Kenexa (KNXA) 10-Q 2006 Q3 Quarterly report

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
EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2006

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

For the transition period from                    to                   

Commission File number 000-51358

Kenexa Corporation

(Exact Name of Registrant as Specified in Its Charter)

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

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

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes  x    No  o

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 in Rule 12b-2 of the Exchange Act.

Large accelerated filer o Accelerated filer o Non-accelerated filer x

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

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

Kenexa Corporation and Subsidiaries
FORM 10-Q
Quarter Ended September 30, 2006
Table of Contents

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

2

PART I FINANCIAL INFORMATION

Item 1: Financial Statements

Kenexa Corporation and Subsidiaries
CONSOLIDATED BALANCE SHEETS
(In thousands, except share and per share data)
(Unaudited)

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

See accompanying notes to consolidated financial statements.

3

Kenexa Corporation and Subsidiaries
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except share and per share data)
(Unaudited)

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

See accompanying notes to consolidated financial statements.

4

Kenexa Corporation and Subsidiaries
Consolidated Statements of Shareholders’ Equity (Deficiency)
(in thousands)
(Unaudited)

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

See accompanying independent auditors’ report and notes to consolidated financial statements.

5

Kenexa Corporation and Subsidiaries
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)

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

See accompanying notes to consolidated financial statements.

6

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

See accompanying notes to consolidated financial statements.

7

Kenexa Corporation and Subsidiaries

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (unaudited)

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

1. Organization

Kenexa Corporation and its subsidiaries (collectively, the “Company”) commenced operations in 1987 as a provider of recruiting services to a wide variety of industries.  In 1993, the Company offered its first automated talent management system. Between 1994 and 1998, the Company acquired 15 businesses that enabled it to offer comprehensive human capital management, or HCM, services integrated with web-based technology.

The Company began its operations in 1987 under its predecessor companies, Insurance Services, Inc., or ISI, and International Holding Company, Inc., or IHC. In December 1999, the Company reorganized its corporate structure by merging ISI and IHC with and into Raymond Karsan Associates, Inc., or RKA, a Pennsylvania corporation and a wholly owned subsidiary of Raymond Karsan Holdings, Inc., or RKH, a Pennsylvania corporation. Each of RKA and RKH were newly created to consolidate the businesses of ISI and IHC. In April 2000, the Company changed its name to TalentPoint, Inc. and changed the name of RKA to TalentPoint Technologies, Inc. In November 2000, the Company changed its name to Kenexa Corporation, and changed the name of TalentPoint Technologies, Inc. to Kenexa Technology, Inc., or Kenexa Technology. Currently, Kenexa transacts business primarily through Kenexa Technology. The Company operates in one segment.

2. Summary of Significant Accounting Policies

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

Principles of Consolidation

The consolidated financial statements of the Company include the accounts of Kenexa Corporation and its subsidiaries.  All significant intercompany accounts and transactions have been eliminated in consolidation.

Cash and Cash Equivalents

Cash and cash equivalents consist of highly liquid investments with remaining maturities of six months or less at the time of purchase.

Prepaid Expenses and Other Assets

Prepaid expenses and other current assets consist primarily of prepaid software maintenance agreements, deferred implementation costs, insurance, taxes and other current assets. Deferred implementation costs represent internal payroll and other costs incurred in connection with the customization of the sites associated with the internet hosting arrangements. These costs are deferred over the implementation period, typically three to four months, and are expensed ratably over the subscription period, typically one to three years.  These amounts aggregated $858 and $1,089 at September 30, 2006 and December 31, 2005, respectively. The current portion of these deferred costs of $675 and $979 at September 30, 2006 and December 31, 2005, respectively, are included in other current assets.  The noncurrent portion of these deferred costs of $183 and $110 at September 30, 2006 and December 31, 2005, respectively, are included in other assets in the accompanying consolidated balance sheets.

8

Software Developed for Service Transactions

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

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

Revenue Recognition

The Company derives its revenue from two sources: (1) subscription revenue for solutions, which is comprised of subscription fees from clients accessing our on-demand software, consulting services, outsourcing services and proprietary content, and from clients purchasing additional support beyond the standard support that is included in the basic subscription fee; and (2) other fees for discrete professional services. Because the Company provides its solutions as a service, the Company follows the provisions of Securities and Exchange Commission Staff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements, as amended by Staff Accounting Bulletin No. 104, Revenue Recognition. On August 1, 2003, the Company adopted Emerging Issues Task Force Issue No. 00-21, Revenue Arrangements with Multiple Deliverables. The Company recognizes revenue when all of the following conditions are met:

·There is persuasive evidence of an arrangement;

·The service has been provided to the client;

·The collection of the fees is probable; and

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

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

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

In determining whether revenues from professional services can be accounted for separately from subscription revenue, the Company considers the following factors for each agreement: availability from other vendors, whether objective and reliable evidence of fair value exists of the undelivered elements, the nature and the timing of when the agreement was signed in comparison to the subscription agreement start date and the contractual dependence of the subscription service on the client’s satisfaction with the other services. If the professional service does not qualify for separate accounting, the Company recognizes the revenue ratably over the remaining term of the subscription contract. In these situations, the Company defers the direct and incremental costs of the professional service over the same period as the revenue is recognized.

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

9

The Company reimburses 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 for out-of-pocket expenses be classified as revenues and not as cost reductions.  Before the December 15, 2001 effective date of EITF 01-14, out-of-pocket reimbursements from clients were netted with the applicable costs. These items primarily include travel, meals and certain telecommunication costs.  For the nine months ended September 30, 2006, reimbursed expenses totaled $1,087.

Self-Insurance

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

Concentration of Credit Risk

Financial instruments which potentially expose the Company to concentration of credit risk consist primarily of accounts receivable.  Credit risk arising from receivables is mitigated due to the large number of clients comprising the Company’s client base and their dispersion across various industries.  The clients are concentrated primarily in the Company’s U.S. market area.  At September 30, 2006, there were no clients that represented more than 10% of the net accounts receivable balance.  There were no clients that individually exceeded 10% of the Company’s revenues.

Cash balances are maintained at several banks.  Accounts located in the United States are insured by the Federal Deposit Insurance Corporation (“FDIC”) up to $100. Certain operating cash accounts may exceed the FDIC limits.

Recent Accounting Pronouncements

In July 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109 (FIN 48), which clarifies the accounting for uncertainty in tax positions. This Interpretation requires that we recognize in our financial statements, the impact of a tax position, if that position is more likely than not of being sustained on audit, based on the technical merits of the position. The provisions of FIN 48 are effective as of the beginning of our 2007 fiscal year, with the cumulative effect of the change in accounting principle recorded as an adjustment to opening retained earnings. We are currently evaluating the impact of adopting FIN 48 on our financial statements.

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

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

In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment” (SFAS 123R). SFAS 123R requires that the cost resulting from all share-based payment transactions be recognized in the financial statements. SFAS 123R also establishes fair value as the measurement method in accounting for share-based payments. The FASB required the provisions of SFAS 123R be adopted for interim or annual periods beginning after June 15, 2005. In April 2005, the SEC adopted a new rule amending the compliance dates for SFAS 123R for public companies. In accordance with this rule, we adopted SFAS 123R effective January 1, 2006 using the modified prospective transition method. We did not modify the terms of any previously granted options in anticipation of the adoption of SFAS 123R.

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

10

In November 2005, the FASB issued FSP FAS 123(R)-3, Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards, to provide an alternative approach of accounting for the tax effects of employee share-based awards. We have elected to adopt the alternative transition method provided in FSP FAS 123(R)-3 for calculating the tax effects of stock-based compensation pursuant to SFAS 123(R). The alternative transition method includes simplified methods to establish the beginning balance of the additional paid-in capital pool (APIC pool) related to the tax effects of employee stock-based compensation, and to determine the subsequent impact on the APIC pool and consolidated statements of cash flows of the tax effects of employee stock-based compensation awards that are outstanding upon the adoption of SFAS 123(R).

Earnings (Loss) Per Share

The Company follows SFAS 128, “Earnings Per Share.” Under SFAS 128, companies that are publicly held or have complex capital structures are required to present basic and diluted earnings per share on the face of the statement of operations.  Earnings (loss) per share are based on the weighted average number of shares and common stock equivalents outstanding during the period.  In the calculation of diluted earnings per share, shares outstanding are adjusted to assume conversion of the Company’s non-interest bearing convertible stock and the exercise of options and warrants if they are dilutive.  In the calculation of basic earnings per share, weighted average numbers of shares outstanding are used as the denominator.  The Company had net income available to common shareholders for the three month period ended September 30, 2006 and 2005 and the nine month period ended September 30, 2006 and a net loss available to common shareholders for the nine month period ended September 30, 2005.  As a result, the common stock equivalents of stock options, warrants and convertible securities issued and outstanding at September 30, 2005 were not included in the computation of diluted earnings per share for the period then ended as they were antidilutive.  Income (loss) per share is computed as follows:

	Three months ended September 30,		Nine months ended September 30,
	2006	2005	2006	2005
Net income	$            4,159	$            2,587	$          10,717	$            3,075
Accretion of redeemable class B common stock and redeemable class C common stock	—	—	—	41,488
Net income (loss) available to common shareholders	$            4,159	$            2,587	$          10,717	$        (38,413	)
Weighted average shares used to compute net income (loss) available to common shareholders per common share - basic	20,407,856	17,436,026	19,626,010	9,558,486
Effect of dilutive stock options and warrants	514,159	415,072	557,985	—
Weighted average shares used to compute net income (loss) available to common shareholders per common share – diluted	20,922,015	17,851,098	20,183,995	9,558,486
Basic net income (loss) per share to common shareholder	$              0.20	$              0.15	$              0.55	$            (4.02	)
Diluted net income (loss) per share to common shareholder	$              0.20	$              0.15	$              0.53	$            (4.02	)

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Stock-Based Compensation

The Company’s 2005 Equity Incentive Plan (the “2005 Option Plan”), which was adopted by the Company’s Board of Directors (the “Board”) in March 2005 and was approved by the Company’s shareholders in June 2005, provides for the granting of stock options to employees and directors at the discretion of the Board or a committee of the Board.  The 2005 Option Plan replaced the Company’s 2000 Stock Option Plan (the “2000 Option Plan”).  As of September 30, 2006, there were options to purchase 1,518,458 shares of common stock outstanding under the 2005 Option Plan.  The Company is authorized to issue up to an aggregate of 4,842,910 shares of its common stock pursuant to stock options granted under the 2005 Option Plan. As of September 30, 2006, there were a total of 3,142,479 shares of common stock not subject to outstanding options and available for issuance under the 2005 Option Plan.  The purpose of stock options is to recognize past services rendered and to provide additional incentive in furthering the continued success of the Company.  Stock options granted under both the 2005 Option Plan and the 2000 Stock Option Plan expire between the fifth and tenth anniversary of the date of grant and generally vest on the third anniversary of the date of grant.  Unexercised stock options may expire up to 90 days after an employee’s termination.

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 and all unvested stock options as of January 1, 2006. Upon adoption we will continue to recognize the cost of previously granted share-based awards under the straight-line basis and anticipate that we will recognize the cost for new share-based awards on a straight-line basis over the requisite service period.

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

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

A summary of the status of the Company’s stock options as of December 31, 2005 and September 30, 2006 and changes during the period then ended is as follows:

	Options Outstanding					Options Exercisable
	Shares available for Grant		Shares		Wtd. Avg. Exercise Price	Shares	Wtd. Avg. Exercise Price
Balance at December 31, 2005	3,265,859		1,562,181		$       11.74	638,781	$       12.08
Granted	(203,000	)	203,000		$       24.03	—	—
Exercised	—		(167,103	)	$       10.54	—	—
Forfeited or expired	79,620		(79,620	)	$       19.39	—	—
Balance at September 30, 2006	3,142,479		1,518,458		$       13.11	503,758	$       12.96

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

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A summary of the status of the Company’s nonvested share options as of December 31, 2005 and September 30, 2006 and changes during the period then ended is presented below:

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

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

SFAS No. 123R also requires us to change the classification of any tax benefits realized upon exercise of stock options in excess of that which is associated with the expense recognized for financial reporting purposes. These amounts are presented as a financing cash inflow rather than as a reduction of income taxes paid in our consolidated statement of cash flows.

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

Prior to January 1, 2006 the Company accounted for stock options under Accounting Principles Board (“APB”) Opinion 25.  Had compensation expense for stock options granted been determined based on the fair value at the grant dates under the provisions of SFAS 123, the Company’s pro forma net income for the three and nine months ended September 30, 2005 would have been as follows:

	For the three months ended September 30, 2005		For the nine months ended September 30, 2005
Net income as reported	$	2,587	$	3,075
Add: stock based employee compensation expense included in reported net income, net of tax	119		514
Deduct: total stock-based compensation expense determined under fair value based method for all awards, net of tax	608		756
Pro forma net income	$	2,098	$	2,833
Accretion of redeemable class B common stock, class C common stock, series A preferred stock and series B preferred stock	$	—	$	(41,488	)
Pro forma net income (loss) available to common shareholders	$	2,098	$	(38,655	)
Basic and diluted net income (loss) per share to common shareholder, as reported:	$	0.15	$	(4.02	)
Basic and diluted net income (loss) per share to common shareholder, pro forma:	$	0.12	$	(4.04	)

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Use of Estimates

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

Fair Value of Financial Instruments

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

3. Property, Equipment and Software

A summary of property, equipment and software and related accumulated depreciation as of September 30, 2006 and December 31, 2005 is as follows:

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

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

4. Other Accrued Liabilities

Other accrued liabilities consist of the following:

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

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5. Line of Credit

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

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

Borrowings under the revolving credit facility are collateralized generally by all of the Company’s assets, including a pledge of the capital stock of its subsidiaries.  Repayment of amounts outstanding under certain notes payable and all issued or issuable shares of common and preferred stock are subordinated to the rights of the lender under terms of the revolving credit facility. The revolving credit facility contains various terms and covenants that provide for restrictions on capital expenditures, payment of dividends, dispositions of assets, investments and acquisitions and require the Company, among other things, to maintain minimum levels of tangible net worth, net income and fixed charge coverage.

6. Commitments and Contingencies

Litigation

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

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

7. Equity

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

8. Related Party

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

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9. Acquisitions

Gantz Wiley Research

On August 14, 2006, the Company, through its wholly-owned subsidiary, Kenexa Technology, Inc., acquired all of the outstanding stock of Gantz Wiley Research, an employee and customer research firm based in Minneapolis, Minnesota, for a purchase price of approximately $2,652 in cash and $3,170 in stock consideration.  The total cost of the acquisition, including estimated legal, accounting, and other professional fees, was approximately $5,851.  In connection with the acquisition $600 of the cash portion of the purchase price was deposited into an escrow account to cover any claims for indemnification made by the Company against Gantz Wiley Research under the acquisition agreement.  The escrow agreement will remain in place for one year from the acquisition date, and any funds remaining in the escrow account at the end of the one year period will be distributed to the stockholder of Gantz Wiley Research.  In addition, the acquisition agreement with Gantz Wiley Research contains an earnout provision which provides for the payment of additional consideration by the Company based upon the annual revenues of Gantz Wiley Research through December 31, 2006.  Depending upon the results, contingent consideration ranging from $300 to $1,300 may be due and payable in cash and equity during the first quarter of 2007 to the former shareholder of Gantz Wiley Research.

Knowledge Workers

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

Webhire

On January 13, 2006, the Company, through its wholly-owned subsidiary, Kenexa Technology, Inc., and Kenexa Acquisition Corp., a wholly-owned subsidiary of Kenexa Technology, completed its acquisition of Webhire, Inc. (“Webhire”) for approximately $34,395 in cash. The total cost of the acquisition, including legal, accounting, and other professional fees of $636, was approximately $35,031.

Approximately $5,000, or 14.5% of the aggregate purchase price, remains deposited in an escrow account to cover any claims for indemnification made by the Company against Webhire under the acquisition agreement.  Assuming there are no indemnification claims, this amount will be released to the former stockholders of Webhire on or about January 13, 2007.

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

The purchase price was allocated as follows:

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

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

In accordance with Statement of Financial Accounting Standard No. 141 the purchase price allocation for Webhire has been updated to reflect additional transaction fees and additional information concerning our deferred income tax analysis since the acquisition.  The deferred income tax and corresponding valuation allowance have been increased to reflect current estimates relating to the utilization of the acquired NOL as well as any NOL limitations from the acquisition.  These adjustments and any future adjustments to the deferred tax asset or corresponding NOL will be adjusted through the goodwill and recorded as part of the transaction.  The valuation of the net operating loss tax attributes of $1,525 was based upon the anticipated use of the present value of cash flows from Webhire’s net operating losses.

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

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

If the Webhire acquisition had occurred on January 1, 2005, the unaudited pro forma results of operations for the three and nine months ended September 30, 2005 would have been:

	(in thousands)
	Three months ended September 30, 2005		Nine months ended September 30, 2005
Revenue	$	20,210	$	56,640
Net loss available to common shareholders – diluted	2,817		(37,714		)
Net loss per share available to common shareholders - diluted	$	0.16	$	(3.95	)

10. Subsequent Events

On October 6, 2006, the Company entered into an Equity Purchase Agreement and Agreement and Plan of Merger to acquire BrassRing Inc. and BrassRing LLC.  The total consideration payable in the acquisition will be approximately $115,000, subject to closing adjustments for working capital.  The acquisition is subject to regulatory approval and the approval of BrassRing’s stockholders and other customary closing conditions.  The Company and BrassRing have made customary representations, warranties and covenants in the Agreement.  The Company expects to complete this acquisition in the fourth quarter of 2006.

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

This Quarterly Report on Form 10-Q, including the following Management’s Discussion and Analysis of Financial Condition and Results of Operations, contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, Section 21E of the Securities Exchange Act of 1934, as amended, and the Private Securities Litigation Reform Act of 1995, that involve a number of risks and uncertainties. Such statements are based on current expectations of future events that involve a number of risks and uncertainties that may cause the actual events to differ materially from those discussed herein. In addition, such forward-looking statements are necessarily dependent upon assumptions, estimates and dates that may be incorrect or imprecise and involve known and unknown risks and other factors. Accordingly, any forward-looking statements included herein do not purport to be predictions of future events or circumstances and may not be realized. Forward-looking statements can be identified by, among other things, the use of forward-looking terminology such as “believes,” “expects,” “may,” “could,” “will,” “should,” “seeks,” “potential,” “anticipates,” “predicts,” “plans,” “estimates,” or “intends,” or the negative of any thereof, or other variations thereon or comparable terminology, or by discussions of strategy or intentions. Given these uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements. Forward-looking statements should be considered in light of various important factors, including those set forth in this report under Part I, Item 1A “Risk Factors” in Kenexa Corporation’s Annual Report on Form 10-K for the year ended December 31, 2005 filed with the Securities and Exchange Commission. All forward-looking statements, and reasons why results may differ, that are included in this report are made as of the date of this report, and except as required by law, we disclaim any obligations to update any such factors or to publicly announce the results of any revisions to any of the forward-looking statements contained herein or reasons why results might differ to reflect future events or developments. References herein to “Kenexa,” “we,” “our,” and “us” collectively refer to Kenexa Corporation, a Pennsylvania corporation, and all of its direct and indirect U.S., U.K., Canada and India subsidiaries.

1. Overview

We provide software, services and proprietary content that enable organizations to more effectively recruit and retain employees. Our solutions are built around a suite of easily configurable software applications that automate talent acquisition and employee performance management best practices. We offer the software applications that form the core of our solutions on an on-demand basis, which materially reduces the costs and risks associated with deploying traditional enterprise applications. We complement our software applications with tailored combinations of outsourcing services, consulting services and proprietary content based on our 18 years of experience assisting clients in addressing their human resource requirements. Together, our software applications and services form solutions that we believe enable our clients to improve the effectiveness of their talent acquisition programs, increase employee productivity and retention, measure key HR metrics and make their talent acquisition and employee performance management programs more efficient.

Since 1999, we have focused on providing talent acquisition and employee performance management solutions on a subscription basis and currently generate a significant portion of our revenue from these subscriptions. For the nine months ended September 30, 2006 and 2005, revenue from these subscriptions comprised approximately 80.2% and 76.5%, respectively, of our total revenue. We generate the remainder of our revenue from discrete professional services that are not provided as part of an integrated solution on a subscription basis. These subscription-based solutions provide us with a recurring revenue stream and we believe represent a more compelling opportunity in terms of growth and profitability than discrete professional services.  As a result, since 1999 discrete professional services have represented a consistently decreasing percentage of our revenue.  We expect that trend to continue.

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

2. Recent Events

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

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On March 8, 2006, we completed our follow-on public offering of 2,425,000 shares of our common stock at a price of $27.00 per share.  We also sold an additional 216,800 shares of our common stock to cover over-allotments of shares.  Our net proceeds from the offering, after payment of all offering expenses and commissions, aggregated approximately $66.3 million.  In addition, certain of our shareholders sold an aggregate of 3,510,700 shares of our common stock in the offering, including an over-allotment of 585,700 shares.  We received no proceeds from the common stock sold by the selling shareholders in the offering.

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

On August 14, 2006, we acquired Gantz Wiley Research, an employee and customer survey data analysis firm based in Minneapolis, Minnesota, for a purchase price of approximately $2.7 million in cash and $3.2 million in stock consideration.  The total cost of the acquisition, including estimated legal, accounting, and other professional fees, was approximately $5.9 million.  In addition, our agreement with Gantz Wiley contains an earnout provision which provides for the payment of additional consideration by the Company based upon the annual revenues of Gantz Wiley Research through December 31, 2006.  Depending upon the results, contingent consideration ranging from $0.3 million to $1.3 million may be due and payable in cash and equity during the first quarter of 2007 to the former shareholder of Gantz Wiley.

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

3. Sources of Revenue

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

Our clients primarily purchase renewable subscriptions for our solutions. The typical term is one to three years, with some terms extending up to five years.  The majority of our subscription agreements are not cancelable for convenience although our clients have the right to terminate their contracts for cause if we fail to provide the agreed upon services or otherwise breach the agreement. A client does not generally have 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 the aggregate contract value up for renewal for 2006, 2007 and 2008. The revenue derived from subscription fees is recognized ratably over the term of the subscription agreement. We generally invoice our clients in advance in monthly or quarterly installments and typical payment terms provide that our clients pay us within 30 days of invoice. Amounts that have been invoiced are recorded in accounts receivable prior to the receipt of payment and in deferred revenue to the extent revenue recognition criteria have not been met. As the subscription component of our revenue has grown and clients’ willingness to pay us in advance for their subscriptions has increased, the amount of deferred revenue on our balance sheet has grown at a higher rate than our revenue. As of September 30, 2006, deferred revenue increased to $18.8 million from $12.6 million at December 31. 2005.  We generally price our solutions based on the number of software applications and services included and the number of client employees. Accordingly, subscription fees are generally greater for larger organizations and for those that subscribe for a broader array of software applications and services.

A small portion of our clients purchase discrete professional services. These services primarily consist of consulting and training services. In addition, we recognize a small amount of revenue from sales of perpetual software licenses. The revenue from these services and licenses is recognized differently depending on the type of service or license provided as described in greater detail below under “Critical Accounting Policies and Estimates.” 

We generate substantially all of our revenue from within the United States. For the nine months ended September 30, 2006, approximately 91.5% of our total revenue was derived from sales in the United States.  During the nine months ended September 30, 2006, approximately 8.5%, of our total revenue was derived from areas outside the United States. Other than the revenue that we generated from clients in the Netherlands and the United Kingdom, which in the aggregate amounted to 4.7% of our total revenue for the nine months ended September 30, 2006, and revenue that was generated from clients in Canada which amounted to 2.5% for the nine months ended September 30, 2006, we did not have revenue from any other country in excess of 1.0% of our total revenue for the nine months ended September 30, 2006.

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4. Key Performance Indicators

The following tables summarize the key performance indicators that we consider to be material in managing our business:

	For the three months ended September 30,						For the nine months ended September 30,
	2006			2005			2006			2005
	(unaudited)			(unaudited)			(unaudited)			(unaudited)
Total Revenue	$	28,012		$	17,234		$	75,735		$	47,571
Subscription revenue as a percentage of total revenue	82.8		%	77.6		%	80.2		%	76.5		%
Income from operations before income tax and interest expense	$	4,768		$	2,586		$	11,976		$	6,726
Net cash provided by operating activities	$	8,818		$	8,412		$	11,145		$	11,372

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

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

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

Net cash provided by operating activities. Net cash provided by operating activities is taken from our consolidated statement of cash flows and represents the amount of cash generated by our operations that is available for investing and financing activities. Historically, our net cash provided by operating activities has exceeded our net income primarily due to the positive impact of deferred revenue. We expect this trend to continue because of the advance payment structure of our subscription agreements and because as our sales increase, we expect incremental costs to decline.

Deferred revenue. We generate revenue primarily from multi-year subscriptions for our on-demand talent acquisition and employee performance management solutions. We recognize revenue from these subscription agreements ratably over the term of the contract, which are typically one to three years. We generally invoice our clients in quarterly or monthly installments in advance. Deferred revenue, which is included in our consolidated balance sheets, is the amount of invoiced subscriptions in excess of the amount recognized as revenue. Deferred revenue represents, in part, the amount that we will record as revenue in our consolidated statements of operations in future periods. As the subscription component of our revenue has grown and customer willingness to pay us in advance for their subscriptions has increased, the amount of deferred revenue on our balance sheet has grown at a higher rate than our revenue growth rate. We expect this trend to continue.

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

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

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5. Results of Operations

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

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

Kenexa Corporation Unaudited Consolidated Statement of Operations
(In thousands)
(Unaudited)

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

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Revenues

Total revenue increased $10.8 million or 62.5% and $28.2 million or 59.2% to $28.0 million and $75.7 million during the three and nine months ended September 30, 2006, respectively compared to the same periods in 2005. Our subscription revenue increased by $9.8 million or 73.3% and $24.4 million or 67.0% to $23.2 million and $60.7 million during the three and nine months ended September 30, 2006, respectively compared to the same periods in 2005. Subscription revenue represented approximately 82.8% and 80.2% of our revenues for three and nine months ended September 30, 2006, respectively. A portion of the increase in subscription revenues is attributable to our recent acquisitions of Webhire and Gantz Wiley in our results. Our other revenue increased by $1.0 million or 25.1% and $3.8 million or 34.0% to $4.8 million and $15.0 million for the three and nine months ended September 30, 2006, respectively, compared to the same periods in 2005.  The year-to-date increase was due primarily to an increase in demand for our consulting services resulting from an increase in our subscription based revenues and the receipt of approximately $0.5 million of non-recurring “success” fees related to meeting certain client-specific objectives.  For the remainder of the year we expect subscription based and other revenue to increase from the prior year due to customer acquisitions and additional sales to existing customers.

Cost of Revenue

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

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

Sales and Marketing (“S&M”) expense

S&M expense primarily consists of personnel and related costs for employees engaged in sales and marketing, including salaries, commissions and other variable compensation, travel expenses and costs associated with trade shows, advertising and other marketing efforts and allocated overhead. We expense our sales commissions at the time the related revenue is recognized, and we recognize revenue from our subscription agreements ratably over the term of the agreements. Investment in sales and marketing commencing in 2003 resulted in significant revenue growth during 2004 and 2005. We intend to continue to invest in sales and marketing to pursue new clients and expand relationships with existing clients. As a result, although we expect S&M expense to increase, we also expect S&M to continue to decrease as a percentage of revenue for the next twelve months.

S&M expense increased $1.8 million or 42.0% and $5.7 million or 48.4% to $6.0 million and $17.4 million for the three and nine months ended September 30, 2006, respectively compared to the same periods in 2005. Increased staff related and other compensation including performance bonuses and commissions contributed $1.0 million and $0.5 million, respectively, to the increase in S&M expense during the quarter ended September 30, 2006 from the prior year. The increase in compensation and travel expense was attributable primarily to 13 additional employees in S&M.  Additionally, $0.2 million in non-cash stock option expense from our adoption of SFAS 123R in 2006 and increased travel expense of $0.1 million also contributed to the increase in S&M expense for the quarter ended September 30, 2006 over the comparable period in the prior year.

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

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General and Administrative (“G&A”) expense

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

G&A expense increased by $1.7 million or 43.0% and $6.1 million or 55.5% to $5.8 million and $17.0 million for the three and nine months ended September 30, 2006, respectively, compared to the same periods in 2005. The $1.7 million increase for the quarter ended September 30, 2006 was due primarily to an increase in salary expenses of $0.5 million related to the addition of 15 employees. In addition, non-cash stock option expense from our adoption of SFAS 123R in 2006, rent expense, associated with our recent acquisitions, and professional fees contributed of $0.2 million, $0.4 million and $0.3 million, respectively, to the increase in G&A expense for the three months ended September 30, 2006 versus the comparable period in the prior year.  The remainder of the $0.3 million increase was attributable to increases in infrastructure expenses such as phone, supplies, utilities, insurance and other expenses.

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

Research and Development (“R&D”) expense

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

R&D expense increased $1.3 million or 130.8% to $2.2 million for the three months ended September 30, 2006 compared to the same period in 2005.    For the nine months ended September 30, 2006, R&D expense increased $2.5 million or 83.3% to $5.6 million.   The increase in R&D for the three and nine month period ended September 30, 2006 was due primarily to the addition of 27 developers.  As a percentage of revenues, R&D expense increased from 5.6% to 7.9% and 6.4% to 7.4%, for the three and nine months ended September 30, 2006, compared to the same periods in 2005.

Depreciation and Amortization

Depreciation and amortization expense increased by $0.4 million and $0.8 million or approximately 75.1% and 51.9% to $0.9 million and $2.4 million for the three and nine months ended September 30, 2006, respectively compared to the same periods in 2005.  In the future, we expect depreciation and amortization expense to increase due to recent capital purchases.

Interest expense income on mandatory redeemable shares

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

Income tax expense on operations

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

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6.  Liquidity and Capital Resources

Since we were formed in 1987, we have financed our operations primarily through internally generated cash flows, our line of credit and the issuance of preferred and common stock. As of September 30, 2006, we had cash and cash equivalents of $83.1 million and accounts receivable of $16.2 million. In addition, we had $0.6 million of debt and $0.3 million in capital equipment leases.

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

We have a $25 million revolving credit facility with PNC Bank, National Association that is collateralized by all of our assets, including a pledge of capital stock of certain of our subsidiaries.

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

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

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

On October 6, 2006, we agreed to acquire BrassRing Inc. for approximately $115 million, subject to closing adjustments for working capital.  We expect to fund the purchase price for the acquisition through a combination of cash and borrowings under our revolving credit facility.   We expect to complete this acquisition in the fourth quarter of 2006.

Operating Activities

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

Investing Activities

Net cash used in investing activities was $40.1 million and $3.0 million for the nine months ended September 30, 2006 and 2005, respectively.  Cash flows from investing activities for the nine months ended September 30, 2006 and September 30, 2005 consisted of the following:

	Nine months September 30,
In millions	2006		2005
Webhire acquisition	$	32.2	—
Knowledge Workers acquisition	$	2.2	—
Gantz Wiley Research acquisition	$	2.7	—
Scottworks acquisition	—		$	0.2
Capitalized software and purchases of computer hardware	$	3.0	$	2.8
Total Cash flows from investing activities	$	40.1	$	3.0

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In the future, we expect our capital expenditures to increase as revenues increase and business needs arise.

Financing Activities

Net cash provided by financing activities was $68.8 million and $21.3 million for the nine months ended September 30, 2006 and 2005, respectively.  For the nine months ended September 30, 2006, net cash provided by financing activity consisted of net proceeds from our follow-on public offering of $66.3 million, net proceeds from stock option exercises of $1.8 million and excess tax benefits from share-based payment arrangements of $1.1 million, partially offset by the repayments of capital lease obligations of $0.3 million and deferred financing costs of $0.1 million.   For the nine months ended September 30, 2005, net cash provided by financing activity consisted of net proceeds from our initial public offering of $61.8 million and the collection of notes receivable of $ 0.2 million offset by the redemption of our series A and B preferred shares of $40.0 million, the repurchase of shares of our common stock owned by certain of our former employees of $0.5 million and repayments of capital lease obligations of $0.2 million.

We believe that our cash and cash equivalent balances and cash flows from operations will be sufficient to satisfy our working capital and capital expenditure requirements for at least the next 12 months.  We intend to continue to invest our cash in excess of current operating requirements in interest-bearing, investment-grade securities. Changes in our operating plans, lower than anticipated revenue, increased expenses or other events, may cause us to seek additional debt or equity financing. Financing may not be available on acceptable terms, or at all, and our failure to raise capital when needed could negatively impact our growth plans and our financial condition and consolidated results of operations. Additional equity financing would be dilutive to the holders of our common stock, and debt financing, if available, may involve significant cash payment obligations and covenants or financial ratios that restrict our ability to operate our business.

Critical Accounting Policies and Estimates

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

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

Revenue Recognition

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

·There is persuasive evidence of an arrangement;

·The service has been provided to the client;

·The collection of the fees is probable; and

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

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

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

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

We record 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 for out-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-pocket reimbursements from clients were netted with the applicable costs.  These items primarily include travel, meals and certain telecommunication costs.

Allowance for Doubtful Accounts

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

Capitalized Software Research and Development Costs

In accordance with EITF Issue 00-3, “Application of AICPA Statement of Position 97-2 to Arrangements That Include the Right to Use Software Stored on Another Entity’s Hardware,” we apply AICPA Statement of Position No. 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use. The costs incurred in the preliminary stages of development are expensed as incurred. Once an application has reached the development stage, internal and external costs, if direct and incremental, will be capitalized until the software is substantially complete and ready for its intended use. Capitalization ceases upon completion of all substantial testing. We also capitalize costs related to specific upgrades and enhancements when it is probable the expenditures will result in additional functionality. Maintenance and training cost are expensed as incurred. Internal use software is amortized on a straight-line basis over its estimated useful life, generally three years. Management evaluates the useful lives of these assets on an annual basis and tests for impairments whenever events or changes in circumstances occur that could impact the recoverability of these assets. There were no impairments to internal software in any of the periods covered in this report.

Goodwill and Other Identified Intangible Asset Impairment

On January 1, 2002, we adopted SFAS No. 142, Goodwill and Other Intangible Assets which superseded Accounting Board Opinion No. 17, Intangible Assets. Upon adoption of SFAS No. 142, we ceased amortization of existing goodwill and are required to review the carrying value of goodwill for impairment. If goodwill becomes impaired, some or all of the goodwill could be written off as a charge to operations. This comparison is performed annually or more frequently if circumstances indicate that the carrying value may not be recoverable. We have reviewed the carrying values of goodwill of each business unit by comparing the carrying values to the estimated fair values of the business components. The fair value is based on management’s estimate of the future discounted cash flows to be generated by the respective business components and comparable company multiples. Such cash flows consider factors such as future operating income, historical trends, as well as demand and competition. Comparable company multiples are based upon public companies in sectors relevant to our business based on our knowledge of the industry. Changes in the underlying business could affect these estimates, which in turn could affect the recoverability of goodwill.  Through September 30, 2006, we have not observed any changes to our business units which would 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-Scholes option-pricing model to calculate the fair value of our stock awards. The calculation of the fair value of the awards using the Black-Scholes option-pricing model is affected by our stock price on the date of grant as well as assumptions regarding the following:

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

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

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

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

Accounting for Income Taxes

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

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

In addition, we operate within multiple taxing jurisdictions and are subject to audit in each jurisdiction. These audits can involve complex issues that may require an extended period of time to resolve. In our opinion, adequate provisions for income taxes have been made for all periods.

Self-Insurance

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

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Item 3: Quantitative and Qualitative Disclosures about Market Risk

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

Foreign Currency Exchange Risk

For the nine months ended September 30, 2006, approximately 91.5% of our total revenue was comprised of sales to clients in the United States. A key component of our business strategy is to expand our international sales efforts, which will expose us to foreign currency exchange rate fluctuations. A 10% change in the value of the U.S. dollar relative to each of the currencies of our non-U.S-generated sales would not have resulted in a material change to our results. As of September 30, 2006, we were not engaged in any foreign currency hedging activities.

The financial position and operating results of our United Kingdom and India operations are consolidated using the local currency as the functional currency. Local currency assets and liabilities are translated at the rate of exchange to the U.S. dollar on the balance sheet date, and the local currency revenue and expenses are translated at average rates of exchange to the U.S. dollar during the period. The related translation adjustments was approximately $0.3 million at September 30, 2006, and is included in accumulated other comprehensive income. The foreign currency translation adjustment is not adjusted for income taxes as it relates to an indefinite investment in a non-U.S. subsidiary.

Interest Rate Risk

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

Item 4: Controls and Procedures

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

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

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PART II: OTHER INFORMATION

Item 1: Legal Proceedings

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

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

Item 1A: Risk Factors

In addition to the other information set forth in this Form 10-Q, you should carefully consider the factors discussed in Part I, Item 1A “Risk Factors” of our Annual Report on Form 10-K for the year ended December 31, 2005 which could materially affect our business, financial condition or future results of operations.  The risks described in our Annual Report on Form 10-K for the year ended December 31, 2005 are not the only risks that we face.  Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial may also materially adversely affect our business, financial condition and future results of operations.  There have been no material changes from the risk factors previously disclosed in Item IA of our Annual Report on Form 10-K for the year ended December 31, 2005.

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

On August 14, 2006, as partial consideration for the Company’s acquisition of all of the outstanding stock of Gantz Wiley Research, the Company issued 138,837 shares of the Company’s common stock to the former sole shareholder of Gantz Wiley Research.  These shares were issued without registration under the Securities Act of 1933, as amended, or the securities laws of certain states, in reliance on the exemptions provided by Section 4(2) of the Securities Act and similar exemptions under applicable state laws.

For the nine months ended September 2006, we issued the following number of shares of common stock upon the “cashless exercise” of outstanding warrants.  We did not receive any proceeds from the exercise of these warrants.

Period	Number of shares of common stock issuable upon exercise of warrant	Number of shares of common stock issued upon “cashless exercise” of warrants
January – March 2006	48,538.88	35,779
April – June 2006	76,673.92	55,958
July – September 2006	551,632.00	98,352

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

Item 3: Defaults Upon Senior Securities

Not applicable.

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

Not applicable.

Item 5: Other Information

Not applicable.

Item 6: Exhibits

The following exhibits are filed herewith:

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

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

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

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SIGNATURES

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

November 10, 2006
Kenexa Corporation

 /s/ Nooruddin S. Karsan

Nooruddin S. Karsan

Chairman of the Board and Chief Executive Officer

/s/ Donald F. Volk

Donald F. Volk

Chief Financial Officer

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EXHIBIT INDEX

Exhibit Number and Description

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

Exhibit 31.2                          0;          Certification by Chief Financial Officer Pursuant to Rule 13a-14(a)/15d-14(a).

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

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