe amounts assigned was recorded to goodwill. The estimated fair values of the intangibles assets are furtherdescribed below.  Customer lists,internally developed software, and net operating loss tax attributes are beingamortized over their estimated useful lives. Goodwill is not amortized but is periodically evaluated for impairment.

In accordance with Statement of Financial AccountingStandard No. 141 the purchase price allocation for Webhire has been updated toreflect additional transaction fees and additional information concerning ourdeferred income tax analysis since the acquisition.  The deferred income tax and correspondingvaluation allowance have been increased to reflect current estimates relatingto the utilization of the acquired NOL as well as any NOL limitations from theacquisition.  These adjustments and anyfuture adjustments to the deferred tax asset or corresponding NOL will beadjusted through the goodwill and recorded as part of the transaction.  The valuation of the net operating loss taxattributes of $1,525 was based upon the anticipated use of the present value ofcash flows from Webhire’s net operating losses. 

The valuation of customer lists in the amount of$1,031, which relates to Webhire’s current customer portfolio, was determinedbased upon estimated discounted incremental future cash flow to be received asa result of these relationships.

Goodwill from the acquisition resulted from our beliefthat the recruiter products developed by Webhire will be complementary to ourKenexa Recruiter product offerings and will help us remain competitive in thetalent acquisition market.  The goodwillfrom the Webhire acquisition will not be deductible for tax purposes.  

If the Webhireacquisition had occurred on January 1, 2005, the unaudited pro forma results ofoperations for the three and nine months ended September 30, 2005 would havebeen:
|                                                                |       | (in thousands)                                    |       |
|----------------------------------------------------------------|------------|--------------------------------------------------------|------------|
| ** **                                                     | ** ** | **Three months  ended  September 30,  2005** | ** ** | **Nine months  ended  September 30,  2005** | ** ** |
| Revenue                                                        |       | $                                                      | 20,210     |   | $ | 56,640 |   |
| Net loss  available to common shareholders – diluted      |       | 2,817                                                  |       | (37,714 | ) |
| Net loss per share  available to common shareholders - diluted |       | $                                                      | 0.16       |   | $ | (3.95 | ) |

 

**10. SubsequentEvents**

On October 6, 2006, the Company entered into anEquity Purchase Agreement and Agreement and Plan of Merger to acquire BrassRingInc. and BrassRing LLC.  The totalconsideration payable in the acquisition will be approximately $115,000,subject to closing adjustments for working capital.  The acquisition is subject to regulatoryapproval and the approval of BrassRing’s stockholders and other customaryclosing conditions.  The Company andBrassRing have made customary representations, warranties and covenants in theAgreement.  The Company expects tocomplete this acquisition in the fourth quarter of 2006.

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**Item 2: Management’sDiscussion and Analysis of Financial Condition and Results of Operations**

This QuarterlyReport on Form 10-Q, including the following Management’s Discussion andAnalysis of Financial Condition and Results of Operations, containsforward-looking statements within the meaning of Section 27A of the SecuritiesAct of 1933, as amended, Section 21E of the Securities Exchange Act of 1934, asamended, and the Private Securities Litigation Reform Act of 1995, that involvea number of risks and uncertainties. Such statements are based on currentexpectations of future events that involve a number of risks and uncertaintiesthat may cause the actual events to differ materially from those discussedherein. In addition, such forward-looking statements are necessarily dependentupon assumptions, estimates and dates that may be incorrect or imprecise andinvolve known and unknown risks and other factors. Accordingly, anyforward-looking statements included herein do not purport to be predictions offuture events or circumstances and may not be realized. Forward-lookingstatements can be identified by, among other things, the use of forward-lookingterminology such as “believes,” “expects,” “may,” “could,” “will,” “should,” “seeks,”“potential,” “anticipates,” “predicts,” “plans,” “estimates,” or “intends,” orthe negative of any thereof, or other variations thereon or comparableterminology, or by discussions of strategy or intentions. Given theseuncertainties, readers are cautioned not to place undue reliance on suchforward-looking statements. Forward-looking statements should be considered inlight of various important factors, including those set forth in this reportunder Part I, Item 1A “Risk Factors” in Kenexa Corporation’s Annual Report onForm 10-K for the year ended December 31, 2005 filed with the Securities andExchange Commission. All forward-looking statements, and reasons why resultsmay differ, that are included in this report are made as of the date of thisreport, and except as required by law, we disclaim any obligations to updateany such factors or to publicly announce the results of any revisions to any ofthe forward-looking statements contained herein or reasons why results mightdiffer to reflect future events or developments. References herein to “Kenexa,”“we,” “our,” and “us” collectively refer to Kenexa Corporation, a Pennsylvaniacorporation, and all of its direct and indirect U.S., U.K., Canada and Indiasubsidiaries. 

**1. Overview**

Weprovide software, services and proprietary content that enable organizations tomore effectively recruit and retain employees. Our solutions are built around asuite of easily configurable software applications that automate talentacquisition and employee performance management best practices. We offer thesoftware applications that form the core of our solutions on an on-demandbasis, which materially reduces the costs and risks associated with deployingtraditional enterprise applications. We complement our software applicationswith tailored combinations of outsourcing services, consulting services andproprietary content based on our 18 years of experience assisting clients inaddressing their human resource requirements. Together, our softwareapplications and services form solutions that we believe enable our clients toimprove the effectiveness of their talent acquisition programs, increaseemployee productivity and retention, measure key HR metrics and make theirtalent acquisition and employee performance management programs more efficient.

Since1999, we have focused on providing talent acquisition and employee performancemanagement solutions on a subscription basis and currently generate asignificant portion of our revenue from these subscriptions. For the ninemonths ended September 30, 2006 and 2005, revenue from these subscriptionscomprised approximately 80.2% and 76.5%, respectively, of our total revenue. Wegenerate the remainder of our revenue from discrete professional services thatare not provided as part of an integrated solution on a subscription basis.These subscription-based solutions provide us with a recurring revenue streamand we believe represent a more compelling opportunity in terms of growth andprofitability than discrete professional services.  As a result, since 1999 discrete professionalservices have represented a consistently decreasing percentage of ourrevenue.  We expect that trend tocontinue.

Wesell our solutions to large and medium-sized organizations through our directsales force.  As of December 31,2005, we had a client base of approximately 2,200 companies, includingapproximately 119 companies on the Fortune 500 list published inApril 2005. As a result of the acquisitions of Webhire, Inc.,Knowledge Workers and Gantz Wiley Research in 2006, we increased our clientbase to approximately 2,400 companies, including approximately 131 companies onthe Fortune 500 list published in April 2005. Our client base includescompanies that we billed for services during the year ended December 31,2005 and does not necessarily indicate an ongoing relationship with each suchclient. Our top 80 clients contributed approximately $50 million, or 64.0%, ofour total revenue for the nine months ended September 30, 2006.

**2. Recent Events**

OnJanuary 13, 2006, we acquired Webhire, Inc., a provider of end-to-end talentacquisition solutions for recruitment and human resource professionals inmiddle-market enterprises across all industries, for approximately $34.4million in cash. The total cost of the acquisition, including legal,accounting, and other professional fees of $0.6 million, was approximately$35.0 million.  The strategicrationale for acquiring Webhire included expanding our market opportunity andproduct suite, broadening our vertical market specialization and increasing ourcustomer base through cross-sales to Webhire’s customers.

18

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On March 8, 2006, we completed our follow-on publicoffering of 2,425,000 shares of our common stock at a price of $27.00 pershare.  We also sold an additional216,800 shares of our common stock to cover over-allotments of shares.  Our net proceeds from the offering, afterpayment of all offering expenses and commissions, aggregated approximately$66.3 million.  In addition, certain of our shareholders soldan aggregate of 3,510,700 shares of our common stock in the offering, includingan over-allotment of 585,700 shares.  Wereceived no proceeds from the common stock sold by the selling shareholders inthe offering.

On April 10, 2006, we acquired Knowledge Workers Inc.,a human capital consulting and technology firm based in Denver Colorado, forapproximately $2.5 million in cash.  Thetotal cost of the acquisition, including estimated legal, accounting, and otherprofessional fess, was approximately $2.6 million.

On August 14, 2006, we acquired Gantz Wiley Research,an employee and customer survey data analysis firm based in Minneapolis,Minnesota, for a purchase price of approximately $2.7 million in cash and $3.2million in stock consideration.  Thetotal cost of the acquisition, including estimated legal, accounting, and otherprofessional fees, was approximately $5.9 million.  In addition, our agreement with Gantz Wileycontains an earnout provision which provides for the payment of additional considerationby the Company based upon the annual revenues of Gantz Wiley Research throughDecember 31, 2006.  Depending upon theresults, contingent consideration ranging from $0.3 million to $1.3 million maybe due and payable in cash and equity during the first quarter of 2007 to theformer shareholder of Gantz Wiley.

On October 6, 2006, we entered into an EquityPurchase Agreement and Agreement and Plan of Merger to acquire BrassRing Inc.and BrassRing LLC.  The totalconsideration payable in the acquisition will be approximately $115 million ,subject to closing adjustments for working capital.  The acquisition is subject to regulatoryapproval and the approval of BrassRing’s stockholders and other customaryclosing conditions.  Both, Kenexa andBrassRing, have made customary representations, warranties and covenants in theAgreement.  We expect to complete thisacquisition in the fourth quarter of 2006.

**3. Sources ofRevenue**

Wederive revenue primarily from two sources: (1) subscription revenue for our solutions,which is comprised of subscription fees from clients accessing our on-demandsoftware, consulting services, outsourcing services and proprietary content,and from clients purchasing additional support that is not included in thebasic subscription fee; and (2) fees for discrete professional services.

Ourclients primarily purchase renewable subscriptions for our solutions. Thetypical term is one to three years, with some terms extending up to fiveyears.  The majority of our subscriptionagreements are not cancelable for convenience although our clients have theright to terminate their contracts for cause if we fail to provide the agreedupon services or otherwise breach the agreement. A client does not generallyhave a right to a refund of any advance payments if the contract is cancelled.We expect that we will maintain our renewal rate of approximately 90.0% of theaggregate contract value up for renewal for 2006, 2007 and 2008. The revenuederived from subscription fees is recognized ratably over the term of thesubscription agreement. We generally invoice our clients in advance in monthlyor quarterly installments and typical payment terms provide that our clientspay us within 30 days of invoice. Amounts that have been invoiced are recorded inaccounts receivable prior to the receipt of payment and in deferred revenue tothe extent revenue recognition criteria have not been met. As the subscriptioncomponent of our revenue has grown and clients’ willingness to pay us inadvance for their subscriptions has increased, the amount of deferred revenueon our balance sheet has grown at a higher rate than our revenue. As ofSeptember 30, 2006, deferred revenue increased to $18.8 million from $12.6million at December 31. 2005.  Wegenerally price our solutions based on the number of software applications andservices included and the number of client employees. Accordingly, subscriptionfees are generally greater for larger organizations and for those thatsubscribe for a broader array of software applications and services.

Asmall portion of our clients purchase discrete professional services. Theseservices primarily consist of consulting and training services. In addition, werecognize a small amount of revenue from sales of perpetual software licenses.The revenue from these services and licenses is recognized differentlydepending on the type of service or license provided as described in greaterdetail below under “Critical Accounting Policies and Estimates.” 

We generate substantially all of our revenue fromwithin the United States. For the nine months ended September 30, 2006,approximately 91.5% of our total revenue was derived from sales in the UnitedStates.  During the nine months endedSeptember 30, 2006, approximately 8.5%, of our total revenue was derived fromareas outside the United States. Other than the revenue that we generated fromclients in the Netherlands and the United Kingdom, which in the aggregateamounted to 4.7% of our total revenue for the nine months ended September 30,2006, and revenue that was generated from clients in Canada which amounted to2.5% for the nine months ended September 30, 2006, we did not have revenue fromany other country in excess of 1.0% of our total revenue for the nine monthsended September 30, 2006.

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**4. Key PerformanceIndicators**

The following tablessummarize the key performance indicators that we consider to be material inmanaging our business:
|                                                                | ** ** | **For the three months ended  September 30,** | ** ** | **For the nine months ended  September 30,** | ** ** |
|----------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                                                     | ** ** | **2006**                                                               | ** ** | **2005**                                                              | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                     | ** ** | **(unaudited)**                                                        | ** ** | **(unaudited)**                                                       | ** ** | **(unaudited)** | ** ** | **(unaudited)** | ** ** |
| Total Revenue                                                  |       | $                                                                      | 28,012     |                                                                  | $          | 17,234 |   | $ | 75,735 |   | $ | 47,571 |   |
| Subscription  revenue as a percentage of total revenue         |       | 82.8                                                                   | %          | 77.6                                                                  | %          | 80.2 | % | 76.5 | % |
| Income from  operations before income tax and interest expense |       | $                                                                      | 4,768      |                                                                  | $          | 2,586 |   | $ | 11,976 |   | $ | 6,726 |   |
|                                                           |       |                                                                   |       |                                                                  |       |   |   |   |   |
| Net cash  provided by operating activities                     |       | $                                                                      | 8,818      |                                                                  | $          | 8,412 |   | $ | 11,145 |   | $ | 11,372 |   |

 
|                  | ** ** | ** ** | ** ** | ** ** | ** ** | **As of September 30,** | ** ** |
|------------------|------------|------------|------------|------------|------------|-------------------------|------------|
| ** **       | ** ** | ** ** | ** ** | ** ** | ** ** | **2006**                | ** ** | **2005** | ** ** |
| ** **       | ** ** | ** ** | ** ** | ** ** | ** ** | **(unaudited)**         | ** ** | **(unaudited)** | ** ** |
| Deferred revenue |       |       |       |       |       | $                       | 18,759     |   | $ | 11,031 |   |
|                  |            |            |            |            |            |                         |            |  |  |  |  |

 

The following is adiscussion of some of the terms used in the tables above.

***Subscription revenue as a percentage of total revenue****.* Subscription revenue as a percentage oftotal revenue can be derived from our consolidated statement of operations.This performance indicator illustrates the evolution of our business towardssubscription-based solutions, which provide us with a recurring revenue streamand which we believe to be a more compelling revenue growth and profitabilityopportunity. We expect that the percentage of subscription revenue will be inthe range of 76-80% of our total revenues through at least 2007.

***Net cash provided by operating activities****.* Net cash provided by operatingactivities is taken from our consolidated statement of cash flows andrepresents the amount of cash generated by our operations that is available forinvesting and financing activities. Historically, our net cash provided byoperating activities has exceeded our net income primarily due to the positiveimpact of deferred revenue. We expect this trend to continue because of theadvance payment structure of our subscription agreements and because as oursales increase, we expect incremental costs to decline.

***Deferred revenue****.* We generate revenue primarily frommulti-year subscriptions for our on-demand talent acquisition and employeeperformance management solutions. We recognize revenue from these subscriptionagreements ratably over the term of the contract, which are typically one tothree years. We generally invoice our clients in quarterly or monthlyinstallments in advance. Deferred revenue, which is included in ourconsolidated balance sheets, is the amount of invoiced subscriptions in excessof the amount recognized as revenue. Deferred revenue represents, in part, theamount that we will record as revenue in our consolidated statements ofoperations in future periods. As the subscription component of our revenue hasgrown and customer willingness to pay us in advance for their subscriptions hasincreased, the amount of deferred revenue on our balance sheet has grown at ahigher rate than our revenue growth rate. We expect this trend to continue.

The following tablereconciles beginning and ending deferred revenue for each of the periodsshown:  
|                                                  | ** ** | **For the  year ended  December 31,** | ** ** | **For the  three months ended  September 30,** | ** ** | **For the  nine months ended  September 30,** | ** ** |
|--------------------------------------------------|------------|------------------------------------------------------|------------|--------------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                                       | ** ** | **2005**                                             | ** ** | **2006**                                                           | ** ** | **2005**                                                          | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                       | ** ** | ** **                                           | ** ** | **(unaudited)**                                                    | ** ** | **(unaudited)**                                                   | ** ** | **(unaudited)** | ** ** | **(unaudited)** | ** ** |
|                                             |       |                                                 |       |                                                               |       |                                                              |       |   |   |   |   |
| Deferred revenue at the  beginning of the period |       | $                                                    | 6,650      |                                                               | $          | 17,078                                                            |       | $ | 8,655 |   | $ | 12,558 |   | $ | 6,650 |   |
| Total invoiced  subscriptions during period      |       | 56,882                                               |       | 24,681                                                             |       | 15,753                                                            |       | 61,428 |   | 40,751 |   |
| Deferred revenue from  acquisition               |       | —                                               |       | 185                                                                |       | —                                                            |       | 5,498 |   | — |   |
| Subscription revenue  recognized during period   |       | (50,974                                              | )          | (23,185                                                            | )          | (13,377                                                           | )          | (60,725 | ) | (36,370 | ) |
| Deferred revenue at end of period                |       | $                                                    | 12,558     |                                                               | $          | 18,759                                                            |       | $ | 11,031 |   | $ | 18,759 |   | $ | 11,031 |   |

 

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**5. Results ofOperations**

**Three and ninemonths ended September 30, 2006 compared to three and nine months endedSeptember 30, 2005**

The following table sets forth for the periodsindicated, the amount and percentage of total revenues represented by certainitems reflected in our unaudited consolidated statements of operations: 

Kenexa CorporationUnaudited Consolidated Statement of Operations(In thousands)(Unaudited)
| ** **                                                          | ** ** | **For the  three months ended  September 30,** | ** ** | **For the  nine months ended  September 30,** | ** ** |
|---------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                                                          | ** ** | **2006**                                                           | ** ** | **2005**                                                          | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                          | ** ** | **Amount**                                                         | ** ** | **Percent of  Revenues**                                     | ** ** | **Amount** | ** ** | **Percent of  Revenues** | ** ** | **Amount** | ** ** | **Percent of  Revenues** | ** ** | **Amount** | ** ** | **Percent of  Revenues** | ** ** |
| Revenue:                                                            |       |                                                               |       |                                                              |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Subscription revenue                                                |       | $                                                                  | 23,185     |                                                              | 82.8       | % | $ | 13,377 |   | 77.6 | % | $ | 60,725 |   | 80.2 | % | $ | 36,370 |   | 76.5 | % |
| Other revenue                                                       |       | 4,827                                                              |       | 17.2                                                              | %          | 3,857 |   | 22.4 | % | 15,010 |   | 19.8 | % | 11,201 |   | 23.5 | % |
|                                                                |       |                                                               |       |                                                              |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Total revenue                                                       |       | 28,012                                                             |       | 100.0                                                             | %          | 17,234 |   | 100.0 | % | 75,735 |   | 100.0 | % | 47,571 |   | 100.0 | % |
| Cost of revenue                                                     |       | 8,392                                                              |       | 30.0                                                              | %          | 4,935 |   | 28.6 | % | 21,419 |   | 28.3 | % | 13,592 |   | 28.6 | % |
|                                                                |       |                                                               |       |                                                              |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Gross profit                                                        |       | 19,620                                                             |       | 70.0                                                              | %          | 12,299 |   | 71.4 | % | 54,316 |   | 71.7 | % | 33,979 |   | 71.4 | % |
|                                                                |       |                                                               |       |                                                              |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Operating expenses:                                                 |       |                                                               |       |                                                              |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Sales and marketing                                                 |       | 5,991                                                              |       | 21.4                                                              | %          | 4,218 |   | 24.5 | % | 17,436 |   | 23.0 | % | 11,748 |   | 24.7 | % |
| General and  administrative                                         |       | 5,771                                                              |       | 20.6                                                              | %          | 4,036 |   | 23.4 | % | 16,972 |   | 22.4 | % | 10,912 |   | 22.9 | % |
| Research and  development                                           |       | 2,218                                                              |       | 7.9                                                               | %          | 961 |   | 5.6 | % | 5,570 |   | 7.4 | % | 3,038 |   | 6.4 | % |
| Depreciation and  amortization                                      |       | 872                                                                |       | 3.1                                                               | %          | 498 |   | 2.9 | % | 2,362 |   | 3.1 | % | 1,555 |   | 3.3 | % |
|                                                                |       |                                                               |       |                                                              |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Total operating  expenses                                           |       | 14,852                                                             |       | 53.0                                                              | %          | 9,713 |   | 56.4 | % | 42,340 |   | 55.9 | % | 27,253 |   | 57.3 | % |
|                                                                |       |                                                               |       |                                                              |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Income from operations  before income tax and interest expense      |       | 4,768                                                              |       | 17.0                                                              | %          | 2,586 |   | 15.0 | % | 11,976 |   | 15.8 | % | 6,726 |   | 14.1 | % |
|                                                                |       |                                                               |       |                                                              |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest (income)  expense                                          |       | (764                                                               | )          | (2.7                                                              | )%         | (220 | ) | (1.3 | )% | (1,566 | ) | (2.1 | )% | (222 | ) | (0.5 | )% |
| Interest (income)  expense on mandatory redeemable preferred shares |       | 0                                                                  |       | 0                                                                 | %          | 0 |   | 0 | % | 0 |   | 0 | % | 3,396 |   | 7.1 | % |
|                                                                |       |                                                               |       |                                                              |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Income (loss) from operations  before income tax                    |       | 5,532                                                              |       | 19.7                                                              | %          | 2,806 |   | 16.3 | % | 13,542 |   | 17.9 | % | 3,552 |   | 7.5 | % |
| Income tax expense from  continuing operations                      |       | 1,373                                                              |       | 4.9                                                               | %          | 219 |   | 1.3 | % | 2,825 |   | 3.7 | % | 477 |   | 1.0 | % |
|                                                                |       |                                                               |       |                                                              |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net income (loss)                                                   |       | 4,159                                                              |       | 14.8                                                              | %          | 2,587 |   | 15.0 | % | 10,717 |   | 14.2 | % | 3,075 |   | 6.5 | % |
|                                                                |       |                                                               |       |                                                              |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Accretion of redeemable  class B common shares and C commons shares |       | 0                                                                  |       | 0                                                                 | %          | 0 |   | 0 | % | 0 |   | 0 | % | 41,488 |   | 87.2 | % |
| Net income (loss) available to common shareholders                  |       | $                                                                  | 4,159      |                                                              | 14.8       | % | $ | 2,587 |   | 15 | % | $ | 10,717 |   | 14.2 | % | $ | (38,413 | ) | (80.7 | )% |

 

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***Revenues***

Totalrevenue increased $10.8 million or 62.5% and $28.2 million or 59.2% to $28.0million and $75.7 million during the three and nine months ended September 30,2006, respectively compared to the same periods in 2005. Our subscriptionrevenue increased by $9.8 million or 73.3% and $24.4 million or 67.0% to $23.2million and $60.7 million during the three and nine months ended September 30,2006, respectively compared to the same periods in 2005. Subscription revenuerepresented approximately 82.8% and 80.2% of our revenues for three and ninemonths ended September 30, 2006, respectively. A portion of the increase insubscription revenues is attributable to our recent acquisitions of Webhire andGantz Wiley in our results. Our other revenue increased by $1.0 million or25.1% and $3.8 million or 34.0% to $4.8 million and $15.0 million for the threeand nine months ended September 30, 2006, respectively, compared to the sameperiods in 2005.  The year-to-dateincrease was due primarily to an increase in demand for our consulting servicesresulting from an increase in our subscription based revenues and the receiptof approximately $0.5 million of non-recurring “success” fees related tomeeting certain client-specific objectives. For the remainder of the year we expect subscription based and otherrevenue to increase from the prior year due to customer acquisitions andadditional sales to existing customers.

***Cost of Revenue***

Ourcost of revenue primarily consists of compensation, employee benefits andtravel-related expenses for our employees and independent contractors whoprovide consulting or other professional services to our clients. Additionally,our application hosting costs, amortization of third-party license royaltycosts, technical support personnel costs, allocated overhead and reimbursedexpenses are also recorded as cost of revenue. Many factors affect our cost ofrevenue, including changes in the mix of products and services, pricing trends,changes in the amount of reimbursed expenses and fluctuations in our clientbase. Because cost as a percentage of revenue is higher for professional servicesthan for software products, an increase in the services component of oursolutions or an increase in discrete professional services as a percentage ofour total revenue would reduce gross profit as a percentage of total revenue.As our business expands, we expect that third-party license royalty costs andpersonnel costs associated with the delivery of our solutions will continue tofall within a range of approximately 26% to 30% of revenues.

 Costof revenue increased by $3.5 million or 70.1% and $7.8 million or 57.6% to $8.4million and $21.4 million for the three and nine months ended September 30,2006, respectively, compared to the same periods in 2005. As a percentage ofrevenue, cost of revenue increased by 1.4% to 30.0% for the three months ended September30, 2006 and remained approximately the same at 28.3% for the nine months endedSeptember 30, 2006 compared to the same periods in 2005.  While the adoption of SFAS 123-R addedapproximately $0.1 million or 0.5% to our cost of revenue as a percentage ofrevenue, for the quarter ended September 30, 2006, the increase in cost ofrevenue as a percentage of revenue, after adjusting for non-cash compensationassociated with the adoption of SFAS 123R, was mostly due to an increase inconsulting salaries.

***Sales and Marketing (“S&M”) expense***

S&Mexpense primarily consists of personnel and related costs for employees engagedin sales and marketing, including salaries, commissions and other variablecompensation, travel expenses and costs associated with trade shows,advertising and other marketing efforts and allocated overhead. We expense oursales commissions at the time the related revenue is recognized, and werecognize revenue from our subscription agreements ratably over the term of theagreements. Investment in sales and marketing commencing in 2003 resulted insignificant revenue growth during 2004 and 2005. We intend to continue toinvest in sales and marketing to pursue new clients and expand relationshipswith existing clients. As a result, although we expect S&M expense toincrease, we also expect S&M to continue to decrease as a percentage ofrevenue for the next twelve months.

S&M expense increased $1.8 million or 42.0% and$5.7 million or 48.4% to $6.0 million and $17.4 million for the three and ninemonths ended September 30, 2006, respectively compared to the same periods in2005. Increased staff related and other compensation including performancebonuses and commissions contributed $1.0 million and $0.5 million,respectively, to the increase in S&M expense during the quarter endedSeptember 30, 2006 from the prior year. The increase in compensation and travelexpense was attributable primarily to 13 additional employees in S&M.  Additionally, $0.2 million in non-cash stockoption expense from our adoption of SFAS 123R in 2006 and increased travel expenseof $0.1 million also contributed to the increase in S&M expense for thequarter ended September 30, 2006 over the comparable period in the prior year.

For the nine months ended September 30, 2006,increased staff related expense and other compensation including performancebonuses and commissions contributed $3.5 million and $0.9 million respectively,to the increase in S&M expense from the prior year.  In addition, $0.5 million in non-cash stock optionexpense from our adoption of SFAS 123R in 2006, $0.5 million in travel expense,and $0.3 million of other expense also contributed to the increase in S&Mexpense for the nine months ended September 30, 2006 over the comparable periodin the prior year.  As a percentage ofrevenues, S&M expense decreased from 24.5% to 21.4%, and 24.7% to 23.0%,respectively, for the three and nine months ended September 30, 2006, comparedto the same periods in 2005 due to increased revenues.

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***General and Administrative (“G&A”) expense***

G&Aexpense primarily consists of personnel and related costs for our executive,finance, human resources and administrative personnel, professional fees andother corporate expenses and allocated overhead. As we expand our business andincur additional expenses associated with being a public company, including thecosts of compliance with the Sarbanes-Oxley Act of 2002 and other regulationsgoverning public companies, we believe that G&A expense will increase in dollaramount and may increase as a percentage of revenue in 2006 and future periods.

##### G&A expense increased by $1.7 million or43.0% and $6.1 million or 55.5% to $5.8 million and $17.0 million for the threeand nine months ended September 30, 2006, respectively, compared to the sameperiods in 2005. The $1.7 million increase for the quarter ended September 30,2006 was due primarily to an increase in salary expenses of $0.5 millionrelated to the addition of 15 employees.In addition, non-cash stock option expensefrom our adoption of SFAS 123R in 2006, rent expense, associated with ourrecent acquisitions, and professional fees contributed of $0.2 million, $0.4million and $0.3 million, respectively, to the increase in G&A expense forthe three months ended September 30, 2006 versus the comparable period in theprior year.  The remainder of the $0.3million increase was attributable to increases in infrastructure expenses suchas phone, supplies, utilities, insurance and other expenses.

The$6.1 million increase for the nine months ended September 30, 2006 was dueprimarily to an increase in staff related expense of $2.0 million related tothe addition of 15 employees from our Webhire acquisition.  In addition, non-cash stock option expensefrom our adoption of SFAS 123R in 2006, travel expense, rent expense andprofessional fees contributed of $0.9 million, $0.3 million $1.0 million and$0.9 million, respectively, to the increase in G&A expense for the ninemonths ended September 30, 2006 versus the comparable period in the prioryear.  The remainder of the increase of$1.0 million was attributable to increases in infrastructure expenses such asphone, supplies, utilities, insurance and other expense.  As a percentage of revenue, G&A expensedecreased from 23.4% to 20.6% for the three month ended September 30, 2006 and2005 and was approximately the same at 22.9% for the nine months endedSeptember 30, 2006 and 2005.

***Research and Development (“R&D”) expense***

R&Dexpense primarily consists of personnel and related costs, including salariesand employee benefits for software engineers, quality assurance engineers,product managers, technical sales engineers and management information systemspersonnel.  Our R&D efforts have beendevoted primarily to new product offerings and incidental enhancements andupgrades to our existing products. Historically, we have capitalized a small percentage of our R&Dexpense.  Capitalized R&D expensetotaled $0.5 million and $0.2 million for the nine months ended September 30,2006 and 2005, respectively. The remaining R&D expense has been expensed asincurred. We expect R&D expense to increase in the future as we employ morepersonnel to support enhancements of our solutions and new solutions offerings.However, we expect R&D expense to decrease as a percentage of revenueprimarily due to increased efficiencies from our global development center.

R&D expense increased $1.3 million or 130.8% to$2.2 million for the three months ended September 30, 2006 compared to the sameperiod in 2005.    For the nine monthsended September 30, 2006, R&D expense increased $2.5 million or 83.3% to$5.6 million.   The increase in R&Dfor the three and nine month period ended September 30, 2006 was due primarilyto the addition of 27 developers.  As apercentage of revenues, R&D expense increased from 5.6% to 7.9% and 6.4% to7.4%, for the three and nine months ended September 30, 2006, compared to thesame periods in 2005.

***Depreciation and Amortization***

Depreciationand amortization expense increased by $0.4 million and $0.8 million orapproximately 75.1% and 51.9% to $0.9 million and $2.4 million for the threeand nine months ended September 30, 2006, respectively compared to the sameperiods in 2005.  In the future, weexpect depreciation and amortization expense to increase due to recent capitalpurchases.

***Interestexpense income on mandatory redeemable shares***

Interest expense on mandatory redeemable shares of$3.4 million for the nine months ended September 30, 2005 was related to theredemption of class A and class B preferred shares upon the closing of theCompany’s initial public offering in June 2005. Because the Company redeemed all of its class A and class B preferredshares in its initial public offing, it no longer records any interest expenseon mandatory redeemable shares.

***Incometax expense on operations***

Income tax expense onoperations increased by $1.2 million and $2.3 million or approximately 500% forthe three and nine months ended September 30, 2006, respectively, compared tothe same periods in 2005.  The increasein expense was due to increased taxable income and the full utilization of ourfederal net operating loss carryforwards from the prior periods.

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**6.  Liquidity and Capital Resources**

Sincewe were formed in 1987, we have financed our operations primarily throughinternally generated cash flows, our line of credit and the issuance ofpreferred and common stock. As of September 30, 2006, we had cash and cashequivalents of $83.1 million and accounts receivable of $16.2 million. Inaddition, we had $0.6 million of debt and $0.3 million in capital equipmentleases.

Ourcash provided from operations was $11.1 million and $11.4 million for the ninemonths ended September 30, 2006 and 2005, respectively.  Cash used in investing activities was $40.1million and $3.0 million for the nine months ended September 30, 2006 and 2005,respectively.  Cash provided by financingactivities was $68.8 million and $21.3 million for the nine months endedSeptember 30, 2006 and 2005, respectively. Our net increase in cash and cash equivalents was $39.6 million for thenine months ended September 30, 2006, resulting primarily from our net proceedsof $66.3 million from our follow-on equity offering completed in March 2006,and our net increase in cash and cash equivalents was $29.6 million for thenine months ended September 30, 2005 resulting primarily from our net proceedsof $21.8 million from our initial public offering completed in September2005.   We expect positive cash flow tocontinue in future periods.

Wehave a $25 million revolving credit facility with PNC Bank, NationalAssociation that is collateralized by all of our assets, including a pledge ofcapital stock of certain of our subsidiaries.

OnJanuary 13, 2006, we acquired Webhire, Inc. for approximately $34.4 million incash. In addition, on that date we borrowed $25.0 million under our revolvingcredit facility.  We repaid all of ourborrowings under our revolving credit facility with a portion of the netproceeds from our follow-on equity offering in March 2006.

On April 10, 2006 we acquired all of the outstandingstock of Knowledge Workers Inc., a human capital consulting and technology firmbased in Denver Colorado, for a purchase price of approximately $2.5 million incash.  The total cost of the acquisition,including estimated legal, accounting, and other professional fees, wasapproximately $2.6 million.

On August 14, 2006 we acquired all of the outstandingstock of Gantz Wiley Research Consulting Group, Inc., an employee and customersurvey data analysis firm based in Minneapolis, MN, for a purchase price ofapproximately $5.8 million in cash and equity. The total cost of the acquisition, including estimated legal,accounting, and other professional fees, was approximately $5.9 million.  In addition, the acquisition agreementcontains an earnout provision which provides for the payment of additionalconsideration by the Company based upon the annual revenues of Gantz WileyResearch through December 31, 2006. Depending upon the results, contingent consideration ranging from $0.3million to $1.3 million may be due and payable in cash and equity during thefirst quarter of 2007 to the former shareholder of Gantz Wiley Research.

On October 6, 2006, we agreed to acquireBrassRing Inc. for approximately $115 million, subject to closing adjustmentsfor working capital.  We expect to fundthe purchase price for the acquisition through a combination of cash andborrowings under our revolving credit facility.   We expect to complete this acquisition inthe fourth quarter of 2006.

***Operating Activities***

Netcash provided by operating activities was $11.1 million and $11.4 million forthe nine months ended September 30, 2006 and 2005, respectively.  Net cash provided by operating activities forthe nine months ended September 30, 2006 resulted primarily from net income ofapproximately $10.7 million, non-cash charges to net income of $4.4 million,and other changes in working capital of $0.5 million, including a $1.1 millionreduction in taxes payable resulting from our adoption of FAS 123R in 2006partially offset by an increase in accounts and unbilled receivables of $4.5million.  Net cash provided by operatingactivities for the nine months ended September 30, 2005 resulted primarily fromnet income of approximately $3.1 million, non-cash charges to net income of$5.7 million, including $3.4 million of interest expense from the redeemablepreferred stock, an increase in deferred revenue of $4.3 million and changes inworking capital of 1.3 million partially offset by an increase in accounts andunbilled receivables of $3.0 million.

***Investing Activities***

Netcash used in investing activities was $40.1 million and $3.0 million for thenine months ended September 30, 2006 and 2005, respectively.  Cash flows from investing activities for thenine months ended September 30, 2006 and September 30, 2005 consisted of thefollowing:
|                                                          | ** ** | **Nine months September 30,** | ** ** |
|----------------------------------------------------------|------------|----------------------------------------------|------------|
| **In millions**                                     | ** ** | **2006**                                     | ** ** | **2005** | ** ** |
| Webhire  acquisition                                     |       | $                                            | 32.2       |   | — |   |
| Knowledge  Workers acquisition                           |       | $                                            | 2.2        |   | — |   |
| Gantz Wiley  Research acquisition                        |       | $                                            | 2.7        |   | — |   |
| Scottworks  acquisition                                  |       | —                                       |       | $ | 0.2 |   |
| Capitalized  software and purchases of computer hardware |       | $                                            | 3.0        |   | $ | 2.8 |   |
| Total Cash flows from  investing activities              |       | $                                            | 40.1       |   | $ | 3.0 |   |

 

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Inthe future, we expect our capital expenditures to increase as revenues increaseand business needs arise.

***Financing Activities***

Netcash provided by financing activities was $68.8 million and $21.3 million forthe nine months ended September 30, 2006 and 2005, respectively.  For the nine months ended September 30, 2006,net cash provided by financing activity consisted of net proceeds from ourfollow-on public offering of $66.3 million, net proceeds from stock optionexercises of $1.8 million and excess tax benefits from share-based paymentarrangements of $1.1 million, partially offset by the repayments of capitallease obligations of $0.3 million and deferred financing costs of $0.1million.   For the nine months endedSeptember 30, 2005, net cash provided by financing activity consisted of netproceeds from our initial public offering of $61.8 million and the collectionof notes receivable of $ 0.2 million offset by the redemption of our series Aand B preferred shares of $40.0 million, the repurchase of shares of our commonstock owned by certain of our former employees of $0.5 million and repaymentsof capital lease obligations of $0.2 million.

Webelieve that our cash and cash equivalent balances and cash flows fromoperations will be sufficient to satisfy our working capital and capitalexpenditure requirements for at least the next 12 months.  We intend to continue to invest our cash inexcess of current operating requirements in interest-bearing, investment-gradesecurities. Changes in our operating plans, lower than anticipated revenue,increased expenses or other events, may cause us to seek additional debt orequity financing. Financing may not be available on acceptable terms, or atall, and our failure to raise capital when needed could negatively impact ourgrowth plans and our financial condition and consolidated results ofoperations. Additional equity financing would be dilutive to the holders of ourcommon stock, and debt financing, if available, may involve significant cashpayment obligations and covenants or financial ratios that restrict our abilityto operate our business.

**CriticalAccounting Policies and Estimates**

Ourdiscussion and analysis of our financial condition and consolidated results ofoperations are based upon our consolidated financial statements, which havebeen prepared in accordance with generally accepted accounting principles inthe United States. The preparation of our consolidated financial statementsrequires us to make estimates and assumptions that affect the reported amountsof assets, liabilities, revenue and expenses and related disclosure ofcontingent assets and liabilities. On an on-going basis, we evaluate ourestimates, including those related to uncollectible accounts receivable andaccrued expenses. We base these estimates on historical experience and variousother assumptions that we believe to be reasonable under the circumstances, theresults of which form the basis for making judgments about the carrying valuesof assets and liabilities that are not readily apparent from other sources. Ouractual results may differ from these estimates.

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

***Revenue Recognition***

Wederive our revenue from two sources: (1) subscription revenues for solutions,which are comprised of subscription fees from clients accessing our on-demandsoftware, consulting services, outsourcing services and proprietary content,and from clients purchasing additional support beyond the standard support thatis included in the basic subscription fee; and (2) other fees for discreteprofessional services. Because we provide our solutions as a service, we followthe provisions of Securities and Exchange Commission Staff Accounting BulletinNo. 101,*Revenue Recognition in FinancialStatements,* as amended by Staff Accounting Bulletin No. 104,*Revenue Recognition.* On August 1, 2003,we adopted Emerging Issues Task Force Issue No. 00-21,*Revenue Arrangements with Multiple Deliverables.*We recognize revenue when all of the following conditions are met:

·                  Thereis persuasive evidence of an arrangement;

·                  Theservice has been provided to the client;

·                  Thecollection of the fees is probable; and

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

Subscription fees and support revenues are recognizedon a monthly basis over the terms of the contracts. Amounts that have beeninvoiced are recorded in accounts receivable and in deferred revenue orrevenue, depending on whether the revenue recognition criteria have been met.

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Discreteprofessional services, when sold with subscription and support offerings, areaccounted for separately since these services have value to the customer on astand-alone basis and there is objective and reliable evidence of fair value ofthe delivered elements. Our arrangements do not contain general rights ofreturn. Additionally, when professional services are sold with other elements,the consideration from the revenue arrangement is allocated among the separateelements based upon the relative fair value. Revenues from professionalservices are recognized as the services are rendered.

Indetermining whether revenues from professional services can be accounted forseparately from subscription revenue, we consider the following factors foreach agreement: availability of professional services from other vendors,whether objective and reliable evidence of the fair value exists of theundelivered elements, the nature and the timing of the agreement execution incomparison to the subscription agreement start date and the contractualdependence of the subscription service on the customer’s satisfaction with theother services. If the professional service does not qualify for separateaccounting, we recognize the revenue ratably over the remaining term of thesubscription contract. In these situations we defer the direct and incrementalcosts of the professional service over the same period as the revenue isrecognized.

Werecord out-of-pocket expenses incurred in accordance with EITF issue 01-14,Income Statement Characterization of Reimbursements Received for “Out-of-Pocket”Expenses Incurred, which requires that reimbursements received forout-of-pocket expenses be classified as revenue and not as cost reductions.Before the December 15, 2001 effective date of EITF Issue 01-14, out-of-pocketreimbursements from clients were netted with the applicable costs.  These items primarily include travel, mealsand certain telecommunication costs.

***Allowance for Doubtful Accounts***

Wemaintain an allowance for doubtful accounts for estimated losses resulting fromclients’ inability to pay us. The provision is based on our historicalexperience and for specific clients that, in our opinion, are likely to defaulton our receivables from them. In order to identify these clients, we performongoing reviews of all clients that have breached their payment terms, as wellas those that have filed for bankruptcy or for whom information has becomeavailable indicating a significant risk of non-recoverability. In addition, wehave experienced significant growth in number of clients, and we have lesspayment history to rely upon with these clients. We rely on historical trendsof bad debt as a percentage of total revenue and apply these percentages to theaccounts receivable associated with new clients and evaluate these clients overtime. To the extent that our future collections differ from our assumptionsbased on historical experience, the amount of our bad debt and allowancerecorded may be different.

***Capitalized Software Research and Development Costs***

Inaccordance with EITF Issue 00-3, “Application of AICPA Statement of Position97-2 to Arrangements That Include the Right to Use Software Stored on AnotherEntity’s Hardware,” we apply AICPA Statement of Position No. 98-1, Accountingfor the Costs of Computer Software Developed or Obtained for Internal Use. Thecosts incurred in the preliminary stages of development are expensed asincurred. Once an application has reached the development stage, internal andexternal costs, if direct and incremental, will be capitalized until thesoftware is substantially complete and ready for its intended use.Capitalization ceases upon completion of all substantial testing. We alsocapitalize costs related to specific upgrades and enhancements when it isprobable the expenditures will result in additional functionality. Maintenanceand training cost are expensed as incurred. Internal use software is amortized ona straight-line basis over its estimated useful life, generally three years.Management evaluates the useful lives of these assets on an annual basis andtests for impairments whenever events or changes in circumstances occur thatcould impact the recoverability of these assets. There were no impairments tointernal software in any of the periods covered in this report.

***Goodwill and Other Identified Intangible Asset Impairment***

OnJanuary 1, 2002, we adopted SFAS No. 142,*Goodwill and Other Intangible Assets* which superseded AccountingBoard Opinion No. 17,*Intangible Assets.*Upon adoption of SFAS No. 142, we ceased amortization of existing goodwill andare required to review the carrying value of goodwill for impairment. Ifgoodwill becomes impaired, some or all of the goodwill could be written off asa charge to operations. This comparison is performed annually or morefrequently if circumstances indicate that the carrying value may not berecoverable. We have reviewed the carrying values of goodwill of each businessunit by comparing the carrying values to the estimated fair values of thebusiness components. The fair value is based on management’s estimate of thefuture discounted cash flows to be generated by the respective businesscomponents and comparable company multiples. Such cash flows consider factorssuch as future operating income, historical trends, as well as demand andcompetition. Comparable company multiples are based upon public companies insectors relevant to our business based on our knowledge of the industry.Changes in the underlying business could affect these estimates, which in turncould affect the recoverability of goodwill. Through September 30, 2006, we have not observed any changes to ourbusiness units which would lead us to believe that our goodwill or otheridentified intangibles’ carrying value exceeds their fair values.

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***Accounting for Stock-Based Compensation***

We use aBlack-Scholes option-pricing model to calculate the fair value of our stockawards. The calculation of the fair value of the awards using the Black-Scholesoption-pricing model is affected by our stock price on the date of grant aswell as assumptions regarding the following:

·                  Volatilityis a measure of the amount by which the stock price is expected to fluctuateeach year during the expected life of the award and is based on a weightedaverage of peer companies, comparable indices and our stock volatility. Anincrease in the volatility would result in an increase in our expense.

·                  Theexpected term represents the period of time that awards granted are expected tobe outstanding and is currently based upon an average of the contractual lifeand the vesting period of the options. With the passage of time actualbehavioral patterns surrounding the expected term will replace the currentmethodology. Changes in the future exercise behavior of employees or in thevesting period of the award could result in a change in the expected term. Anincrease in the expected term would result in an increase to our expense.

·                  The risk-freeinterest rate is based on the U.S. Treasury yield curve in effect at time ofgrant. An increase in the risk-free interest rate would result in an increasein our expense.

 Stock-basedcompensation expense recognized during the period is based on the value of thenumber of awards that are expected to vest. In determining the stock-basedcompensation expense to be recognized, a forfeiture rate is applied to the fairvalue of the award. This rate represents the number of awards that are expectedto be forfeited prior to vesting and is based on Kenexa’s employee historicalbehavior. Changes in the future behavior of employees could impact this rate. Adecrease in this rate would result in an increase in our expense.

***Accounting for Income Taxes***

We accountfor income taxes in accordance with FASB Statement No. 109, “Accounting forIncome Taxes,” or SFAS 109, which requires that deferred tax assets andliabilities be recognized using enacted tax rates for the effect of temporarydifferences between the book and tax basis of recorded assets and liabilities.SFAS 109 also requires that deferred tax assets be reduced by a valuationallowance if it is more likely than not that some portion of all of thedeferred tax asset will not be realized.

Therealization of the deferred tax assets is evaluated quarterly by assessing thevaluation allowance and by adjusting the amount of the allowance, if necessary.The factors used to assess the likelihood of realization are the forecast offuture taxable income and available tax planning strategies that could beimplemented to realize the net deferred tax assets. We have used tax-planningstrategies to realize or renew net deferred tax assets in order to avoid thepotential loss of future tax benefits.

Inaddition, we operate within multiple taxing jurisdictions and are subject toaudit in each jurisdiction. These audits can involve complex issues that mayrequire an extended period of time to resolve. In our opinion, adequateprovisions for income taxes have been made for all periods.

***Self-Insurance***

Weare self-insured for the majority of our health insurance costs, includingclaims filed and claims incurred but not reported subject to certain stop lossprovisions. We estimate our liability based upon management’s judgment andhistorical experience. We also rely on the advice of consulting administratorsin determining an adequate liability for self-insurance claims. For the ninemonths ended September 30, 2006 our self-insurance accrual totaled $0.3million. We continuously review the adequacy of our insurance coverage.Material differences may result in the amount and timing of insurance expenseif actual experience differs significantly from management’s estimates.

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**Item 3:Quantitative and Qualitative Disclosures about Market Risk**

Marketrisk represents the risk of loss that may impact our financial position due toadverse changes in financial market prices and rates. Our market risk exposureis primarily a result of fluctuations in interest rates and foreign currency exchangerates. We do not hold or issue financial instruments for trading purposes.

***Foreign Currency Exchange Risk***

Forthe nine months ended September 30, 2006, approximately 91.5% of our totalrevenue was comprised of sales to clients in the United States. A key componentof our business strategy is to expand our international sales efforts, whichwill expose us to foreign currency exchange rate fluctuations. A 10% change inthe value of the U.S. dollar relative to each of the currencies of ournon-U.S-generated sales would not have resulted in a material change to ourresults. As of September 30, 2006, wewere not engaged in any foreign currency hedging activities.

Thefinancial position and operating results of our United Kingdom and Indiaoperations are consolidated using the local currency as the functionalcurrency. Local currency assets and liabilities are translated at the rate ofexchange to the U.S. dollar on the balance sheet date, and the local currencyrevenue and expenses are translated at average rates of exchange to the U.S.dollar during the period. The related translation adjustments was approximately$0.3 million at September 30, 2006, and is included in accumulated othercomprehensive income**.** The foreigncurrency translation adjustment is not adjusted for income taxes as it relatesto an indefinite investment in a non-U.S. subsidiary.

***Interest Rate Risk***

Theprimary objective of our investment activities is to preserve principal whilemaximizing income without significantly increasing risk. Some of the securitiesin which we invest may be subject to market risk. This means that a change inprevailing interest rates may cause the principal amount of the investment tofluctuate. To minimize this risk in the future, we intend to maintain our portfolioof cash equivalents and short-term investments in a variety of securities,including commercial paper, money market funds, government and non-governmentdebt securities and certificates of deposit. Our cash equivalents, whichconsist solely of money market funds, are not subject to market risk becausethe interest paid on these funds fluctuates with the prevailing interest rate.We do not believe that a 10% change in interest rates would have a significanteffect on our interest income.

**Item 4: Controlsand Procedures**

Under thesupervision of and with the participation of our management, including ourprincipal executive officer and principal financial officer, we conducted anevaluation of the effectiveness of the design and operation of our disclosurecontrols and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under theSecurities Exchange Act of 1934 as of the end of the period covered by thisreport, or the Evaluation Date. Based upon the evaluation, our principalexecutive officer and principal financial officer concluded that our disclosurecontrols and procedures were effective as of the Evaluation Date. Disclosurecontrols are controls and procedures designed to reasonably ensure thatinformation required to be disclosed in our reports filed under the ExchangeAct, such as this report, is recorded, processed, summarized and reportedwithin the time periods specified in the SEC’s rules and forms. Disclosurecontrols include controls and procedures designed to reasonably ensure thatsuch information is accumulated and communicated to our management, includingour chief executive officer and chief financial officer, as appropriate toallow timely decisions regarding required disclosure.

In connection withthis evaluation, our management identified no changes in our internal controlover financial reporting that occurred during the most recent fiscal quarterthat materially affected, or are reasonably likely to materially affect, ourinternal control over financial reporting.

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**PART II: OTHER INFORMATION**

**Item 1: LegalProceedings**

On January 27, 2006 the Company and Gallupsettled the outstanding claim and entered into a confidential settlementagreement. On January 30, 2006, the Court entered a consent order relatingto the settlement. The terms of the settlement will not have a material adverseeffect on our results of operations or financial position.

We are involved in claims, including those identifiedabove, which arise in the ordinary course of business. In the opinion ofmanagement, we have made adequate provision for potential liabilities, if any,arising from any such matters.  However,litigation is inherently unpredictable, and the costs and other effects ofpending or future litigation, governmental investigations, legal andadministrative cases and proceedings (whether civil or criminal), settlements,judgments and investigations, claims and changes in any such matters, anddevelopments or assertions by or against us relating to intellectual propertyrights and intellectual property licenses, could have a material adverse effecton our business, financial condition and operating results.

**Item 1A: RiskFactors**

In addition to the otherinformation set forth in this Form 10-Q, you should carefully consider thefactors discussed in Part I, Item 1A “Risk Factors” of our Annual Report onForm 10-K for the year ended December 31, 2005 which could materially affectour business, financial condition or future results of operations.  The risks described in our Annual Report onForm 10-K for the year ended December 31, 2005 are not the only risks that weface.  Additional risks and uncertaintiesnot currently known to us or that we currently deem to be immaterial may alsomaterially adversely affect our business, financial condition and futureresults of operations.  There have beenno material changes from the risk factors previously disclosed in Item IA ofour Annual Report on Form 10-K for the year ended December 31, 2005.

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

On August 14,2006, as partial consideration for the Company’s acquisition of all of theoutstanding stock of Gantz Wiley Research, the Company issued 138,837 shares ofthe Company’s common stock to the former sole shareholder of Gantz WileyResearch.  These shares were issuedwithout registration under the Securities Act of 1933, as amended, or thesecurities laws of certain states, in reliance on the exemptions provided bySection 4(2) of the Securities Act and similar exemptions under applicablestate laws.

For the nine months endedSeptember 2006, we issued the following number of shares of common stock uponthe “cashless exercise” of outstanding warrants.  We did not receive any proceeds from theexercise of these warrants.
| Period                     | ** ** | **Number of shares of common stock  issuable upon exercise of warrant** | ** ** | **Number of shares of common stock issued  upon “cashless exercise” of warrants** | ** ** |
|----------------------------|------------|----------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|
| January – March  2006 |       | 48,538.88                                                                                                            |       | 35,779                                                                                                                                        |       |
| April – June  2006    |       | 76,673.92                                                                                                            |       | 55,958                                                                                                                                        |       |
| July – September 2006 |       | 551,632.00                                                                                                           |       | 98,352                                                                                                                                        |       |

 

The term “cashlessexercise” refers to the surrender of a portion of a warrant as payment for theexercise price of the portion of the warrant exercised. No underwriters wereinvolved in the foregoing sales of securities. The sale of these securities wasexempt from registration under the Securities Act in reliance on Section 4(2)thereof or Regulation D promulgated thereunder relating to sales not involvinga public offering.

**Item 3: DefaultsUpon Senior Securities**

Notapplicable.

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**Item 4: Submissionof Matters to a Vote of Security Holders**

Notapplicable.

**Item 5: OtherInformation**

Notapplicable.

**Item 6: Exhibits**

The following exhibits are filed herewith:

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         CertificationFurnished Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 906of the Sarbanes-Oxley Act of 2002.

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**SIGNATURES**

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned, thereunto duly authorized.

November 10, 2006Kenexa 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*                           |
|          |                                                      |          |  |

** **

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**EXHIBIT INDEX**

Exhibit Number and Description

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

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

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

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