Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
As of October 31, 2007, there were 17,632,211 shares outstanding of the registrant’s common stock, $0.01 par value.
Condensed Consolidated Statements of Income (unaudited)
For the Three and Nine Months Ended September 30, 2007 and 2006
(In thousands, except per share amounts)
| | | Three Months Ended September 30, | | | Nine Months Ended September 30, | |
| | | | | | | | | | | | | |
Revenues: | | | | | | | | | | | | |
| Product | | $ | 15,032 | | | $ | 11,967 | | | $ | 41,740 | | | $ | 30,414 | |
| Services | | | | | | | | | | | | | | | | |
| Total revenues | | | | | | | | | | | | | | | | |
Cost of revenues: | | | | | | | | | | | | | | | | |
| Product | | | 4,232 | | | | 2,707 | | | | 10,173 | | | | 6,073 | |
| Services | | | | | | | | | | | | | | | | |
| Total cost of revenues | | | | | | | | | | | | | | | | |
| Gross profit | | | | | | | | | | | | | | | | |
Operating expenses: | | | | | | | | | | | | | | | | |
| Sales and marketing | | | 9,231 | | | | 7,535 | | | | 26,680 | | | | 21,283 | |
| Research and development | | | 4,348 | | | | 3,519 | | | | 12,472 | | | | 9,933 | |
| General and administrative | | | | | | | | | | | | | | | | |
| Total operating expenses | | | | | | | | | | | | | | | | |
| Operating income | | | | | | | | | | | | | | | | |
Other income (expense): | | | | | | | | | | | | | | | | |
| Interest income, net | | | 412 | | | | 162 | | | | 1,268 | | | | 382 | |
| Other income (expense), net | | | | | | | (25 | ) | | | (69 | ) | | | (89 | ) |
| Total other income, net | | | | | | | | | | | | | | | | |
| Income before income taxes | | | 2,495 | | | | 1,806 | | | | 6,620 | | | | 3,957 | |
| Income tax benefit (expense) | | | | | | | | | | | (163 | ) | | | | |
| Net income | | $ | | | | $ | | | | $ | | | | $ | | |
| | | | | | | | | | | | | | | | | |
Net income per share: | | | | | | | | | | | | | | | | |
| Basic | | $ | | | | $ | | | | $ | | | | $ | | |
| Diluted | | $ | | | | $ | | | | $ | | | | $ | | |
| | | | | | | | | | | | | | | | | |
Shares used to compute net income per share: | | | | | | | | | | | | | | | | |
| Basic | | | 17,461 | | | | 16,626 | | | | 17,388 | | | | 16,438 | |
| Diluted | | | 19,407 | | | | 18,545 | | | | 19,336 | | | | 18,010 | |
See Accompanying Notes to Condensed Consolidated Financial Statements
Condensed Consolidated Statement of Shareholders’ Equity (unaudited)
For the Nine Months Ended September 30, 2007
(In thousands)
| | | | | | | | | | | | | |
| | | | | | | | | Additional Paid-in Capital | | | | | | | |
| | | | | | | | | | | | | | | | |
Balances, December 31, 2006 | | | 17,139 | | | $ | 171 | | | $ | 72,528 | | | $ | (48,421 | ) | | $ | 24,278 | |
| | | | | | | | | | | | | | | | | | | | | |
| Issuances of common stock | | | 8 | | | | -- | | | | 150 | | | | -- | | | | 150 | |
| Exercise of stock options | | | 387 | | | | 4 | | | | 1,624 | | | | -- | | | | 1,628 | |
| Stock-based compensation | | | -- | | | | -- | | | | 2,286 | | | | -- | | | | 2,286 | |
| Net income | | | | | | | | | | | | | | | | | | | | |
Balances, September 30, 2007 | | | | | | $ | | | | $ | | | | $ | (41,964 | ) | | $ | | |
See Accompanying Notes to Condensed Consolidated Financial Statements
Condensed Consolidated Statements of Cash Flows (unaudited)
For the Nine Months Ended September 30, 2007 and 2006
(In thousands)
| | | Nine Months Ended | |
| | | | | | | |
Operating activities: | | | | | | |
| Net income | | $ | 6,457 | | | $ | 8,692 | |
| Adjustments to reconcile net income to net cash provided by operating activities: | | | | | | | | |
| Depreciation | | | 1,941 | | | | 1,327 | |
| Accretion of investment income | | | (317 | ) | | | (51 | ) |
| Stock-based compensation expense related to stock options | | | 2,286 | | | | 1,617 | |
| Deferred income tax | | | -- | | | | (5,000 | ) |
| Loss on disposal of fixed assets | | | -- | | | | 4 | |
| Changes in operating assets and liabilities: | | | | | | | | |
| Accounts receivable | | | (8,191 | ) | | | (4,048 | ) |
| Prepaid expenses | | | (699 | ) | | | (1,733 | ) |
| Other current assets | | | 216 | | | | (71 | ) |
| Other assets | | | (49 | ) | | | (80 | ) |
| Accounts payable and accrued liabilities | | | 1,192 | | | | 974 | |
| Accrued compensation and related expenses | | | 662 | | | | 372 | |
| Deferred product revenues | | | 908 | | | | 301 | |
| Deferred services revenues | | | | | | | | |
| Net cash provided by operating activities | | | | | | | | |
| | | | | | | | | |
Investing activities: | | | | | | | | |
| Purchases of available-for-sale investments | | | (15,192 | ) | | | (10,895 | ) |
| Sales of available-for-sale investments | | | 18,115 | | | | 5,189 | |
| Purchases of property and equipment | | | (3,601 | ) | | | (1,866 | ) |
| Acquisition of professional services division | | | (1,033 | ) | | | | |
| Net cash used in investing activities | | | (1,711 | ) | | | (7,572 | ) |
| | | | | | | | | |
Financing activities: | | | | | | | | |
| Proceeds from stock options exercised | | | 1,628 | | | | 2,258 | |
| Proceeds from issuance of common stock | | | | | | | | |
| Net cash provided by financing activities | | | | | | | | |
| | | | | | | | | |
| Net increase in cash and cash equivalents | | | 9,899 | | | | 1,456 | |
| Cash and cash equivalents, beginning of period | | | | | | | | |
| Cash and cash equivalents, end of period | | $ | | | | $ | | |
| | | | | | | | | |
| Cash paid during the period for: | | | | | | | | |
| Interest | | $ | -- | | | $ | 46 | |
| Income taxes | | | 147 | | | | 314 | |
See Accompanying Notes to Condensed Consolidated Financial Statements
Notes to Condensed Consolidated Financial Statements
September 30, 2007 and 2006 (unaudited)
Interactive Intelligence, Inc. (the “Company”) is a leading provider of software applications for contact centers and is leveraging that leadership position to provide mission critical voice over Internet protocol (“VoIP”) applications to enterprises. The Company’s products are installed at international corporations, public agencies, telecommunication companies, distributed organizations, government and commercial enterprises. The Company participates in three distinct markets, all of whose needs are increasing for VoIP-based systems:
| · | Enterprise IP Telephony |
The Company commenced principal operations in 1994 and revenues were first recognized in 1997. Since then, the Company has established wholly-owned subsidiaries in Australia, France, the Netherlands and the United Kingdom. The Company also currently has international branch offices in Canada, Germany, China, Japan, Korea, Malaysia, Singapore and Sweden. The Company markets its software applications in the Americas, Europe, the Middle East, Africa, and Asia/Pacific.
The accompanying unaudited condensed consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America for interim financial information and with the instructions for Form 10-Q and Article 10 of Regulation S-X. Accordingly, certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed, or omitted, pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”). In the Company’s opinion, the condensed consolidated financial statements include all adjustments necessary (which are of a normal and recurring nature) for the fair presentation of the results of the interim periods presented.
The accompanying condensed consolidated balance sheet at December 31, 2006 has been derived from the audited consolidated financial statements at that date but does not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements.
These condensed consolidated financial statements should be read in conjunction with the Company’s audited consolidated financial statements for the year ended December 31, 2006, included in the Company’s most recent Annual Report on Form 10-K as filed with the SEC. The Company’s results of operations for any interim period are not necessarily indicative of the results of operations for any other interim period or for a full fiscal year.
Interactive Intelligence, Inc.
Notes to Condensed Consolidated Financial Statements (continued)
2. | SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES |
Principles of Consolidation
The accompanying condensed consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries after elimination of all significant intercompany accounts and transactions.
Use of Estimates
The preparation of the accompanying condensed consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Despite management’s best effort to establish good faith estimates and assumptions, actual results could differ from these estimates.
Revenue Recognition
The Company generates product revenues from licensing the right to use its software applications and in certain instances providing hardware as a component of its solution, and generates services revenues primarily from annual support fees, annual renewal fees, professional services and educational services.
Product Revenues
The Company’s license agreements are either perpetual or annually renewable. For any revenues to be recognized from a license agreement, the following criteria must be met:
| · | Persuasive evidence of an arrangement exists; |
| · | The fee is fixed or determinable; |
| · | Collection is probable; and |
· Delivery has occurred.
For a perpetual license agreement, upon meeting the revenue recognition criteria above, the Company immediately recognizes as product revenues the amount of initial license fees if sufficient vendor specific objective evidence of fair value (“VSOE”) exists to support allocating a portion of the total fee to the undelivered elements of the arrangement. If sufficient VSOE of the undelivered elements does not exist, the Company recognizes the initial license fee as product revenues ratably over the initial term of the support agreement once support is the only undelivered element. The support period is generally 12 months but may be up to 18 months for initial orders because support begins when the licenses are downloaded, when support commences, or no more than six months following the contract date. The Company determines VSOE of support in perpetual agreements based on substantive renewal rates the customer must pay to renew the support. The VSOE of other services is based on amounts charged when the services are sold in stand-alone sales.
For an annually renewable license agreement, upon meeting the revenue recognition criteria above, the Company recognizes a majority of the initial license fees under these agreements as product revenues ratably over the initial license period, which is generally 12 months, and the remainder of the initial license fees are recognized as services revenues over the same time period.
The Company recognizes revenues related to any hardware sales when the hardware is delivered and all other revenue recognition criteria are met.
Services Revenues
Services revenues are primarily recognized for renewal fees and support related to annually renewable license agreements and support fees for perpetual license agreements. For annually renewable agreements, the allocation of the initial order between product revenues and services revenues is based on the average renewal rates of all time based contracts. The Company applies the allocation of product revenues and services revenues consistently to all annually renewable agreements. Under annually renewable license agreements, after the initial license period, the Company’s customers may renew their license agreement for an additional period, typically 12 months, by paying a renewal fee. The revenue for the annual renewal fees are all classified under services revenue and the revenue is recognized ratably over the contract period. Under perpetual license agreements, the Company recognizes annual support fees as services revenues ratably over the post-contract support period, which is typically 12 months.
Interactive Intelligence, Inc.
Notes to Condensed Consolidated Financial Statements (continued)
The Company also generates revenues from other services that it provides to its partners and customers. These additional revenues include fees for professional services and educational services. Revenues from professional services, which include implementing the Company’s products for a customer, and educational services, which consist of training courses for partners and customers, are recognized as the related services are performed.
Stock-Based Compensation
The Company accounts for its employee and director stock options in accordance with Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004), Share-Based Payment (“SFAS 123R”) and the guidance of the SEC Staff Accounting Bulletin No. 107 (“SAB 107”), which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors, based on fair values. As permitted by SFAS 123R, the Company used the Black-Scholes option-pricing model as its method of valuation for share-based payment awards. The Company’s determination of fair value of share-based payment awards on the date of grant using an option-pricing model is affected by the Company’s stock price as well as assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to, the Company’s expected stock price volatility over the term of the awards and an expected risk-free rate of return. If factors change and the Company uses different assumptions for estimating stock-based compensation expense in future periods, stock-based compensation expense may differ materially in the future from that recorded in the current period.
Stock-based compensation expense for employee stock options recognized under SFAS 123R for the three and nine months ended September 30, 2007 was $812,000 and $2.3 million, respectively, compared to $451,000 and $1.6 million during the same periods in 2006.
Income Taxes
Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carry-forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.
SFAS No. 109, Accounting for Income Taxes (“SFAS 109”), establishes financial accounting and reporting standards for the effect of income taxes. The Company is subject to income taxes in both the United States and numerous foreign jurisdictions. Significant judgment is required in evaluating the Company’s tax positions and determining its provision for income taxes. The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entity’s financial statements or tax returns. Variations in the actual outcome of these future tax consequences could materially impact the Company’s financial position, results of operations, or cash flows.
In assessing the recoverability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon generation of future taxable income during the periods in which temporary differences become deductible. Management considers projected future taxable income and tax planning strategies in making this assessment and ensuring that the deferred tax asset valuation allowance is adjusted as appropriate.
See Note 7 for further information on the Company’s income taxes.
Legal Proceedings
Liabilities for loss contingencies arising from claims, assessments, litigation, fines, and penalties and other sources are recorded when it is probable that a liability has been incurred and the amount of the assessment and/or remediation can be reasonably estimated. Legal costs incurred in connection with loss contingencies are expensed as incurred.
Reclassifications
Certain reclassifications have been made to prior year amounts to conform to the current period presentation.
Prior to January 1, 2007, costs related to the development of the Company’s packaged solutions were included in cost of services. Beginning January 1, 2007, for all periods, these costs have been reclassified from cost of services to research and development expenses. Prior to July 1, 2007, costs related to certain commissions for the sale of services were included in cost of services. Beginning July 1, 2007, for all periods, these costs have been reclassified from cost of services to sales and marketing expenses. Prior to October 1, 2006, costs related to our skill development funds, which were incurred by us as incentives for our partners, were included in sales and marketing expenses. Beginning October 1, 2006, for all periods, these costs have been reclassified as a reduction in product revenues as they are contingent on our partners’ sales activity.
As these reclassifications occurred between line items on the consolidated statement of income for the respective periods, they have had no impact on operating income, net income or earnings per share as previously reported.
Interactive Intelligence, Inc.
Notes to Condensed Consolidated Financial Statements (continued)
Basic net income per share is calculated based on the weighted-average number of common shares outstanding in accordance with SFAS No. 128, Earnings per Share. Diluted net income per share is calculated based on the weighted-average number of common shares outstanding plus the effect of dilutive potential common shares. When the Company reports net income, the calculation of diluted net income per share excludes shares underlying stock options outstanding that would be antidilutive. Potential common shares are composed of shares of common stock issuable upon the exercise of stock options (in thousands, except per share amounts).
| | | Three Months Ended September 30, | | | Nine Months Ended September 30, | | |
| | | | | | | | | | | | | | |
Net income, as reported (A) | | $ | | | | $ | | | | $ | | | | $ | | |
| | | | | | | | | | | | | | | |
| Weighted average shares of common stock outstanding (B) | | | 17,461 | | | | 16,626 | | | | 17,388 | | | | 16,438 | |
| Dilutive effect of employee stock options | | | | | | | | | | | | | | | | |
| Common stock and common stock equivalents (C) | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | |
Net income per share: | | | | | | | | | | | | | | |
| Basic (A/B) | | $ | 0.15 | | | $ | 0.40 | | | $ | 0.37 | | | $ | 0.53 | |
| Diluted (A/C) | | | 0.13 | | | | 0.36 | | | | 0.33 | | | | 0.48 | |
The Company’s calculation of diluted net income per share for the three months ended September 30, 2007 and 2006 excludes stock options to purchase approximately 756,000 and 362,000 shares of the Company’s common stock, respectively, and diluted net income per share for the nine months ended September 30, 2007 and 2006, excludes stock options to purchase approximately 618,000 and 379,000 shares of the Company’s common stock, respectively, as their effect would be antidilutive.
4. | STOCK-BASED COMPENSATION |
The Company’s Stock Option Plans, adopted in 1995, 1999 and 2006, authorize the Board of Directors or the Compensation Committee, as applicable, to grant incentive and nonqualified stock options, and, in the case of the 2006 Equity Incentive Plan (the “2006 Plan”), stock appreciation rights, restricted stock, restricted stock units, performance shares, performance units and other stock-based awards. After adoption of the 2006 Plan, the Company may no longer issue grants from previous plans, but any shares subject to awards under the 1999 Stock Option and Incentive Plan and the Outside Directors Stock Option Plan (collectively, the “1999 Plans”) that are cancelled will be added to shares available under the 2006 Plan. The number of shares available under the 2006 Plan is subject to adjustment for certain changes in the Company’s capital structure. The exercise price of options granted under the 2006 Plan is equal to the closing price of the Company’s common stock, as reported by The NASDAQ Global Market, on the last trading day prior to the date of grant.
Prior to 2007, options were granted based on historical performance after the Company’s quarterly and/or annual results were known, and generally vested in equal annual installments over four years from the first anniversary of the date of grant. In fiscal 2007, the Company began granting stock options as of the beginning of the year. Stock option grants are now categorized into two groups: (1) non-executive officer and director grants and (2) executive officer grants. Stock options granted to non-executive officers and directors are subject only to time vesting. The fair value of these non-executive officer and director option grants is determined on the date of grant and the related compensation expense is recognized for the entire award on a straight-line basis over the vesting period. Stock options granted to executive officers are subject to cancellation if specified performance targets for fiscal 2007 (as defined in the executives’ 2007 compensation plans) are not achieved. If the applicable performance targets are achieved, the options will vest in four equal annual installments beginning January 1, 2009. The fair value of the executive officer option grants is determined on the date of grant and the related compensation expense is recognized over the requisite service period, including the initial period for which the performance targets must be met, for each separately vesting portion of the award as if each vesting tranche was a separate award. The valuation assumptions used for each method are similar, although tailored for each vesting tranche of the awards for the executive officer grants.
Interactive Intelligence, Inc.
Notes to Condensed Consolidated Financial Statements (continued)
For most options granted through December 31, 2004, the term of each option is ten years from the date of grant. In 2005, the Company began issuing options with a term of six years from the date of grant.
If an incentive stock option is granted to an employee who, at the time the option is granted, owns stock representing more than ten percent of the voting power of all classes of stock of the Company, the exercise price of the option may not be less than 110% of the market value per share on the date the option is granted and the term of the option shall be not more than five years from the date of grant.
The plans may be terminated by the Company’s Board of Directors at any time.
Expense Information under SFAS 123R
The following table summarizes the allocation of stock-based compensation expense related to employee and director stock options under SFAS 123R for the three and nine months ended September 30, 2007 and 2006 and their related impact on net income per share (in thousands, except per share amounts):
| | | Three Months Ended September 30, | | | Nine Months Ended September 30, | |
| | | | | | | | | | | | | |
Stock-based compensation expense by category: | | | | | | | | | | | | |
| Cost of services | | $ | 70 | | | $ | 38 | | | $ | 184 | | | $ | 116 | |
| Sales and marketing | | | 313 | | | | 219 | | | | 943 | | | | 768 | |
| Research and development | | | 153 | | | | 69 | | | | 411 | | | | 179 | |
| General and administrative | | | | | | | | | | | | | | | | |
Total stock-based compensation expense | | $ | | | | $ | | | | $ | | | | $ | | |
| | | | | | | | | | | | | | | | | |
Effect of stock-based compensation expense on net income per share: | | | | | | | | | | | | | | | | |
| Basic | | $ | (0.05 | ) | | $ | (0.03 | ) | | $ | (0.13 | ) | | $ | (0.10 | ) |
| Diluted | | $ | (0.04 | ) | | $ | (0.02 | ) | | $ | (0.12 | ) | | $ | (0.09 | ) |
5. | CONCENTRATION OF CREDIT RISK |
No customer or partner represented a greater than 10% concentration of the Company’s accounts receivable as of September 30, 2007 or December 31, 2006. In addition, no customer or partner had greater than 10% concentration of the Company’s revenues for the three and nine months ended September 30, 2007 and 2006.
6. | COMMITMENTS AND CONTIGENCIES |
Legal Proceedings
From time to time, the Company has received notification from competitors and other technology providers claiming that the Company’s technology infringes their proprietary rights. The Company cannot assure you that these matters can be resolved amicably without litigation, or that the Company will be able to enter into licensing arrangements on terms and conditions that would not have a material adverse effect on its business, financial condition or results of operations.
In November 2002, the Company received a notification from the French government as a result of a tax audit that had been conducted encompassing the years 1998, 1999, 2000 and 2001. In December 2005, the Company received an additional notification from the French government as a result of an updated tax audit that they conducted. Both of these assessments claim various taxes are owed related to Value Added Tax (“VAT”) and corporation taxes in addition to what has previously been paid and accrued. In May 2007, the French court ruled against the Company on the first notification and declared the amounts due ($3.3 million for VAT and $332,000 for corporation taxes). Because the judgment from the French court was against Interactive Intelligence France S.A.R.L. (the “SARL”), a wholly owned subsidiary of the Company, the Company does not believe that the French government can impose the liability on Interactive Intelligence, Inc. and the SARL does not have any significant assets with which to pay. In addition, the Company’s tax counsel and advisors contend that the case is without merit and the Company has two more appeal routes, which could take up to ten years to resolve.
As of September 30, 2007, the assessment related to VAT was approximately $6.0 million and the assessment related to corporation taxes was approximately $723,000. As of September 30, 2007, the Company has recorded what it deems an appropriate amount for the corporate tax assessment. No accrual has been made by the Company with respect to the VAT assessment.
Interactive Intelligence, Inc.
Notes to Condensed Consolidated Financial Statements (continued)
The Company has filed for VAT refunds in France of more than $600,000, which the Company has not recorded as a receivable and to which the French government has not yet responded. The Company believes that these VAT refunds could be used to offset amounts owed to the French government in connection with the assessments, if necessary. Although the Company is appealing both the VAT and corporation tax assessments, it cannot assure you that these matters will be resolved without further litigation or that it will not have to pay some or all of the assessments.
From time to time, the Company is also involved in certain legal proceedings in the ordinary course of conducting its business. While the ultimate liability pursuant to these actions cannot currently be determined, the Company believes these legal proceedings will not have a material adverse effect on its financial position or results of operations. Litigation in general, and intellectual property litigation in particular, can be expensive and disruptive to normal business operations. Moreover, the results of complex legal proceedings are difficult to predict.
Lease Commitment
During the second quarter of 2007, the Company entered into an amendment of its corporate office operating lease under which the current leased space will be expanded to an office building currently under construction and adjacent to the Company’s corporate headquarters. The rent for the additional space through the lease expiration date will be approximately $16.3 million, payable in pro-rata monthly installments, as defined in the amendment and will commence as the Company utilizes the additional space, which is expected to be no earlier than March 1, 2008. In consideration for entering into the amendment, the landlord agreed to pay the Company a discretionary allowance of $450,000 which is payable as the Company utilizes the additional space in the office building. The Company intends to use this allowance for certain costs associated with the Company’s corporate headquarters and/or the additional space, as defined in the amendment. This amendment did not have any financial statement impact, and there were no material changes related to this amendment, during the quarter ended September 30, 2007.
Other Contingencies
The Company has received and may continue to receive certain payroll tax credits and real estate tax abatements that were granted to the Company based upon certain growth projections. If the Company’s actual results are less than those projections, the Company may be subject to repayment of some or all of the payroll tax credits or payment of additional real estate taxes in the case of the abatements. The Company does not believe that it will be subject to payment of any money related to these taxes, however the Company cannot provide assurance as to the outcome.
The Company recorded its income taxes in accordance with SFAS 109. Management considers, when assessing the realizability of deferred tax assets, whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, if any, projected future taxable income, and tax planning strategies in making this assessment.
Interactive Intelligence, Inc.
Notes to Condensed Consolidated Financial Statements (continued)
The Company had $44.1 million of tax net operating loss carry-forwards and $4.7 million in tax credit carry-forwards at December 31, 2006. Included in the net operating loss carry-forwards was $8.7 million related to disqualifying dispositions of stock options. The tax benefit of the disqualifying tax dispositions deductions, if realized for financial reporting purposes, will be recorded as a credit to additional paid-in capital.
During the third quarter of 2006, the Company recorded a non-cash tax benefit of $5.0 million to reduce the valuation allowance for its deferred tax assets as a result of improved performance of the business during the prior three years and the level of projections for future taxable income during the periods in which the deferred tax assets are deductible. The Company had a valuation allowance of $20.9 million at December 31, 2006. Management will continue to evaluate the recoverability of the deferred tax assets on a quarterly basis and will adjust, as necessary, the valuation allowance to reflect deferred tax assets deemed more likely than not to be recovered.
Effective January 1, 2007, the Company adopted FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes an interpretation of FASB Statement No. 109 (“FIN 48”). FIN 48 prescribes a recognition threshold and measurement attributes for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. Adoption of FIN 48 had no impact on the Company’s consolidated financial position and results of operations.
Upon adoption of FIN 48, the Company identified an uncertain tax position related to certain tax credits that the Company currently believes may not meet the “more likely than not” recognition threshold under FIN 48 to be sustained upon examination. Since this uncertain tax position has not been utilized and had a full valuation allowance established, the effect would be to reduce the gross deferred tax asset and valuation allowance by up to $4.7 million. This amount relates to unrecognized tax benefits that would impact the effective tax rate if recognized absent the valuation allowance. The Company and its subsidiaries file income tax returns in the U.S. federal jurisdiction, and various states and foreign jurisdictions. Tax years 2004 and forward remain open for examination for federal tax purposes and tax years 2003 and forward remain open for examination for the Company’s more significant state tax jurisdictions. To the extent utilized in future years’ tax returns, net operating loss and capital loss carry forwards at September 30, 2007 will remain subject to examination until the respective tax year is closed.
Asset Purchase Agreement
During the second quarter of 2007, the Company entered into an asset purchase agreement with Alliance Systems Ltd. (“Alliance”), and $853,000 in cash was paid to Alliance on the date of the acquisition. In connection with the acquisition, during July 2007 a hold back provision for $180,000 was paid in full to Alliance, upon achievement of certain conditions as specified in the asset purchase agreement. Except for this payment of the hold back, there were no material changes related to this acquisition during the quarter ended September 30, 2007.
The purchase price allocations for the Company’s acquisition of the professional services division of Alliance were based on a third-party valuation report which was prepared in accordance with the provisions of SFAS No. 141, Business Combinations (“SFAS No. 141”) and are subject to adjustment. The following table summarizes the fair value of the intangible and other assets acquired and liabilities assumed at the date of acquisition (in thousands):
| Goodwill | | $ | 996 | |
| Customer relationships | | | 50 | |
| Fixed assets | | | | |
| Total assets acquired | | $ | 1,082 | |
| Deferred services revenue | | | (49 | ) |
Net assets acquired | | $ | | |
The premium paid over the fair value of the net assets acquired in the purchase, or goodwill, was primarily attributed to expected synergies from the Company’s acquisition of a professional services team having prior experience with the Company’s solutions and their implementation.
Interactive Intelligence, Inc.
Notes to Condensed Consolidated Financial Statements (continued)
Goodwill
As a result of recording goodwill related to the acquisition discussed above, goodwill will be reviewed for impairment at least annually, during the fourth quarter, in accordance with the provisions of SFAS No. 142, Goodwill and Other Intangible Assets. The goodwill impairment test is a two-step test. Under the first step, the fair value of the reporting unit is compared with its carrying value (including goodwill). If the fair value of the reporting unit is less than its carrying value, an indication of goodwill impairment exists for the reporting unit and the Company must perform step two of the impairment test (measurement). Under step two, an impairment charge is recognized for any excess of the carrying amount of the reporting unit’s goodwill over the implied fair value of that goodwill.
The implied fair value of goodwill is determined by allocating the fair value of the reporting unit in a manner similar to a purchase price allocation, in accordance with SFAS No. 141. The residual fair value after this allocation is the implied fair value of the reporting unit goodwill. Fair value of the reporting unit is determined using a discounted cash flow analysis. For purposes of the impairment test, the Company is considered one reporting unit.
9. | RECENT ACCOUNTING PRONOUNCEMENTS |
In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities - Including an amendment of SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities (“SFAS 159”). SFAS 159 permits entities to choose to measure many financial assets and financial liabilities at fair value. Unrealized gains and losses on items for which the fair value option has been elected are reported in earnings. SFAS 159 is effective for the fiscal year beginning January 1, 2008. The Company is currently evaluating the impact, if any, of the adoption of SFAS 159. The Company does not expect the adoption of SFAS 159 will have a material impact on its consolidated financial position, results of operations or cash flows.
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (“SFAS 157”). SFAS 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. This Statement applies to previous accounting pronouncements that require or permit fair value measurements. Accordingly, this Statement does not require any new fair value measurements. SFAS 157 is effective for the fiscal year beginning January 1, 2008. The Company is currently evaluating the impact, if any, of the adoption of SFAS 157. The Company does not expect the adoption of SFAS 157 will have a material impact on its consolidated financial position, results of operations or cash flows.
| Management’s Discussion and Analysis of Financial Condition and Results of Operations. |
The following Management’s Discussion and Analysis of Financial Condition and Results of Operations is intended to provide our investors with an understanding of our past performance, our financial condition and our prospects and should be read in conjunction with other sections of this Quarterly Report on Form 10-Q. Investors should carefully review the information contained in this report under Part II, Item 1A “Risk Factors” and in the Item 1A “Risk Factors” section of our Annual Report on Form 10-K for the fiscal year ended December 31, 2006. The following will be discussed and analyzed:
· Forward-Looking Information
· Overview
· Financial Highlights
· Historical Results of Operations
· Liquidity and Capital Resources
· Critical Accounting Policies and Estimates
Forward-Looking Information
Certain statements in this Quarterly Report on Form 10-Q contain “forward-looking” information (as defined in the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933, as amended and Section 21E of the Securities Exchange Act of 1934, as amended) that involves risks and uncertainties which may cause actual results to differ materially from those predicted in the forward-looking statements. Forward-looking statements can often be identified by their use of such verbs as “expects”, “anticipates”, “believes”, “intend”, “plan”, “may”, “should”, “will”, “would”, “will be”, “will continue”, “will likely result”, or similar verbs or conjugations of such verbs. If any of our assumptions on which the statements are based prove incorrect or should unanticipated circumstances arise, our actual results could materially differ from those anticipated by such forward-looking statements. The differences could be caused by a number of factors or combination of factors, including, but not limited to, rapid technological changes in the industry; our ability to maintain profitability, to manage successfully our growth and increasingly complex third party relationships, to maintain successful relationships with our current and any new partners, to maintain and improve our current products and to develop new products and to protect our proprietary rights adequately; and other factors set forth in our Securities and Exchange Commission (“SEC”) filings, including the Item 1A “Risk Factors” section of our Annual Report on Form 10-K for the fiscal year ended December 31, 2006.
Overview
Interactive Intelligence, Inc. (“Interactive Intelligence”, “we”, “us” or “our”) was formed in 1994 as an Indiana corporation and maintains its world headquarters and executive offices at 7601 Interactive Way, Indianapolis, IN 46278. Our telephone number is (317) 872-3000. You can find our website at http://www.inin.com. Our periodic and current reports and all amendments to those reports required to be filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 are available free of charge through our investor relations page located on our Website at http://www.inin.com/investors.
We are a leading provider of software applications for contact centers and we are leveraging that leadership position to provide mission critical voice over Internet protocol (“VoIP”) applications to enterprises. Our solutions are utilized in contact centers of international corporations, public agencies, telecommunications companies, distributed organizations, government and commercial enterprises, and increasingly for the remote and mobile workforce. We also offer a pre-integrated all-software Internet Protocol Private Branch Exchange (“IP PBX”), a phone and communications solution for mid-sized enterprises that relies on the Microsoft Corporation (“Microsoft”) platform. We offer innovative software products and services for multi-channel contact management, business communications, messaging and session initiation protocol (“SIP”)-supported VoIP.
Our application-based solutions are integrated on a platform that scales to thousands of users, and are developed to satisfy today’s diverse interaction needs in markets for:
| · | Enterprise IP Telephony |
By implementing our all-in-one solutions, businesses are able to unify communications, enhance workforce effectiveness and productivity, and readily adapt to constantly changing market and customer requirements. Moreover, organizations are able to reduce the cost and complexity of traditional “multi-point” legacy communications hardware systems that are seldom fully integrated.
Financial Highlights
For the three months ended September 30, 2007, revenues grew 6% over the previous three month period and 31% over the three months ended September 30, 2006. The increase takes into account a reclassification in the third quarter of 2006 related to our skills development funds as discussed in Note 2 of our Notes to Condensed Consolidated Financial Statements (“Note 2”).
Factors that affect revenues in any particular quarter include potential customers’ budget constraints, personnel resources to implement our solutions, historical product order patterns and willingness to implement a critical telecommunications system. Revenues in any particular quarter can greatly fluctuate from other periods.
The amount of orders we receive, while impacting product revenues, does not have an exact correlation to revenues because the terms in the contracts, collection history with the customer or partner, and any other contractual conditions affect whether we can recognize the order during the quarter or in subsequent quarters. Consequently, product revenues for any particular quarter are impacted not only by orders received in the current quarter but also by orders received in previous quarters that are being recognized in the current quarter.
The information below shows our total revenues (in millions) for the most recent five quarters and the years ended December 31, 2006, 2005 and 2004 and the percentage change over the previous period (including the impact of the 2006 reclassification discussed above and in Note 2).
Period | | Revenues | | | % Growth | |
Three months ended: | | | | | | |
| September 30, 2007 | | $ | 28.7 | | | | 6 | % |
| June 30, 2007 | | | 27.0 | | | | 12 | |
| March 31, 2007 | | | 24.2 | | | | 1 | |
| December 31, 2006 | | | 23.9 | | | | 8 | |
| September 30, 2006 | | | 22.0 | | | | 14 | |
| | | | | | | | | |
Year ended December 31: | | | | | | | | |
| 2006 | | $ | 83.0 | | | | 32 | % |
| 2005 | | | 62.9 | | | | 14 | |
| 2004 | | | 55.1 | | | | 7 | |
Product revenues increased during the three and nine months ended September 30, 2007, compared to the same periods in 2006, as a result of increased demand for our software and appliances, third party products we license and third party hardware we sell. We have experienced increasing annual revenue growth in all major geographies in part due to an increase in demand for our contact center solutions. We also attribute annual revenue growth to a number of other factors including but not limited to: adoption of VoIP technologies by our customers; increasing market awareness of our solutions; improvements in scalability and the reliability of our products; reductions in hardware costs to deploy our solutions making our solutions more financially attractive to customers; changes in our sales program to target new customers; and establishment of an inside sales group to work with current customers.
Services revenues increased significantly during the three and nine months ended September 30, 2007, compared to the same periods in 2006, primarily due to additional support fees and annually renewable license fees, which were recognized for our growing installed customer base, and an increase in revenues from professional services as more of our larger, direct customers utilized our professional services group to assist in implementing our solutions.
Our costs of products continue to increase due to appliances we have developed and licensed, additional hardware delivered by us and increased royalty expenses as a result of licensing more third party software as part of the orders received.
Costs of services and operating expenses for the three and nine months ended September 30, 2007 increased significantly compared to the same periods in 2006 primarily due to a 26% increase in company-wide staffing at September 30, 2007 compared to September 30, 2006 and related costs.
Since January 1, 2006, we have accounted for our employee and director stock options in accordance with Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004), Share-Based Payment (“SFAS 123R”) and the guidance of the SEC Staff Accounting Bulletin No. 107 (“SAB 107”), which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors, based on fair values. As a result, we have incurred stock-based compensation expense each quarter as stock options are granted and vested. The following is a brief summary of our stock-based compensation expense for the three and nine months ended September 30, 2007 and 2006 and the related impact on net income per share (in thousands, except per share amounts):
| | | Three Months Ended September 30, | | | Nine Months Ended September 30, | |
| | | | | | | | | | | | | |
Total stock-based compensation expense | | $ | | | | $ | | | | $ | | | | $ | | |
| | | | | | | | | | | | | | | | | |
Effect of stock-based compensation expense on net income per share: | | | | | | | | | | | | | | | | |
| Basic | | $ | (0.05 | ) | | $ | (0.03 | ) | | $ | (0.13 | ) | | $ | (0.10 | ) |
| Diluted | | $ | (0.04 | ) | | $ | (0.02 | ) | | $ | (0.12 | ) | | $ | (0.09 | ) |
Based on currently issued non-vested options as of September 30, 2007, we expect stock-based compensation expenses related to SFAS 123R to be approximately $835,000 for the fourth quarter of 2007.
During the second quarter of 2007, we acquired certain intangible and other assets and assumed certain liabilities of the professional services division of Alliance for $1.0 million. A total of 13 professional services engineers and one sales representative joined our company immediately following the consummation of the acquisition. These individuals possessed previous experience with our solutions and their implementation. We funded the $1.0 million purchase price with cash available from operations, which also included a hold back provision of $180,000 to cover costs for training and recruiting if any of the acquired Alliance employees left our company within 90 days after closing the transaction. The hold back was paid in full in July 2007. This acquisition has enabled us to immediately expand our professional services group in an effort to more effectively support our customers. See Note 8 of Notes to Condensed Consolidated Financial Statements for further information.
During the third quarter of 2006, we recorded a non-cash tax credit of $5.0 million to reduce the valuation allowance for our deferred tax assets. We had a valuation allowance of $20.9 million at December 31, 2006. We have not recorded a reduction of the deferred tax valuation allowance since the three months ended September 30, 2006; however, we continue to evaluate the recoverability of the deferred tax assets on a quarterly basis.
Historical Results of Operations
The following table presents certain financial data, derived from our unaudited statements of income, as a percentage of total revenues for the periods indicated. The operating results for the three and nine months ended September 30, 2007 and 2006 are not necessarily indicative of the results that may be expected for the full year or for any future period.
| | | Three Months Ended September 30, | | | Nine Months Ended September 30, | |
| | | | | | | | | | | | | |
Revenues: | | | | | | | | | | | | |
| Product | | | 52 | % | | | 54 | % | | | 52 | % | | | 51 | % |
| Services | | | | | | | | | | | | | | | | |
| Total revenues | | | | | | | | | | | | | | | | |
Cost of revenues: | | | | | | | | | | | | | | | | |
| Product | | | 15 | | | | 12 | | | | 13 | | | | 10 | |
| Services | | | | | | | | | | | | | | | | |
| Total cost of revenues | | | | | | | | | | | | | | | | |
| Gross profit | | | | | | | | | | | | | | | | |
Operating expenses: | | | | | | | | | | | | | | | | |
| Sales and marketing | | | 32 | | | | 34 | | | | 33 | | | | 36 | |
| Research and development | | | 15 | | | | 16 | | | | 16 | | | | 17 | |
| General and administrative | | | | | | | | | | | | | | | | |
| Total operating expenses | | | | | | | | | | | | | | | | |
| Operating income | | | 8 | | | | 7 | | | | 7 | | | | 6 | |
Other income (expense): | | | | | | | | | | | | | | | | |
| Interest income, net | | | 1 | | | | 1 | | | | 1 | | | | 1 | |
| Other income (expense) | | | | | | | | | | | | | | | | |
| Total other income (expense) | | | | | | | | | | | | | | | | |
| Income before income taxes | | | 9 | | | | 8 | | | | 8 | | | | 7 | |
| Income tax benefit (expense) | | | | | | | | | | | | | | | | |
| Net income | | | 9 | % | | | 30 | % | | | 8 | % | | | 15 | % |
Comparison of Three and Nine Months Ended September 30, 2007 and 2006
Revenues
Product Revenues
| | | Three Months Ended September 30, | | | Nine Months Ended September 30, | |
| | | | | | | | | | | | | |
| | | ($ in thousands) | |
| Product revenues | | $ | 15,032 | | | $ | 11,967 | | | $ | 41,740 | | | $ | 30,414 | |
| Change from prior year period | | | 26 | % | | | 54 | % | | | 37 | % | | | 25 | % |
| Percentage of total revenues | | | 52 | % | | | 54 | % | | | 52 | % | | | 51 | % |
Product revenues, which include software and hardware revenues, increased during the three and nine months ended September 30, 2007 compared to the same periods in 2006 across all major geographies. During the quarter and nine months, we recognized increased hardware revenues, which was primarily due to a higher demand for our media server and gateway appliances which have added to the scalability and functionality of our solutions. During the nine months ended September 30, 2007, we have experienced increases in orders greater than $100,000 and increases in orders from our existing customer base compared to the same period in 2006.
Services Revenues
| | | Three Months Ended September 30, | | | Nine Months Ended September 30, | |
| | | | | | | | | | | | | |
| | | ($ in thousands) | |
| Services revenues | | $ | 13,676 | | | $ | 10,030 | | | $ | 38,141 | | | $ | 28,766 | |
| Change from prior year period | | | 36 | % | | | 35 | % | | | 33 | % | | | 36 | % |
| Percentage of total revenues | | | 48 | % | | | 46 | % | | | 48 | % | | | 49 | % |
Services revenues include the portion of the initial license arrangement allocated to maintenance and support revenues from annually renewable and perpetual contracts, license renewals of annually renewable contracts, and support fees for perpetual contracts, as well as professional services, education and other miscellaneous revenues.
The increase during the three and nine months ended September 30, 2007 compared to the same periods in 2006 was primarily due to our growing installed base of customers and related payments of annual license renewal fees and support fees for perpetual licenses. License renewal and support revenues increased by $1.8 million and $4.9 million during the three and nine months ended September 30, 2007, respectively, or 22% and 21%, respectively, compared to the same periods in 2006. As new customers license our solutions, we expect that our services revenues will increase as these customers continue to renew their licenses and pay for ongoing support for our solutions.
During the three and nine months ended September 30, 2007, revenues from professional services increased $1.6 million and $3.8 million, respectively, from the same periods in 2006 due to more of our larger, direct customers utilizing our professional services group to assist in implementing our solutions. In April 2007, we acquired the professional services division of Alliance, which added 13 engineers to our professional services group and increased our resources to serve our customers. We anticipate these revenues related to professional services will continue to increase in the future if the number of our large, direct customers continues to grow.
Educational and other services revenues increased $278,000 and $605,000 for the three and nine months ended September 30, 2007, respectively, compared to the same periods in 2006. These revenues have and will fluctuate based on the number of customers and partners that attend our educational classes, and the amount of assistance our customers and partners need for implementation and installation.
Cost of Revenues
| | | Three Months Ended September 30, | | | Nine Months Ended September 30, | |
| | | | | | | | | | | | | |
| | | ($ in thousands) | |
| Cost of revenues: | | | | | | | | | | | | |
| Product | | $ | 4,232 | | | $ | 2,707 | | | $ | 10,173 | | | $ | 6,073 | |
| Services | | | | | | | | | | | | | | | | |
| Total cost of revenues | | $ | | | | $ | | | | $ | | | | $ | | |
| Change from prior year period | | | 49 | % | | | 76 | % | | | 58 | % | | | 47 | % |
| Product costs as a % of product revenues | | | 28 | % | | | 23 | % | | | 24 | % | | | 20 | % |
| Services costs as a % of services revenues | | | 40 | % | | | 38 | % | | | 41 | % | | | 35 | % |
Costs of product consist of hardware costs, principally for appliances which we have developed, servers, telephone handsets and gateways, royalties for third party software and other technologies included in our solutions and, to a lesser extent, software packaging costs, which include product media, duplication and documentation. Costs of product can fluctuate depending on which software applications are licensed to our customers, the third party software, if any, which is licensed by the end user from us as part of our software applications and the dollar amount of orders for hardware.
Costs of product increased $1.5 million or 56% and $4.1 million or 68% during the three and nine months ended September 30, 2007, respectively, compared to the same periods in 2006. Hardware costs represented $1.0 million and $2.1 million of the increase during the three and nine months ended September 30, 2007, respectively, compared to the same periods in 2006. Royalties paid to third parties increased $295,000 and $1.5 million during the three and nine months ended September 30, 2007, respectively, compared to the same periods in 2006, as we licensed more third party software. In addition, we also increased staffing in our distribution center during 2007 compared to 2006, which resulted in our compensation expense increasing $121,000 and $316,000 for the three and nine months ended September 30, 2007, respectively.
Costs of services consist primarily of compensation expenses for technical support, educational and professional services personnel and other costs associated with supporting our partners and customers. These expenses increased during the three and nine months ended September 30, 2007, as compared to the same periods in 2006, primarily due to a $1.4 million and $3.8 million increase in compensation expense, respectively, as a result of a 35% staffing increase in our services personnel at September 30, 2007 compared to September 30, 2006. As a result of the increased professional services activity, travel related expenses increased $107,000 and $331,000 for the three and nine months ended September 30, 2007, respectively, compared to the same periods in 2006. During 2007, we experienced more demand for our professional services personnel to implement our solutions at our customers’ sites, which resulted in additional costs of $352,000 related to contracting outsourced professionals for the nine months ended September 30, 2007 compared to 2006. In the second quarter of 2007, we acquired the professional services division of Alliance, which added 13 engineers to our professional services group and contributed significantly to our increased compensation expenses in the second and third quarters of 2007.
We anticipate these costs will continue to increase if the number of our large, direct customers continues to grow.
Gross Profit
| | | Three Months Ended September 30, | | | Nine Months Ended September 30, | |
| | | | | | | | | | | | | |
| | | ($ in thousands) | |
| Gross profit | | $ | 18,943 | | | $ | 15,462 | | | $ | 54,233 | | | $ | 42,986 | |
| Change from prior year period | | | 23 | % | | | 35 | % | | | 26 | % | | | 25 | % |
| Percentage of total revenues | | | 66 | % | | | 70 | % | | | 68 | % | | | 73 | % |
Gross profit as a percentage of total revenues decreased during the three and nine months ended September 30, 2007 compared to the same periods in 2006, primarily due to additional costs of products and services as discussed previously. The gross margin on our hardware sales is less than the gross margin on our software licenses; therefore, as we continue to sell more hardware, our total gross margin percentage may decrease compared to historical margins. Gross margin in any particular quarter is dependent upon revenues recognized versus costs of product and costs of services incurred and is expected to vary.
Operating Expenses
Sales and Marketing
| | | Three Months Ended September 30, | | | Nine Months Ended September 30, | |
| | | | | | | | | | | | | |
| | | ($ in thousands) | |
| Sales and marketing expenses | | $ | 9,231 | | | $ | 7,535 | | | $ | 26,680 | | | $ | 21,283 | |
| Change from prior year period | | | 23 | % | | | 22 | % | | | 25 | % | | | 17 | % |
| Percentage of total revenues | | | 32 | % | | | 34 | % | | | 33 | % | | | 36 | % |
| Percentage of net product revenues | | | 85 | % | | | 81 | % | | | 85 | % | | | 87 | % |
Sales and marketing expenses are comprised primarily of compensation expenses, travel and entertainment expenses and promotional costs related to our sales, marketing, and channel management operations. Compensation expense increased $1.3 million during the three months ended September 30, 2007, which was due in part to a 17% staffing increase in our sales and marketing personnel at September 30, 2007 compared to September 30, 2006. Also contributing to the increase in compensation expense was an increase of $500,000 for commission expense during the third quarter of 2007, which was primarily related to the increase in product gross profit and increases in commissionable services during those periods. We also incurred $255,000 of additional costs as a result of increased marketing events and other activities. Depreciation expense increased $101,000 during the quarter primarily due to leasehold improvements in several new sales and marketing offices. These additional expenses during the three months ended September 30, 2007 were offset by a decrease of $176,000 in partner referral fees.
During the nine months ended September 30, 2007, compensation expense increased $3.7 million due to the staffing increase in sales and marketing personnel as mentioned previously and also included a lump sum severance payment we made to a former executive officer of $175,000. Also contributing to the increase in compensation expense was an increase of $1.0 million for commission expense during the first nine months of 2007, which was related to the increase in product gross profit and increases in commissionable services. We also incurred an increase of $480,000 related to increased marketing events and other activities, an increase of $277,000 for travel related expenses, and an increase of $187,000 related to depreciation expense primarily due to leasehold improvements in several new sales and marketing offices. These additional expenses during the nine months ended September 30, 2007 were primarily offset by a decrease of $114,000 in partner sales referral fees as more partner referral fees were paid to partners during the first nine months of 2006 than in the related period in 2007.
Sales and marketing expenses as a percentage of total revenues and as a percentage of net product revenues can fluctuate during any period based on changes in sales and marketing expenses and gross profit margins.
Research and Development
| | | Three Months Ended September 30, | | | Nine Months Ended September 30, | |
| | | | | | | | | | | | | |
| | | ($ in thousands) | |
| Research and development expenses | | $ | 4,348 | | | $ | 3,519 | | | $ | 12,472 | | | $ | 9,933 | |
| Change from prior year period | | | 24 | % | | | 15 | % | | | 26 | % | | | 5 | % |
| Percentage of total revenues | | | 15 | % | | | 16 | % | | | 16 | % | | | 17 | % |
Research and development expenses are comprised primarily of compensation and depreciation expenses. Research and development expenses increased during the three and nine months ended September 30, 2007, as compared to the same periods in 2006, primarily due to an increase in compensation expense of $765,000 and $2.1 million, respectively, as a result of a 24% staffing increase in our research and development personnel at September 30, 2007 compared to September 30, 2006. In addition, we incurred incremental research and development costs of $250,000 during the nine months ended September 30, 2007, which were related to increases in depreciation expense, recruiting and consulting fees.
General and Administrative
| | | Three Months Ended September 30, | | | Nine Months Ended September 30, | |
| | | | | | | | | | | | | |
| | | ($ in thousands) | |
| General and administrative expenses | | $ | 3,310 | | | $ | 2,739 | | | $ | 9,660 | | | $ | 8,106 | |
| Change from prior year period | | | 21 | % | | | 27 | % | | | 19 | % | | | 31 | % |
| Percentage of total revenues | | | 11 | % | | | 13 | % | | | 12 | % | | | 14 | % |
General and administrative expenses are comprised of compensation expense and general corporate expenses that are not allocable to other departments including legal and other professional fees and bad debt expense. General and administrative expenses increased during the three and nine months ended September 30, 2007, as compared to the same periods in 2006, primarily due to an increase in compensation expense of $370,000 and $856,000, respectively, as a result of a 25% staffing increase in our general and administrative personnel at September 30, 2007 compared to September 30, 2006. For the nine months ended September 30, 2007, we also incurred an increase of $153,000 of higher professional services expenses primarily related to accounting and legal fees.
Other Income (Expense)
Interest Income, Net
| | | Three Months Ended September 30, | | | Nine Months Ended September 30, | |
| | | | | | | | | | | | | |
| | | ($ in thousands) | |
| Cash, cash equivalents and short-term investments (average) | | $ | 33,261 | | | $ | 21,255 | | | $ | 30,733 | | | $ | 18,734 | |
| Interest income | | | 412 | | | | 201 | | | | 1,268 | | | | 430 | |
| Return on investment (annualized) | | | 5.0 | % | | | 3.8 | % | | | 5.5 | % | | | 3.1 | % |
Interest income, net is primarily comprised of interest earned from investments and interest-bearing cash accounts. Interest expense and fees in 2006, which were not material, were also included in interest income, net. Interest earned on investments improved during the three and nine months ended September 30, 2007, compared to the same periods in 2006, due primarily to increasing cash and investment balances, better monitoring of funds in which we have invested to increase our return on investment and higher interest rates and lower fees.
Other Income (Expense), Net
| | | Three Months Ended September 30, | | | Nine Months Ended September 30, | |
| | | | | | | | | | | | | |
| | | ($ in thousands) | |
| Other income (expense) | | $ | 29 | | | $ | (25 | ) | | $ | (69 | ) | | $ | (89 | ) |
Other expense, net includes foreign currency transaction gains and losses, as well as foreign tax withholdings. These amounts depend on the amount of revenue that is generated in certain international currencies, particularly the Euro, and the exchange gain or loss that results from foreign currency disbursements and receipts. The other income recognized during the three months ended September 30, 2007 and the decrease in other expense recognized during the first nine months of 2007, compared to the same periods in 2006, was primarily due to an increase in foreign exchange gains realized and a decrease in foreign tax withholdings compared to the same periods in 2006.
Liquidity and Capital Resources
We generate cash from the collections we receive related to licensing our contact center and IP-PBX applications and from annual license renewals, maintenance and support and other services revenues. We also had in place an unused $3.0 million line of credit as of September 30, 2007, that subsequently expired on October 31, 2007. We did not renew our line and will consider obtaining a new line in the future. We use cash primarily for paying our employees (including salaries, commissions and benefits), leasing office space, paying travel expenses, marketing activities, paying vendors for other services and supplies and purchasing property and equipment.
We determine liquidity by combining cash and cash equivalents and short-term investments as shown in the table below. Our total liquidity position as of September 30, 2007 improved compared with our position as of December 31, 2006 due mainly to increased net income, increasing deferred revenue balances and increased cash collections. We believe that our current liquidity position, when combined with our anticipated cash flows from operations, will be sufficient to satisfy our operating cash needs over the next 12 months. If cash flows from operations are less than anticipated or we have additional cash needs (such as an unfavorable outcome in legal proceedings), our liquidity may not be sufficient to cover our needs. In this case, we may be forced to raise additional capital, either through the capital markets or debt financings. We may not be able to receive favorable terms in raising this capital.
| | | September 30, | | | December 31, | |
| | | | | | | |
| | | ($ in thousands) | |
| Cash and cash equivalents | | $ | 23,430 | | | $ | 13,531 | |
| Short-term investments | | | | | | | | |
| Liquidity, net | | $ | | | | $ | | |
Our operating activities resulted in net cash provided of $9.8 million and $6.6 million for the nine months ended September 30, 2007 and 2006, respectively. The $3.2 million of additional net cash provided was primarily a result of net income and higher deferred revenues offset by an increasing accounts receivables balance.
The amount that we report as cash and cash equivalents or as temporary investments fluctuates depending on investing decisions in each period. Purchases of short-term investments are reported as a use of cash and the related receipt of proceeds upon maturity of the investment is reported as a source of cash.
Net cash used in investing activities was $1.7 million and $7.6 million for the nine months ended September 30, 2007 and 2006, respectively. During the second quarter of 2007, we used $853,000 of cash from operations to acquire the professional services division of Alliance. In addition, during July 2007 we paid $180,000 to Alliance related to a hold back provision that was owed as part of the asset purchase agreement. During the nine months ended September 30, 2007, we purchased $4.3 million of additional available-for-sale investments; however these additional purchases were offset by $12.9 million of additional available-for-sale investments that matured during the first nine months of 2007 compared to the same period in 2006. We also purchased property and equipment totaling $3.6 million during the first nine months of 2007 compared to $1.9 million during the same period in 2006. These purchases related mainly to hardware and leasehold improvements for our corporate headquarters and regional offices. As our operations continue to grow and we add new employees, we anticipate that our purchases of property and equipment will continue to increase in future periods.
Net cash provided by financing activities was $1.8 million and $2.4 million for the nine months ended September 30, 2007 and 2006, respectively. The decrease in cash provided was mainly due to lower proceeds from stock options that were exercised during the nine months ended September 30, 2007.
During the second quarter of 2007, we entered into an amendment of our corporate office operating lease under which the current leased space will be expanded to an office building currently under construction and adjacent to our corporate headquarters. The rent for the additional space through the lease expiration date will be approximately $16.3 million, payable in pro-rata monthly installments, as defined in the amendment and will commence as we utilize the additional space, which is expected to be no earlier than March 1, 2008. In consideration for entering into the amendment, the landlord agreed to pay us a discretionary allowance of $450,000 which is payable as we utilize the additional space in the office building. We intend to use this allowance for certain costs associated with our corporate headquarters and/or the additional space, as defined in the amendment. This amendment did not have any financial statement impact, and there were no material changes related to this amendment, during the quarter ended September 30, 2007.
On October 17, 2007, October 23, 2007, and October 26, 2007, we filed separately with the SEC the first, second and third amendments, respectively, to the registration statement on Form S-3 utilizing the “shelf” registration process, which was originally filed on October 19, 2006. This registration statement, as amended, was declared effective by the SEC on October 31, 2007 and will allow us to offer and sell up to 3,000,000 shares of our common stock from time to time in one or more transactions. In addition, under this shelf registration statement, as amended, Dr. Donald E. Brown, our Chairman of the Board, President and CEO, registered 1,000,000 shares of our common stock that he owns for sale from time to time. Although the shelf registration statement, as amended, will permit us to offer and sell up to 3,000,000 shares of our common stock, doing so remains at the discretion of our Board of Directors, and there is no assurance that we would be able to complete any such offering of our common stock.
As of September 30, 2007, there have been no material changes in our contractual obligations as set forth in the Contractual Obligations table disclosed in our Annual Report on Form 10-K for the year ended December 31, 2006, as supplemented by the Contractual Obligations table disclosed in our Quarterly Reports on Form 10-Q for the periods ended March 31, 2007 and June 30, 2007.
Off-Balance Sheet Arrangements
Except as set forth in the Contractual Obligations table disclosed in our Annual Report on Form 10-K for the year ended December 31, 2006, as supplemented by the Contractual Obligations table disclosed in our Quarterly Reports on Form 10-Q for the periods ended March 31, 2007 and June 30, 2007, we have no off-balance sheet arrangements that have or are reasonably likely to have a current or future material impact on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources as of September 30, 2007.
Critical Accounting Policies and Estimates
We believe the accounting policies listed below are important to understanding our historical and future performance, as these policies affect the reported amounts of revenues and income and are the more significant areas involving management’s judgments and estimates. These policies, and our procedures related to these policies, are described below. See also Note 2 of Notes to Consolidated Financial Statements included in our Annual Report on Form 10-K for the year ended December 31, 2006 for a further summary of our other significant accounting policies.
Sources of Revenues and Revenue Recognition Policy
We generate product revenues from licensing the right to use our software applications and in certain instances providing hardware as a component of our solution, and we generate services revenues primarily from annual support fees, annual renewal fees, professional services and educational services.
Product Revenues
Our license agreements are either perpetual or annually renewable. For any revenues to be recognized from a license agreement, the following criteria must be met:
| · | Persuasive evidence of an arrangement exists; |
| · | The fee is fixed or determinable; |
| · | Collection is probable; and |
For a perpetual license agreement, upon meeting the revenue recognition criteria above, we immediately recognize as product revenues the amount of initial license fees if sufficient vendor specific objective evidence of fair value (“VSOE”) exists to support allocating a portion of the total fee to the undelivered elements of the arrangement. If sufficient VSOE of the undelivered elements does not exist, we recognize the initial license fee as product revenues ratably over the initial term of the support agreement once support is the only undelivered element. The support period is generally 12 months but may be up to 18 months for initial orders because support begins when the licenses are downloaded, when support commences, or no more than six months following the contract date. We determine VSOE of support in perpetual agreements based on substantive renewal rates the customer must pay to renew the support. The VSOE of other services is based on amounts charged when the services are sold in stand-alone sales.
For an annually renewable license agreement, upon meeting the revenue recognition criteria above, we recognize a majority of the initial license fees under these agreements as product revenues ratably over the initial license period, which is generally 12 months, and the remainder of the initial license fees are recognized as services revenues over the same time period.
We recognize revenues related to any hardware sales when the hardware is delivered and all other revenue recognition criteria are met.
Services Revenues
Services revenues are primarily recognized for renewal fees and support related to annually renewable license agreements and support fees for perpetual license agreements. For annually renewable agreements, the allocation of the initial order between product revenues and services revenues is based on the average renewal rates of all time based contracts. We apply the allocation of product revenues and services revenues consistently to all annually renewable agreements. Under annually renewable license agreements, after the initial license period, our customers may renew their license agreement for an additional period, typically 12 months, by paying a renewal fee. The revenue for the annual renewal fees are all classified under services revenue and the revenue is recognized ratably over the contract period. Under perpetual license agreements, we recognize annual support fees as services revenues ratably over the post-contract support period, which is typically 12 months.
We also generate revenues from other services that we provide to our partners and customers. These additional revenues include fees for professional services and educational services. Revenues from professional services, which include implementing our products for a customer, and educational services, which consist of training courses for partners and customers, are recognized as the related services are performed.
Stock-Based Compensation Expense
We account for our employee and director stock options in accordance with SFAS 123R and the guidance of SAB 107, which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors, based on fair values. As permitted by SFAS 123R, we continued to use the Black-Scholes option-pricing model as our method of valuation for share-based payment awards. Our determination of fair value of share-based payment awards on the date of grant using an option-pricing model is affected by our stock price as well as assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to, our expected stock price volatility over the term of the awards and an expected risk-free rate of return. If factors change and we use different assumptions for estimating stock-based compensation expense in future periods, stock-based compensation expense may differ materially in the future from that recorded in the current period.
Stock-based compensation expense for employee stock options recognized under SFAS 123R for the three and nine months ended September 30, 2007 was $812,000 and $2.3 million, respectively, compared to $451,000 and $1.6 million, respectively, during the same periods in 2006.
Income Taxes
Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carry-forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.
SFAS No. 109, Accounting for Income Taxes, establishes financial accounting and reporting standards for the effect of income taxes. We are subject to income taxes in both the United States and numerous foreign jurisdictions. Significant judgment is required in evaluating our tax positions and determining our provision for income taxes. The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entity’s financial statements or tax returns. Variations in the actual outcome of these future tax consequences could materially impact our financial position, results of operations, or cash flows.
In assessing the recoverability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon generation of future taxable income during the periods in which temporary differences become deductible. Management considers projected future taxable income and tax planning strategies in making this assessment and ensuring that the deferred tax asset valuation allowance is adjusted as appropriate.
See Note 7 of Notes to Condensed Consolidated Financial Statements for further information on our income taxes.
Allowance for Doubtful Accounts Receivable
We evaluate bad debt expense based on a percentage of revenue reported each period. We review the allowance for doubtful accounts for each reporting period based on a detailed analysis of our accounts receivable to determine that the amount of the allowance for doubtful accounts receivable is appropriately stated at the end of that period. In the analysis of accounts receivable, we primarily consider the age of the partner’s or customer’s receivable and also consider the creditworthiness of the partner or customer, the economic conditions of the customer’s industry, and general economic conditions, among other factors. If payment is not made timely, we contact the customer or partner to try to obtain payment. If this is not successful, we institute other collection practices such as generating collection letters, involving our sales representatives and ultimately terminating the customer’s or partner’s access to future upgrades, licenses and customer support. Once all collection efforts are exhausted, the receivable is written off against the allowance for doubtful accounts.
Research and Development
Through September 30, 2007, all research and development expenditures have been expensed as incurred. Based on our product development process and technological feasibility, the date at which capitalization of development costs may begin is established upon completion of a working model. Costs incurred between completion of the working model and the point at which the product is ready for general release have been insignificant.
Legal Proceedings
Liabilities for loss contingencies arising from claims, assessments, litigation, fines, and penalties and other sources are recorded when it is probable that a liability has been incurred and the amount of the assessment and/or remediation can be reasonably estimated. Legal costs incurred in connection with loss contingencies are expensed as incurred.
| Quantitative and Qualitative Disclosures about Market Risk. |
We develop products in the United States and license our products in the Americas, Europe, the Middle East and Africa and Asia/Pacific. As a result, our financial results could be affected by various factors, including changes in foreign currency exchange rates or weak economic conditions in foreign markets. As most sales are currently made in U.S. dollars, a strengthening of the dollar could make our products less competitive in foreign markets. Additionally, as our business matures in foreign markets, we may offer our products and services in certain other local currencies. As a result, we will be subject to foreign currency fluctuations, which may have an adverse affect on our company.
We manage our interest rate risk by maintaining an investment portfolio with debt instruments of high credit quality and relatively short average maturities. We also manage interest rate risk by maintaining sufficient cash and cash equivalent balances such that we are typically able to hold our investments to maturity. Through October 31, 2007, we had a line of credit with a variable interest rate based upon the bank’s prime rate. We did not incur any interest expense on this line during the three and nine months ended September 30, 2007 and 2006.
We maintain a set of disclosure controls and procedures that are designed to ensure that information required to be disclosed by us in the reports filed by us under the Securities Exchange Act of 1934, as amended (the “Exchange Act”) is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. We carried out an evaluation, under the supervision and with the participation of our management, including our President and Chief Executive Officer (principal executive officer) and our Chief Financial Officer (principal financial officer), of the effectiveness of the design and operation of our disclosure controls and procedures as of September 30, 2007 pursuant to Rule 13a-15(b) of the Exchange Act. Based on that evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures were effective.
There have been no changes in our internal control over financial reporting that occurred during the three months ended September 30, 2007 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
PART II. OTHER INFORMATION
The information set forth in Note 6 of Notes to Condensed Consolidated Financial Statements included in Part I, Item 1 of this report is incorporated herein by reference.
In addition to the information set forth in this Report and before deciding to invest in, or retain, shares of our common stock, you also should carefully review and consider the information contained in our other reports and periodic filings that we make with the SEC, including, without limitation, the information contained under the caption Item 1A “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2006. Those risk factors could materially affect our business, financial condition and results of operations.
The risks that we describe in our public filings are not the only risks that we face. Additional risks and uncertainties not currently known to us, or that we presently deem to be immaterial, also may materially adversely affect our business, financial condition and results of operations. During the three months ended September 30, 2007, there were no material changes from risk factors previously disclosed in our Annual Report on Form 10-K for the year ended December 31, 2006.
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned hereunto duly authorized.
