**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

 

**FORM10-Q**

 

ý       **QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For the quarterly period ended March 31, 2006**

 

o       **TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For the transition period from                      to                     **

 

**Commission File number 000-51358**

 

**KenexaCorporation**

(ExactName of Registrant as Specified in Its Charter)

 

| **Pennsylvania**                                                 |   | **23-3024013**                            |
|------------------------------------------------------------------|--------|-------------------------------------------|
| (State  or other jurisdiction of  incorporation or organization) |   | (I.R.S.  Employer  Identification Number) |

 

| **650 East Swedesford Road**              |       |        |
|-------------------------------------------|------------|-------------|
| **Wayne, PA**                             | ** ** | **19087**   |
| (Address  of Principal Executive Offices) |       | (Zip  Code) |

 

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

 

Indicate by check markwhether the registrant: (1) has filed all reports required to be filed bySection 13 or 15 (d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.

Yes  ý   No  o

 

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer , ora non-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act.

Yes  o   No  ý

 

| Large accelerated  filer  o |   | Accelerated  filer  o |   | Non-accelerated  filer  ý |
|---------------------------------------|--------|---------------------------------|--------|------------------------------------------|

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).

Yes  o   No  ý

 

On May 11, 2006, 20,246,165shares of the registrant’s Common Stock, $0.01 par value, were outstanding.

 

 

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**Kenexa Corporation and Subsidiaries**

**FORM 10-Q**

**Quarter Ended March 31, 2006**

**Table of Contents**

 
| PART I: FINANCIAL  INFORMATION |                                                                                             |
|--------------------------------|--------------------------------------------------------------------------------------------------|
|                           | Item 1: Financial  Statements (unaudited)                                                        |   |
|                           |                                                                                             | Consolidated Balance  sheets as of March 31, 2006 and December 31, 2005 |   |
|                           |                                                                                             | Consolidated  Statements of Operations for the three months ended March 31, 2006 and 2005 |   |
|                           |                                                                                             | Consolidated  Statements of Cash Flows for the three months ended March 31, 2006 and 2005 |   |
|                           |                                                                                             | Notes to  Consolidated Financial Statements |   |
|                           |                                                                                             |   | 1. Organization |   |
|                           |                                                                                             |   | 2. Summary of  Significant Accounting Policies |   |
|                           |                                                                                             |   | 3. Property,  Equipment and Software |   |
|                           |                                                                                             |   | 4. Other Accrued  Liabilities |   |
|                           |                                                                                             |   | 5. Line of Credit |   |
|                           |                                                                                             |   | 6. Commitments and  Contingencies |   |
|                           |                                                                                             |   | 7. Equity |   |
|                           |                                                                                             |   | 8. Related Party |   |
|                           |                                                                                             |   | 9. Acquisition |   |
|                           | Item  2: Management’s Discussion and Analysis of Financial Concern and Risks of  Operations |   |
|                           |                                                                                             |   | 1.Overview |   |
|                           |                                                                                             |   | 2. Recent Events |   |
|                           |                                                                                             |   | 3. Sources of  Revenue |   |
|                           |                                                                                             |   | 4. Key  Performance Indicators |   |
|                           |                                                                                             |   | 5. Results of  Operations: |   |
|                           |                                                                                             |   | Three  months ended March 31, 2006 compared to three months ended March 31, 2005 |   |
|                           |                                                                                             |   | 6.  Liquidity and Capital Resources |   |
|                           | Item  3: Quantitative and Qualitative Disclosures about Market Research                          |   |
|                           | Item 4:  Controls and Procedures                                                                 |   |
| PART 2:  OTHER INFORMATION     |                                                                                             |
|                           | Item 1:  Legal Proceedings                                                                       |   |
|                           | Item  2: Unregistered Sales of Equity Securities and Use of proceeds                             |   |
|                           | Item  3: Defaults upon senior Securities                                                         |   |
|                           | Item  4: Submission of matters to a vote of security holders                                     |   |
|                           | Item 5:  Other Information                                                                       |   |
|                           | Item 6: Exhibits                                                                                 |   |
| Signatures                     |                                                                                             |
| Exhibit Index                  |                                                                                             |

 

2

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**PART I FINANCIAL INFORMATION**

 

**Item 1:Financial Statements**

 

**Kenexa Corporation and Subsidiaries**

**CONSOLIDATED BALANCE SHEETS**

(Inthousands, except share and per share data)

(Unaudited)

 
| ** **                                                                                                           | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|----------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| **Assets**                                                                                                           |       |                     |       |                        |       |
| Current assets                                                                                                       |       |                     |       |                        |       |
| Cash and cash equivalents                                                                                            |       | $                        | 79,481     |                        | $          | 43,499 |   |
| Accounts receivable, net of allowance for  doubtful accounts of $526 and $447                                        |       | 12,188                   |       | 10,306                      |       |
| Unbilled receivables                                                                                                 |       | 775                      |       | 312                         |       |
| Deferred income taxes                                                                                                |       | 8,129                    |       | 2,519                       |       |
| Prepaid expenses and other current assets                                                                            |       | 3,173                    |       | 2,134                       |       |
| **Total current assets**                                                                                             |       | 103,746                  |       | 58,770                      |       |
| Property and equipment, net of accumulated  depreciation                                                             |       | 5,871                    |       | 4,737                       |       |
| Software, net of accumulated depreciation                                                                            |       | 1,451                    |       | 850                         |       |
| Goodwill                                                                                                             |       | 38,358                   |       | 8,815                       |       |
| Intangible assets, net of accumulated  amortization                                                                  |       | 1,154                    |       | 125                         |       |
| Deferred financing costs, net of  accumulated amortization                                                           |       | 137                      |       | 50                          |       |
| Other assets                                                                                                         |       | 673                      |       | 552                         |       |
| **Total assets**                                                                                                     |       | $                        | 151,390    |                        | $          | 73,899 |   |
|                                                                                                                 |       |                     |       |                        |       |
| **Liabilities and Shareholders’ Equity**                                                                        |       |                     |       |                        |       |
| Current liabilities                                                                                                  |       |                     |       |                        |       |
| Accounts payable                                                                                                     |       | $                        | 2,966      |                        | $          | 2,306 |   |
| Notes payable, current                                                                                               |       | 96                       |       | 95                          |       |
| Commissions payable                                                                                                  |       | 928                      |       | 834                         |       |
| Other accrued liabilities                                                                                            |       | 3,229                    |       | 2,177                       |       |
| Accrued compensation and benefits                                                                                    |       | 4,876                    |       | 4,590                       |       |
| Deferred revenue                                                                                                     |       | 16,164                   |       | 12,588                      |       |
| Capital lease obligations                                                                                            |       | 268                      |       | 219                         |       |
| **Total current liabilities**                                                                                        |       | 28,527                   |       | 22,809                      |       |
| Capital lease obligations, less current  portion                                                                     |       | 179                      |       | 185                         |       |
| Notes payable, less current portion                                                                                  |       | 84                       |       | 108                         |       |
| Other liabilities                                                                                                    |       | 43                       |       | 55                          |       |
| **Total liabilities**                                                                                                |       | 28,833                   |       | 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; 20,200,126 and 17,459,044 shares issued, respectively |       | 202                      |       | 174                         |       |
| Additional paid-in capital                                                                                           |       | 164,623                  |       | 97,140                      |       |
| Deferred compensation                                                                                                |       | —                   |       | (1,040                      | )          |
| Notes receivable for common stock                                                                                    |       | (90                      | )          | (120                        | )          |
| Accumulated other comprehensive loss                                                                                 |       | (75                      | )          | (30                         | )          |
| Accumulated deficit                                                                                                  |       | (42,103                  | )          | (45,382                     | )          |
| **Total shareholders’ equity**                                                                                  |       | 122,557                  |       | 50,742                      |       |
| **Total liabilities and shareholders’ equity**                                                                  |       | $                        | 151,390    |                        | $          | 73,899 |   |

 

*See accompanying notes to consolidated financial statements.*

 

3

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**Kenexa Corporation and Subsidiaries**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

(Inthousands, except share and per share data)

(Unaudited)

 
| ** **                                                                                                      | ** ** | **March 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|
| ** **                                                                                                      | ** ** | **2006**           | ** ** | **2005** | ** ** |
| Revenue                                                                                                         |       |               |       |   |   |
| Subscription revenue                                                                                            |       | $                  | 17,593     |   | $ | 10,871 |   |
| Other revenue                                                                                                   |       | 5,422              |       | 3,461 |   |
| Total revenue                                                                                                   |       | 23,015             |       | 14,332 |   |
| Cost of revenue (exclusive of depreciation,  shown separately below)                                            |       | 6,354              |       | 4,060 |   |
| Gross profit                                                                                                    |       | 16,661             |       | 10,272 |   |
| Operating expenses:                                                                                             |       |               |       |   |   |
| Sales and marketing                                                                                             |       | 5,728              |       | 3,603 |   |
| General and administrative                                                                                      |       | 5,287              |       | 3,313 |   |
| Research and development                                                                                        |       | 1,536              |       | 1,120 |   |
| Depreciation and amortization                                                                                   |       | 722                |       | 552 |   |
| Total operating expenses                                                                                        |       | 13,273             |       | 8,588 |   |
|                                                                                                            |       |               |       |   |   |
| Income from operations before income taxes  and interest expense                                                |       | 3,388              |       | 1,684 |   |
| Interest (income) expense                                                                                       |       | (120               | )          | 12 |   |
| Interest on mandatory redeemable shares                                                                         |       | —             |       | 8,534 |   |
| Income (loss) from operations before income  tax                                                                |       | 3,508              |       | (6,862 | ) |
| Income tax expense on operations                                                                                |       | 229                |       | 40 |   |
| Net income (loss)                                                                                               |       | $                  | 3,279      |   | $ | (6,902 | ) |
| Accretion of redeemable class B common  shares and class C common shares                                        |       | —             |       | 2,797 |   |
| Net income (loss) available to common  shareholders                                                             |       | $                  | 3,279      |   | $ | (9,699 | ) |
|                                                                                                            |       |               |       |   |   |
| Basic net income (loss) per share to common  shareholders                                                       |       | $                  | 0.18       |   | $ | (1.88 | ) |
| Weighted average shares used to compute net  income (loss) to common shareholders per common share – basic |       | 18,217,945         |       | 5,169,870 |   |
|                                                                                                            |       |               |       |   |   |
| Diluted net income (loss) per share to  common shareholders                                                     |       | $                  | 0.17       |   | $ | (1.88 | ) |
| Weighted average shares used to compute net  loss available to common shareholders per common share - diluted   |       | 18,952,231         |       | 5,169,870 |   |

 

*See accompanying notes to consolidated financial statements*.

 

4

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 **KenexaCorporation and Subsidiaries**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

(Inthousands)

(Unaudited)

 
| ** **                                                                               | ** ** | **Three Months ended  March 31,** | ** ** |
|------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                               | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
|                                                                                     |       |                                             |       |   |   |
| **Cash flows from operating activities**                                                 |       |                                             |       |   |   |
| Net income (loss)                                                                        |       | $                                                | 3,279      |   | $ | (6,902 | ) |
| Adjustments to reconcile net income (loss)  to net cash provided by operating activities |       |                                             |       |   |   |
| Depreciation and amortization                                                            |       | 722                                              |       | 562 |   |
| Share-based compensation                                                                 |       | 572                                              |       | 158 |   |
| Excess tax benefits from share-based  payment arrangements                               |       | (361                                             | )          | — |   |
| Amortization of deferred financing fees                                                  |       | 32                                               |       | 22 |   |
| Bad debt expense                                                                         |       | 4                                                |       | 34 |   |
| Accrued interest on mandatory redeemable  preferred stock                                |       | —                                           |       | 8,534 |   |
| Deferred taxes                                                                           |       | (937                                             | )          | — |   |
| Changes in assets and liabilities                                                        |       |                                             |       |   |   |
| Accounts and unbilled receivables                                                        |       | (241                                             | )          | (105 | ) |
| Prepaid expenses and other current assets                                                |       | (588                                             | )          | (55 | ) |
| Other assets                                                                             |       | 87                                               |       | 15 |   |
| Accounts payable                                                                         |       | (42                                              | )          | (673 | ) |
| Accrued compensation and other accrued  liabilities                                      |       | 29                                               |       | 63 |   |
| Commissions payable                                                                      |       | 94                                               |       | 136 |   |
| Deferred revenue                                                                         |       | (1,737                                           | )          | (1,078 | ) |
| Other liabilities                                                                        |       | (11                                              | )          | 39 |   |
| **Net cash provided by operating activities**                                            |       | 902                                              |       | 750 |   |
| ** **                                                                               |       |                                             |       |   |   |
| **Cash flows from investing activities**                                                 |       |                                             |       |   |   |
| Purchases of property and equipment                                                      |       | (879                                             | )          | (328 | ) |
| Acquisition, net of cash acquired                                                        |       | (32,069                                          | )          | — |   |
| **Net cash used in investing activities**                                                |       | (32,948                                          | )          | (328 | ) |
| ** **                                                                               |       |                                             |       |   |   |
| **Cash flows from financing activities**                                                 |       |                                             |       |   |   |
| Repayments of notes payable                                                              |       | (49                                              | )          | — |   |
| Repurchase of common shares                                                              |       | —                                           |       | (515 | ) |
| Collections of notes receivable                                                          |       | 30                                               |       | — |   |
| Excess tax benefits from share-based  payment arrangements                               |       | 361                                              |       | — |   |
| IPO Costs                                                                                |       | —                                           |       | (157 | ) |
| Net proceeds from follow-on offering of  common stock                                    |       | 67,333                                           |       | — |   |
| Deferred financing costs                                                                 |       | (119                                             | )          | (13 | ) |
| Net proceeds from option exercises                                                       |       | 694                                              |       | — |   |
| Repayments of capital lease obligations                                                  |       | (174                                             | )          | (75 | ) |
| **Net cash (used in) provided by financing activities**                                  |       | 68,076                                           |       | (760 | ) |
|                                                                                     |       |                                             |       |   |   |
| Effect of exchange rate changes on cash and  cash equivalents                            |       | (48                                              | )          | — |   |
| Net increase (decrease) in cash and cash  equivalents                                    |       | 35,982                                           |       | (338 | ) |
| Cash and cash equivalents at beginning of  year                                          |       | 43,499                                           |       | 9,494 |   |
|                                                                                     |       |                                             |       |   |   |
| **Cash and cash equivalents at end of year**                                             |       | $                                                | 79,481     |   | $ | 9,156 |   |

 

*See accompanying notes to consolidated financial statements.*

 

5

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| ** **                                                                      | ** ** | **Three Months ended  March 31,** | ** ** |
|---------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                      | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
|                                                                            |       |                                             |       |   |   |
| **Supplemental disclosures of cash flow  information**                          |       |                                             |       |   |   |
|                                                                            |       |                                             |       |   |   |
| Cash paid during the year for:                                                  |       |                                             |       |   |   |
| Interest expense                                                                |       | $                                                | 344        |   | $ | 20 |   |
| Income taxes                                                                    |       | $                                                | 965        |   | $ | 90 |   |
|                                                                            |       |                                             |       |   |   |
| **Non-cash investing and financing activities**                                 |       |                                             |       |   |   |
| Capital lease obligations                                                       |       | $                                                | 56         |   | $ | — |   |
| Notes receivable applied to accrued bonus                                       |       | —                                           |       | $ | 151 |   |
| Accretion of class B common stock and class  C common stock to redemption value |       | —                                           |       | $ | 2,797 |   |

 

*See accompanying notes to consolidated financial statements.*

 

6

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**Kenexa Corporation and Subsidiaries**

 

**NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS(unaudited)**

 

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

 

**1.Organization**

 

Kenexa Corporation and itssubsidiaries (collectively the “Company”) commenced operations in 1987 as aprovider of recruiting services to a wide variety of industries. In 1993, theCompany offered its first automated talent management system. Between 1994 and1998, the Company acquired 15 businesses that enabled it to offer comprehensivehuman capital management, or HCM, services integrated with web-basedtechnology.

 

The Company began itsoperations in 1987 under its predecessor companies, InsuranceServices, Inc., or ISI, and International Holding Company, Inc., orIHC. 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 Karsan Holdings, Inc.,or RKH, a Pennsylvania corporation. Each of RKA and RKH were newly created toconsolidate the businesses of ISI and IHC. In April 2000, the Companychanged its name to TalentPoint, Inc. and changed the name of RKA toTalentPoint Technologies, Inc. In November 2000, the Company changedits name to Kenexa Corporation, and changed the name of TalentPointTechnologies, Inc. to Kenexa Technology, Inc., or Kenexa Technology.Currently, Kenexa transacts business primarily through Kenexa Technology. TheCompany operates in one segment.

 

**2. Summaryof Significant Accounting Policies**

 

The accompanying financialstatements for the three months ended March 31, 2006 and 2005 have beenprepared by the Company without audit. In the opinion of management, alladjustments (which include only normal recurring adjustments) necessary topresent fairly the financial position and the results of operations and cashflows for the three months ended March 31, 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 threemonths ended March 31, 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**

 

The consolidated financialstatements of the Company include the accounts of Kenexa Corporation and itssubsidiaries. All significant intercompany accounts and transactions have beeneliminated in consolidation.

 

**Cash andCash Equivalents**

 

Cash and cash equivalentsconsist of highly liquid investments with remaining maturities of three monthsor less at the time of purchase.

 

**Prepaid Expensesand Other Assets**

 

Prepaid expenses and othercurrent assets consist primarily of prepaid software maintenance agreements,deferred implementation costs, insurance, taxes and other current assets.Deferred implementation costs represent internal payroll and other costsincurred in connection with the customization of the sites associated with theinternet hosting arrangements. These costs are deferred over the implementationperiod, typically three to four months, and are expensed ratably over the subscriptionperiod, typically one to three years. These amounts aggregated $1,089 and$1,004 at December 31, 2005 and March 31, 2006, respectively. The currentportion of these deferred costs of $979 and $876 at December 31, 2005 and March31, 2006, respectively, and are included in other current assets. Thenoncurrent portion of $110 and $128 at December 31, 2005 and March 31, 2006,respectively, are included in other assets in the accompanying consolidatedbalance sheets.

 

7

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**SoftwareDeveloped for Service Transactions**

 

In accordance with EITF00-3, “Application of AICPA Statement of Position 97-2 to Arrangements ThatInclude the Right to Use Software Stored on Another Entity’s Hardware”, theCompany applies AICPA Statement of Position No. 98-1,*Accounting for the Costs of Computer Software Developed or Obtainedfor Internal Use*. The costs incurred in the preliminary stages ofdevelopment are expensed as incurred. Once an application has reached thedevelopment stage, internal and external costs, if direct and incremental, willbe capitalized until the software is substantially complete and ready for itsintended use. Capitalization ceases upon completion of all substantial testing.The Company also capitalizes costs related to specific upgrades andenhancements when it is probable the expenditures will result in additionalfunctionality. Maintenance and training costs are expensed as incurred.Internal use software is amortized on a straight-line basis over its estimateduseful life, generally three years. Management evaluates the useful lives ofthese assets on an annual basis and tests for impairments whenever events orchanges in circumstances occur that could impact the recoverability of theseassets. There were no impairments to internal software in any of the periodscovered in this report.

 

The Company capitalizedsoftware costs for the three months ended March 31, 2006 of $1,253. Amortizationof capitalized internal-use software costs for the three months ended March 31,2006 was $276.

 

**RevenueRecognition**

 

The Company derives itsrevenue from two sources: (1) subscription revenue for solutions, which iscomprised of subscription fees from clients accessing our on-demand software,consulting services, outsourcing services and proprietary content, and fromclients purchasing additional support beyond the standard support that isincluded in the basic subscription fee; and (2) other fees for discreteprofessional services. Because the Company provides its solutions as a service,the Company follows the provisions of Securities and Exchange Commission StaffAccounting Bulletin No. 101,*RevenueRecognition in Financial Statements,* as amended by Staff AccountingBulletin No. 104,*Revenue Recognition.*On August 1, 2003, the Company adopted Emerging Issues Task Force Issue No.00-21,*Revenue Arrangements with MultipleDeliverables.* The Company recognizes revenue when all of thefollowing 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.

 

Subscription fees andsupport revenues are recognized on a monthly basis over the terms of the contracts.Amounts that have been invoiced are recorded in accounts receivable and indeferred revenue or revenue, depending on whether the revenue recognitioncriteria have been met.

 

Discrete professionalservices and other revenues, when sold with subscription and support offerings,are accounted for separately since these services have value to the customer ona stand-alone basis and there is objective and reliable evidence of fair valueof the delivered elements. The Company’s arrangements do not contain generalrights of return. Additionally, when professional services are sold with otherelements, the consideration from the revenue arrangement is allocated among theseparate elements based upon the relative fair value. Professional services andother revenues are recorded as follows: Consulting revenues are recognized uponcompletion of the contracts that are of short duration (generally less than 60days) and as the services are rendered for contracts of longer duration.

 

In determining whetherrevenues from professional services can be accounted for separately fromsubscription revenue, the Company considers the following factors for eachagreement: availability from other vendors, whether objective and reliableevidence of fair value exists of the undelivered elements, the nature and thetiming of when the agreement was signed in comparison to the subscriptionagreement start date and the contractual

 

8

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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.

 

Deferred revenue representspayments received or accounts receivable from the Company’s clients for amountsbilled in advance of subscription services being provided.

 

The Company records ‘*Out-of-Pocket’ Expenses Incurred* (“EITF01-14”), which requires that reimbursements received for out-of-pocket expensesbe classified as revenues and not as cost reductions. Before the December 15,2001 effective date of EITF 01-14, out-of-pocket reimbursements from clientswere netted with the applicable costs. These items primarily include travel,meals and certain telecommunication costs. For the three months ended March 31,2006, reimbursed expenses totaled $264.

 

**Self-Insurance**

 

The Company is self-insuredfor the majority of its health insurance costs, including claims filed andclaims incurred but not reported subject to certain stop loss provisions. TheCompany estimated the liability based upon management’s judgment and historicalexperience. At December 31, 2005 and March 31, 2006, self-insurance accrualstotaled $190 and $303, respectively. Management continuously reviews theadequacy of the Company’s stop loss insurance coverage. Material differencesmay result in the amount and timing of insurance expense if actual experiencediffers significantly from management’s estimates.

 

**Concentrationof Credit Risk**

 

Financial instruments whichpotentially expose the Company to concentration of credit risk consist primarilyof accounts receivable. Credit risk arising from receivables is mitigated dueto the large number of clients comprising the Company’s client base and theirdispersion across various industries. The clients are concentrated primarily inthe Company’s U.S. market area. At March 31, 2006, there were no clients thatrepresented more than 10% of the net accounts receivable balance. There were noclients that individually exceeded 10% of the Company’s revenues.

 

Cash balances are maintainedat several banks. Accounts located in the United States are insured by theFederal Deposit Insurance Corporation (“FDIC”) up to $100,000. Certainoperating cash accounts may exceed the FDIC limits.

 

**RecentAccounting Pronouncements**

 

In May 2005, FASB issuedSFAS 154, “Accounting Changes and Error Corrections—a replacement of APBOpinion No. 20 and FASB Statement No. 3”. SFAS 154 changes the requirements forthe accounting for and reporting of a change in accounting principle, andapplies to all voluntary changes in accounting principle. It also applies tochanges required by an accounting pronouncement in the unusual instance thatthe pronouncement does not include specific transition provisions. Thisstatement requires retrospective application to prior periods’ financial statementsof changes in accounting principle, unless it is impracticable to determineeither the period-specific effects or the cumulative effect of the change. SFAS154 is effective for accounting changes made in fiscal years beginning afterDecember 15, 2005. We do not expect that adoption of this statement will have amaterial impact on our results of operations or financial condition

 

In March 2005, the FinancialAccounting Standards Board (the FASB) issued Interpretation No. 47, *Accounting for Conditional Asset RetirementObligations*, an interpretation of SFAS No. 143, *Accounting for Asset Retirement Obligations*.This Interpretation clarifies that an entity is required to recognize aliability for the fair value of a conditional asset retirement obligation whenincurred if the liability’s fair value can be reasonably estimated. Theprovisions of this pronouncement are effective for fiscal years ending afterDecember 15, 2005. The Company does not expect the adoption of InterpretationNo. 47 to have any material financial statement impact.

 

9

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In December 2004, the FASBissued Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-BasedPayment” (SFAS 123R). SFAS 123R requires that the cost resulting from allshare-based payment transactions be recognized in the financial statements.SFAS 123R also establishes fair value as the measurement method in accountingfor share-based payments. The FASB required the provisions of SFAS 123R be adoptedfor interim or annual periods beginning after June 15, 2005. In April 2005, theSEC adopted a new rule amending the compliance dates for SFAS 123R for publiccompanies. In accordance with this rule, we adopted SFAS 123R effective January1, 2006 using the modified prospective transition method. We did not modify theterms of any previously granted options in anticipation of the adoption of SFAS123R.

 

We expect the application ofthe expensing provisions of SFAS 123R will result in a pretax expense of approximately$2.3 million in 2006. Based on the same assumptions used to value our 2006compensation expense, we estimate our pretax expense associated with ourstock-based compensation plans will approximate $2.1 million in 2007 and $1.5million in 2008.

 

In November 2005, theFASB issued FSP FAS 123(R)-3, Transition Election Related to Accounting for theTax Effects of Share-Based Payment Awards, to provide an alternative approachof accounting for the tax effects of employee share-based awards. We have electedto adopt the alternative transition method provided in FSP FAS 123(R)-3 forcalculating the tax effects of stock-based compensation pursuant to SFAS123(R). The alternative transition method includes simplified methods toestablish the beginning balance of the additional paid-in capital pool (APICpool) related to the tax effects of employee stock-based compensation, and todetermine the subsequent impact on the APIC pool and consolidated statements ofcash flows of the tax effects of employee stock-based compensation awards thatare outstanding upon the adoption of SFAS 123(R).

 

10

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**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 the weighted average number of shares and commonstock equivalents outstanding during the period. In the calculation of dilutedearnings per share, shares outstanding are adjusted to assume conversion of theCompany’s non-interest bearing convertible stock and the exercise of optionsand 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 income available to common shareholders forthe period ended March 31, 2006 and a net loss available to common shareholdersfor the period ended March 31, 2005. As a result, the common stock equivalentsof stock options, warrants and convertible securities issued and outstanding atMarch 31, 2005 were not included in the computation of diluted earnings pershare for the period then ended as they were antidilutive. Income (loss) pershare is computed as follows:

 

| ** **                                                                                                                  | ** ** | **Three Months Ended  March 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                                                                  | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
| ** **                                                                                                                  | ** ** | ** **                                       | ** ** | ** ** | ** ** |
| Net income (loss)                                                                                                           |       | $                                                | 3,279      |   | $ | (6,902 | ) |
| Accretion of redeemable class B common  stock and redeemable class C common stock                                           |       | —                                           |       | 2,797 |   |
|                                                                                                                        |       |                                             |       |   |   |
| Net income (loss) available to common  shareholders                                                                         |       | $                                                | 3,279      |   | $ | (9,699 | ) |
|                                                                                                                        |       |                                             |       |   |   |
| Weighted average shares used to compute net  income (loss) available to common shareholders per common share - basic        |       | 18,217,945                                       |       | 5,169,870 |   |
|                                                                                                                        |       |                                             |       |   |   |
| Effect of dilutive stock options and  warrants                                                                              |       | 734,286                                          |       | — |   |
|                                                                                                                        |       |                                             |       |   |   |
| Weighted average shares used to compute net  income (loss) available to common shareholders per common share – diluted |       | 18,952,231                                       |       | 5,169,870 |   |
|                                                                                                                        |       |                                             |       |   |   |
| Basic net income (loss) per share to common  shareholder                                                                    |       | $                                                | 0.18       |   | $ | (1.88 | ) |
|                                                                                                                        |       |                                             |       |   |   |
| Diluted net income (loss) per share to  common shareholder                                                                  |       | $                                                | 0.17       |   | $ | (1.88 | ) |

 

11

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**Stock-BasedCompensation**

 

The Company’s 2005 Equity IncentivePlan (the “2005 Option Plan”), which was adopted by the Company’s Board ofDirectors (the “Board”) in March 2005 and was approved by the Company’sshareholders in June 2005, provides for the granting of stock options toemployees and directors at the discretion of the Board or a committee of theBoard. The 2005 Option Plan replaced the Company’s 2000 Stock Option Plan (the “2000Option Plan”). As of March 31, 2006, there were options to purchase 1,614,958shares of common stock outstanding under the 2000 Option Plan. The Company isauthorized to issue up to an aggregate of 4,842,910 shares of its common stockpursuant to stock options granted under the 2005 Option Plan. As of March 31,2006, there were a total of 3,149,579 shares of common stock not subject tooutstanding options and available for issuance under the 2005 Option Plan.. Thepurpose of stock options is to recognize past services rendered and to provideadditional incentive in furthering the continued success of the Company. Stockoptions granted under both the 2005 Option Plan and the 2000 Stock Option Planexpire on the tenth anniversary of the date of grant and generally vest on thethird anniversary of the date of grant. . Unexercised stock options may expirenot more than 90 days after an employee’s termination.

 

On January 1, 2006, weadopted SFAS No. 123R using the Modified Prospective Approach (“MPA”). TheMPA requires that compensation expense be recorded for restricted stock and allunvested stock options as of January 1, 2006. Upon adoption we willcontinue to recognize the cost of previously granted share-based awards underthe straight-line basis and anticipate that we will recognize the cost for newshare-based awards on a straight-line basis over the requisite service period.

 

SFAS 123R requires companiesto estimate the fair value of share-based payment awards on the date of grantusing an option-pricing model. In 2005 and 2006, the fair value of each grantwas estimated using the Black-Scholes valuation model. Expected volatility wasbased upon a weighted average of peer companies, comparable indices, and theCompany’s stock volatility. The expected life was determined based upon anaverage of the contractual life and vesting period of the options. Theestimated forfeiture rate was based upon an analysis of historical data. Therisk-free rate was based on U.S. Treasury zero coupon bond yields at the timeof grant. The following table provides the assumptions used in determining thefair value of the stock-based awards for the three months ended March 31, 2006and March 31, 2005, respectively.

 
| ** **               | ** ** | **March 31,  2005** | ** ** | **March 31,  2006** | ** ** |
|--------------------------|------------|--------------------------|------------|--------------------------|------------|
| Expected volatility      |       | 51.3                     | %          | 39.5                     | %          |
| Expected dividends       |       | 0                        |       | 0                        |       |
| Expected term (in years) |       | 10                       |       | 4                        |       |
| Risk-free rate           |       | 4.5                      | %          | 4.7                      | %          |

 

A summary of the status ofthe Company’s stock options as of December 31, 2005 and March 31, 2006 andchanges 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                      |       | (133,000                              | )          | 133,000                      |       | $                                   | 21.52      |   | — |   | — |   |
| Exercised                    |       | —                                |       | (63,503                      | )          | $                                   | 10.93      |   | — |   | — |   |
| Forfeited or expired         |       | 16,720                                |       | (16,720                      | )          | $                                   | 16.37      |   | — |   | — |   |
| Balance at March 31, 2006    |       | 3,149,579                             |       | 1,614,958                    |       | $                                   | 12.53      |   | 569,358 |   | $ | 12.19 |   |

 

The weighed-average grantdate fair value of options granted during the quarter ended March 31, 2006 andMarch 31, 2005 were $8.05 and $12.10, respectively. The total intrinsic valueof options exercised during the quarter ended March 31, 2006 was $902. Nooptions were exercised during the quarter ended March 31, 2005.

 

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A summary of the status ofthe Company’s nonvested share options as of December 31, 2005 and March 31,2006 and changes during the period then ended is presented below:

 

| **Nonvested Shares**      | ** ** | **Shares** | ** ** | **Wtd. Avg.  Grant Date  Fair Value** | ** ** |
|--------------------------------|------------|------------|------------|------------------------------------------------------|------------|
| Nonvested at December 31, 2005 |       | 923,400    |       | $                                                    | 8.10       |   |
| Granted                        |       | 133,000    |       | $                                                    | 8.05       |   |
| Vested                         |       | 0          |       | $                                                    | 0          |   |
| Forfeited or expired           |       | (10,800    | )          | $                                                    | 7.60       |   |
| Nonvested at March 31, 2006    |       | 1,045,600  |       | $                                                    | 8.09       |   |

 

As of March 31, 2006, therewas $6.4 million of total unrecognized compensation cost related to nonvestedshare-based compensation arrangements granted under the 2005 Option Plan andthe 2000 Option Plan. That cost is expected to be recognized over aweighted-average period of 4.25 years.

 

SFAS No. 123R alsorequires us to change the classification of any tax benefits realized uponexercise of stock options in excess of that which is associated with theexpense recognized for financial reporting purposes. These amounts arepresented as a financing cash inflow rather than as a reduction of income taxespaid in our consolidated statement of cash flows.

 

In accordance with StaffAccounting Bulletin No. 107, we classified stock-based compensation within costof goods sold, selling, general and administrative expenses and research anddevelopment corresponding to the same line as the cash compensation paid torespective employees, officers and non-employee directors.

 

Prior to January 1, 2006 theCompany accounted for stock options under Accounting Principles Board (“APB”)Opinion 25. Had compensation expense for stock options granted been determinedbased on the fair value at the grant dates under the provisions ofSFAS 123, the Company’s pro forma net loss for the quarter ended March 31,2005 would not have been materially different.

 
| ** **                                                                                                                  | ** ** | **For the  quarter  ended  March 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                                                                  | ** ** | **2005**                                         | ** ** |
|                                                                                                                        |       |                                             |       |
| Net loss as reported                                                                                                        |       | $                                                | (6,902     | ) |
| Add: stock based employee compensation  expense included in reported net income, net of tax                            |       | 158                                              |       |
| Deduct: total stock-based compensation  expense determined under fair value based method for all awards, net of tax    |       | 33                                               |       |
|                                                                                                                        |       |                                             |       |
| Pro forma net income (loss)                                                                                                 |       | $                                                | (6,777     | ) |
|                                                                                                                        |       |                                             |       |
| Accretion of redeemable class B common  stock, class C common stock, series A preferred stock and series B preferred  stock |       | $                                                | 2,797      |   |
|                                                                                                                        |       |                                             |       |
| Net loss available to common shareholders                                                                                   |       | $                                                | (9,574     | ) |
|                                                                                                                        |       |                                             |       |
| Basic and diluted net loss per share to  common shareholder as reported:                                                    |       | $                                                | (1.88      | ) |
| Basic and diluted net loss per share to  common shareholder, pro forma:                                                     |       | $                                                | (1.85      | ) |

 

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**Use ofEstimates**

 

The preparation of financialstatements in conformity with accounting principles generally accepted in theUnited States of America requires management to make estimates and assumptionsthat affect the reported amounts of assets and liabilities, disclosure ofcontingent assets and liabilities at the date of the financial statements andthe reported amounts of revenues and expenses during the reporting period.Actual results could differ from those estimates.

 

**Fair Valueof Financial Instruments**

 

The carrying amounts of theCompany’s financial assets and liabilities, including cash, accounts receivableand accounts payable at March 31, 2005 and 2006 approximate fair value of theseinstruments.

 

14

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**3.Property, Equipment and Software**

 

A summary of property,equipment and software and related accumulated depreciation as of March 31,2006 and December 31, 2005 is as follows:

 

| ** **                    | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|-------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| Equipment                     |       | $                        | 7,435      |                        | $          | 7,338 |   |
| Software                      |       | 7,854                    |       | 6,583                       |       |
| Office furniture and fixtures |       | 1,178                    |       | 1,175                       |       |
| Leasehold improvements        |       | 681                      |       | 645                         |       |
| Land                          |       | 708                      |       | 578                         |       |
| Software in development       |       | 1,222                    |       | 846                         |       |
|                          |       |                     |       |                        |       |
| Total                         |       | 19,078                   |       | 17,164                      |       |
| Less accumulated depreciation |       | 11,756                   |       | 11,578                      |       |
|                          |       |                     |       |                        |       |
| Net                           |       | $                        | 7,322      |                        | $          | 5,587 |   |

 

Equipment, office furnitureand fixtures included capital leases totaling $2,339 and $2,241 at March 31,2006 and December 31, 2005, respectively. Depreciation expense, includingassets under capital leases, was $701 and $2,074 for the three months endedMarch 31, 2006 and year ended December 31, 2005, respectively.

 

**4. OtherAccrued Liabilities**

 

Other accrued liabilitiesconsist of the following:

 
| ** **                           | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|--------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| Accrual for discontinued operations  |       | $                        | 31         |                        | $          | 71 |   |
| Accrued professional fees            |       | 401                      |       | 260                         |       |
| Straight line rent accrual           |       | 379                      |       | 199                         |       |
| Other taxes payable (non-income tax) |       | 126                      |       | 220                         |       |
| Income taxes payable                 |       | 1,884                    |       | 1,084                       |       |
| Other liabilities                    |       | 408                      |       | 342                         |       |
|                                 |       |                     |       |                        |       |
| Total other accrued liabilities      |       | $                        | 3,229      |                        | $          | 2,176 |   |

 

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**5. Line ofCredit**

 

On December 29, 2005,the Company entered into an amendment (the “2005 Amendment”) to its revolvingcredit facility with PNC Bank, N.A. Under the terms of the 2005 Amendment, theCompany’s maximum borrowings under the revolving credit facility increased from$10 million to $25 million, including availability of up to$2 million for letters of credit. No amounts were outstanding on the lineon March 31, 2006. On January 13, 2006 the Company borrowed $25 million fromthe revolving credit facility for working capital purposes. On March 14, 2006the Company repaid the balance due on the revolving credit facility.

 

The Company’s borrowingsunder the revolving credit facility bear interest at tiered rates based upon theratio of Net Funded Debt to EBITDA as defined in the 2005 Amendment. TheCompany may also elect interest rates on its borrowings calculated by referenceto LIBOR plus a margin based upon the ratio of its Net Funded Debt to EBITDAratio. Interest on LIBOR borrowings is calculated on an actual/360 daybasis and is paid on the last day of each interest period. LIBOR advances areavailable for periods of 1, 2, 3 or 6 months. LIBOR pricing is adjustedfor any statutory reserves. The revolving credit facility will terminate onDecember 31, 2008, at which time all outstanding borrowings must berepaid, and all outstanding letters of credit, if any, must be cashcollateralized.

 

Borrowings under therevolving credit facility are collateralized generally by all of the Company’sassets, including a pledge of the capital stock of its subsidiaries. Repaymentof amounts outstanding under certain notes payable and all issued or issuableshares of common and preferred stock are subordinated to the rights of thelender under terms of the revolving credit facility. . The revolving creditfacility contains various terms and covenants that provide for restrictions oncapital expenditures, payment of dividends, dispositions of assets, investmentsand acquisitions and require the Company, among other things, to maintainminimum levels of tangible net worth, net income and fixed charge coverage.

 

**6.Commitments and Contingencies**

 

**Litigation**

 

On January 27, 2006 theCompany and Gallup settled an outstanding claim and entered into a confidentialsettlement agreement. On January 30, 2006, the Court entered a consentorder relating to the settlement. The terms of the settlement did not have amaterial adverse effect on the results of operations or financial position.

 

The Company is involved inclaims, including those identified above, which arise in the ordinary course ofbusiness. In the opinion of management, the Company has made adequate provisionfor 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 the Company relating to intellectualproperty rights and intellectual property licenses, could have a materialadverse effect on the Company’s business, financial condition and operatingresults.

 

**7. Equity**

 

On March 8, 2006, theCompany completed a follow-on offering for 2,425,000 shares of its common stockat $27.00 per share. The Company also sold an additional 216,800 shares of itscommon stock to cover over-allotments of shares. The aggregate net proceeds tothe Company from the offering, after payment of all offering expenses andcommissions, were approximately $67,333 after payment of all offering fees. Currentunpaid offering expenses were $409 at March 31, 2006. In addition, 3,510,700shares, which included an over-allotment of 585,700 shares, of its common stockwere sold in the offering by selling shareholders. The company received noproceeds from common stock sold by the selling shareholders in the offering.

 

16

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**8. RelatedParty**

 

One of the Company’sdirectors, Barry M. Abelson, is a partner in the law firm of Pepper HamiltonLLP. This firm has represented the Company since 1997. The Company paid PepperHamilton LLP, net of insurance coverage, $922 and $11 for the three monthsended March 31, 2006 and 2005, respectively, for costs associated with theCompany’s follow-on offering and other general legal matters.

 

17

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**9.Acquisition**

 

On January 13, 2006,the Company, through its wholly-owned subsidiary, Kenexa Technology, Inc.,and Kenexa Acquisition Corp., a wholly-owned subsidiary of Kenexa Technology,completed its acquisition of Webhire, Inc.(“Webhire”) for approximately$34.4 million in cash. The total cost of the acquisition including legal,accounting, and other professional fees of $0.5 million was approximately$34.9 million.

 

The Company acquired all ofthe outstanding stock of Webhire through existing cash of which approximately$5.0 million or 14.5% of the aggregate purchase price remains depositedinto an escrow account to cover any claims for indemnification made by theCompany against Webhire under the acquisition agreement. Assuming there are noindemnification claims, this amount will be released to Webhire on or aboutJanuary 13, 2007. The strategic rationale for acquiring Webhire includedexpanding Kenexa’s market opportunity and product suite, broadening Kenexa’svertical market specialization and increasing Kenexa’s customer base throughcross-sales to Webhire’s customers.

 

Webhire’s results ofoperations were included in the Company’s consolidated financial statementsbeginning 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  $83         |       | 2,109      |       |                     |       |
| 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                                              |       | 29,520     |       | Indeterminable           |       |
| Deferred Income Taxes                                 |       | 4,673      |       | 15 years                 |       |
|                                                  |       |       |       |                     |       |
| Less: Liabilities Assumed                             |       |       |       |                     |       |
| Notes Payable                                         |       | 26         |       |                     |       |
| Capital Lease Obligations                             |       | 102        |       |                     |       |
| Accounts Payable                                      |       | 294        |       |                     |       |
| Accrued Expenses                                      |       | 1,416      |       |                     |       |
| Other Liabilities                                     |       | 226        |       |                     |       |
| Deferred Revenue                                      |       | 5,313      |       |                     |       |
|                                                  |       |       |       |                     |       |
| Total Cash Purchase Price                             |       | $          | 34,939     |                     |       |   |

 

The purchase price wasallocated to the tangible and identified intangible assets and the excess ofthe total purchase price over the amounts assigned was recorded to goodwill. Theestimated fair values of the intangible assets are further described below. Customerlists, internally developed software, and net operating loss tax attributes arebeing amortized over their estimated useful lives. Goodwill is not amortizedbut is periodically evaluated for impairment.

 

The valuation of customer listsin the amount of $1.0 million, which relates to Webhire’s current customerportfolio, was determined based upon estimated discounted incremental futurecash flow to be received as a result of these relationships.

 

18

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The valuation of the netoperating loss  tax attributes of $4.7million was based upon the anticipated use of the present value of cash flowsfrom Webhire’s net operating losses.

 

Goodwill from theacquisition resulted from our belief that the recruiter products developed byWebhire will be complementary to our Kenexa Recruiter product offerings andwill help us remain competitive in the talent acquisition market. The goodwillfrom the Webhire acquisition will not be deductible for tax purposes.

 

If the Webhire acquisitionhad occurred on January 1, 2005, the unaudited pro forma results of operationsfor quarter ended March 31, 2005 would have been:

 

| ** **                                                     | ** ** | **(in thousands)**                      | ** ** |
|----------------------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                                     | ** ** | **Quarter Ended  March 31,  2005** | ** ** |
| Revenue                                                        |       | $                                            | 17,419     |   |
| Net loss available to common shareholders –  diluted      |       | (9,347                                       | )          |
| Net loss per share available to common  shareholders - diluted |       | $                                            | (1.81      | ) |

 

**10.Subsequent Events**

 

On April 10, 2006 theCompany acquired all fo the outstanding stock of Knowledge Workers, Inc., a human capital consulting and technologyfirm based in Denver, Colorado, for a purchase price of approximately $2.5million in cash. The Company acquired all assets and liabilities of KnowledgeWorkers Inc. using its existing cash. The total cost of the acquisition includingestimated legal, accounting, and other professional fess will be approximately$2.6 million. The Company deposited $0.1 million into escrow to cover anyclaims for indemnification made by the Company or Knowledge Workers.

 

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**Item 2:Management’s Discussion and Analysis of Financial Condition and Results ofOperations**

 

This Quarterly Report onForm 10-Q, including the following Management’s Discussion and Analysis ofFinancial Condition and Results of Operations, contains forward-lookingstatements within the meaning of Section 27A of the Securities Act of 1933, asamended, Section 21E of the Securities Exchange Act of 1934, as amended, andthe Private Securities Litigation Reform Act of 1995, that involve a number ofrisks and uncertainties. Such statements are based on current expectations offuture events that involve a number of risks and uncertainties that may causethe actual events to differ materially from those discussed herein. Inaddition, such forward-looking statements are necessarily dependent uponassumptions, estimates and dates that may be incorrect or imprecise and involveknown and unknown risks and other factors. Accordingly, any forward-lookingstatements included herein do not purport to be predictions of future events orcircumstances and may not be realized. Forward-looking statements can beidentified by, among other things, the use of forward-looking terminology suchas “believes,” “expects,” “may,” “could,” “will,” “should,” “seeks,” “potential,”“anticipates,” “predicts,” “plans,” “estimates,” or “intends,” or the negativeof any thereof, or other variations thereon or comparable terminology, or bydiscussions of strategy or intentions. Given these uncertainties, readers arecautioned not to place undue reliance on such forward-looking statements.Forward-looking statements should be considered in light of various importantfactors, including those set forth in this report under Part I, Item 1A “RiskFactors” in Kenexa Corporation’s Annual Report on Form 10K for the year endedDecember 31, 2005 filed with the Securities and Exchange Commission. Allforward-looking statements, and reasons why results may differ, that areincluded in this report are made as of the date of this report, and except asrequired by law, we disclaim any obligations to update any such factors or topublicly announce the results of any revisions to any of the forward-lookingstatements contained herein or reasons why results might differ to reflectfuture events or developments. References herein to “Kenexa,” “we,” “our,” and “us”collectively refer to Kenexa Corporation, a Pennsylvania corporation, and allof its direct and indirect U.S., U.K., Canada and India subsidiaries.

 

**Overview**

 

We provide software, servicesand proprietary content that enable organizations to more effectively recruitand retain employees. Our solutions are built around a suite of easilyconfigurable software applications that automate talent acquisition andemployee performance management best practices. We offer the softwareapplications that form the core of our solutions on an on-demand basis, whichmaterially reduces the costs and risks associated with deploying traditionalenterprise applications. We complement our software applications with tailoredcombinations of outsourcing services, consulting services and proprietarycontent based on our 18 years of experience assisting clients in addressingtheir human resource requirements. Together, our software applications andservices form solutions that we believe enable our clients to improve theeffectiveness of their talent acquisition programs, increase employeeproductivity and retention, measure key HR metrics and make their talentacquisition and employee performance management programs more efficient.

 

Since 1999, we have focusedon providing talent acquisition and employee performance management solutionson a subscription basis and currently generate a significant portion of ourrevenue from these subscriptions. For the three months ended March 31, 2006 and2005, revenue from these subscriptions comprised approximately 76.4% and 76.0%,respectively, of our total revenue. We generate the remainder of our revenuefrom discrete professional services that are not provided as part of anintegrated solution on a subscription basis. These subscription-based solutionsprovide us with a recurring revenue stream and we believe represent a morecompelling opportunity in terms of growth and profitability than discreteprofessional services. As a result, since 1999 discrete professional serviceshave represented a consistently decreasing percentage of our revenue. We expectthat trend to continue.

 

We sell our solutions tolarge- and medium-sized organizations through our direct sales force. As ofDecember 31, 2005, we had a client base of approximately 2,200 companies,including approximately 119 companies on the Fortune 500 list published inApril 2005. As a result of our acquisition of Webhire, Inc. inJanuary 2006, we increased our client base to approximately 2,400companies, including approximately 131 companies on the Fortune 500 listpublished in April 2005. Our client base includes companies that we billedfor services during the year ended December 31, 2005 and does not necessarilyindicate an ongoing relationship with each such client. Our top 80 clientscontributed approximately 15 million or 66.3% of our total revenue for thethree months ended March 31, 2006.

 

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**RecentEvents**

 

On January 13, 2006, weacquired Webhire, Inc., a provider of end-to-end talent acquisition solutionsfor recruitment and human resource professionals in middle-market enterprisesacross all industries, for approximately $34.4 million in cash. The total costof the acquisition including legal, accounting, and other professional fees of$0.5 million were approximately $34.9 million. . The strategicrationale for acquiring Webhire included expanding Kenexa’s market opportunityand product suite, broadening Kenexa’s vertical market specialization andincreasing Kenexa’s customer base through cross-sales to Webhire’s customers

 

On March 8, 2006, wecompleted our follow-on public offering of 2,425,000 shares of our common stockat a price of $27.00 per share. We sold an additional 216,800 shares of ourcommon stock to cover over-allotments of shares. Our net proceeds from theoffering, after payment of all offering expenses and commissions, aggregatedapproximately $67.3 million. Current unpaid offering expenses were $0.4 millionat March 31, 2006. In addition, certain of our shareholders sold an aggregateof 3,510,700 shares of our common stock in the offering, including anover-allotment of 585,700 shares. We received no proceeds from the common stocksold by the selling shareholders in the offering.

 

On April 10, 2006, weacquired Knowledge Workers, Inc., a human capital consulting and technologyfirm based in Denver Colorado, for approximately $2.5 million in cash. Weexpect that the total cost of the acquisition including estimated legal,accounting, and other professional fess, will be approximately $2.6 million. TheCompany deposited $0.1 million into escrow to cover any claims forindemnification made by the Company or Knowledge Workers.

 

**3. Sourcesof Revenue**

 

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

 

Our clients primarilypurchase renewable subscriptions for our solutions. The typical term is one tothree years, with some terms extending up to five years. The majority of oursubscription agreements are not cancelable for convenience although our clientshave the right to terminate their contracts for cause if we fail to provide theagreed upon services or otherwise breach the agreement. A client does notgenerally have a right to a refund of any advance payments if the contract iscancelled. We expect that we will maintain our renewal rate of approximately90.0% of the aggregate contract value up for renewal for 2006, 2007 and 2008.The revenue derived from subscription fees is recognized ratably over the termof the subscription agreement. We generally invoice our clients in advance inmonthly or quarterly installments and typical payment terms provide that ourclients pay us within 30 days of invoice. Amounts that have been invoiced arerecorded in accounts receivable prior to the receipt of payment and in deferredrevenue to the extent revenue recognition criteria have not been met. As thesubscription component of our revenue has grown and clients’ willingness to payus in advance for their subscriptions has increased, the amount of deferredrevenue on our balance sheet has grown at a higher rate than our revenue. As ofMarch 31, 2006, deferred revenue increased to $16.2 million from $12.5 millionat December 31, 2005. We generally price our solutions based on the number ofsoftware applications and services included and the number of client employees.Accordingly, subscription fees are generally greater for larger organizationsand for those that subscribe for a broader array of software applications andservices.

 

A small portion of ourclients purchase discrete professional services. These services primarilyconsist of consulting and training services. In addition, we recognize a smallamount of revenue from sales of perpetual software licenses. The revenue fromthese services and licenses is recognized differently depending on the type ofservice or license provided as described in greater detail below under “CriticalAccounting Policies and Estimates.”

 

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We generate substantiallyall of our revenue from within the United States. For the three months endedMarch 31, 2006, approximately 92.2% of our total revenue was derived fromsales in the United States. During the three months ended March 31, 2006,approximately 7.8%, of our total revenue was derived from areas outside theUnited States. Other than the revenue that we generated from clients in theNetherlands and the United Kingdom, which in the aggregate amounted to 2.5% ofour total revenue for the three months ended March 31, 2006, and revenuethat was generated from clients in Canada which amounted to 1.3% for the threemonths ended March 31, 2006, we did not have revenue from any othercountry in excess of 1.0% of our total revenue for the three months endedMarch 31, 2006.

 

**4. KeyPerformance Indicators**

 

The following tablessummarize the key performance indicators that we consider to be material inmanaging our business:

 
| ** **                                                     | ** ** | **For the Three Months  Ended March 31,** | ** ** |
|----------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                     | ** ** | **2006**                                                           | ** ** | **2005** | ** ** |
| Total Revenue                                                  |       | $                                                                  | 23,015     |   | $ | 14,332 |   |
|                                                           |       |                                                               |       |   |   |
| Subscription revenue as a percentage of  total revenue         |       | 76.4                                                               | %          | 76.0 | % |
|                                                           |       |                                                               |       |   |   |
| Income from operations before income tax  and interest expense |       | $                                                                  | 3,388      |   | $ | 1,684 |   |
|                                                           |       |                                                               |       |   |   |
| Net cash provided by operating activities                      |       | $                                                                  | 902        |   | $ | 750 |   |

 
| ** **       | ** ** | **As of March 31,** | ** ** |
|------------------|------------|------------------------------------|------------|
| ** **       | ** ** | **2006**                           | ** ** | **2005** | ** ** |
|             |       |                               |       |   |   |
| Deferred revenue |       | $                                  | 16,164     |   | $ | 5,572 |   |
|                  |            |                                    |            |  |  |  |  |

 

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 74-80% of our total revenues.

 

***Net cash provided by operating activities****.* Net cash provided by operating activities istaken from our consolidated statement of cash flows and represents the amountof cash generated by our operations that is available for investing andfinancing activities. Historically, our net cash provided by operatingactivities has exceeded our net income primarily due to the positive impact ofdeferred revenue. We expect this trend to continue because of the advancepayment structure of our subscription agreements and because as our salesincrease, we expect incremental costs to decline.

 

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***Deferred revenue****.*We generate revenue primarily from multi-year subscriptions for our on-demandtalent acquisition and employee performance management solutions. We recognizerevenue from these subscription agreements ratably over the term of thecontract, which are typically one to three years. We generally invoice ourclients in quarterly or monthly installments in advance. Deferred revenue,which is included in our consolidated balance sheets, is the amount of invoicedsubscriptions in excess of the amount recognized as revenue. Deferred revenuerepresents, in part, the amount that we will record as revenue in our consolidatedstatements of operations in future periods. As the subscription component ofour revenue has grown and customer willingness to pay us in advance for theirsubscriptions has increased, the amount of deferred revenue on our balancesheet has grown at a higher rate than our revenue growth rate. We expect thistrend to continue.

 

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

 
| ** **                                       | ** ** | **For the Year Ended  December, 31** | ** ** | **For the Three Months  Ended March 31,** | ** ** |
|--------------------------------------------------|------------|----------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                       | ** ** | **2005**                                                 | ** ** | **2006**                                                           | ** ** | **2005** | ** ** |
| ** **                                       | ** ** | ** **                                               | ** ** | **(unaudited)**                                                    | ** ** | **(unaudited)** | ** ** |
|                                             |       |                                                     |       |                                                               |       |   |   |
| Deferred revenue at the beginning of the  period |       | $                                                        | 6,650      |                                                               | $          | 12,558 |   | $ | 6,650 |   |
| Total invoiced subscriptions during period       |       | 56,882                                                   |       | 15,886                                                             |       | 9,793 |   |
| Deferred revenue from acquisition                |       | —                                                   |       | 5,313                                                              |       | — |   |
| Subscription revenue recognized during  period   |       | (50,974                                                  | )          | (17,593                                                            | )          | (10,871 | ) |
| Deferred revenue at end of period                |       | $                                                        | 12,558     |                                                               | $          | 16,164 |   | $ | 5,572 |   |

 

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**RESULTS OFOPERATIONS**

 

**ThreeMonths Ended March 31, 2006 Compared to Three Months Ended March 31, 2005**

 

The following table setsforth for the periods indicated, the amount and percentage of total revenuesrepresented by certain items reflected in our unaudited consolidated statementsof operations:

 

KenexaCorporation Unaudited Consolidated Statement of Operations

(Inthousands)

 
| ** **                                                          | ** ** | **For the  Three Months Ended  March 31,** | ** ** |
|---------------------------------------------------------------------|------------|----------------------------------------------------------------|------------|
| ** **                                                          | ** ** | **2006**                                                       | ** ** | **2005** | ** ** |
| ** **                                                          | ** ** | **Amount**                                                     | ** ** | **Percent of  Revenues** | ** ** | **Amount** | ** ** | **Percent of  Revenues** | ** ** |
| Revenue:                                                            |       |                                                           |       |   |   |   |   |   |   |
| Subscription revenue                                                |       | $                                                              | 17,593     |   | 76.4 | % | $ | 10,871 |   | 76.0 | % |
| Other revenue                                                       |       | 5,422                                                          |       | 23.6 | % | 3,461 |   | 24.0 | % |
|                                                                |       |                                                           |       |   |   |   |   |   |   |
| Total revenue                                                       |       | 23,015                                                         |       | 100.0 | % | 14,332 |   | 100.0 | % |
| Cost of revenue                                                     |       | 6,354                                                          |       | 27.6 | % | 4,060 |   | 28.3 | % |
|                                                                |       |                                                           |       |   |   |   |   |   |   |
| Gross profit                                                        |       | 16,661                                                         |       | 72.4 | % | 10,272 |   | 71.7 | % |
|                                                                |       |                                                           |       |   |   |   |   |   |   |
| Operating expenses:                                                 |       |                                                           |       |   |   |   |   |   |   |
| Sales and marketing                                                 |       | 5,728                                                          |       | 24.9 | % | 3,603 |   | 25.1 | % |
| General and administrative                                          |       | 5,287                                                          |       | 23.0 | % | 3,313 |   | 23.1 | % |
| Research and development                                            |       | 1,536                                                          |       | 6.7 | % | 1,120 |   | 7.8 | % |
| Depreciation and amortization                                       |       | 722                                                            |       | 3.1 | % | 552 |   | 3.9 | % |
|                                                                |       |                                                           |       |   |   |   |   |   |   |
| Total operating expenses                                            |       | 13,273                                                         |       | 57.7 | % | 8,588 |   | 59.9 | % |
|                                                                |       |                                                           |       |   |   |   |   |   |   |
| Income from operations before income tax  and interest expense      |       | 3,388                                                          |       | 14.7 | % | 1,684 |   | 11.7 | % |
|                                                                |       |                                                           |       |   |   |   |   |   |   |
| Interest (income) expense                                           |       | (120                                                           | )          | (0.5 | )% | 12 |   | 0.1 | % |
| Interest (income) expense on mandatory  redeemable preferred shares |       | —                                                         |       | — | % | 8,534 |   | 59.5 | % |
|                                                                |       |                                                           |       |   |   |   |   |   |   |
| Income (loss) from operations before income  tax                    |       | 3,508                                                          |       | 15.2 | % | (6,862 | ) | (47.9 | )% |
| Income tax expense from continuing  operations                      |       | 229                                                            |       | 1.0 | % | 40 |   | 0.3 | % |
|                                                                |       |                                                           |       |   |   |   |   |   |   |
| Net income (loss)                                                   |       | 3,279                                                          |       | 14.2 | % | (6,902 | ) | (48.2 | )% |
| Accretion of redeemable class B common  shares and C commons shares |       | —                                                         |       | — | % | 2,797 |   | (19.5 | )% |
| Net income (loss) available to common  shareholders                 |       | $                                                              | 3,279      |   | 14.2 | % | $ | (9,699 | ) | (67.7 | )% |

 

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**ThreeMonths Ended March 31, 2006 Compared to Three Months Ended March 31, 2005**

 

***Revenues***

 

Total revenue increased by$8.7 million or 61% to $23.0 million during the three months ended March 31,2006 compared to the same period in 2005. Our subscription revenue increased by$6.7 million or 62% to $17.6 million during the three months ended March 31,2006 compared to the same period in 2005. Subscription revenue representedapproximately 76.4% of our revenue for the three months ended March 31, 2006. Thisincrease is primarily attributable to the Webhire acquisition and integrationof our two sales forces and the continued acceptance of our on-demand model.Our other revenue increased by $2.0 million or 57% to $5.4 million for thethree months ended March 31, 2006 compared to the same period in 2005. Thisincrease was due to primarily to an increase in demand for our consultingservices resulting from an increase in our subscription based revenues and thereceipt of approximately $0.5 million of non-recurring “success” fees relatedto meeting certain client-specific objectives. For the remainder of the year weexpect subscription based and other revenue to increase from the prior year dueto customer acquisitions and additional sales to existing customers.

 

***Cost of Revenue***

 

Our cost of revenueprimarily consists of compensation, employee benefits and travel-relatedexpenses for our employees and independent contractors who provide consultingor other professional services to our clients. Additionally, our applicationhosting costs, amortization of third-party license royalty costs, technicalsupport personnel costs, allocated overhead and reimbursed expenses are alsorecorded as cost of revenue. Many factors affect our cost of revenue, includingchanges in the mix of products and services, pricing trends, changes in theamount of reimbursed expenses and fluctuations in our client base. Because costas a percentage of revenue is higher for professional services than forsoftware products, an increase in the services component of our solutions or anincrease in discrete professional services as a percentage of our total revenuewould reduce gross profit as a percentage of total revenue. As our businessexpands, we expect that third-party license royalty costs and personnel costsassociated with the delivery of our solutions will continue to fall within arange of approximately 26% to 30% of revenues.

 

Cost of revenue increased by$2.3 million or 57% to $6.4 million for the three months ended March 31, 2006compared to the same period in 2005. The increase in cost of revenue inabsolute dollars was primarily due to our increased revenue. Cost of revenuedecreased 0.7% as a percentage of revenue for the three months ended March 31,2006 compared to the same period in 2005. While the adoption of SFAS 123-Radded approximately $0.1 million or 0.5% to our cost of revenue and cost ofrevenue as a percentage of revenue, respectively, for the quarter ended March31, 2006, the decrease in cost of revenue as a percentage of revenue, afteradjusting for non-cash compensation associated with the adoption of SFAS 123R,was mostly due to an increase in revenue with minimal corresponding costs.

 

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

 

S&M expense primarilyconsist of personnel and related costs for employees engaged in sales andmarketing, including salaries, commissions and other variable compensation,travel expenses and costs associated with trade shows, advertising and othermarketing efforts and allocated overhead. We expense our sales commissions atthe time the related revenue is recognized, and we recognize revenue from oursubscription agreements ratably over the term of the agreements. Investment insales and marketing commencing in 2003 resulted in significant revenue growthduring 2004 and 2005. We intend to continue to invest in sales and marketing topursue new clients and expand relationships with existing clients. As a result,we expect S&M expense to increase. We do not, however, expect sales andmarketing expense to increase significantly as a percentage of revenue.

 

S&M expense increased by$2.1 million or 59% to $5.7 million for the three months ended March 31, 2006compared to the same period in 2005. Increased compensation expense and relatedtravel expenses contributed approximately $1.6 million and $0.2 million,respectively, to the increase in S&M expense during the quarter ended March31, 2006 from the prior year. The increase in compensation and travel expensewas attributable primarily to 13 additional employees in S&M acquired inour Webhire acquisition. Additionally, $0.2 million in non-cash stock

 

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option expense from ouradoption of SFAS 123R in 2006 and $0.1 million of other expense alsocontributed to the increase in S&M expense for the quarter ended March 31,2006 over the comparable period in the prior year. As a percentage of revenues,S&M expense decreased from 25.1% to 24.9% for the three months ended March31, 2006 compared to the same period in 2005.

 

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

 

G&A expenses primarilyconsists of personnel and related costs for our executive, finance, humanresources and administrative personnel, professional fees and other corporateexpenses and allocated overhead. As we expand our business and incur additionalexpenses associated with being a public company, including the costs ofcompliance with the Sarbanes-Oxley Act of 2002 and other regulations governingpublic 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$2.0 million or 60% to $5.3 million for the three months ended March 31, 2006compared to the same period in 2005. The $2.0 million increase for the quarterended March 31, 2006 was due primarily to an increase in salary expenses of$0.6 million related to the addition of 15 employees from our Webhireacquisition. In addition non-cash stock option expense from our adoption ofSFAS 123R in 2006, travel expense, rent expense and professional feescontributed of $0.2 million, $0.2 million $0.3 million and $0.2 million,respectively, to the increase in G&A expense for the three months endedMarch 31, 2006 versus the comparable period in the prior year. The remainder ofthe increase of $0.5 million was attributable to increases in infrastructureexpenses such as phone, supplies, utilities, insurance and other. As apercentage of revenue, G&A expense was approximately the same at 23% foreach of the three months ended March 31, 2006 and 2005.

 

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

 

R&D expense primarilyconsists of personnel and related costs, including salaries and employeebenefits for software engineers, quality assurance engineers, product managers,technical sales engineers and management information systems personnel. OurR&D efforts have been devoted primarily to new product offerings andincidental enhancements and upgrades to our existing products. Historically, wehave capitalized a small percentage of our R&D expense. Capitalized R&Dexpense totaled $0.2 million and $0.1 million for the three months ended March31, 2006 and 2005, respectively. The remaining R&D expense has beenexpensed as incurred. We expect R&D expense to increase in the future as weemploy more personnel to support enhancements of our solutions and newsolutions offerings. However, we expect R&D expense to decrease as apercentage of revenue primarily due to increased efficiencies from our globaldevelopment center.

 

R&D expense increased by$0.4 million or 37% to $1.5 million for the three months ended March 31, 2006compared to the same period in 2005. The $0.4 million increase in R&Dexpense for the three months ended March 31, 2006 was primarily due to theaddition of 27 developers. As a percentage of revenue  R&D expense decreased from 7.8% to 6.7%for the three months ended March 31, 2006 compared to the same period in 2005.

 

***Depreciation and Amortization***

 

Depreciation and amortizationexpense increased by $0.2 million or approximately 31% to $0.7 million for thethree months ended March 31, 2006 compared to the same period in 2005. In thefuture we expect depreciation and amortization expense to increase due torecent capital purchases.

 

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**LIQUIDITYAND CAPITAL RESOURCES**

 

Since we were formed in1987, we have financed our operations primarily through internally generatedcash flows, our line of credit and the issuance of preferred and common stock.As of March 31, 2006, we had cash and cash equivalents of $79.5 million andaccounts receivable of $12.2 million. In addition, we had $.2 million of debtand less than $0.5 million in capital equipment leases.

 

Our cash provided from operationswas $0.9 million and $0.8 million for the three months ended March 31, 2006 and2005, respectively. Cash used in investing activities was $32.9 million and$0.3 million for the three months ended March 31, 2006 and 2005, respectively. Whilecash provided by financing activities was $68.1 million for the three monthsended March 31, 2006, cash used in financing activities was $0.8 million forthe three months ended March 31, 2005. Our net increase in cash and cashequivalents was $36.0 million for the three months ended March 31, 2006,primarily from our net proceeds of $67.3 million from our follow-on equityoffering completed in March 2006 partially offset by our acquisition of Webhirefor approximately $32 million and our net decrease in cash and cash equivalentswas $0.3 million for the three months ended March 31, 2005. We expect thispositive cash flow to continue in future periods.

 

We have a $25 millionrevolving credit facility with PNC Bank, National Association that iscollateralized by all of our assets, including a pledge of capital stock ofcertain of our subsidiaries.

 

On January 13, 2006, weacquired Webhire, Inc. for approximately $34.4 million in cash. In addition, onthat date we borrowed $25.0 million under our revolving credit facility. Werepaid all of our borrowings under our revolving credit facility with a portionof the net proceeds from our follow-on equity offering in March 2006.

 

***Operating Activities***

 

Net cash provided byoperating activities was $0.9 million and $0.8 million for the three monthsended March 31, 2006 and 2005, respectively. Net cash provided by operatingactivities for the three months ended March 31, 2006 primarily resulted fromnet income of approximately $3.3 million and non-cash charges to net income of $1.3million partially offset by a decrease in deferred revenue of $1.7 million andchanges in working capital of $2.0 million including a $0.4 million reductionin taxes payable resulting from our adoption of FAS 123R in 2006. Net cashprovided by operating activities for the three months ended March 31, 2005primarily resulted from non-cash charges to net income of $9.3 million offsetby a net loss of $6.9 million, a decrease in deferred revenue of $1.0 millionand working capital changes of $0.6 million. For the three months ended March31, 2005, non-cash charges include $8.5 million of interest expense from theredeemable preferred stock. As a result of the redemption of all of theoutstanding shares of our preferred stock in connection with our initial publicoffering in June 2005, we will not have this expense in the future..

 

***Investing Activities***

 

Net cash used in investingactivities was $33.0 million and $0.3 million for the three months ended March31, 2006 and 2005, respectively. Cash flows from investing activities for thethree months ended March 31, 2006 was primarily related to a $32.1 millionacquisition of Webhire, Inc. and $0.9 million for capitalized softwareactivities and purchases of computer hardware. Capital expenditures for thethree months ended March 31, 2005 were entirely related to capitalized softwareactivities and purchases of computer hardware. In the future we expect ourcapital expenditures to increase as revenues increase and business needs arise.

 

***Financing Activities***

 

Net cash provided by and(used in) financing activities was $68.1 million and ($0.8) million for thethree months ended March 31, 2006 and 2005, respectively. For the three monthsended March 31, 2006, net cash provided by financing activity consisted of netproceeds from our follow-on public offering of $67.3 million, net proceeds fromstock option exercises of $0.7 million and excess tax benefits from share-basedpayment arrangements of $0.4 million, partially offset by the repayments ofcapital lease obligations of $0.2 million and deferred financing costs of $0.1million. For the three months ended March 31, 2005, net cash used in financing

 

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activities consisted of therepurchase of shares of our common stock owned by certain of our formeremployees of $0.5 million, initial public offering costs of $0.2 million andrepayments of capital lease obligations of $0.1 million.

 

We believe that our cash andcash equivalent balances and cash flows from operations will be sufficient tosatisfy our working capital and capital expenditure requirements for at leastthe next 12 months. We intend to continue to invest our cash in excess ofcurrent 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**

 

Our discussion and analysisof our financial condition and consolidated results of operations are basedupon our consolidated financial statements, which have been prepared inaccordance with generally accepted accounting principles in the United States.The preparation of our consolidated financial statements requires us to makeestimates and assumptions that affect the reported amounts of assets,liabilities, revenue and expenses and related disclosure of contingent assetsand liabilities. On an on-going basis, we evaluate our estimates, includingthose related to uncollectible accounts receivable and accrued expenses. Webase these estimates on historical experience and various other assumptionsthat we believe to be reasonable under the circumstances, the results of whichform the basis for making judgments about the carrying values of assets andliabilities that are not readily apparent from other sources. Our actualresults may differ from these estimates.

 

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

 

***Revenue Recognition***

 

We derive our revenue fromtwo sources: (1) subscription revenues for solutions, which are comprised ofsubscription fees from clients accessing our on-demand software, consultingservices, outsourcing services and proprietary content, and from clientspurchasing additional support beyond the standard support that is included inthe basic subscription fee; and (2) other fees for discrete professionalservices. Because we provide our solutions as a service, we follow theprovisions of Securities and Exchange Commission Staff Accounting Bulletin No.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:

 

•                  There is persuasive evidence of anarrangement;

 

•                  The service has been provided to the client;

 

•                  The collection of the fees is probable; and

 

•                  The amount of fees to be paid by the customeris fixed or determinable.

 

Subscription fees andsupport revenues are recognized on a monthly basis over the terms of thecontracts. Amounts that have been invoiced are recorded in accounts receivableand in deferred revenue or revenue, depending on whether the revenuerecognition criteria have been met.

 

Discrete professionalservices and other revenues, when sold with subscription and support offerings,are accounted for separately since these services have value to the customer ona stand-alone basis and there is objective

 

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and reliable evidence offair value of the delivered elements. Our arrangements do not contain generalrights of return. Additionally, when professional services are sold with otherelements, the consideration from the revenue arrangement is allocated among theseparate elements based upon the relative fair value. Professional services andother revenues are recorded as follows: Consulting revenues are recognized uponcompletion of the contracts that are of short duration (generally less than 60days) and as the services are rendered for contracts of a longer duration.

 

In determining whetherrevenues from professional services can be accounted for separately fromsubscription revenue, we consider the following factors for each agreement:availability of professional services from other vendors, whether objective andreliable evidence of the fair value exists of the undelivered elements, thenature and the timing of the agreement execution in comparison to thesubscription agreement start date and the contractual dependence of thesubscription service on the customer’s satisfaction with the other services. Ifthe professional service does not qualify for separate accounting, we recognizethe revenue ratably over the remaining term of the subscription contract. Inthese situations we defer the direct and incremental costs of the professionalservice over the same period as the revenue is recognized.

 

We record out-of-pocketexpenses incurred in accordance with EITF issue 01-14, Income StatementCharacterization of Reimbursements Received for “Out-of-Pocket” ExpensesIncurred, which requires that reimbursements received for out-of-pocketexpenses be classified as revenue and not as cost reductions. Before theDecember 15, 2001 effective date of EITF Issue 01-14, out-of-pocketreimbursements from clients were netted with the applicable costs. These itemsprimarily include travel, meals and certain telecommunication costs.

 

***Allowance for Doubtful Accounts***

 

We maintain an allowance fordoubtful accounts for estimated losses resulting from clients’ inability to payus. The provision is based on our historical experience and for specificclients that, in our opinion, are likely to default on our receivables fromthem. In order to identify these clients, we perform ongoing reviews of allclients that have breached their payment terms, as well as those that have filedfor bankruptcy or for whom information has become available indicating asignificant risk of non-recoverability. In addition, we have experiencedsignificant growth in number of clients, and we have less payment history torely upon with these clients. We rely on historical trends of bad debt as apercentage of total revenue and apply these percentages to the accountsreceivable associated with new clients and evaluate these clients over time. Tothe extent that our future collections differ from our assumptions based onhistorical experience, the amount of our bad debt and allowance recorded may bedifferent.

 

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

 

In accordance with EITFIssue 00-3, “Application of AICPA Statement of Position 97-2 to ArrangementsThat Include the Right to Use Software Stored on Another Entity’s Hardware,” weapply AICPA Statement of Position No. 98-1, Accounting for the Costs ofComputer Software Developed or Obtained for Internal Use. The costs incurred inthe preliminary stages of development are expensed as incurred. Once anapplication has reached the development stage, internal and external costs, ifdirect and incremental, will be capitalized until the software is substantiallycomplete and ready for its intended use. Capitalization ceases upon completionof all substantial testing. We also capitalize 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.

 

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

 

On January 1, 2002, we adoptedSFAS No. 142,*Goodwill and Other IntangibleAssets* which superseded Accounting Board Opinion No. 17,*Intangible Assets.* Upon adoption of SFASNo. 142, we ceased amortization of existing goodwill and are required to reviewthe carrying value of goodwill for impairment. If goodwill becomes impaired,some or all of the goodwill could be written off as a charge to operations.This comparison is performed annually or more frequently if circumstancesindicate that the carrying value may not be recoverable. We have

 

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reviewed the carrying valuesof goodwill of each business unit by comparing the carrying values to theestimated fair values of the business components. The fair value is based onmanagement’s estimate of the future discounted cash flows to be generated bythe respective business components and comparable company multiples. Such cashflows consider factors such as future operating income, historical trends, aswell as demand and competition. Comparable company multiples are based uponpublic companies in sectors relevant to our business based on our knowledge ofthe industry. Changes in the underlying business could affect these estimates,which in turn could affect the recoverability of goodwill. Through March 31,2006 we have not observed any changes to our business units which would lead usto believe that our goodwill or other identified intangibles’ carrying valueexceeds their fair values.

 

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

 

We use a Black-Scholesoption-pricing model to calculate the fair value of our stock awards. Thecalculation 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:

 

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

 

•                  The expected term is determined using thesimplified method as provided by SAB 107 for “plain vanilla” options. With thepassage of time actual behavioral patterns surrounding the expected term willreplace our current methodology. Changes in the future exercise behavior ofemployees or in the vesting period of the award could result in a change in theexpected term. An increase in the expected term would result in an increase toour expense.

 

•                  The risk-free interest rate is based on theU.S. Treasury yield curve in effect at time of grant. As the risk-free interestrate increases, our expense will increase.

 

Stock-based compensationexpense recognized during the period is based on the value of the number ofawards that are expected to vest. In determining the stock-based compensationexpense to be recognized, a forfeiture rate is applied to the fair value of theaward. This rate represents the number of awards that are expected to be forfeitedprior to vesting and is based on Kenexa’s employee historical behavior. Changesin the future behavior of employees could impact this rate. A decrease in thisrate would result in an increase in our expense.

 

***Accounting for Income Taxes***

 

We account for income taxesin accordance with FASB Statement No. 109, “Accounting for Income Taxes,” orSFAS 109, which requires that deferred tax assets and liabilities be recognizedusing enacted tax rates for the effect of temporary differences between the bookand tax basis of recorded assets and liabilities. SFAS 109 also requires thatdeferred tax assets be reduced by a valuation allowance if it is more likelythan not that some portion of all of the deferred tax asset will not berealized.

 

The realization of thedeferred tax assets is evaluated quarterly by assessing the valuation allowanceand by adjusting the amount of the allowance, if necessary. The factors used toassess the likelihood of realization are the forecast of future taxable incomeand available tax planning strategies that could be implemented to realize thenet deferred tax assets. We have used tax-planning strategies to realize orrenew net deferred tax assets in order to avoid the potential loss of futuretax benefits.

 

In addition, we operatewithin multiple taxing jurisdictions and are subject to audit in eachjurisdiction. These audits can involve complex issues that may require anextended period of time to resolve. In our opinion, adequate provisions forincome taxes have been made for all periods.

 

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***Self-Insurance***

 

We are self-insured for themajority of our health insurance costs, including claims filed and claimsincurred but not reported subject to certain stop loss provisions. We estimateour liability based upon management’s judgment and historical experience. Wealso rely on the advice of consulting administrators in determining an adequateliability for self-insurance claims. For the three months ended March 31, 2006our self-insurance accrual totaled $0.3 million. We continuously review theadequacy of our insurance coverage. Material differences may result in theamount and timing of insurance expense if actual experience differssignificantly from management’s estimates.

 

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

 

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

 

***Foreign Currency Exchange Risk***

 

For the three months endedMarch 31, 2006, approximately 92.2% of our total revenue was comprised of salesto clients in the United States. A key component of our business strategy is toexpand our international sales efforts, which will expose us to foreigncurrency exchange rate fluctuations. A 10% change in the value of the U.S.dollar relative to each of the currencies of our non-U.S-generated sales wouldnot have resulted in a material change to our results. As of March 31, 2006, wewere not engaged in any foreign currency hedging activities.

 

The financial position andoperating results of our United Kingdom and India operations are consolidatedusing the local currency as the functional currency. Local currency assets andliabilities are translated at the rate of exchange to the U.S. dollar on thebalance sheet date, and the local currency revenue and expenses are translatedat average rates of exchange to the U.S. dollar during the period. The relatedtranslation adjustments was less than $0.1 million at March 31, 2006, and isincluded in accumulated other comprehensive income**.** The foreign currency translation adjustment is not adjustedfor income taxes as it relates to an indefinite investment in a non-U.S.subsidiary.

 

***Interest Rate Risk***

 

The primary objective of ourinvestment activities is to preserve principal while maximizing income withoutsignificantly increasing risk. Some of the securities in which we invest may besubject to market risk. This means that a change in prevailing interest ratesmay cause the principal amount of the investment to fluctuate. To minimize thisrisk in the future, we intend to maintain our portfolio of cash equivalents andshort-term investments in a variety of securities, including commercial paper,money market funds, government and non-government debt securities andcertificates of deposit. Our cash equivalents, which consist solely of moneymarket funds, are not subject to market risk because the interest paid on thesefunds fluctuates with the prevailing interest rate. We do not believe that a10% change in interest rates would have a significant effect on our interestincome.

 

**Item 4:Controls and Procedures**

 

Under the supervision andwith the participation of our management, including our principal executiveofficer and principal financial officer, we conducted an evaluation of theeffectiveness of the design and operation of our disclosure controls andprocedures, as defined in Rules 13a-15(e) and 15d-15(e) under the SecuritiesExchange Act of 1934 as of the end of the period covered by this report, or theEvaluation Date. Based upon the evaluation, our principal executive officer andprincipal financial officer concluded that our disclosure controls andprocedures were effective as of the Evaluation Date. Disclosure controls arecontrols and procedures designed to reasonably ensure that information requiredto be disclosed in our reports filed under the Exchange Act, such as thisreport, is recorded, processed, summarized and reported within the time periodsspecified in the SEC’s rules and forms. Disclosure controls include controlsand procedures designed to reasonably ensure that such information isaccumulated and communicated to our management, including our chief executiveofficer and chief financial officer, as appropriate to allow timely decisionsregarding required disclosure.

 

In connection with thisevaluation, our management identified no changes in our internal control overfinancial reporting that occurred during the most recent fiscal quarter thatmaterially affected, or are reasonably likely to materially affect, ourinternal control over financial reporting.

 

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**PART II: OTHER INFORMATION**

 

**Item 1:Legal Proceedings**

 

On January 27, 2006 theCompany and Gallup settled the 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 willnot have a material adverse effect on our results of operations or financial position.

 

We are involved in claims,including those identified above, which arise in the ordinary course ofbusiness. In the opinion of management, we have made adequate provision forpotential 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:Risk Factors**

 

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 risksdescribed in our Annual Report on Form 10-K for the year ended December 31,2005 are not the only risks that we face. 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.

 

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

 

Not applicable.

 

**Item 3:Defaults Upon Senior Securities**

 

Not applicable.

 

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

 

Not applicable.

 

**Item 5:Other Information**

 

Not applicable.

 

**Item 6:Exhibits**

 

The following exhibits arefiled herewith:

 

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

 

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

 

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

 

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**SIGNATURES**

 

Pursuant to the requirementsof the Securities Exchange Act of 1934, the registrant has duly caused thisreport to be signed on its behalf by the undersigned, thereunto dulyauthorized.

 

May 12, 2006

Kenexa Corporation

 

 
| */s/  Nooruddin S. Karsan*                          |   |
|-----------------------------------------------------|--------|
| *Nooruddin S. Karsan*                               |
| *Chairman of the Board and Chief Executive Officer* |
|                                                |
|                                                |
| */s/  Donald F. Volk*                               |   |
| *Donald  F. Volk*                                   |
| *Chief  Financial Officer*                          |
|                                                     |        |  |

 

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**EXHIBIT INDEX**

 

Exhibit Number andDescription

 

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

 

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

 

Exhibit32.1    Certification Furnished Pursuantto 18 U.S.C. Section 1350 as Adopted Pursuant to Section 906 of theSarbanes-Oxley Act of 2002.

 

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