**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

**FORM 10-Q**

**x**QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGEACT OF 1934

**For the quarterly periodended March 31, 2007**

**OR**

**o**TRANSITION REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGEACT OF 1934

**For the transitionperiod from         to        **

**Commission File number 000-51358**

**Kenexa Corporation**

 (Exact Name of Registrant as Specified in ItsCharter)

| **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 mark whether the registrant: (1) hasfiled all reports required to be filed by Section 13 or 15 (d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2)has been subject to such filing requirements for the past 90 days.

Yes x   No o

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

Large accelerated filer  o                                   Acceleratedfiler  x                            Non-acceleratedfiler  o

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act).

Yes  o    No  x

On May 7, 2007, 25,267,614 shares of the registrant’sCommon Stock, $0.01 par value, were outstanding.

 

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**KenexaCorporation and Subsidiaries**

**FORM10-Q**

**QuarterEnded March 31, 2007**

**Table ofContents**

 
| PART I: FINANCIAL  INFORMATION                                                                       |   |   |
|------------------------------------------------------------------------------------------------------|--------|--------|
| Item 1:  Financial Statements (unaudited)                                                            |   |   |
| Consolidated  Balance sheets as of March 31, 2007 and December 31, 2006                              |   |   |
| Consolidated  Statements of Operations for the three months ended March 31, 2007 and March  31, 2006 |   |   |
| Consolidated  Statements of Shareholders’ Equity as of March 31, 2007 and December 31, 2006     |   |   |
| Consolidated  Statements of Cash Flows for the three months ended March 31, 2007 and March  31, 2006 |   |   |
| Notes to  Consolidated Financial Statements                                                          |   |   |
| Item 2: Management’s Discussion and Analysis of  Financial Concern and Risks of Operations      |   |   |
| Item 3: Quantitative and Qualitative Disclosures about  Market Research                              |   |   |
| Item  4: Controls and Procedures                                                                     |   |   |
| PART  2: OTHER INFORMATION                                                                           |   |   |
| Item  1: Legal Proceedings                                                                           |   |   |
| Item  1A: Risk Factors                                                                               |   |   |
| 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**

**KenexaCorporation and Subsidiaries**

**ConsolidatedBalance Sheets**

(In thousands,except share data)

(Unaudited)
| ** **                                                                                                                            | ** ** | **March 31,  2007** | ** ** | **December 31,  2006** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| **Assets**                                                                                                                            | ** ** | ** **               | ** ** | ** **                  | ** ** |
| Current assets                                                                                                                        |       |                     |       |                        |       |
| Cash and cash  equivalents                                                                                                            |       | $                        | 33,111     |                        | $          | 42,502 |   |
| Short term  investments                                                                                                               |       | 78,573                   |       | —                      |       |
| Accounts  receivable, net of allowance for doubtful accounts of $1,017 and $975                                                       |       | 29,139                   |       | 31,493                      |       |
| Unbilled  receivables                                                                                                                 |       | 1,925                    |       | 1,005                       |       |
| Deferred income  taxes                                                                                                                |       | 9,765                    |       | 8,093                       |       |
| Prepaid expenses  and other current assets                                                                                            |       | 2,592                    |       | 3,578                       |       |
| **Total current assets**                                                                                                              |       | 155,105                  |       | 86,671                      |       |
| ** **                                                                                                                            |       |                     |       |                        |       |
| Property and  equipment, net of accumulated depreciation                                                                              |       | 10,223                   |       | 8,469                       |       |
| Software, net of  accumulated depreciation                                                                                            |       | 1,811                    |       | 2,122                       |       |
| Goodwill                                                                                                                              |       | 162,405                  |       | 161,329                     |       |
| Intangible  assets, net of accumulated amortization                                                                                   |       | 4,393                    |       | 4,570                       |       |
| Deferred income  taxes non current                                                                                                    |       | 1,932                    |       | 1,430                       |       |
| Deferred  financing costs, net of accumulated amortization                                                                            |       | 866                      |       | 1,295                       |       |
| Other assets                                                                                                                          |       | 1,652                    |       | 1,573                       |       |
| **Total assets**                                                                                                                      |       | $                        | 338,387    |                        | $          | 267,459 |   |
| ** **                                                                                                                            | ** ** | ** **               | ** ** | ** **                  | ** ** |
| **Liabilities and Shareholders’  Equity**                                                                                        |       |                     |       |                        |       |
| Current liabilities                                                                                                                   |       |                     |       |                        |       |
| Accounts payable                                                                                                                      |       | $                        | 7,423      |                        | $          | 5,672 |   |
| Line of credit                                                                                                                        |       | —                   |       | 20,000                      |       |
| Notes payable,  current                                                                                                               |       | 123                      |       | 138                         |       |
| Commissions  payable                                                                                                                  |       | 1,194                    |       | 1,674                       |       |
| Accrued compensation  and benefits                                                                                                    |       | 5,573                    |       | 9,878                       |       |
| Other accrued  liabilities                                                                                                            |       | 7,386                    |       | 6,086                       |       |
| Deferred revenue                                                                                                                      |       | 31,655                   |       | 31,251                      |       |
| Capital lease  obligations                                                                                                            |       | 199                      |       | 229                         |       |
| **Total current liabilities**                                                                                                         |       | 53,553                   |       | 74,928                      |       |
| ** **                                                                                                                            |       |                     |       |                        |       |
| Term loan                                                                                                                             |       | —                   |       | 45,000                      |       |
| Capital lease  obligations, less current portion                                                                                      |       | 112                      |       | 145                         |       |
| Notes payable,  less current portion                                                                                                  |       | 95                       |       | 111                         |       |
| Other  liabilities                                                                                                                    |       | —                   |       | 114                         |       |
| **Total liabilities**                                                                                                                 |       | 53,760                   |       | 120,298                     |       |
| ** **                                                                                                                            | ** ** | ** **               | ** ** | ** **                  | ** ** |
| **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; 25,266,814 and 20,897,777  shares issued and outstanding, respectively |       | 253                      |       | 209                         |       |
| Additional  paid-in capital                                                                                                           |       | 309,018                  |       | 176,345                     |       |
| Accumulated  other comprehensive income                                                                                               |       | 150                      |       | 96                          |       |
| Accumulated  deficit                                                                                                                  |       | (24,794                  | )          | (29,489                     | )          |
| **Total shareholders’ equity**                                                                                                   |       | 284,627                  |       | 147,161                     |       |
| **Total liabilities and shareholders’ equity**                                                                                   |       | $                        | 338,387    |                        | $          | 267,459 |   |

 

*See notes to consolidated financial statements.*

3

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**KenexaCorporation and Subsidiaries**

**ConsolidatedStatements of Operations**

(In thousands,except share and per share data)

(Unaudited)
| ** **                                                                                                          | ** ** | **Three months ended  March 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                                                          | ** ** | **2007**                                         | ** ** | **2006** | ** ** |
| Revenue                                                                                                             |       |                                             |       |   |   |
| Subscription  revenue                                                                                               |       | $                                                | 34,687     |   | $ | 17,593 |   |
| Other revenue                                                                                                       |       | 7,530                                            |       | 5,422 |   |
| Total revenue                                                                                                       |       | 42,217                                           |       | 23,015 |   |
| Cost of revenue                                                                                                     |       | 11,432                                           |       | 6,354 |   |
| Gross profit                                                                                                        |       | 30,785                                           |       | 16,661 |   |
| Operating expenses:                                                                                                 |       |                                             |       |   |   |
| Sales and  marketing                                                                                                |       | 8,230                                            |       | 5,728 |   |
| General and  administrative                                                                                         |       | 9,672                                            |       | 5,287 |   |
| Research and  development                                                                                           |       | 4,323                                            |       | 1,536 |   |
| Depreciation and  amortization                                                                                      |       | 1,430                                            |       | 722 |   |
| Total operating  expenses                                                                                           |       | 23,655                                           |       | 13,273 |   |
|                                                                                                                |       |                                             |       |   |   |
| Income from operations  before income taxes and interest income                                                     |       | 7,130                                            |       | 3,388 |   |
| Interest income                                                                                                     |       | 123                                              |       | 120 |   |
| Income from operations  before income tax                                                                           |       | 7,253                                            |       | 3,508 |   |
| Income tax expense on  operations                                                                                   |       | 2,558                                            |       | 229 |   |
| Net income available to  common shareholders                                                                        |       | $                                                | 4,695      |   | $ | 3,279 |   |
| Basic and diluted  income per share:                                                                                |       |                                             |       |   |   |
|                                                                                                                |       |                                             |       |   |   |
| Basic net income per  weighted average common share outstanding:                                                    |       | $                                                | 0.20       |   | $ | 0.18 |   |
| Weighted average shares  used to compute net income available to common shareholders per common share –  basic |       | 24,047,807                                       |       | 18,217,945 |   |
|                                                                                                                |       |                                             |       |   |   |
| Diluted net income per  weighted average common share outstanding:                                                  |       | $                                                | 0.19       |   | $ | 0.17 |   |
| Weighted average shares used to compute net income available to  common shareholders per common share - diluted     |       | 24,479,548                                       |       | 18,952,231 |   |

 

*See notes to consolidated financial statements.*

4

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**KenexaCorporation and Subsidiaries**

**ConsolidatedStatements of Shareholders’ Equity (Deficiency)**

(in thousands)
| ** **                                                                       | ** ** | **Common  stock** | ** ** | **Additional  paid-in  capital** | ** ** | **Accumulated  (deficit)** | ** ** | **Accumulated  other  comprehensive  (loss) income** | ** ** | **Deferred  compensation** | ** ** | **Note  receivable  on common  stock** | ** ** | **Total  stockholders’  equity** | ** ** | **Comprehensive  income** | ** ** |
|----------------------------------------------------------------------------------|------------|-------------------|------------|----------------------------------|------------|----------------------------|------------|-----------------------------------------------------------|------------|----------------------------|------------|---------------------------------------------|------------|---------------------------------------|------------|---------------------------|------------|
| Balance, December 31,  2005                                                      |       | $                 | 174        |                             | $          | 97,140                     |       | $                                                         | (45,382    | )                          | $          | (30                                         | )          | $                                     | (1,040     | )                         | $          | (120 | ) | $ | 50,742 |   | $ | 5,967 |   |
| Payments  received on notes receivable for class A common stock             |       | —            |       | —                           |       | —                     |       | —                                                    |       | —                     |       | 120                                         |       | 120                                   |       | —                    |       |
| Gain  on currency exchange                                                       |       | —            |       | —                           |       | —                     |       | 126                                                       |       | —                     |       | —                                      |       | 126                                   |       | 126                       |       |
| Reclassification  of deferred compensation balance to additional paid-in capital |       | —            |       | (1,040                           | )          | —                     |       | —                                                    |       | 1,040                      |       | —                                      |       | —                                |       | —                    |       |
| Share-based  compensation                                                        |       | —            |       | 3,076                            |       | —                     |       | —                                                    |       | —                     |       | —                                      |       | 3,076                                 |       | —                    |       |
| Income  tax benefits realized from activity in employee stock plans              |       | —            |       | 2,762                            |       | —                     |       | —                                                    |       | —                     |       | —                                      |       | 2,762                                 |       | —                    |       |
| Option  exercises                                                                |       | 4                 |       | 4,360                            |       | —                     |       | —                                                    |       | —                     |       | —                                      |       | 4,364                                 |       | —                    |       |
| Conversion  of class B, D & E warrants                                       |       | 3                 |       | (3                               | )          | —                     |       | —                                                    |       | —                     |       | —                                      |       | —                                |       | —                    |       |
| Public  stock offering, net                                                      |       | 26                |       | 66,255                           |       | —                     |       | —                                                    |       | —                     |       | —                                      |       | 66,281                                |       | —                    |       |
| Common  Stock Issuance for Gantz Wiley Research Acquisition                      |       | 2                 |       | 3,168                            |       | —                     |       | —                                                    |       | —                     |       | —                                      |       | 3,170                                 |       | —                    |       |
| Common  Stock Issuance for Psychometrics Services Ltd. Acquisition               |       | —            |       | 627                              |       | —                     |       | —                                                    |       | —                     |       | —                                      |       | 627                                   |       | —                    |       |
| Net  Income                                                                      |       |              |       |                             |       | 15,893                     |       |                                                      |       |                       |       |                                        |       | 15,893                                |       | 15,893                    |       |
| Balance, December 31,  2006                                                      |       | $                 | 209        |                             | $          | 176,345                    |       | $                                                         | (29,489    | )                          | $          | 96                                          |       | $                                     | —     |                      | $          | — |   | $ | 147,161 |   | $ | 16,019 |   |
| Gain  on currency exchange                                                       |       | —            |       | —                           |       | —                     |       | 54                                                        |       | —                     |       | —                                      |       | 54                                    |       | 54                        |       |
| Share-based  compensation                                                        |       | —            |       | 715                              |       | —                     |       | —                                                    |       | —                     |       | —                                      |       | 715                                   |       | —                    |       |
| Income  tax benefits realized from activity in employee stock plans              |       | —            |       | 341                              |       | —                     |       | —                                                    |       | —                     |       | —                                      |       | 341                                   |       | —                    |       |
| Option  exercises                                                                |       | 1                 |       | 396                              |       | —                     |       | —                                                    |       | —                     |       | —                                      |       | 397                                   |       | —                    |       |
| Employee  stock purchase plan                                                    |       | —            |       | 35                               |       | —                     |       | —                                                    |       | —                     |       | —                                      |       | 35                                    |       | —                    |       |
| Public  stock offering, net                                                      |       | 43                |       | 130,536                          |       | —                     |       | —                                                    |       | —                     |       | —                                      |       | 130,579                               |       | —                    |       |
| Common  Stock Issuance for Gantz-Wiley earn out                                  |       | —            |       | 650                              |       | —                     |       | —                                                    |       | —                     |       | —                                      |       | 650                                   |       | —                    |       |
| Net  income                                                                      |       | —            |       | —                           |       | 4,695                      |       | —                                                    |       | —                     |       | —                                      |       | 4,695                                 |       | 4,695                     |       |
| Balance, March 31, 2007                                                          |       | $                 | 253        |                             | $          | 309,018                    |       | $                                                         | (24,794    | )                          | $          | 150                                         |       | $                                     | —     |                      | $          | — |   | $ | 284,627 |   | $ | 4,749 |   |

 

*See notes to consolidated financial statements.*

5

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**KenexaCorporation and Subsidiaries**

**ConsolidatedStatements of Cash Flows**

(In thousands)

(Unaudited)

 
| ** **                                                                        | ** ** | **Three months ended  March 31,** | ** ** |
|-----------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                        | ** ** | **2007**                                         | ** ** | **2006** | ** ** |
|                                                                              |       |                                             |       |   |   |
| **Cash flows from operating  activities**                                         | ** ** | ** **                                       | ** ** | ** ** | ** ** |
| Net income from  operations                                                       |       | $                                                | 4,695      |   | $ | 3,279 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities |       |                                             |       |   |   |
| Depreciation and  amortization                                                    |       | 1,430                                            |       | 722 |   |
| Share-based  compensation                                                         |       | 715                                              |       | 572 |   |
| Excess tax benefits  from share-based payment arrangements                        |       | (341                                             | )          | (361 | ) |
| Amortization of  deferred financing fees                                          |       | 510                                              |       | 32 |   |
| Bad debt expense                                                                  |       | (2                                               | )          | 4 |   |
| Deferred taxes                                                                    |       | (1,979                                           | )          | (937 | ) |
| **Changes in assets and  liabilities**                                            | ** ** | ** **                                       | ** ** | ** ** | ** ** |
| Accounts and  unbilled receivables                                                |       | 1,399                                            |       | (241 | ) |
| Prepaid expenses  and other current assets                                        |       | 971                                              |       | (588 | ) |
| Other assets                                                                      |       | (83                                              | )          | 87 |   |
| Accounts payable                                                                  |       | 1,231                                            |       | (42 | ) |
| Accrued  compensation and other accrued liabilities                               |       | (2,163                                           | )          | 29 |   |
| Commissions  payable                                                              |       | (480                                             | )          | 94 |   |
| Deferred revenue                                                                  |       | 378                                              |       | (1,737 | ) |
| Other  liabilities                                                                |       | (114                                             | )          | (11 | ) |
| **Net cash provided by operating  activities**                                    |       | 6,167                                            |       | 902 |   |
| ** **                                                                        |       |                                             |       |   |   |
| **Cash flows from investing  activities**                                         | ** ** | ** **                                       | ** ** | ** ** | ** ** |
| Purchases of  property and equipment                                              |       | (2,693                                           | )          | (879 | ) |
| Purchases of  available-for-sale securities                                       |       | (78,573                                          | )          | — |   |
| Acquisitions,  net of cash acquired                                               |       | (1,046                                           | )          | (32,069 | ) |
| **Net cash used in investing  activities**                                        |       | (82,312                                          | )          | (32,948 | ) |
| ** **                                                                        |       |                                             |       |   |   |
| **Cash flows from financing  activities**                                         | ** ** | ** **                                       | ** ** | ** ** | ** ** |
| Net repayments  under line of credit                                              |       | (65,000                                          | )          | — |   |
| Repayments of  notes payable                                                      |       | (32                                              | )          | (49 | ) |
| Collections of  notes receivable                                                  |       | —                                           |       | 30 |   |
| Share issuance  from Employee stock purchase plan                                 |       | 35                                               |       | — |   |
| Excess tax  benefits from share-based payment arrangements                        |       | 341                                              |       | 361 |   |
| Net proceeds  from public offering                                                |       | 131,100                                          |       | 67,333 |   |
| Deferred  financing costs                                                         |       | (81                                              | )          | (119 | ) |
| Net proceeds  from option exercises                                               |       | 397                                              |       | 694 |   |
| Repayments of  capital lease obligations                                          |       | (59                                              | )          | (174 | ) |
| **Net cash provided by financing  activities**                                    |       | 66,701                                           |       | 68,076 |   |
|                                                                              |       |                                             |       |   |   |
| Effect of exchange rate  changes on cash and cash equivalents                     |       | 53                                               |       | (48 | ) |
| Net (decrease) increase  in cash and cash equivalents                             |       | (9,391                                           | )          | 35,982 |   |
| Cash and cash  equivalents at beginning of year                                   |       | 42,502                                           |       | 43,499 |   |
| ** **                                                                        |       |                                             |       |   |   |
| **Cash and cash equivalents at  end of period**                                   |       | $                                                | 33,111     |   | $ | 79,481 |   |
|                                                                              |       |                                             |       |   |   |
| **Supplemental disclosures of  cash flow information**                            | ** ** | ** **                                       | ** ** | ** ** | ** ** |
|                                                                              |       |                                             |       |   |   |
| Cash paid during the  period for:                                                 |       |                                             |       |   |   |
| Interest expense                                                                  |       | $                                                | 622        |   | $ | 344 |   |
| Income taxes                                                                      |       | $                                                | 1,009      |   | $ | 965 |   |
|                                                                              |       |                                             |       |   |   |
| **Non-cash investing and  financing activities**                                  | ** ** | ** **                                       | ** ** | ** ** | ** ** |
| Capital lease  obligations                                                        |       | $                                                | —     |   | $ | 56 |   |
| Common Stock Issuance  for Gantz-Wiley earn out                                   |       | $                                                | 650        |   | — |   |

 

*See notes to consolidated financial statements.*

6

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**KenexaCorporation and Subsidiaries**

**Notesto Consolidated Financial Statements - Unaudited**

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

**1.Organization**

Kenexa Corporation and its subsidiaries (collectively,the “Company”) commenced operations in 1987 as a provider of recruitingservices to a wide variety of industries. In 1993, the Company offered itsfirst automated talent management system. Between 1994 and 2006, the Companyacquired 25 businesses that enabled it to offer comprehensive human capitalmanagement, or HCM, services integrated with web-based technology.

The Company began its operations in 1987 under itspredecessor companies, Insurance Services, Inc., or ISI, and InternationalHolding Company, Inc., or IHC, in 1987. In December 1999, the Companyreorganized its corporate structure by merging ISI and IHC with and intoRaymond Karsan Associates, Inc., or RKA, a Pennsylvania corporation and awholly owned subsidiary of Raymond Karsan Holdings, Inc., or RKH, a Pennsylvaniacorporation. Each of RKA and RKH were newly created to consolidate thebusinesses of ISI and IHC. In April 2000, the Company changed its name toTalentPoint, Inc. and changed the name of RKA to TalentPointTechnologies, Inc. In November 2000, the Company changed its name toKenexa Corporation and changed the name of TalentPoint Technologies, Inc.to Kenexa Technology, Inc., or Kenexa Technology. Currently, Kenexatransacts business primarily through Kenexa Technology. The Company operates inone segment.

**2.Summary of Significant Accounting Policies**

Theaccompanying financial statements for the three months ended March 31, 2007 and2006 have been prepared by the Company without audit.  In the opinion of management, all adjustments(which include only normal recurring adjustments) necessary to present fairlythe financial position and the results of operations and cash flows for thethree months ended March 31, 2007 and 2006 have been made.  Certain information and footnote disclosuresnormally included in financial statements prepared in accordance withaccounting principles generally accepted in the United States have beencondensed or eliminated.  The results forthe three months ended March 31, 2007 are not necessarily indicative of theresults to be expected for the year ended December 31, 2007 or for any otherinterim period.

**Principlesof Consolidation**

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

**Cash andCash Equivalents**

Cash and cash equivalentsconsist of highly liquid investments with remaining maturities of three monthsor less at the time of purchase.  Cashwhich is restricted for lease deposits is included in other assets.

**Financial Instruments**

Short term investmentsconsist of investments with original maturities of greater than three monthsand remaining maturities of less than one year. Investments with maturities beyond one year are classified as short-termbased on their highly liquid nature and because such marketable securitiesrepresent the investment in cash that is available for current operations.  All cash and short term investments areclassified as available for sale and are recorded at market value; unrealizedgains and losses (excluding other-than-temporary impairments) are reflected inother comprehensive income.   Short terminvestments consist of tax free municipal bonds with credit ratings of AA orhigher.

**PrepaidExpenses and Other Assets**

Prepaid expenses andother current assets consist primarily of prepaid software maintenanceagreements, deferred implementation costs, insurance and other currentassets.  Deferred implementation costsrepresent internal payroll and other costs incurred in connection with thecustomization of the sites associated with internet hosting arrangements.  These costs are deferred over theimplementation period, typically three to four months, and are expensed ratablyover the subscription period, typically one to three years.  These amounts aggregated $858 and $985 atMarch 31, 2007 and December 31, 2006, respectively.  The current portion of these deferred costsof $412 and $636 at March 31, 2007 and December 31, 2006, respectively, isincluded in other current assets and the non-current portion of $446 and $349at March 31, 2007 and December 31, 2006, respectively, is included inother assets in the accompanying consolidated balance sheets.

7

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**Software Developed for Internal Use**

 

In accordance with EITF 00-3, “Application of AICPAStatement of Position 97-2 to Arrangements That Include the Right to UseSoftware Stored on Another Entity’s Hardware”, the Company applies AICPAStatement of Position No. 98-1, *Accountingfor the Costs of Computer Software Developed or Obtained for Internal Use*.The costs incurred in the preliminary stages of development are expensed asincurred. Once an application has reached the development stage, internal andexternal costs, if direct and incremental, will be capitalized until thesoftware is substantially complete and ready for its intended use.Capitalization ceases upon completion of all substantial testing. The Companyalso capitalizes costs related to specific upgrades and enhancements when it isprobable the expenditures will result in additional functionality. Maintenanceand training cost are expensed as incurred. Internal use software is amortizedon a straight-line basis over its estimated useful life, generally three years.Management evaluates the useful lives of these assets on an annual basis andtests for impairments whenever events or changes in circumstances occur thatcould impact the recoverability of these assets. There were no impairments tointernal software in any of the periods covered in this audit report.

The Company capitalizedinternal-use software costs for the three months ended March 31, 2007 and theyear ended December 31, 2006 of $241 and $1,954, respectively.  Amortization of capitalized internal-usesoftware costs for the three months ended March 31, 2007 and the year endedDecember 31, 2006 were $319 and $1,291, respectively.

**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 solution 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 IssueNo. 00-21, *Revenue Arrangements withMultiple Deliverables.* The Company recognizes revenue when all ofthe following conditions are met:

·  Thereis persuasive evidence of an arrangement;

·  Theservice has been provided to the client;

·  Thecollection of the fees is probable; and

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

 

Subscription fees andsupport revenues are recognized on a monthly basis over the lives 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 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 than60 days) and as the services are rendered for contracts of longerduration.

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 dependence of the subscription serviceon the client’s satisfaction with the other services. If the professionalservice does not qualify for separate accounting, the Company recognizes therevenue ratably over the remaining term of the subscription contract. In thesesituations the Company defers the direct and incremental costs of theprofessional service over the same period as the revenue is recognized.

Deferred revenuerepresents payments received or accounts receivable from the Company’s clientsfor amounts billed in advance of subscription services being provided.

8

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The Company records “*Out-of-Pocket*”*Expenses Incurred* (“EITF 01-14”), which requires thatreimbursements received for out-of-pocket expenses be classified as revenuesand not as cost reductions. Before the effective date of EITF 01-14,out-of-pocket reimbursements from clients were netted with the applicablecosts. These items primarily include travel, meals and certaintelecommunication costs.  For the threemonths ended March 31, 2007 and 2006, reimbursed expenses totaled $422 and$264, respectively.

**Self-Insurance**

The Company isself-insured for the majority of its health insurance costs, including claimsfiled and claims incurred but not reported subject to certain stop-lossprovisions. The Company estimated the liability based upon management’sjudgment and historical experience. At March 31, 2007 and December 31,2006, self-insurance accruals totaled $485 and $340, respectively.  Management continuously reviews the adequacyof the Company’s stop-loss insurance coverage. Material differences may resultin the amount and timing of insurance expense if actual experience differssignificantly from management’s estimates.

**Concentrationof Credit Risk**

Financial instrumentswhich potentially expose the Company to concentration of credit risk consistprimarily of accounts receivable. Credit risk arising from receivables ismitigated due to the large number of clients comprising the Company’s clientbase and their dispersion across various industries.  The clients are concentrated primarily in theCompany’s U.S. market area.  At March 31,2007, there were no clients that represented more than 10% of the net accountsreceivable balance. There were no clients that individually exceeded 10% of theCompany’s revenues.

Cash balances aremaintained at several banks. Accounts located in the United States are insuredby the Federal Deposit Insurance Corporation (“FDIC”) up to $100. Certainoperating cash accounts may exceed the FDIC limits.

**EarningsPer Share**

The Company follows SFAS 128, “Earnings PerShare.” Under SFAS 128, companies that are publicly held or have complexcapital structures are required to present basic and diluted earnings per shareon the face of the statement of operations. Earnings per share are based on the weighted average number of sharesand common stock equivalents outstanding during the period.  In the calculation of diluted earnings pershare, shares outstanding are adjusted to assume conversion of the Company’snon-interest bearing convertible stock and the exercise of options and warrantsif they are dilutive.  In the calculationof basic earnings per share, weighted average numbers of shares outstanding areused as the denominator.  The Company hada net income available to common shareholders for the periods ended March 31,2007 and 2006.  Income per share iscomputed as follows:
|                                                                                                                        | ** ** | **Three months ended  March 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                                                             | ** ** | **2007**                                         | ** ** | **2006** | ** ** |
| Numerator:                                                                                                             |       |                                             |       |   |   |
| Net income  available to common shareholders                                                                           |       | $                                                | 4,695      |   | $ | 3,279 |   |
|                                                                                                                   |       |                                             |       |   |   |
| Denominator:                                                                                                           |       |                                             |       |   |   |
| Weighted average  shares used to compute net income available to common shareholders per common  share - basic         |       | 24,047,807                                       |       | 18,217,945 |   |
| Effect of  dilutive stock options and warrants                                                                         |       | 431,741                                          |       | 734,286 |   |
|                                                                                                                   |       |                                             |       |   |   |
| Weighted average  shares used to compute net income available to common shareholders per common  share – dilutive |       | 24,479,548                                       |       | 18,952,231 |   |
|                                                                                                                   |       |                                             |       |   |   |
| Basic net income  per share to common shareholder                                                                      |       | $                                                | 0.20       |   | $ | 0.18 |   |
|                                                                                                                   |       |                                             |       |   |   |
| Diluted net income per  share to common shareholder                                                                    |       | $                                                | 0.19       |   | $ | 0.17 |   |

 

9

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**Share-based compensation**

On January 1, 2006,we adopted SFAS No. 123R using the Modified Prospective Approach (“MPA”).The MPA requires that compensation expense be recorded for restricted stock andall unvested stock options as of January 1, 2006. Since the adoption we continueto recognize the cost of previously granted share-based awards under thestraight-line basis and recognize the cost for new share-based awards on astraight-line basis over the requisite service period.

**RecentAccounting Pronouncements**

In September 2006, theFASB issued SFAS No. 157, “Fair Value Measurements.”  SFAS No. 157clarifies the principle that fair value should be based on the assumptionsmarket participants would use when pricing an asset or liability andestablishes a fair-value hierarchy that prioritizes the information used todevelop those assumptions. Under SFAS No. 157, fair-value measurements would beseparately disclosed by level within the fair-value hierarchy. SFAS No. 157 iseffective for fiscal years beginning after November 15, 2007.  We do notbelieve the adoption of SFAS No. 157 will have a material impact on ourconsolidated financial position, results of operations or cash flows.

Weadopted the Financial Accounting Standard Board’s Interpretation No. 48, *Accounting for Income Tax Uncertainties* (“FIN48”), on January 1, 2007.  FIN 48 clarifies the accounting for uncertainincome tax positions recognized in financial statements and requires the impactof a tax position to be recognized in the financial statements if that positionis more likely than not of being sustained by the taxing authority.  As ofDecember 31, 2006 and March 31, 2007, we had an insignificant amount ofunrecognized tax benefits, none of which would materially affect our effectivetax rate if recognized.  We do not expect that the amount of unrecognizedtax benefits will significantly increase or decrease within the next twelvemonths.  Our policy is to recognize interest and penalties on unrecognizedtax benefits in interest expense and general and administrative expense in theconsolidated statements of operations.  The amount of interest andpenalties for the three months ended March 31, 2007 was insignificant. Tax years beginning in 2004 are subject to examination by taxing authorities,although net operating loss and credit carryforwards from all years are subjectto examinations and adjustments for at least three years following the year inwhich the attributes are used.

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

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

The application of the provisions of SFAS 123Rresulted in a pretax expense of approximately $715 for the three months ended March31, 2007. Based on the same assumptions used to value our 2006 compensationexpense, we estimate our pretax expense associated with our share-basedcompensation plans will approximate $3,562 in 2007 and $3,232 in 2008.

**Use ofEstimates**

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

**FairValue of Financial Instruments**

Thecarrying amounts of the Company’s financial assets and liabilities, includingcash, accounts receivable and accounts payable at March 31, 2007 and 2006approximate fair value of these instruments.

10

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**3. Acquisitions**

**Psychometric Services**

On November 20, 2006, theCompany acquired all of the outstanding stock of Psychometric Services, Ltd., aprovider of user friendly psychometric tests, based in Harrow, United Kingdom,for a purchase price of approximately $7,459 in cash and $627 in stockconsideration.  The total cost of theacquisition, including legal, accounting, and other professional fees of $295,was approximately $8,382.  In connectionwith the acquisition $758 of the cash portion of the purchase price wasdeposited into an escrow account to cover any claims for indemnification madeby the Company against Psychometrics Services under the acquisitionagreement.   The escrow agreement willremain in place for one year from the acquisition date, and any funds remainingin the escrow account at the end of the one year period will be distributed tothe stockholders of Psychometric Services Ltd. The purchase price has been allocated on a preliminary basis to theassets acquired and liabilities assumed based upon management’s best estimateof fair value with any excess over the net tangible and intangible assetsacquired allocated to goodwill.    In accordance with Statementof Financial Accounting Standard No. 141 the purchase price and relatedpurchase price allocation may be updated to reflect changes such as any additionaltransaction fees or the valuation of certain assets acquired or liabilitiesassumed.

**BrassRing**

On November 13, 2006, theCompany acquired BrassRing, LLC, a provider of talent management solutions,combining innovative technology, consulting, and outsourcing with recruitmentexpertise to build successful workforces to meet the specific needs of clients,for approximately $114,708 in cash.  Thetotal cost of the acquisition, including legal, accounting, and otherprofessional fees of $3,007, was approximately $117,714.  On the date of close, approximately$11,500 or 10% of the aggregate purchase price was deposited into anescrow account to cover any claims for indemnification made by the Companyagainst BrassRing under the acquisition agreement.  Assuming there are no indemnification claims,this amount will be released to BrassRing on or about May 13, 2008.

BrassRing’s results of operations were included in theCompany’s consolidated financial statements beginning on November 13, 2006.

The purchase price was allocated as follows:
| Description                               | ** ** | **Amount** | ** ** | **Amortization  period** | ** ** |
|-------------------------------------------|------------|------------|------------|--------------------------|------------|
| Assets acquired                           |       |       |       |                     |       |
| Cash and short-term investments           |       | $          | 10,567     |                     |       |   |
| Accounts receivable                       |       | 6,326      |       |                     |       |
| Prepaid expenses and other current assets |       | 1,499      |       |                     |       |
| Property & equipment                  |       | 1,776      |       |                     |       |
| Other long-term assets                    |       | 520        |       |                     |       |
| Technology-related assets                 |       | 368        |       | 1.5  years               |       |
| Contract-related assets                   |       | 416        |       | 5  years                 |       |
| Goodwill                                  |       | 105,607    |       | Indeterminable           |       |
| Other intangibles, net                    |       | 24         |       |                     |       |
| Deferred income taxes                     |       | 3,331      |       | 5  years                 |       |
|                                      |       |       |       |                     |       |
| Less: Liabilities  assumed                |       |       |       |                     |       |
| Accounts payable                          |       | 3,875      |       |                     |       |
| Accrued salary                            |       | 880        |       |                     |       |
| Deferred federal income taxes             |       | 21         |       |                     |       |
| Deferred revenue                          |       | 7,445      |       |                     |       |
| Deferred rent                             |       | 499        |       |                     |       |
| Total cash  purchase price                |       | $          | 117,714    |                     |       |   |

 

11

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The purchase price wasinitially allocated on a preliminary basis to the assets acquired andliabilities assumed based upon management’s best estimate of fair value withany excess over the net tangible and intangible assets acquired allocated togoodwill.    In accordance with Statement of Financial AccountingStandard No. 141, the purchase price and related purchase price allocation wasupdated to reflect additional transaction fees totaling $96 incurred during thequarter ended March 31, 2007 and the valuation of additional liabilitiesassumed for severance totaling $880 and other insignificant changes to workingcapital.  The estimated fair values ofthe intangibles assets are further described below.  Contract-related assets, technology-related assets,and net operating loss tax attributes are being amortized over their estimateduseful lives.   Goodwill is not amortizedbut is periodically evaluated for impairment.

The valuation ofcontract-related assets in the amount of $416, which relates to BrassRing’scurrent customer portfolio, was determined based upon estimated discountedincremental future cash flow to be received as a result of these relationships.

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

If the BrassRing acquisitionhad occurred on January 1, 2006, the unaudited pro forma results of operationsfor the quarter ended March 31, 2006 would have been:
|                                                                       | ** ** | **Period ended  March 31, 2006** | ** ** |
|-----------------------------------------------------------------------|------------|-------------------------------------------------|------------|
| Revenue                                                               |       | $                                               | 32,668     |   |
| Net income  available to common shareholders                          |       | 3,444                                           |       |
| Net income per  share available to common shareholders – basic   |       | $                                               | 0.19       |   |
| Net income per share  available to common shareholders – diluted |       | $                                               | 0.18       |   |

 

**Gantz Wiley Research**

On August 14, 2006, theCompany, through its wholly-owned subsidiary, Kenexa Technology, Inc.,acquired all of the outstanding stock of Gantz Wiley Research, an employee andcustomer research firm based in Minneapolis, Minnesota, for a purchase price includingcontingent consideration, of approximately $3,302 in cash and $3,820 in stockconsideration.  The total cost of theacquisition, including estimated legal, accounting, and other professional feesof $46,  was approximately $7,168.  The acquisition agreement with Gantz WileyResearch also contained an earnout provision which provided for the payment ofadditional consideration by the Company based upon the annual revenues of GantzWiley Research through December 31, 2006. Based upon the results, contingent consideration of  $1,300 was paid in cash and equity during thefirst quarter of 2007 to the former shareholder of Gantz Wiley Research.  The related liability has been reflected inthe financial statements at December 31, 2006 and is included in the total costof the acquisition.  In connection withthe acquisition, $600 of the cash portion of the purchase price was depositedinto an escrow account to cover any claims for indemnification made by theCompany against Gantz Wiley Research under the acquisition agreement.   The escrow agreement will remain in placefor one year from the acquisition date, and any funds remaining in the escrowaccount at the end of the one year period will be distributed to thestockholder of Gantz Wiley Research.  The purchase price has been allocated on a preliminary basis to theassets acquired and liabilities assumed based upon management’s best estimateof fair value with any excess over the net tangible and intangible assetsacquired allocated to goodwill.    In accordance with Statementof Financial Accounting Standard No. 141 the purchase price and relatedpurchase price allocation may be updated to reflect changes such as anyadditional transaction fees or the valuation of certain assets acquired orliabilities assumed.

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**KnowledgeWorkers**

On April 10, 2006, the Company, through itswholly-owned subsidiary, Kenexa Technology, Inc., and Kenexa AcquisitionCorp., a wholly-owned subsidiary of Kenexa Technology, acquired all of theoutstanding stock of Knowledge Workers, Inc., a human capital consulting andtechnology firm based in Denver, Colorado, for a purchase price ofapproximately $2,476 in cash.  The totalcost of the acquisition, including estimated legal, accounting, and otherprofessional fees, was approximately $2,580. In connection with the acquisition the Company deposited $100 into anescrow account to cover any claims for indemnification made by the Companyagainst Knowledge Workers, Inc. under the acquisition agreement.   The escrow agreement will remain in placefor two years from the acquisition date. The purchase price has been allocated on a preliminary basis to theassets acquired and liabilities assumed based upon management’s best estimateof fair value with any excess over the net tangible and intangible assetsacquired allocated to goodwill.    In accordance with Statementof Financial Accounting Standard No. 141 the purchase price and relatedpurchase price allocation may be updated to reflect changes such as anyadditional transaction fees or the valuation of certain assets acquired orliabilities assumed.

**Webhire**

On January 13, 2006, the Company, through itswholly-owned subsidiary, Kenexa Technology, Inc., and Kenexa AcquisitionCorp., a wholly-owned subsidiary of Kenexa Technology, completed itsacquisition of Webhire, Inc. (“Webhire”) for approximately $34,395 incash. The total cost of the acquisition, including legal, accounting, and otherprofessional fees of $666, was approximately $35,061.

Approximately $5,000, or 14.3% of the aggregatepurchase price, remains deposited in an escrow account to cover any claims forindemnification made by the Company against Webhire under the acquisitionagreement.  Assuming there are noindemnification claims, this amount will be released to the former stockholdersof Webhire on or about June 13, 2007.

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

**4.Property, Equipment and Software**

A summary of property, equipment and software andrelated accumulated depreciation as of March 31, 2007 and December 31,2006 is as follows: 
|                                    | ** ** | **March 31, 2007** | ** ** | **December 31, 2006** | ** ** |
|------------------------------------|------------|------------------------------|------------|---------------------------------|------------|
|                               |       |                         |       |                            |       |
| Equipment                          |       | $                            | 10,699     |                            | $          | 8,914 |   |
| Software                           |       | 10,047                       |       | 9,934                           |       |
| Office furniture  and fixtures     |       | 1,223                        |       | 1,225                           |       |
| Leasehold  improvements            |       | 1,306                        |       | 1,282                           |       |
| Land                               |       | 708                          |       | 708                             |       |
| Building  construction in progress |       | 619                          |       | 430                             |       |
| Software in  development           |       | 491                          |       | 237                             |       |
|                               |       | 25,093                       |       | 22,730                          |       |
| Less accumulated  depreciation     |       | 13,059                       |       | 12,139                          |       |
|                               |       | $                            | 12,034     |                            | $          | 10,591 |   |

 

Equipment, officefurniture and fixtures included capital leases totaled $2,499 at March 31, 2007and December 31, 2006. Depreciation and amortization expense, includingamortization of assets under capital leases, was $1,249 and $3,312 for theperiod ended March 31, 2007 and December 31, 2006, respectively.

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**5. Other Accrued Liabilities**

Other accrued liabilities consist of the following:
|                                       | ** ** | **March 31, 2007** | ** ** | **December 31, 2006** | ** ** |
|---------------------------------------|------------|------------------------------|------------|---------------------------------|------------|
| Accrued  professional fees            |       | $                            | 123        |                            | $          | 361 |   |
| Straight line  rent accrual           |       | 1,444                        |       | 1,405                           |       |
| Other taxes payable  (non-income tax) |       | 358                          |       | 666                             |       |
| Income taxes  payable                 |       | 3,909                        |       | 740                             |       |
| Other  liabilities                    |       | 1,552                        |       | 1.614                           |       |
| Contingent  purchase price            |       | —                       |       | 1,300                           |       |
| Total other accrued  liabilities      |       | $                            | 7,386      |                            | $          | 6,086 |   |

 

**6. Lineof Credit**

OnNovember 13, 2006, the Company entered into a new secured credit agreementwith PNC Bank, N.A., as administrative agent, in connection with itsacquisition of BrassRing (the “Credit Agreement”).   The new Credit Agreement increased themaximum amount available under the facility from $25,000 to $75,000, consistingof (i) a $25,000 revolving credit facility, including a sublimit of up to$2,000 for letters of credit, and (ii) a $50,000 term loan.  Borrowings under the Credit Agreement aresecured by substantially all of the Company’s assets and the assets of itssubsidiaries.   This credit facilityreplaced the prior $25,000 revolving credit facility with PNC Bank.  As of December 31, 2006 the Company hadborrowings of $65,000 from the credit facility with a weighted averageinterest rate of 7.9% per annum

OnMarch 26, 2007, the Company entered into a First Amendment to CreditAgreement  (the “Amendment”) with PNC Bank.   The Amendment increasedthe maximum amount available under the revolving credit facility portion of theCredit Agreement from $25 million to $50 million, including a sublimit of up to$2 million for letters of credit.  In January 2007, the Company repaid thebalance of its obligations relating to the term loan portion of the CreditAgreement with the net proceeds from the Company’s public offering of itscommon stock in January 2007.  The Amendment provides that the CreditAgreement will terminate, and all borrowings will become due and payable, onMarch 26, 2010.  The Company and each of the U.S. subsidiaries of Technologyare guarantors of the obligations of Technology under the Credit Agreement, asamended by the Amendment.

OnDecember 29, 2005, the Company entered into a Third Amendment andModification to the Revolving Credit and Security Agreement with PNC Bank,N.A., originally dated July 15, 2003, and as amended on October 10,2003 and March 22, 2005. The Third Amendment increased the maximum amountavailable under the credit facility from $10,000 to $25,000, including asublimit of up to $2,000 for letters of credit. No amounts wereoutstanding on the line on December 31, 2005. On January 13, 2006,the Company borrowed $25,000 from the credit facility for working capitalpurposes.

The Company’s borrowings under the credit facilitybear interest at tiered rates based upon the ratio of Net Funded Debt toModified EBITDA Ratio as defined in the Credit Agreement. The Company may alsoelect interest rates on its borrowings calculated by reference to  (i) the higher of PNC’s prime rate or thecurrent Federal Funds rate plus 1⁄2% (the “Base Rate”), or (ii) the Eurodollarrate (the “Eurodollar Rate”), in either case plus a margin based upon the ratioof the Company and its consolidated subsidiaries’ Net Funded Debt to EBITDAratio.   Interest is payable quarterlyfor Base Rate loans and at the end of the applicable interest period forEurodollar Rate loans.   Eurodollar Rateadvances will be available for periods of 1, 2, 3, 6 or, if available to alllenders under the Credit Agreement, 9 or 12 months.   Eurodollar Rate pricing will be adjusted forany statutory reserves.

Repayment of amounts outstanding under certain notespayable and all issued or issuable shares of common and preferred stock aresubordinated to the rights of the lender under terms of the Credit Agreement.The Credit Agreement contains various terms and covenants that provide forrestrictions on capital expenditures, payment of dividends, dispositions ofassets, investments and acquisitions and require the Company, among otherthings, to maintain minimum levels of tangible net worth, net income and fixedcharge coverage.  The Company wascompliant with covenants at March 31, 2007.

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**7. Commitments and Contingencies**

 

**Litigation**

OnJanuary 27, 2006, the Company and Gallup settled the outstanding claim andentered into a confidential settlement agreement. On January 30, 2006, theCourt entered a consent order relating to the settlement. The terms of thesettlement will not have a material adverse effect on our results of operationsor financial position.

We are involved inclaims, 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 of pending or future litigation, governmentalinvestigations, legal and administrative cases and proceedings (whether civilor criminal), settlements, judgments and investigations, claims and changes inany such matters, and developments or assertions by or against us relating tointellectual property rights and intellectual property licenses, could have amaterial adverse effect on our business, financial condition and operatingresults.

**8.Equity**

OnJanuary 18, 2007, the Company completed a public offering of 3,750,000 sharesof its common stock at a price to the public of $31.86 per share. Net proceedsto the Company aggregated approximately $114,000 after payment of all offeringfees and underwriters’ commission and offering expenses of $5,475.  OnJanuary 24, 2007, the underwriters exercised their over-allotment option underthe terms of the underwriting agreement to purchase 562,500 additional sharesof common stock. Net proceeds to the Company following the sale of theoverallotment shares were $17,100.

**9.Stock Plans**

The Company’s 2005 Equity Incentive Plan (the “2005Option Plan”), which was adopted by the Company’s Board of Directors (the “Board”)in March 2005 and was approved by the Company’s shareholders in June 2005,provides for the granting of stock options to employees and directors at thediscretion of the Board or a committee of the Board.  The 2005 Option Plan replaced the Company’s2000 Stock Option Plan (the “2000 Option Plan”).  The purpose of stock options is to recognizepast services rendered and to provide additional incentive in furthering thecontinued success of the Company.  Stockoptions granted under both the 2005 Option Plan and the 2000 Stock Option Planexpire between the fifth and tenth anniversary of the date of grant andgenerally vest on the third anniversary of the date of grant.  Unexercised stock options may expire up to90 days after an employee’s termination.

As of March 31, 2007, there were options to purchase1,571,771 shares of common stock outstanding under the 2005 Option Plan.  The Company is authorized to issue up to anaggregate of 4,842,910 shares of its common stock pursuant to stock optionsgranted under the 2005 Option Plan.  Asof March 31, 2007, there were a total of 2,832,846 shares of common stock notsubject to outstanding options and available for issuance under the 2005 OptionPlan.

SFAS 123R requires companies to estimate the fairvalue of share-based payment awards on the date of grant using anoption-pricing model.  In 2007 and 2006,the fair value of each grant was estimated using the Black-Scholes valuationmodel.  Expected volatility was basedupon a weighted average of peer companies, comparable indices, and the Company’sstock volatility.  The expected life wasdetermined based upon an average of the contractual life and vesting period ofthe options.  The estimated forfeiturerate was based upon an analysis of historical data.   The risk-free rate was based on U.S.Treasury zero coupon bond yields at the time of grant.  The following table provides the assumptionsused in determining the fair value of the share-based awards for the threemonths ended March 31, 2007 and year ended December 31, 2006, respectively.
|                           | ** ** | **Three months ended  March 31, 2007** | ** ** | **Year ended  December 31, 2006** | ** ** |
|---------------------------|------------|------------------------------------------------------------|------------|--------------------------------------------------|------------|
|                      |       |                                                       |       |                                             |       |
| Expected  volatility      |       | 47.70                                                      | %          | 39.5 – 41.98                                | %          |
| Expected  dividends       |       | 0                                                          |       | 0                                                |       |
| Expected term  (in years) |       | 4                                                          |       | 4-5                                              |       |
| Risk-free rate            |       | 4.46                                                       |       | 4.6 – 5.1                                   | %          |

 

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A summary of thestatus of the Company’s stock options as of March 31, 2007 and December 31,2006 and changes during the period then ended is as follows:
|                               | ** ** | **Options Outstanding**          | ** ** | **Options Exercisable** | ** ** |
|-------------------------------|------------|---------------------------------------|------------|------------------------------|------------|
| ** **                    | ** ** | **Shares  available for  grant** | ** ** | **Shares**                   | ** ** | **Wtd. avg.  exercise  price** | ** ** | **Shares** | ** ** | **Wtd. avg.  exercise  price** | ** ** |
| Balance at  December 31, 2005 |       | 3,265,859                             |       | 1,562,181                    |       | $ | 11.74 |   | 638,781 |   | $ | 12.08 |   |
| Granted                       |       | (316,333                              | )          | 316,333                      |       | $ | 25.24 |   | — |   | — |   |
| Exercised                     |       | —                                |       | (387,986                     | )          | $ | 11.25 |   | — |   | — |   |
| Forfeited or expired          |       | 188,520                               |       | (188,520                     | )          | $ | 15.47 |   | — |   | — |   |
| Balance at  December 31, 2006 |       | 3,138,046                             |       | 1,302,008                    |       | $ | 14.63 |   | 321,208 |   | $ | 14.26 |   |
| Granted                       |       | (314,000                              | )          | 314,000                      |       | $ | 34.97 |   |   |   |   |   |
| Exercised                     |       | —                                |       | (35,437                      | )          | $ | 11.20 |   |   |   |   |   |
| Forfeited or expired          |       | 8,800                                 |       | (8,800                       | )          | $ | 28.60 |   |   |   |   |   |
| Balance at March 31,  2007    |       | 2,832,846                             |       | 1,571,771                    |       | $ | 18.69 |   | 330,571 |   | $ | 13.28 |   |

 

The total intrinsic value of options outstanding,exercisable and exercised for the period ended March 31, 2007 was $20,861,$5,914 and $882, respectively.   Theweighted average fair value for options granted during the period ended March31, 2007 and December 31, 2006 was $14.82 and $11.05, respectively.

A summary of the status of the Company’s nonvestedshare options as of December 31, 2006 and March 31, 2007 is presented below:
| Nonvested Shares           | ** ** | **Shares** | ** ** | **Wtd. Avg.  Grant Date  Fair Value** | ** ** |
|---------------------------------|------------|------------|------------|------------------------------------------------------|------------|
| Nonvested at  December 31, 2005 |       | 923,400    |       | $                                                    | 8.10       |   |
| Granted                         |       | 316,333    |       | $                                                    | 11.05      |   |
| Vested                          |       | (76,333    | )          | $                                                    | 15.31      |   |
| Forfeited or expired            |       | (182,600   | )          | $                                                    | 7.23       |   |
| Nonvested at  December 31, 2006 |       | 980,800    |       | $                                                    | 8.65       |   |
| Granted                         |       | 314,000    |       | $                                                    | 14.82      |   |
| Vested                          |       | (44,800    | )          | $                                                    | 12.78      |   |
| Forfeited or expired            |       | (8,800     | )          | $                                                    | 12.65      |   |
| Nonvested at March 31,  2007    |       | 1,241,200  |       | $                                                    | 10.03      |   |

 

Between January 1, 2007and March 31, 2007, the Company granted options to certain employees topurchase an aggregate of 314,000 shares of the Company’s common stock at aweighted exercise price of $34.97 per share. The Company granted the options atprevailing market prices ranging from $34.10 to $36.33 per share.

Between January 1, 2006and December 31, 2006, the Company granted options to certain employees topurchase an aggregate of 316,333 shares of the Company’s common stock at aweighted exercise price of $25.24 per share. The Company granted the options atprevailing market prices ranging from $21.10 to $32.69 per share.

As of March 31, 2007, there was $8,985 of totalunrecognized compensation cost related to nonvested share-based compensationarrangements granted under the 2005 Option Plan and the 2000 Option Plan.  That cost is expected to be recognized over aweighted-average period of 3.25 years.

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

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

The following table shows total share-basedcompensation expense included in the Consolidated Statement of Operations:
|                                        | ** ** | **Three months ended March 31,** | ** ** |
|----------------------------------------|------------|------------------------------------------------------|------------|
| ** **                             | ** ** | **2007**                                             | ** ** | **2006** | ** ** |
|                                   |       |                                                 |       |   |   |
| Cost of Revenue                        |       | $                                                    | 177        |   | $ | 116 |   |
| Sales and  marketing                   |       | 179                                                  |       | 201 |   |
| General and  administrative            |       | 321                                                  |       | 220 |   |
| Research and  development              |       | $                                                    | 38         |   | $ | 35 |   |
| Pre-tax  share-based compensation      |       | 715                                                  |       | 572 |   |
| Income tax  benefit                    |       | 278                                                  |       | 216 |   |
| Share-based  compensation expense, net |       | $                                                    | 437        |   | $ | 356 |   |

 

**EmployeeStock Purchase Plan**

The Employee StockPurchase Plan, which was approved May 2006, enables substantially all of theCompany’s U.S. and foreign employees to purchase shares of our common stock ata discounted offering price.  Theoffering price is 95% of the closing market price of our common stock on theNASDAQ National Market, LLC on the offering date.  500,000 common shares are available to ouremployees for purchase under the Plan. The Plan is not considered acompensatory plan in accordance with SFAS 123(R) and requires no compensationexpense to be recognized.  1,100 sharesof our common stock were purchased under the employee stock purchase planduring the ended March 31, 2007.

**10.Related Party**

Oneof the Company’s directors, Barry M. Abelson, is a partner in the law firm ofPepper Hamilton LLP. This firm has represented the Company since 1997. For thequarters ended March 31, 2007 and 2006, the Company paid Pepper Hamilton LLP,net of insurance coverage, $276 and $922, respectively, for general legalmatters.  The amount payable toPepper Hamilton as of March 31, 2007 was $485.

**11.  Income Taxes**

The Company’s tax provisionfor interim periods is determined using an estimate of its annual effectiverate.  The 2007 effective tax rate isestimated to be lower than the 35% statutory rate primarily due to anticipatedearnings in subsidiaries outside the U.S. in jurisdictions where the effectiverate is lower than in the U.S.

Effective January 1, 2007,the Company adopted the provisions of FASB Interpretation No. 48 “Accountingfor Uncertainty in Income Taxes,” (“FIN 48”). As of January 1, 2007 unrecognized tax benefits totaled $234 which wasrecorded as an increase to goodwill.

As a result of theimplementation of FIN 48, the Company recognized an increase of $6 in theliability for unrecognized tax benefits which was accounted for as an increaseto goodwill.

We recognize interest andpenalties related to our tax contingencies as other tax expense.  Our January 1, 2007 tax liabilities include$89 of interest related to the adoption of FIN 48.

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It is not expected that theamount of unrecognized tax benefits will change in the next 12 months, howeverthe Company does not expect any change to have a significant impact on theresults of operations or financial position of the Company.

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

This QuarterlyReport on Form 10-Q, including the following Management’s Discussion andAnalysis of Financial Condition and Results of Operations, containsforward-looking statements within the meaning of Section 27A of the SecuritiesAct of 1933, as amended, Section 21E of the Securities Exchange Act of 1934, asamended, and the Private Securities Litigation Reform Act of 1995, that involvea number of risks and uncertainties. Such statements are based on currentexpectations of future events that involve a number of risks and uncertaintiesthat may cause the actual events to differ materially from those discussedherein. In addition, such forward-looking statements are necessarily dependentupon assumptions, estimates and dates that may be incorrect or imprecise andinvolve known and unknown risks and other factors. Accordingly, anyforward-looking statements included herein do not purport to be predictions offuture events or circumstances and may not be realized. Forward-lookingstatements can be identified by, among other things, the use of forward-lookingterminology such as “believes,” “expects,” “may,” “could,” “will,” “should,” “seeks,”“potential,” “anticipates,” “predicts,” “plans,” “estimates,” or “intends,” orthe negative of any thereof, or other variations thereon or comparableterminology, or by discussions of strategy or intentions. Given theseuncertainties, readers are cautioned not to place undue reliance on suchforward-looking statements. Forward-looking statements should be considered inlight of various important factors, including those set forth in this reportunder Part I, Item 1A “Risk Factors” in Kenexa Corporation’s Annual Report onForm 10-K for the year ended December 31, 2006 filed with the Securities andExchange Commission. All forward-looking statements, and reasons why resultsmay differ, that are included in this report are made as of the date of thisreport, and except as required by law, we disclaim any obligations to updateany such factors or to publicly announce the results of any revisions to any ofthe forward-looking statements contained herein or reasons why results mightdiffer to reflect future events or developments. References herein to “Kenexa,”“we,” “our,” and “us” collectively refer to Kenexa Corporation, a Pennsylvaniacorporation, and all of its direct and indirect U.S., U.K., Canada, India, andother foreign subsidiaries.

**1. Overview**

Weprovide software, services and proprietary content that enable organizations tomore effectively recruit and retain employees. Our solutions are built around asuite of easily configurable software applications that automate talentacquisition and employee performance management best practices. We offer thesoftware applications that form the core of our solutions on an on-demandbasis, which materially reduces the costs and risks associated with deployingtraditional enterprise applications. We complement our software applicationswith tailored combinations of outsourcing services, consulting services andproprietary content based on our 19 years of experience assisting clients inaddressing their human resource requirements. Together, our softwareapplications and services form solutions that we believe enable our clients toimprove the effectiveness of their talent acquisition programs, increaseemployee productivity and retention, measure key HR metrics and make theirtalent acquisition and employee performance management programs more efficient.

Since1999, we have focused on providing talent acquisition and employee performancemanagement solutions on a subscription basis and currently generate asignificant portion of our revenue from these subscriptions. For the threemonths ended March 31, 2007 and 2006, revenue from these subscriptionscomprised approximately 82.2% and 76.0%, respectively, of our total revenue. Wegenerate the remainder of our revenue from discrete professional services thatare not provided as part of an integrated solution on a subscription basis.These subscription-based solutions provide us with a recurring revenue streamand we believe represent a more compelling opportunity in terms of growth andprofitability than discrete professional services.  As a result, since 1999 discrete professionalservices have represented a consistently decreasing percentage of our revenue.  We expect that trend to continue.

We sellour solutions to large and medium-sized organizations through our direct salesforce.  As of December 31, 2006, wehad a client base of approximately 3,000 companies, including approximately 166companies on the Fortune 500 list published in April 2006. Our client baseincludes companies that we billed for services during the year endedDecember 31, 2006 and does not necessarily indicate an ongoingrelationship with each such client. Our top 80 clients contributedapproximately $22.8 million, or 54.0%, of our total revenue for the threemonths ended March 31, 2007.

**2. Recent Events**

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

On August 14, 2006, we acquired Gantz-Wiley ResearchConsulting Group, Inc., an employee and customer survey data analysis firm basedin Minneapolis, Minnesota, for a purchase price of approximately $3.3 millionin cash and $3.8 million in stock consideration.  The total cost of theacquisition, including estimated legal, accounting, and other professionalfees, was approximately $7.2 million.  In addition, our agreement withGantz-Wiley contained an earnout provision which provided for the payment ofadditional consideration by the Company based upon the annual revenues ofGantz-Wiley Research through December 31, 2006.  Based upon these results,we paid an additional consideration of $1.3 million in cash and equity duringthe first quarter of 2007 to the former shareholder of Gantz-Wiley.

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On November 13, 2006, weacquired BrassRing Inc. and BrassRing LLC (“BrassRing”), a provider of talentmanagement solutions, for approximately $114.7 million in cash.  The totalcost of the acquisition, including legal, accounting, and other professionalfees of $3.0 million, was approximately $117.7 million.  Thestrategic rationale for acquiring BrassRing included expansion of opportunities with large, global customers, expansion ofglobal infrastructure and product capabilities, and creation of cross-marketing opportunities.

On November 13,2006, we entered into a new secured credit facility with PNC Bank, N.A., asadministrative agent, in connection with our acquisition of BrassRing. Ourobligations under the new credit facility are secured by substantially all ofour assets and the assets of our subsidiaries. This credit facility replacedour prior $25 million revolving credit facility with PNC Bank. Under the termsof the credit facility, we borrowed $75 million on November 13, 2006 to fundour acquisition of BrassRing.

OnNovember 20, 2006, we acquired Psychometric Services Limited., or PSL, aprovider of online and paper-based assessment products, training andconsultancy based in the United Kingdom, for approximately $7.5 million in cashand $0.6 million in stock consideration. The strategic rationale for acquiring PSL was to add PSL’s library ofcontent and team of psychologists to extend Kenexa’s value proposition and tofurther differentiate Kenexa from a domain expertise perspective.  Inaddition, we believe that the acquisition of PSL advances Kenexa’s efforts tobuild its international infrastructure, while adding an attractive customerlist of commercial and government entities in the UK.

On January 18, 2007, we completed a public offering of3,750,000 shares of our common stock at a price to the public of $31.86 per share. We also sold an additional 562,500 shares of our common stock to coverover-allotments of shares.  Our net proceeds from the offering, afterpayment of all offering expenses and commissions, aggregated approximately$131.0 million. We repaid all of the outstanding borrowings under ourcredit facility with a portion of the net proceeds from the offering.

OnMarch 26, 2007, we entered into a First Amendment to Credit Agreement withPNC Bank.   The amendment increased the maximum amount available under therevolving credit facility portion of the Credit Agreement from $25 million to$50 million, including a sublimit of up to $2 million for letters ofcredit.   The amendment provides that the credit agreement willterminate, and all borrowings will become due and payable, on March 26, 2010.

 **3.****Sources of Revenue**

Wederive revenue primarily from two sources: (1) subscription revenue for oursolutions, which is comprised of subscription fees from clients accessing ouron-demand software, consulting services, outsourcing services and proprietarycontent, and from clients purchasing additional support that is not included inthe basic subscription fee; and (2) fees for discrete professional services.

Ourclients primarily purchase renewable subscriptions for our solutions. Thetypical term is one to three years, with some terms extending up to fiveyears.  The majority of our subscriptionagreements are not cancelable for convenience although our clients have theright to terminate their contracts for cause if we fail to provide the agreedupon services or otherwise breach the agreement. A client does not generallyhave a right to a refund of any advance payments if the contract is cancelled.We expect that we will maintain our renewal rate of approximately 90.0% of theaggregate contract value up for renewal for 2007 and 2008. The revenue derived from subscription fees is recognizedratably over the term of the subscription agreement. We generally invoice ourclients in advance in monthly or quarterly installments and typical paymentterms provide that our clients pay us within 30 days of invoice. Amounts thathave been invoiced are recorded in accounts receivable prior to the receipt ofpayment and in deferred revenue to the extent revenue recognition criteria havenot been met. As the subscription component of our revenue has grown andclients’ willingness to pay us in advance for their subscriptions hasincreased, the amount of deferred revenue on our balance sheet has grown at ahigher rate than our revenue. As of March 31, 2007, deferred revenue increasedto $31.7 million from $31.3 million at December 31, 2006.  We generally price our solutions based on thenumber of software applications and services included and the number of clientemployees. Accordingly, subscription fees are generally greater for largerorganizations and for those that subscribe for a broader array of softwareapplications and services.

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

We generate substantially all of our revenue fromwithin the United States. For the three months ended March 31, 2007,approximately 87.2% of our total revenue was derived from sales in the UnitedStates.  Other than the revenue that wegenerated from clients in the Netherlands and the United Kingdom, which in theaggregate amounted to 8.4% of our total revenue for the three months endedMarch 31, 2007, and revenue that was generated from clients in Switzerland whichamounted to 1.2% for the three months ended March 31, 2007, we did not haverevenue from any other country in excess of 1.0% of our total revenue for thethree months ended March 31, 2007.

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**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,** | ** ** |
|----------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|
| ** **                                                     | ** ** | **2007**                                                                 | ** ** | **2006** | ** ** |
| ** **                                                     | ** ** | **(unaudited)**                                                          | ** ** | **(unaudited)** | ** ** |
| Total Revenue                                                  |       | $                                                                        | 42,217     |   | $ | 23,015 |   |
|                                                           |       |                                                                     |       |   |   |
| Subscription  revenue as a percentage of total revenue         |       | 82.2                                                                     | %          | 76.4 | % |
|                                                           |       |                                                                     |       |   |   |
| Income from  operations before income tax and interest expense |       | $                                                                        | 7,130      |   | $ | 3,388 |   |
|                                                           |       |                                                                     |       |   |   |
| Net cash  provided by operating activities                     |       | $                                                                        | 6,167      |   | $ | 902 |   |
|                                                           |       |                                                                     |       |   |   |

 
|                  | ** ** | **As of March 31,** | ** ** |
|------------------|------------|---------------------|------------|
| ** **       | ** ** | **2007**            | ** ** | **2006** | ** ** |
| ** **       | ** ** | **(unaudited)**     | ** ** | **(unaudited)** | ** ** |
| Deferred revenue |       | $                   | 31,655     |   | $ | 16,164 |   |
|                  |            |                     |            |  |  |  |  |

 

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

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

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

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

The following tablereconciles beginning and ending deferred revenue for each of the periods shown:
|                                                  | ** ** | **For the  year ended  December 31,** | ** ** | **For the  three months ended  March 31,** | ** ** |
|--------------------------------------------------|------------|------------------------------------------------------|------------|----------------------------------------------------------------|------------|
| ** **                                       | ** ** | ** **                                           | ** ** | ** **                                                     | ** ** | ** ** | ** ** |
| ** **                                       | ** ** | **2006**                                             | ** ** | **2007**                                                       | ** ** | **2006** | ** ** |
| ** **                                       | ** ** | ** **                                           | ** ** | **(unaudited)**                                                | ** ** | **(unaudited)** | ** ** |
|                                             |       |                                                 |       |                                                           |       |   |   |
| Deferred revenue  at the beginning of the period |       | $                                                    | 12,588     |                                                           | $          | 31,251 |   | $ | 12,558 |   |
| Total invoiced  subscriptions during period      |       | 95,087                                               |       | $                                                              | 35,091     |   | 15,886 |   |
| Deferred revenue  from acquisitions              |       | 14,046                                               |       | —                                                         |       | 5,313 |   |
| Subscription  revenue recognized during period   |       | (90,470                                              | )          | (34,687                                                        | )          | (17,593 | ) |
| Deferred revenue at end  of period               |       | $                                                    | 31,251     |                                                           | $          | 31,655 |   | $ | 16,164 |   |

** **

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**5.Results of Operations**

**Three months ended March 31, 2007 compared to three monthsended March 31, 2006**

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

Kenexa CorporationUnaudited Consolidated Statement of Operations

(In thousands)
| ** **                                                     | ** ** | **For the  Three Months Ended  March 31,** | ** ** |
|----------------------------------------------------------------|------------|----------------------------------------------------------------|------------|
| ** **                                                     | ** ** | **2007**                                                       | ** ** | **2006** | ** ** |
| ** **                                                     | ** ** | **Amount**                                                     | ** ** | **Percent of  Revenues** | ** ** | **Amount** | ** ** | **Percent of  Revenues** | ** ** |
| Revenue:                                                       |       |                                                           |       |   |   |   |   |   |   |
| Subscription  revenue                                          |       | $                                                              | 34,687     |   | 82.2 | % | $ | 17,593 |   | 76.4 | % |
| Other revenue                                                  |       | 7,530                                                          |       | 17.8 | % | 5,422 |   | 23.6 | % |
|                                                           |       |                                                           |       |   |   |   |   |   |   |
| Total revenue                                                  |       | 42,217                                                         |       | 100.0 | % | 23,015 |   | 100.0 | % |
| Cost of revenue                                                |       | 11,432                                                         |       | 27.1 | % | 6,354 |   | 27.6 | % |
|                                                           |       |                                                           |       |   |   |   |   |   |   |
| Gross profit                                                   |       | 30,785                                                         |       | 72.9 | % | 16,661 |   | 72.4 | % |
|                                                           |       |                                                           |       |   |   |   |   |   |   |
| Operating  expenses:                                           |       |                                                           |       |   |   |   |   |   |   |
| Sales and  marketing                                           |       | 8,230                                                          |       | 19.5 | % | 5,728 |   | 24.9 | % |
| General and  administrative                                    |       | 9,672                                                          |       | 22.9 | % | 5,287 |   | 23.0 | % |
| Research and  development                                      |       | 4,323                                                          |       | 10.2 | % | 1,536 |   | 6.7 | % |
| Depreciation and  amortization                                 |       | 1,430                                                          |       | 3.4 | % | 722 |   | 3.1 | % |
|                                                           |       |                                                           |       |   |   |   |   |   |   |
| Total operating  expenses                                      |       | 23,655                                                         |       | 56.0 | % | 13,273 |   | 57.7 | % |
|                                                           |       |                                                           |       |   |   |   |   |   |   |
| Income from  operations before income tax and interest expense |       | 7,130                                                          |       | 16.9 | % | 3,388 |   | 14.7 | % |
|                                                           |       |                                                           |       |   |   |   |   |   |   |
| Interest income                                                |       | 123                                                            |       | 0.3 | % | 120 |   | 0.5 | % |
|                                                           |       |                                                           |       |   |   |   |   |   |   |
| Income from  operations before income tax                      |       | 7,253                                                          |       | 17.2 | % | 3,508 |   | 15.2 | % |
| Income tax  expense from continuing operations                 |       | 2,558                                                          |       | 6.1 | % | 229 |   | 1.0 | % |
|                                                           |       |                                                           |       |   |   |   |   |   |   |
| Net income available to  common shareholders                   |       | $                                                              | 4,695      |   | 11.1 | % | $ | 3,279 |   | 14.2 | % |

 

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***Revenues***

Totalrevenue increased by $19.2 million or 83.4% to $42.2 million during the threemonths ended March 31, 2007 compared to the same period in 2006.   Our subscription revenue increased by $17.1million or 97.2% to $34.7 million during the three months ended March 31, 2007compared to the same period in 2006. Subscription revenue represented approximately 82.2% of our revenue forthe three months ended March 31, 2007. This increase is primarily attributable to the BrassRing, Gantz-Wiley,Psychometrics and Knowledge Workers acquisitions and integration of our twosales forces and the continued acceptance of our on-demand model.  Revenue from our acquisitions contributed$11.2 million to our total revenue increase for the three months ended March31, 2007.  Our other revenue increased by$2.1 million or 38.9% to $7.5 million for the three months ended March 31, 2007compared to the same period in 2006. This increase was due to primarily to anincrease in demand for our consulting services resulting from an increase inour subscription based revenues.  For theremainder of the year we expect subscription based and other revenue toincrease from the prior year due to customer acquisitions and additional salesto existing customers.

***Cost of Revenue***

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

Costof revenue increased by $5.1 million or 80% to $11.4 million for the threemonths ended March 31, 2007 compared to the same period in 2006. The additionof 113 employees, brought on by our recent acquisitions contributedapproximately $3.0 million to the cost of revenue increase for the three monthsended March 31, 2007 versus the prior year. Additionally, other consulting and external services needed to supportour customer’s requirements added approximately $1.9 million to the increaseduring the quarter ended March 31, 2007. As a percentage of revenue, cost of revenue decreased 0.5% for the threemonths ended March 31, 2007 compared to the same period in 2006.  The decrease in cost of revenue as apercentage of revenue was mostly due to an increase in revenue with minimalcorresponding costs.

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

S&Mexpense primarily consists of personnel and related costs for employees engagedin sales and marketing, including salaries, commissions and other variablecompensation, travel expenses and costs associated with trade shows,advertising and other marketing efforts and allocated overhead. We expense oursales commissions at the time the related revenue is recognized, and werecognize revenue from our subscription agreements ratably over the term of theagreements. Investment in sales and marketing commencing in 2003 resulted insignificant revenue growth during 2004 through 2006. We intend to continue toinvest in sales and marketing to pursue new clients and expand relationships withexisting clients. As a result, although we expect S&M expense to increasein total dollars, we also expect S&M to continue to decrease as apercentage of revenue for the next twelve months.

S&Mexpense increased by $2.5 million or 44% to $8.2 million for the three monthsended March 31, 2007 compared to the same period in 2006.  Increased compensation expense, relatedtravel and other expenses contributed approximately $2.0 million and $0.5million, respectively, to the increase in S&M expense during the quarterended March 31, 2007 from the prior year. The increase in compensation andtravel expense was attributable to the addition of 50 employees hired inconnection with our acquisitions in the prior year as well as 18 employeesneeded to support our organic growth.  As a percentage of revenues, S&M expense decreased from 24.9% to19.5% for the three months ended March 31, 2007 compared to the same period in2006 due to increased revenues.

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

G&Aexpense primarily consists of personnel and related costs for our executive,finance, human resources and administrative personnel, professional fees andother corporate expenses and allocated overhead. As we expand our business andincur additional expenses associated with being a public company, including thecosts of compliance with the Sarbanes-Oxley Act of 2002 and other regulationsgoverning public companies, we believe that G&A expense will increase indollar amount and may increase as a percentage of revenue in 2007 and futureperiods.

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G&Aexpense increased by $4.4 million or 83% to $9.7 million for the three monthsended March 31, 2007 compared to the same period in 2006. The $4.4 millionincrease for the quarter ended March 31, 2007 was due primarily to an increasein staff related expenses of $1.7 million related to the addition of 26employees hired in connection with our acquisitions in the prior year as wellas 18 employees needed to support our organic growth.  In addition, rent expense, professional fees andoffice supplies contributed of $0.6 million, $0.9 million and $0.4 million,respectively, to the increase in G&A expense for the three months endedMarch 31, 2007 versus the comparable period in the prior year.  The remainder of the increase of $0.8 millionwas attributable to increases in infrastructure expenses such as phone,supplies, utilities, insurance and other. As a percentage of revenue, G&A expense was approximately the sameat 22% for each of the three months ended March 31, 2007 and 2006.

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

R&Dexpense primarily consists of personnel and related costs, including salariesand employee benefits for software engineers, quality assurance engineers,product managers, technical sales engineers and management information systemspersonnel.  Our R&D efforts have beendevoted primarily to new product offerings and incidental enhancements andupgrades to our existing products.  Historically,we have capitalized a small percentage of our R&D expense.  Capitalized R&D expense totaled $0.2million and $0.1 million for the three months ended March, 2007 and 2006,respectively. The remaining R&D expense has been expensed as incurred. Weexpect R&D expense to be in a range of 6–9% of our revenues due to the continuedgrowth of our business.

R&Dexpense increased by $2.8 million or 181% to $4.3 million for the three monthsended March 31, 2007 compared to the same period in 2006.  The $2.8 million increase in R&D expensefor the three months ended March 31, 2007 was primarily due to the addition of62 developers hired in connection with our acquisitions in the prior year aswell as 50 developers needed to support our broadening and deepening solutionsuite.  As a percentage of revenueR&D expense increased from 6.7% to 10.2% for the three months ended March31, 2007 compared to the same period in 2006.

***Depreciation and Amortization***

Depreciationand amortization expense increased by $0.7 million or approximately 98% for thethree months ended March 31, 2007, compared to the same period in 2006.  In the future, we expect depreciation andamortization expense to increase due to recent capital purchases.

***Incometax expense on operations***

Income tax expense onoperations increased by $2.3 million for the three months ended March 31, 2007compared to the same periods in 2006. The increase in expense was due to increased taxable income and the fullutilization of our federal net operating loss carryforwards from the priorperiods.

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**6.  Liquidity and Capital Resources**

Sincewe were formed in 1987, we have financed our operations primarily throughinternally generated cash flows, our line of credit and the issuance ofpreferred and common stock. As of March 31, 2007, we had cash and cashequivalents of $33.1 million and short term investments of $78.6 million. Inaddition, we had $0.3 million in capital equipment leases.

Ourcash provided from operations was $6.2 million and $0.9 million for the threemonths ended March 31, 2007 and 2006, respectively.  Cash used in investing activities was $82.3million and $32.9 million for the three months ended March 31, 2007 and 2006,respectively.  Cash provided by financingactivities was $66.7 million and $68.1 million for the three months ended March31, 2007 and 2006, respectively.  Our netdecrease in cash and cash equivalents was $9.4 million for the three monthsended March 31, 2007, resulting primarily from the purchase ofavailable-for-sale securities.  Our netincrease in cash and cash equivalents was $36.0 million for the three monthsended March 31, 2006 resulting primarily from our net proceeds, after therepayment of outstanding indebtedness under our credit facility, of $67.3million from our public offering completed in March 2006.   We expect positive cash flow to continue infuture periods.

OnJanuary 18, 2007, we completed a public offering of 3,750,000 shares of ourcommon stock at a price to the public of $31.86 per share.  We also soldan additional 562,500 shares of our common stock to cover over-allotments ofshares.  Our net proceeds from the offering, after payment of all offeringexpenses and commissions, aggregated approximately $131.0 million.   We used a portion of the net proceeds fromthe offering to repay all of the outstanding indebtedness under the creditfacility.

OnMarch 26, 2007, we entered into a First Amendment to Credit Agreement withPNC Bank.   The Amendment increased the maximum amount available under therevolving credit facility portion of the Credit Agreement from $25 million to$50 million, including a sublimit of up to $2 million for letters ofcredit.   The amendment provides that the credit agreement willterminate, and all borrowings will become due and payable, on March 26, 2010.

***Operating Activities***

Netcash provided by operating activities was $6.2 million and $0.9 million for thethree months ended March 31, 2007 and 2006, respectively.  Net cash provided by operating activities forthe three months ended March 31, 2007 resulted primarily from net income ofapproximately $4.7 million, non-cash charges to net income of $2.7 million, andother changes in working capital of $1.2 million, which included a $0.3 millionreduction in taxes payable from the excess tax benefits from share basedpayments.    Net cash provided byoperating activities for the three months ended March 31, 2006 primarilyresulted from net income of approximately $3.3 million and non-cash charges tonet income of $1.3 million partially offset by a decrease in deferred revenueof $1.7 million and changes in working capital of $2.0 million which included a$0.4 million reduction in taxes payable resulting from our adoption of FAS 123Rin 2006.

***Investing Activities***

Netcash used in investing activities was $82.3 million and $32.9 million for thethree months ended March 31, 2007 and 2006, respectively.  Cash flows from investing activities for thethree months ended March 31, 2007 and March 31, 2006 consisted of thefollowing:
|                                                          | ** ** | **Three months March 31,** | ** ** |
|----------------------------------------------------------|------------|-------------------------------------------|------------|
| **In millions**                                     | ** ** | **2007**                                  | ** ** | **2006** | ** ** |
| Webhire  acquisition                                     |       | —                                    |       | $ | 32.0 |   |
| Psychometrics  acquisition                               |       | $                                         | 0.3        |   | — |   |
| Gantz Wiley  Research acquisition                        |       | $                                         | 0.6        |   | — |   |
| BrassRing  acquisition                                   |       | $                                         | 0.1        |   | — |   |
| Capitalized  software and purchases of computer hardware |       | $                                         | 2.7        |   | $ | 0.9 |   |
| Purchases of  available for sale investments             |       | $                                         | 78.6       |   |   |   |
| Total Cash flows from  investing activities              |       | $                                         | 82.3       |   | $ | 32.9 |   |

 

In thefuture, we expect our capital expenditures to increase as revenues increase andbusiness needs arise.

***Financing Activities***

Netcash provided by financing activities was $66.7 million and $68.1 million forthe three months ended March 31, 2007 and 2006, respectively.  For the three months ended March 31, 2007,net cash provided by financing activity consisted of net proceeds from our follow-onpublic offering of $131.1 million, net proceeds from stock option exercises of$0.4 million and excess tax benefits from share-based payment arrangements of$0.4 million, partially offset by the repayment of our credit facility of $65.0million, 

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capital leaseobligations and deferred financing costs of $0.1 million.   For the three months ended March 31, 2006,net cash provided by financing activity consisted of net proceeds from ourfollow-on public offering of $67.3 million, net proceeds from stock optionexercises of $0.7 million and excess tax benefits from share-based paymentarrangements of $0.4 million, partially offset by the repayments of capitallease obligations of $0.2 million and deferred financing costs of $0.1 million.

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

**CriticalAccounting Policies and Estimates**

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

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

***Revenue Recognition***

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

·                  Thereis persuasive evidence of an arrangement;

·                  Theservice has been provided to the client;

·                  Thecollection of the fees is probable; and

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

Subscription fees 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.

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

Indetermining whether revenues from professional services can be accounted forseparately from subscription revenue, we consider the following factors foreach agreement: availability of professional services from other vendors,whether objective and reliable evidence of the fair value exists of theundelivered elements, the nature and the timing of the agreement execution incomparison to the subscription agreement start date and the contractual dependenceof the subscription service on the customer’s satisfaction with the otherservices. If the professional service does not qualify for separate accounting,we recognize the revenue 

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ratably over theremaining term of the subscription contract. In these situations we defer thedirect and incremental costs of the professional service over the same periodas the revenue is recognized.

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

***Allowance for Doubtful Accounts***

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

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

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

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

OnJanuary 1, 2002, we adopted SFAS No. 142,*Goodwill and Other Intangible Assets* which superseded AccountingBoard Opinion No. 17,*Intangible Assets.*Upon adoption of SFAS No. 142, we ceased amortization of existing goodwill andare required to review the carrying value of goodwill for impairment. Ifgoodwill becomes impaired, some or all of the goodwill could be written off asa charge to operations. This comparison is performed annually or more frequentlyif circumstances indicate that the carrying value may not be recoverable. Wehave reviewed the carrying values of goodwill of each business unit bycomparing the carrying values to the estimated fair values of the businesscomponents. The fair value is based on management’s estimate of the futurediscounted cash flows to be generated by the respective business components andcomparable company multiples. Such cash flows consider factors such as futureoperating income, historical trends, as well as demand and competition.Comparable company multiples are based upon public companies in sectorsrelevant to our business based on our knowledge of the industry. Changes in theunderlying business could affect these estimates, which in turn could affectthe recoverability of goodwill.  ThroughMarch 31, 2007, we have not observed any changes to our business units whichwould lead us to believe that our goodwill or other identified intangibles’carrying value exceeds their fair values.

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***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 ameasure of the amount by which the stock price is expected to fluctuate eachyear during the expected life of the award and is based on a weighted averageof peer companies, comparable indices and our stock volatility.   An increase in the volatility would resultin an increase in our expense.

·                  The expectedterm represents the period of time that awards granted are expected to beoutstanding and is    currently based uponan average of the contractual life and the vesting period of the options.    With the passage of time actual behavioralpatterns surrounding the expected term will replace the 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-freeinterest rate is based on the U.S. Treasury yield curve in effect at time of grant.An increase in the risk-free interest rate would result in an increase in ourexpense.

 

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 beforfeited prior to vesting and is based on Kenexa’s employee historicalbehavior. Changes in the future behavior of employees could impact this rate. Adecrease in this rate would result in an increase in our expense.

***Accounting for Income Taxes***

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

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

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

***Self-Insurance***

We areself-insured for the majority of our health insurance costs, including claimsfiled and claims incurred but not reported subject to certain stop lossprovisions. We estimate our liability based upon management’s judgment andhistorical experience. We also rely on the advice of consulting administratorsin determining an adequate liability for self-insurance claims. For the three monthsended March 31, 2007 our self-insurance accrual totaled $0.5 million. Wecontinuously review the adequacy of our insurance coverage. Materialdifferences may result in the amount and timing of insurance expense if actualexperience differs significantly from management’s estimates.

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**Item3: Quantitative and Qualitative Disclosures about Market Risk**

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

***Foreign Currency Exchange Risk***

Forthe three months ended March 31, 2007, approximately 87.2% of our total revenuewas comprised of sales to clients in the United States. A key component of ourbusiness strategy is to expand our international sales efforts, which willexpose us to foreign currency exchange rate fluctuations. A 10% change in thevalue of the U.S. dollar relative to each of the currencies of ournon-U.S-generated sales would not have resulted in a material change to ourresults. As of March 31, 2007, we werenot engaged in any foreign currency hedging activities.

Thefinancial position and operating results of our United Kingdom and Indiaoperations are consolidated using the local currency as the functionalcurrency. Local currency assets and liabilities are translated at the rate ofexchange to the U.S. dollar on the balance sheet date, and the local currencyrevenue and expenses are translated at average rates of exchange to the U.S.dollar during the period. The related translation adjustments was approximately$0.1 million at March 31, 2007, and is included in accumulated othercomprehensive income**.** The foreigncurrency translation adjustment is not adjusted for income taxes as it relatesto an indefinite investment in a non-U.S. subsidiary.

***Interest Rate Risk***

Theprimary objective of our investment activities is to preserve principal whilemaximizing income without significantly increasing risk. Some of the securitiesin which we invest may be subject to market risk. This means that a change inprevailing interest rates may cause the principal amount of the investment tofluctuate. To minimize this risk in the future, we intend to maintain ourportfolio of cash equivalents and short-term investments in a variety ofsecurities, including commercial paper, money market funds, government andnon-government debt securities and certificates of deposit. Our cashequivalents, which consist solely of money market funds, are not subject tomarket risk because the interest paid on these funds fluctuates with theprevailing interest rate. We do not believe that a 10% change in interest rateswould have a significant effect on our interest income.

**Item4: Controls and Procedures**

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

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

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**PART II: OTHER INFORMATION**

**Item 1:Legal Proceedings**

OnJanuary 27, 2006, the Company and Gallup settled the outstanding claim andentered into a confidential settlement agreement. On January 30, 2006, theCourt entered a consent order relating to the settlement. The terms of thesettlement will not have a material adverse effect on our results of operationsor financial position.

We areinvolved in claims, including those identified above, which arise in theordinary course of business. In the opinion of management, we have madeadequate provision for potential liabilities, if any, arising from any suchmatters.  However, litigation isinherently unpredictable, and the costs and other effects of pending or futurelitigation, governmental investigations, legal and administrative cases andproceedings (whether civil or criminal), settlements, judgments and investigations,claims and changes in any such matters, and developments or assertions by oragainst us relating to intellectual property rights and intellectual propertylicenses, could have a material adverse effect on our business, financialcondition 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, 2006 which could materially affectour business, financial condition or future results of operations.  The risks described in our Annual Report onForm 10-K for the year ended December 31, 2006 are not the only risks that weface.  Additional risks and uncertaintiesnot currently known to us or that we currently deem to be immaterial may alsomaterially adversely affect our business, financial condition and futureresults of operations.  There have beenno material changes from the risk factors previously disclosed in Item IA ofour Annual Report on Form 10-K for the year ended December 31, 2006.

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

On March 8, 2007,as partial consideration for the Company’s acquisition of all of the outstandingstock of Gantz Wiley Research, the Company issued 20,000 shares of the Company’scommon stock to the former sole shareholder of Gantz Wiley Research.  These shares were issued without registrationunder the Securities Act of 1933, as amended, or the securities laws of certainstates, in reliance on the exemptions provided by Section 4(2) of theSecurities Act and similar exemptions under applicable state laws.

**Item 3:Defaults Upon Senior Securities**

Notapplicable.

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

Notapplicable.

**Item 5:Other Information**

Notapplicable.

**Item 6:Exhibits**

The following exhibits are filed herewith:

10.1    First Amendment to Credit Agreement dated March 26, 2007 by and among Kenexa Technology, Inc., the several     banks and other financial institutions from time to time parties thereto, and PNC Bank, National Association, as administrative agent (incorporated by reference to Exhibit 10.1 filed with the Company’s Current Report on Form 8-K dated March 26, 2007.)

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

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

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

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**SIGNATURES**

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

May 10, 2007

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 and Description

Exhibit 10.1    First Amendment to Credit Agreement dated March 26, 2007 by and among Kenexa Technology, Inc., the several     banks and other financial institutions from time to time parties thereto, and PNC Bank, National Association, as administrative agent (incorporated by reference to Exhibit 10.1 filed with the Company’s Current Report on Form 8-K dated March 26, 2007.)

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

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

Exhibit 32.1    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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