Kenexa (KNXA) 10-Q 2012 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, 2012

OR 

¨ 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 incorporation or organization)	(I.R.S. Employer Identification Number)
650 East Swedesford Road, Wayne, PA	19087
(Address of Principal Executive Offices)	(Zip Code)

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

Indicate by check mark whether the registrant: (1) 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   ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No   ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See definition of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.  (Check one): 

Large Accelerated Filer ¨Accelerated filer xNon-accelerated Filer ¨   Smaller reporting company ¨

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

Yes  ¨   No  x

On November 7, 2012, 27,606,704 shares of the registrant’s Common Stock, $0.01 par value, were outstanding.

1

Kenexa Corporation and Subsidiaries

FORM 10-Q

Quarter Ended September 30, 2012

Table of Contents 

PART 1:  FINANCIAL INFORMATION	Page
Item 1:  Financial Statements
Consolidated Balance Sheets as of September 30, 2012 (unaudited) and December 31, 2011	3
Consolidated Statements of Operations for the three and nine months ended September 30, 2012 and 2011 (unaudited)	4
Consolidated Statements of Comprehensive Loss for the three and nine months ended September 30, 2012 and 2011 (unaudited)	5
Consolidated Statements of Shareholders’ Equity for the nine months ended September 30, 2012 (unaudited)        and the year ended December 31, 2011	6
Consolidated Statements of Cash Flows for the nine months ended September 30, 2012 and 2011 (unaudited)	7
Notes to Consolidated Financial Statements (unaudited)	8
Item 2: Management’s Discussion and Analysis of Financial Condition and Results of Operations	30
Item 3: Quantitative and Qualitative Disclosures about Market Risk	42
Item 4: Controls and Procedures	43
PART II: OTHER INFORMATION
Item 1: Legal Proceedings	43
Item 1A: Risk Factors	44
Item 2: Unregistered Sales of Equity Securities and Use of Proceeds	44
Item 3: Defaults Upon Senior Securities	44
Item 4: Mine Safety Disclosures	44
Item 5: Other Information	44
Item 6: Exhibits	45
Signatures	46
Exhibit Index	47

2

PART 1 FINANCIAL INFORMATION 

Item 1:  Financial Statements 

Kenexa Corporation and Subsidiaries

Consolidated Balance Sheets

(In thousands, except share and per share data) 

	September 30,		December 31,
	2012		2011
		(unaudited)
ASSETS
Current assets:
Cash and cash equivalents	$	57,041	$	67,459
Short-term investments		6,847		51,807
Accounts receivable, net of allowance for doubtful accounts of $2,848 and $3,045		64,507		52,664
Unbilled receivables		6,577		3,385
Income tax receivable		80		196
Deferred income taxes		5,552		5,477
Prepaid expenses and other current assets		16,523		9,555
Total current assets		157,127		190,543
Long-term investments		-		9,710
Property and equipment, net		23,768		18,632
Software, net		32,507		27,179
Goodwill		67,588		43,265
Intangible assets, net		78,096		73,074
Deferred income taxes, non-current		30,485		35,092
Deferred financing costs, net		130		354
Other long-term assets		9,557		7,795
Total assets	$	399,258	$	405,644
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable	$	9,223	$	7,909
Notes payable, current		11		11
Term loan, current		-		5,000
Commissions payable		6,746		3,673
Accrued compensation and benefits		20,004		18,061
Other accrued liabilities		18,885		13,970
Deferred revenue		91,847		81,795
Capital lease obligations		1,195		282
Total current liabilities		147,911		130,701
Revolving credit line and term loan		-		25,000
Capital lease obligations, less current portion		2,852		218
Deferred revenue, less current portion		5,009		7,042
Deferred income taxes		1,236		1,823
Other long-term liabilities		4,066		5,330
Total liabilities		161,074		170,114
Commitments and Contingencies
Temporary equity
Noncontrolling interest		4,855		4,990
Shareholders' equity
Preferred stock, $0.01 par value; authorized 10,000,000 shares; issued and outstanding: none		-		-
Common stock, par value $0.01; authorized 100,000,000 shares; shares issued and outstanding: 27,603,010 and 27,124,276, respectively		276		271
Additional paid-in-capital		397,007		385,511
Accumulated deficit		(157,734)		(149,376)
Accumulated other comprehensive loss		(6,220)		(5,866)
Total shareholders' equity		233,329		230,540
Total liabilities and shareholders' equity	$	399,258	$	405,644

See notes to consolidated financial statements.

3

Kenexa Corporation and Subsidiaries

Consolidated Statements of Operations

(Unaudited; in thousands, except share and per share data) 

	Three Months Ended					Nine Months Ended
		September 30,				September 30,
		2012		2011		2012		2011
Revenues:
Subscription	$	64,190	$	53,462	$	181,739	$	149,532
Other		26,558		22,241		73,095		55,164
Total revenues		90,748		75,703		254,834		204,696
Cost of revenues		32,580		29,693		97,970		79,905
Gross profit		58,168		46,010		156,864		124,791
Operating expenses:
Sales and marketing		20,474		16,390		58,214		46,353
General and administrative		20,361		15,114		48,961		41,081
Research and development		8,148		4,912		22,126		14,176
Depreciation and amortization		11,247		8,244		32,763		24,168
Total operating expenses		60,230		44,660		162,064		125,778
(Loss) income from operations		(2,062)		1,350		(5,200)		(987)
Interest (income) expense, net		(265)		59		(870)		(725)
(Loss) gain on change in fair market value of investments, net		(19)		(127)		22		(391)
(Loss) gain before income taxes		(2,346)		1,282		(6,048)		(2,103)
Income tax (expense) benefit		(1,869)		(1,602)		(2,529)		(2,172)
Net loss	$	(4,215)	$	(320)	$	(8,577)	$	(4,275)
Loss (income) allocated to noncontrolling interest		35		(288)		219		(437)
Accretion associated with variable interest entity		-		(2,507)		-		(3,159)
Net loss allocable to common shareholders'	$	(4,180)	$	(3,115)	$	(8,358)	$	(7,871)
Basic and diluted net loss per share	$	(0.15)	$	(0.12)	$	(0.31)	$	(0.31)
Weighted average common shares - basic & diluted		27,503,535		27,043,135		27,339,019		25,002,236

See notes to consolidated financial statements.

4

Kenexa Corporation and Subsidiaries 

Consolidated Statements of Comprehensive Loss

(Unaudited; in thousands) 

	Three Months Ended				Nine Months Ended
	September 30,				September 30,
		2012		2011		2012		2011
Net loss	$	(4,215)	$	(320)	$	(8,577)	$	(4,275)
Loss (income) allocated to noncontrolling interest		35		(288)		219		(437)
Accretion associated with variable interest entity		-		(2,507)		-		(3,159)
Net loss allocable to common shareholders'	$	(4,180)	$	(3,115)	$	(8,358)	$	(7,871)
Other
Gain (loss) on currency translation adjustments		640		(1,802)		(354)		(1,083)
Unrealized loss on investments		-		(320)		-		(377)
Comprehensive loss	$	(3,540)	$	(5,237)	$	(8,712)	$	(9,331)

See notes to consolidated financial statements.

5

Kenexa Corporation and Subsidiaries

Consolidated Statements of Shareholders’ Equity

(In thousands; except share data) 

								Accumulated
								other		Total
	Common Stock			Additional		Accumulated		comprehensive		shareholders'
	Shares	Amount		paid-in-capital		deficit		loss		equity
Balance December 31, 2010	22,900,253	$	229	$	281,791	$	(145,271)	$	(3,882)	$	132,867
Loss on currency translation adjustments	-		-		-		-		(1,984)		(1,984)
Share-based compensation expense	-		-		6,369		-		-		6,369
APIC pool adjustments	-		-		(344)		-		-		(344)
Stock options exercised	719,052		7		8,920		-		-		8,927
Issuance of restricted shares	7,104		-		-		-		-		-
Vested restricted stock units converted to shares	24,450		-		-		-		-		-
Employee stock purchase plan	23,417		-		545		-		-		545
Income allocated to noncontrolling interest	-		-		-		(234)		-		(234)
Accretion associated with noncontrolling interest (variable interest entity)	-		-		(3,159)		-		-		(3,159)
Public stock offering, net	3,450,000		35		91,389		-		-		91,424
Net loss	-		-		-		(3,871)		-		(3,871)
Balance December 31, 2011	27,124,276	$	271	$	385,511	$	(149,376)	$	(5,866)	$	230,540
Loss on currency translation adjustments	-		-		-		-		(354)		(354)
Share-based compensation expense	-		-		6,710		-		-		6,710
APIC pool adjustments	-		-		(2,297)		-		-		(2,297)
Stock options exercised	408,125		4		6,626		-		-		6,630
Issuance of restricted shares	6,036		-		-		-		-		-
Vested restricted stock units converted to shares	50,206		1		(1)		-		-		-
Restricted shares withheld for payroll tax payments	(2,627)		-		(76)		-		-		(76)
Employee stock purchase plan	16,994		-		534		-		-		534
Loss allocated to noncontrolling interest	-		-		-		219		-		219
Net loss	-		-		-		(8,577)		-		(8,577)
Balance September 30, 2012 (unaudited)	27,603,010	$	276	$	397,007	$	(157,734)	$	(6,220)	$	233,329

See notes to consolidated financial statements.

6

 Kenexa Corporation and Subsidiaries 

Consolidated Statements of Cash Flows  

(Unaudited; in thousands) 

		Nine months ended September 30,
		2012		2011
Cash flows from operating activities
Net loss from operations	$	(8,577)	$	(4,275)
Adjustments to reconcile net loss to net cash provided by operating activities:
Depreciation and amortization		32,763		24,168
Loss on disposal of property and equipment		22		95
Amortization of bond premium		563		-
Realized loss on available-for-sale securities		32		62
Share-based compensation expense		6,710		4,593
Amortization of deferred financing costs		224		159
Bad debt (recoveries) expense, net		(413)		843
Deferred income tax benefit		(1,705)		(546)
Changes in assets and liabilities, net of business combinations
Accounts and unbilled receivables		(10,778)		(10,580)
Prepaid expenses and other current assets		(6,692)		(3,122)
Income taxes receivable		142		(893)
Other long-term assets		(2,004)		3,368
Accounts payable		439		585
Accrued compensation and other accrued liabilities		7,513		6,687
Commissions payable		2,938		339
Deferred revenue		3,475		11,037
Other liabilities		(1,516)		(1,078)
Net cash provided by operating activities		23,136		31,442
Cash flows from investing activities
Capitalized software and purchases of property and equipment		(22,174)		(17,999)
Purchases of available-for-sale securities		(1,469)		(86,076)
Sales of available-for-sale securities		55,545		18,330
Acquisitions, net of cash acquired		(42,236)		(11,520)
Net cash used in investing activities		(10,334)		(97,265)
Cash flows from financing activities
Borrowings under revolving credit line and term loan		-		3,000
Repayments under revolving credit line and term loan		(30,000)		(31,250)
Repayments of notes payable		(74)		(87)
Repayments of capital lease obligations		(335)		(426)
Purchase of additional interest in variable interest entity		-		(229)
Proceeds from common stock issued through Employee Stock Purchase Plan		534		391
Shares authorized, but not issued, to settle employees withholding liability		(76)		-
Net proceeds from option exercises		6,630		8,255
Net proceeds from public offering		-		91,432
Net cash (used in) provided by financing activities		(23,321)		71,086
Effect of exchange rate changes on cash and cash equivalents		101		(136)
Net (decrease) increase in cash and cash equivalents		(10,418)		5,127
Cash and cash equivalents at beginning of period		67,459		52,455
Cash and cash equivalents at end of period	$	57,041	$	57,582
Supplemental disclosures of cash flow information
Cash paid during the period for:
Interest expense	$	769	$	1,168
Income taxes	$	2,464	$	3,992
Income taxes refunded	$	290	$	-
Noncash investing and financing activities
Capital lease obligations incurred	$	3,882	$	568

See notes to consolidated financial statements.

7

Kenexa Corporation and Subsidiaries

Notes to Consolidated Financial Statements - Unaudited (Continued)

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

1. Organization

Kenexa Corporation and its subsidiaries (collectively the “Company” or “Kenexa”) is a leading provider of software-as-a-service, or SaaS, solutions that enable organizations to more effectively recruit and retain employees. Kenexa’s solutions are built around a suite of easily configurable software applications that automate talent acquisition and employee performance management best practices. Kenexa’s software applications are complemented with tailored combinations of proprietary content, outsourcing services and consulting services based on its 25 years of experience assisting customers in addressing their Human Resource (HR) requirements. Together, the software applications, content and services form complete solutions that customers find more effective than the point technology or service solutions available from alternative vendors. The Company believes that these solutions enable its customers 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. 

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. Although the Company has several product lines, our chief decision makers determine resource allocation decisions and assess and evaluate periodic performance under one operating segment. 

2. Summary of Significant Accounting Policies  

The accompanying consolidated financial statements as of September 30, 2012 and for the three and nine months ended September 30, 2012 and 2011 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 nine months ended September 30, 2012 and 2011 have been made. The results for the three and nine months ended September 30, 2012 are not necessarily indicative of the results to be expected for the year ended December 31, 2012 or for any other interim period. Certain information and footnote disclosures normally included in the Company’s annual consolidated financial statements have been condensed or omitted and, accordingly, the accompanying financial information should be read in conjunction with the consolidated financial statements and notes thereto contained in the Company’s Annual Report on Form 10-K, filed with the United States Securities and Exchange Commission for the year ended December 31, 2011.  

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, and such differences may be material to the Company’s consolidated financial statements.  

Principles of Consolidation

The consolidated financial statements of the Company include the accounts of Kenexa Corporation and its subsidiaries and variable interest entity as described in Footnote 5 – Variable Interest Entity in the Notes to Consolidated Financial Statements. All significant intercompany accounts and transactions have been eliminated in consolidation.

8

Kenexa Corporation and Subsidiaries

Notes to Consolidated Financial Statements - Unaudited (Continued)

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

Fair Value of Financial Instruments

The carrying amounts of the Company’s financial assets and liabilities, including cash and cash equivalents, restricted cash, accounts receivable, short and long-term investments, if presented, accounts payable and accrued expenses at September 30, 2012 and December 31, 2011 approximate fair value of these instruments due to their short-term nature.  

In accordance with ASC 820, “Fair Value Measurements and Disclosure”, the Company uses three levels of inputs to measure fair value: 

• Level 1 - Quoted prices in active markets for identical assets or liabilities.

• Level 2 - Observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, quoted prices in markets with insufficient volume or infrequent transactions (less active markets), or valuations in which all significant inputs are observable or can be obtained from observable market data.

• Level 3 - Unobservable inputs to the valuation methodology that are significant to the measurement of the fair value of assets or liabilities.

Financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement. As of September 30, 2012, the Company’s financial assets valued based on Level 1 inputs consisted of cash and cash equivalents in a U.S. Treasury money market fund and its financial assets valued based on Level 2 inputs consisted of municipal bonds.  

Foreign Currency Translation

The financial position and operating results of the Company’s foreign 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 revenues and expenses are translated at average rates of exchange to the U.S. dollar during the reporting period. The related translation adjustments are reported in the shareholders’ equity section of the balance sheet and resulted in a net reduction in shareholders’ equity of $354 and $1,984 for the period ended September 30, 2012 and for the year ended December 31, 2011, respectively. The foreign currency translation adjustment is not adjusted for income taxes as it relates to an indefinite investment in a non-U.S. subsidiary. Transaction net gains and losses resulting from the Company’s foreign operations resulted in net losses of $316 and $31 for the three and nine months ended September 30, 2012, respectively, and net losses of $492 and $534 for the three and nine months ended September 30, 2011, respectively.  

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 by the large number of customers comprising the Company's customer base and their dispersion across various industries. The Company does not require collateral. The customers are concentrated primarily in the Company’s U.S. market area. At September 30, 2012 and December 31, 2011, there were no customers that represented more than 10% of the net accounts receivable balance. The Company’s top 3 customers represented, collectively, approximately 8.5% and 9.0% at September 30, 2012 and December 31, 2011, respectively, of the Company’s net accounts receivable balance. In addition, no one customer individually exceeded 10% of the Company’s revenues. The Company’s top 3 customers represented, collectively, approximately 10.0% of the Company’s total revenues for the three and nine months ended September 30, 2012, and 13.5% and 11.6% for the three and nine months ended September 30, 2011, respectively.  

9

Kenexa Corporation and Subsidiaries

Notes to Consolidated Financial Statements - Unaudited (Continued)

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

Cash and Cash Equivalents

Cash and cash equivalents consist of highly liquid investments with remaining maturities of three months or less at the time of purchase. Cash balances are maintained at several banks. Cash held in fixed term deposits with original maturities of three months or less at the time of purchase totaled $662 at September 30, 2012 and $500 at December 31, 2011. Accounts located in the United States are insured by the Federal Deposit Insurance Corporation ("FDIC") up to $100 (which has been temporarily increased to $250 through December 31, 2013). Certain operating cash accounts may periodically exceed the FDIC limits. 

Cash and cash equivalents in foreign denominated currencies which are held in foreign banks totaled $21,086 and $13,536 and represented 37.0% and 20.1% of our total cash and cash equivalents balance at September 30, 2012 and December 31, 2011, respectively.

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 estimates the liability based upon management’s judgment and historical experience and records the amount on a gross basis. At September 30, 2012 and December 31, 2011, self-insurance accruals totaled $1,298 and $1,083. There were no stop loss recoveries at September 30, 2012 and December 31, 2011. Management continuously reviews the adequacy of the Company’s stop loss insurance coverage. Material differences may result in the amount and timing of health insurance claims if actual experience differs significantly from management’s estimates.  

Long-Lived Assets

The Company evaluates its long-lived assets, including certain identifiable assets, for impairment whenever events or circumstances indicate that the carrying value of such assets may not be recoverable. The Company noted no triggering event during the period ended September 30, 2012, which would give rise to an impairment analysis. It is possible that the estimated future cash flows of the asset groupings will be reduced, which may result in an impairment in future periods. If such assets are considered to be impaired, the impairment is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets.  

Guarantees 

The Company’s software license agreements typically provide for indemnifications of customers for intellectual property infringement claims. The Company also warrants to customers, when requested, that the Company’s software products operate substantially in accordance with standard specifications for a limited period of time. The Company has not incurred significant obligations under customer indemnification or warranty provisions historically, and does not expect to incur significant obligations in the future. Accordingly, the Company does not maintain accruals for potential customer indemnification or warranty-related obligations.

10

Kenexa Corporation and Subsidiaries

Notes to Consolidated Financial Statements - Unaudited (Continued)

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

Revenue Recognition

The Company derives its revenue from two sources: (1) subscription revenue for solutions, which is comprised of subscription fees from customers accessing the Company’s on-demand software (application services), proprietary content, outsourcing services and consulting services and from customers purchasing additional support beyond the standard support that is included in the basic subscription fee; and (2) other fees for discrete consulting services. Because the Company provides its solutions as a service, the Company follows the provisions of ASC 605-10, “Revenue Recognition” and ASC 605-25 “Multiple Elements Arrangements.”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 customer;

•   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 lives 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. Deferred revenue represents payments received or accounts receivable from the Company's customers for amounts billed in advance of subscription services being provided.  

The Company records expenses billed to customers in accordance with ASC 605-45,  “Revenue Recognition-Principal Agent Considerations,” which requires that reimbursements received for out-of-pocket expenses be classified as revenues and not as cost reductions. These items primarily include travel, meals and agency fees. Reimbursed expenses totaled $1,500 and  $4,754 for the three and nine months ended September 30, 2012, respectively, and $1,974 and $4,562 for the three and nine months ended September 30, 2011, respectively.  

The Company’s arrangements with customers may include provision of consulting services, grant of software licenses and delivery of data. For arrangements that contain multiple deliverables, the selling price hierarchy established in ASU 2009-13 is used to determine the selling price of each deliverable. The selling price hierarchy allows for the use of an estimated selling price (“ESP”) to determine the allocation of arrangement consideration to each deliverable in a multiple-element arrangement in the absence of vendor specific objective evidence (“VSOE”) or third-party evidence (“TPE”).  

To qualify as a separate unit of accounting, deliverable items must have value to the customer on a standalone basis and, if the arrangement includes a general right of return relative to the delivered item(s), delivery or performance of the undelivered item(s) is considered probable and substantially in our control. If the arrangement does not meet all criteria above, the entire amount of the transaction is deferred until all elements are delivered. 

11

Kenexa Corporation and Subsidiaries

Notes to Consolidated Financial Statements - Unaudited (Continued)

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

The Company determines the selling price in multiple-element arrangements using VSOE or TPE if available. VSOE is determined based on the price charged for the same deliverable when sold separately and TPE is established based on the price charged by our competitors or third parties for the same deliverable. If the Company is unable to determine the selling price because VSOE or TPE does not exist, the ESP is used. The Company determines its ESP for its application services and license fees based on the following:  

• The Company utilizes a pricing model for its products which considers market factors such as customer demand for our products and the geographic regions where the products are sold. In addition, the model considers entity-specific factors such as volume based pricing, discounts for bundled products and total contract commitment. Management approval of the model ensures that all of the Company’s selling prices are consistent and within an acceptable range for use with the relative selling price method.

• While the pricing model currently in use captures all critical variables, unforeseen changes due to external market forces may result in the Company revising some of its inputs. These modifications may result in the consideration allocation in future periods differing from the one presently in use. Absent a significant change in the pricing inputs or the way in which the industry structures its deals, future changes in the pricing model are not expected to materially affect the Company’s allocation of arrangement consideration.

• The Company determined the ESP for consulting services based on sales of those services sold separately or on consulting rates estimated based on the value of the services being provided.

The revenue guidance contained in ASU 2009-13 modifies the way the Company accounts for certain arrangements, by allowing the Company to separate consulting services and corresponding license fees into two separate units of accounting. These two deliverables represent the primary elements in those arrangements and are recognized upon performance or delivery of each service or product, respectively to the end customer. Revenue related to consulting services is recognized as obligations are fulfilled on a proportional performance basis and typically earned over a three to six month period, while the license fees may be recognized over a one to five year period. After the adoption of ASU 2009-13, costs associated with the delivery of our consulting services are expensed as incurred.   

Multiple element arrangements consisting of multiple products are impacted by the new revenue guidance. Under ASU 2009-13, total consideration for an arrangement is allocated to each product or service using the hierarchy of VSOE, third party evidence or the relative selling price method and is recognized as each product or service is delivered to the customer. Consistent with current practice, revenue may be deferred if the arrangement includes any unusual terms including extended payment terms, specified acceptance terms, or hold backs payable upon final acceptance of the product or service.

Income Taxes

The Company files a consolidated income tax return with its subsidiaries for federal tax purposes and on various bases depending on applicable taxing statutes for state and local as well as foreign tax purposes. Deferred income taxes are provided using the asset and liability method for temporary differences between the financial statement and tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. Valuation allowances are established when necessary to reduce net deferred tax assets to the amounts which are more likely than not expected to be realized.  

Other Taxes 

Non-income taxes such as sales and value-added taxes are presented on a net basis within general and administrative expense, on the statement of operations. 

12

Kenexa Corporation and Subsidiaries

Notes to Consolidated Financial Statements - Unaudited (Continued)

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

Loss Per Share 

The Company follows ASC 260, “Earnings Per Share,” which requires companies that are publicly held or have complex capital structures to present basic and diluted earnings per share on the face of the statement of operations. Earnings (loss) per share is 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 exercise of options if they are dilutive. In the calculation of basic earnings per share, weighted average numbers of shares outstanding are used as the denominator.  

As a result of the variable interest entity commencing in 2009 and its corresponding put option, the Company uses the two-class method of calculating earnings per share as the put feature was issued by the Company and requires adjustments to the carrying value of the noncontrolling interest and the income allocable to common shareholders. There were no common stock equivalents of stock options and restricted stock issued and outstanding included in the computation of diluted earnings per share for the three and nine months ended September 30, 2012 and 2011 since their effect was antidilutive. A summary of the computation for basic and diluted net loss per share is presented in the table below.    

	Three months ended September 30,					Nine months ended September 30,
		2012		2011			2012		2011
Numerator:
Net loss allocable to common shareholders	$	(4,180)	$	(3,115)		$	(8,358)	$	(7,871)
Denominator:
Weighted average shares used to compute net loss allocable to common shareholders per common share - basic		27,503,535		27,043,135			27,339,019		25,002,236
Effect of dilutive stock options		—		—			—		—
Weighted average shares used to compute net loss allocable to common shareholders per common share – dilutive		27,503,535		27,043,135	��		27,339,019		25,002,236
Basic and diluted net loss per share	$	(0.15)	$	(0.12)		$	(0.31)	$	(0.31)
Total antidilutive stock options and unvested restricted stock issued and outstanding or granted		442,132		981,276			877,471		943,276

13

Kenexa Corporation and Subsidiaries

Notes to Consolidated Financial Statements - Unaudited (Continued)

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

Recently Adopted Accounting Pronouncements 

In June 2011, the FASB issued ASU 2011-05, “Comprehensive Income (Topic 220) – Presentation of Comprehensive Income”, which requires disclosure of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. ASU 2011-05 eliminates the option to present the components of other comprehensive income as part of the statement of changes in shareholders’ equity. ASU 2011-05 is effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. In December 2011, the FASB has issued ASU 2011-12, Comprehensive Income (Topic 220), that deferred the requirement to separately present within net income reclassification adjustments of items out of accumulated other comprehensive income. The adoption of this standard is presented in the current financial statements and only impacted the presentation format of the Company’s consolidated financial statements. 

In September 2011, the FASB issued ASU 2011-08, “Intangibles – Goodwill and Other (Topic 350)—Testing Goodwill for Impairment (revised topic)”. The revised standard is intended to reduce the cost and complexity of the annual goodwill impairment test by providing entities an option to perform a “qualitative” assessment to determine whether further impairment testing is necessary. The revised standard is effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. The adoption of this standard did not materially impact the Company’s consolidated financial statements.The Company noted no triggering event during the nine months ended September 30, 2012, which would give rise to an impairment analysis.   

In July 2012, the FASB issued ASU 2012-02, “Intangibles—Goodwill and Other (Topic 350): Testing Indefinite-Lived Intangible Assets for Impairment,” (ASU 2012-02). ASU 2012-02 amends the guidance in ASC 350-30 on testing indefinite-lived intangible assets, other than goodwill, for impairment by allowing an entity to perform a qualitative impairment assessment before proceeding to the two-step impairment test. If the entity determines, on the basis of qualitative factors, that the fair value of the indefinite-lived intangible asset is not more likely than not (i.e., a likelihood of more than 50 percent) impaired, the entity would not need to calculate the fair value of the asset. In addition, the ASU does not amend the requirement to test these assets for impairment between annual tests if there is a change in events or circumstances; however, it does revise the examples of events and circumstances that an entity should consider in interim periods. ASU 2012-02 is effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012, with early adoption being permitted. The adoption of this standard will not have a material effect on our Consolidated Results of Operations and Financial Condition.

3.  Investments  

Short-term and long-term investments at September 30, 2012 and December 31, 2011 are comprised of municipal bonds with varying maturities and credit risk ratings of A1 and VMIG 1 or greater by various rating agencies. Investments are recorded at fair value based on current market rates and are classified as available-for-sale securities. The current yield on the Company’s municipal bonds at September 30, 2012 was 5.14%. Available-for-sale securities are reported at fair value with changes in the related unrealized gains and losses included in comprehensive loss in the accompanying consolidated financial statements. The cost of securities is determined based on the specific identification method. At September 30, 2012, the cost of the available-for-sale securities approximated their fair value. 

14

Kenexa Corporation and Subsidiaries

Notes to Consolidated Financial Statements - Unaudited (Continued)

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

4. Acquisitions  

The Ashbourne Group 

On August 2, 2011, the Company entered into a share purchase agreement with The Ashbourne Group (“Ashbourne”), a supplier of HR and occupational psychology services based in London, England, for a purchase price of approximately $1,846 in cash. The total cost of the acquisition, including legal, accounting, and other professional fees of $10, was approximately $1,856. The acquisition of Ashbourne provides the Company with valuable assessment, learning and development products based on government competencies and performance standards. The purchase price has been allocated to the assets acquired and liabilities assumed based upon management’s best estimate of fair value with any excess over the net tangible and intangible assets acquired allocated to goodwill. Due to the nature of the acquisition, the goodwill and related intangible assets from the Ashbourne acquisition will be amortized and deducted for tax purposes. 

Batrus & Hollweg, L.C. 

On November 14, 2011, the Company entered into a share purchase agreement with Batrus & Hollweg, L.C. (“BHI”), a provider of talent management solutions, primarily in the hospitality sector based in Texas, for a purchase price of approximately $14,656 including cash and contingent consideration. The total cost of the acquisition, including legal, accounting, and other professional fees of $46, was approximately $14,702. At the date of the acquisition, the Company accrued contingent consideration of $5,113, which was subsequently adjusted to $2,534 during the quarter ended June 30, 2012. The adjustment was due in part to a revision of the preliminary earnout calculation totaling $2,355 and a change in the forecasted projections which reduced the earnout by $224. The adjustments were recorded to goodwill and operations, respectively, during the quarter ended June 30, 2012. The Company expects to pay $835 by March 31, 2013 and the remaining $1,699 by March 31, 2014. The contingent consideration is calculated based on the Company’s estimated revenue growth within the hospitality industry. In connection with the acquisition, $1,000 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 BHI under the acquisition agreement. The escrow agreement will remain in place for approximately eighteen months from the acquisition date, and any funds remaining in the escrow account at the end of the eighteenth month will be distributed to the former stockholders of BHI. The acquisition of BHI will add to the Company's existing research and content portfolio. In addition, it will increase the Company’s presence in the hospitality sector. The purchase price has been preliminarily allocated to the assets acquired and liabilities assumed based upon management’s best estimate of fair value with any excess over the net tangible assets acquired allocated to goodwill and intangible assets. The Company is in the process of finalizing its estimate of contingent consideration as it relates to the revenue and profitability forecasts and the overall integration of the BHI product portfolio and its impact on the calculation. During the measurement period and as the forecasts and calculation are finalized, the Company will record adjustments, if necessary. Due to the nature of the acquisition, the goodwill and related intangible assets from the BHI acquisition will be amortized and deducted for tax purposes. 

OutStart 

On February 6, 2012, the Company acquired substantially all of the outstanding capital stock of OutStart, Inc. (“OutStart”), a leading provider of SaaS e-learning solutions and services, based in Boston, Massachusetts, for a purchase price of approximately $46,229, including adjustments for certain working capital accounts as defined in the purchase agreement. The total cost of the acquisition, including legal, accounting, and other professional fees of $217, was approximately $46,446. In connection with the acquisition, $3,500 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 OutStart under the acquisition agreement. The escrow agreement will remain in place for fifteen months from the acquisition date, and any funds remaining in the escrow account will be distributed to the former stockholders of OutStart.  

The acquisition of OutStart expanded the Company’s reach into the e-learning market and enabled Kenexa to provide a broader and deeper suite of talent management solutions. OutStart’s Learning Management Suite, which includes award-winning social and mobile learning solutions, is being integrated with Kenexa’s Global Talent Management solutions including its Performance Management suite.  

15

Kenexa Corporation and Subsidiaries

Notes to Consolidated Financial Statements - Unaudited (Continued)

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

OutStart’s results of operations have been included in the Company’s consolidated financial statements beginning on February 6, 2012. The purchase price has been preliminarily allocated to the assets acquired and liabilities assumed based upon management’s best estimate of fair value with any excess over the net tangible and intangible assets acquired allocated to goodwill. The value of the deferred tax asset remains open pending the resolution of the value. The fair value of deferred revenue was determined based upon the estimated direct cost of fulfilling the obligation to the customer plus a normal profit margin. Customer lists and intellectual property are being amortized over their estimated useful lives. The estimated fair values of the intangible assets are listed below. The valuation of the identified intangibles was determined based upon estimated discounted incremental future cash flow to be received as a result of these intangibles. Goodwill is not amortized but is periodically evaluated for impairment.  

Goodwill from the acquisition resulted from our belief that the products developed by OutStart will be complementary to our Kenexa Global Talent Management solution and will help us remain competitive in the talent acquisition market. The Company is evaluating the acquired deferred tax asset and will record adjustments, if necessary. 

The purchase price was allocated as follows: 

Description	Amount		Amortization period
Assets acquired
Cash and cash equivalents	$	5,128
Accounts receivable		3,835
Prepaid expenses and other current assets		239
Property & equipment		129
Other long-term assets		202
Other intangibles		2,100		1 year
Customer relationships		8,300		15 years
Acquired development		11,300		10 years
Goodwill		25,300		Indefinite
Less: Liabilities assumed
Accounts payable		778
Accrued compensation and benefits		1,009
Accrued other liabilities		473
Notes payable		74
Commissions payable		134
Long-term tax liability		222
Deferred tax liability, net		3,295
Deferred revenue, net		4,319
Total cash purchase price	$	46,229

Unaudited pro forma results of operations to reflect the acquisition as if it had occurred on the first date of all periods presented are shown below.  

	Three Months Ended  September 30, 2011		Nine Months Ended   September 30, 2012		Nine Months Ended  September 30, 2011
Revenue	$	80,933	$	256,373	$	220,831
Net loss allocable to common shareholders	$	(3,022)	$	(7,464)	$	(7,601)
Net loss per share—basic and diluted	$	(0.11)	$	(0.27)	$	(0.30)

16

Kenexa Corporation and Subsidiaries

Notes to Consolidated Financial Statements - Unaudited (Continued)

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

5. Variable Interest Entity  

On January 20, 2009, the Company entered into an ownership interest transfer agreement (“the agreement”) with Shanghai Runjie Management Consulting Company, (“R and J”) in Shanghai, China. In conjunction with the agreement, the Company paid $1,337 as an initial equity contribution and to compensate the former owners of R and J, who transferred their existing business into a new entity, Shanghai Kenexa Human Resources Consulting Co., Ltd., (the “variable interest entity”). The initial payment provided the Company with a 46% ownership interest in the variable interest entity, and a presence in China’s human capital management market. In 2011 and 2010, based upon the preceding year’s operating results for R and J, the Company paid an additional $2,296 and $31, respectively, for an additional 1% ownership interest, for each year, in the variable interest entity. At September 30, 2012, the Company had a 49% ownership interest in the variable interest entity. 

On August 25, 2012, in connection with its pending acquisition by IBM, the Company entered into agreements with R and J and the variable interest entity pursuant to which it will divest its current ownership interest in the variable interest entity. Under the terms of the agreements, the Company will receive approximately $160 in exchange for its ownership interest in the variable interest entity and will pay R and J approximately $6,816 to release and settle all claims and liabilities, including the cancellation of loans from Kenexa to the variable interest entity totaling approximately $1,816. The Equity Interest Transfer Agreement is subject to customary governmental approvals by the Ministry of Commerce of the People’s Republic of China and the State Administration of Industry and Commerce.

The variable interest entity is consolidated in the Company’s financial statements because of the Company’s implicit guarantee to provide financing as well as its significant influence over the day-to-day operations. The equity interests of R and J not owned by the Company are reported as a noncontrolling interest in the Company’s accompanying consolidated balance sheet. All inter-company transactions are eliminated. See Footnote 2 – Summary of Significant Accounting Policies Principles of Consolidation for additional details. 

Pursuant to ASC 480 “Distinguishing Liabilities from Equity” (formerly Emerging Issues Task Force Abstracts Topic No. D-98, “Classification and Measurement of Redeemable Securities”)due to the put rights included in the agreement, the Company has presented the estimated fair value of R and J’s 51% ownership interest and the calculated value of the put right in the variable interest entity amounting to $4,855 and $4,990 at September 30, 2012 and December 31, 2011, respectively, in noncontrolling interest and classified the amount as temporary equity on the consolidated balance sheet.

6.  Goodwill

The Company has recorded goodwill in accordance with the provisions of ASC 350, “Intangibles-Goodwill and Other,” which requires the Company to annually review the carrying value of goodwill for impairment. If goodwill becomes impaired, some or all of the goodwill would be written off as a charge to operations. This comparison is performed annually or more frequently if circumstances change that would more likely than not reduce the fair value of the reporting unit below its carrying amount. The Company evaluates the carrying value of goodwill under two reporting units within a single segment. The Company performs an annual review in the fourth quarter of each year, or more frequently if indicators of potential impairment exist, to determine if the carrying value of the recorded goodwill is impaired. 

The Company evaluates its goodwill by comparing the fair values of its reporting units, based upon management's estimate of the future discounted cash flows to be generated by the business using level three inputs and comparable company multiples, to their carrying values. These 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 the Company's business based on its knowledge of the industry. Changes in the underlying business could affect these estimates, which in turn could affect the recoverability of goodwill. Management noted no triggering event during the nine months ended September 30, 2012, which would give rise to an impairment analysis. 

17

Kenexa Corporation and Subsidiaries

Notes to Consolidated Financial Statements - Unaudited (Continued)

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

The changes in the carrying amount of goodwill, which include adjustments for earnouts, taxes, foreign currency, and acquisitions for the period ended September 30, 2012, are as follows:   

Balance as of December 31, 2011	$	43,265
Acquisitions or adjustments:
Quorum (1)		1,135
BHI (2)		(2,460)
OutStart		25,300
Foreign currency and other		348
Balance as of September 30, 2012	$	67,588

(1) Quorum International Holdings Limited (“Quorum”) was acquired by the Company on April 2, 2008. The acquisition agreement included an earnout based upon the gross profit of Quorum for each of the twelve month periods ending June 30, 2009 and June 30, 2010. Based upon the results through June 30, 2010, no earnout was initially thought to be due, however based upon subsequent review, Management and the former owners determined that an earnout was in fact due. The additional consideration of $1,135 was accrued and recorded to goodwill in accordance with permissible acquisition accounting guidelines in the financial statements at March 31, 2012. The Company paid the additional consideration of $1,135 during the quarter ended June 30, 2012. 

(2) $2,355 of the adjustment, as described in Footnote 4 – Acquisitions in the Notes to Consolidated Financial Statements, relates to a revision of the preliminary earnout calculation.

7. Intangible Assets

Intangible assets consist of intellectual property, non-compete agreements, customer lists and trademarks. Intellectual property, non-compete agreements and trademarks are amortized on a straight-line basis over their estimated useful lives or contract periods, generally ranging from 3 to 20 years. Customer lists are amortized based on the attrition rate of our customers. The amounts were based, in part, on an analysis of the incremental cash flows expected to be derived from the customer lists using historic retention rates and an appropriate discount rate. Amortization expense related to these intangible assets was $5,783 and $16,999 for the three and nine months ended September 30, 2012, respectively, and $3,571 and $10,685 for the three and nine months ended September 30, 2011, respectively.   

Intangible assets subject to amortization at September 30, 2012 and December 31, 2011 consist of the following: 

	September 30, 2012							December 31, 2011
	Gross Carrying Amount		Accumulated Amortization		Net		Weighted Average Useful Life (in years)	Gross Carrying Amount		Accumulated Amortization		Net	Weighted Average Useful Life (in years)
Customer lists	$	82,212	$	(26,927)	$	55,285	9.1	$	71,783	$	(17,809)	$ 53,974	9.6
Intellectual property		37,612		(16,510)		21,102	3.8		26,134		(9,316)	16,818	2.2
Non-compete		1,000		(843)		157	0.3		2,007		(1,546)	461	0.7
Trademarks		2,251		(699)		1,552	4.8		2,232		(411)	1,821	5.6
Fully amortized intangibles		5,413		(5,413)		—	—		4,199		(4,199)	—	—
Total	$	128,488	$	(50,392)	$	78,096	7.4	$	106,355	$	(33,281)	$ 73,074	7.4

18

Kenexa Corporation and Subsidiaries

Notes to Consolidated Financial Statements - Unaudited (Continued)

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

The estimated amortization expense for intangible assets for the next five years and thereafter is as follows: 

Period		Amortization Expense
Remainder of 2012	$	5,766
2013		17,217
2014		10,734
2015		8,393
2016		7,267
Thereafter		28,719
Total	$	78,096

8. Software Developed for Internal Use

The Company applies ASC 350, “Intangibles-Goodwill and Other, Internal-Use Software.” The costs incurred in the preliminary stages of development are expensed as incurred. Once an application has reached the development stage and technological feasibility has been established, internal and external costs, if direct and incremental, are 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 costs 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 these consolidated financial statements.  

The total R&D spend, comprised of R&D expense and capitalized internal use software for the periods ended September 30, 2012 and 2011 is as follows: 

	Nine months ended September 30,
	2012		2011
Capitalized internal-use software costs	$	15,482	$	11,255
Research and development expenses		22,126		14,176
Total capitalized software costs and research and development expenses	$	37,608	$	25,431

Amortization of capitalized internal-use software costs was $4,000 and $10,772 for the three and nine months ended September 30, 2012 and $2,540 and $7,113 for the three and nine months ended September 30, 2011, respectively.

9. Property, Equipment and Software

Property and equipment are stated at cost. Equipment under capital lease is stated at the lower of the fair market value at the date of acquisition or net present value of the minimum lease payments at inception of the lease. Depreciation and amortization expense are recognized on a straight-line basis over the assets' estimated useful lives or, if shorter, the lease terms for leasehold improvements. Estimated useful lives are generally 7 years for office furniture, and 3 to 5 years for computer equipment and software. Reviews are regularly performed if facts and circumstances exist that indicate that the carrying amount of assets may not be recoverable or that the useful life is shorter than originally estimated. Costs of maintenance and repairs are charged to expense as incurred. When property and equipment or leasehold improvements are sold or otherwise disposed of, the fixed asset account and related accumulated depreciation account are relieved and any gain or loss is included in results of operations. Costs of software not yet placed into service are accumulated as software in development. Upon placement into service, the costs of the assets are transferred to software.  

19

Kenexa Corporation and Subsidiaries

Notes to Consolidated Financial Statements - Unaudited (Continued)

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

A summary of property, equipment and capitalized software and related accumulated depreciation and amortization as of September 30, 2012 and December 31, 2011 is as follows:  

		September 30, 2012	December 31, 2011
Equipment	$	28,421	$	22,543
Software		69,262		52,370
Office furniture and fixtures		3,885		2,754
Leasehold improvements		4,757		3,959
Land		628		628
Building		7,634		7,490
Software in development		8,157		7,992
Total property, equipment and software		122,744		97,736
Less accumulated depreciation and amortization		66,469		51,925
Total property, equipment and software, net of accumulated depreciation and amortization	$	56,275	$	45,811

Depreciation and amortization expense is excluded from cost of revenues. Equipment and office furniture and fixtures included gross assets under capital leases totaled $6,655 and $2,820 at September 30, 2012 and December 31, 2011, respectively. Depreciation and amortization expense, including amortization of assets under capital leases, was $5,463 and $15,763 for the three and nine months ended September 30, 2012, respectively, and $4,673 and $13,483 for the three and nine months ended September 30, 2011, respectively.

10. Other Accrued Liabilities

Other accrued liabilities consist of the following:  

		September 30, 2012	December 31, 2011
Accrued professional fees	$	1,819	$	322
Straight line rent accrual		3,858		2,928
Other taxes payable		1,572		1,505
Income taxes payable		6,994		3,436
Other liabilities		3,265		3,385
Contingent purchase price (1)		1,377		2,394
Total other accrued liabilities	$	18,885	$	13,970

(1) Contingent purchase price for the period ended September 30, 2012 relates to the earnout provisions for the BHI acquisition. Contingent purchase price for the year ended December 31, 2011 relates to the Quorum acquisition (refer to Footnote 4 – Acquisitions and Footnote 6 – Goodwill for additional information.)

20

Kenexa Corporation and Subsidiaries

Notes to Consolidated Financial Statements - Unaudited (Continued)

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

11. Line of Credit 

On October 20, 2010, the Company entered into a senior secured credit agreement (the “amended credit agreement”) with PNC Bank.  The maximum amount available under the amended credit agreement is $60,000, comprised of a $35,000 revolving facility, including a sublimit of up to $5,000 for letters of credit and a sublimit of up to $2,500 for swing loans (the “Revolving Facility”), and a $25,000 term facility (the “Term Facility”). The Company may request to increase the maximum amount available under the Revolving Facility to $50,000.  The amended credit agreement will terminate, and all borrowings will become due and payable, on October 19, 2013. The Company and each of its U.S. subsidiaries are guarantors of the obligations under the amended credit agreement. Borrowings under the amended credit agreement are secured by substantially all of the Company’s assets (including a pledge of the capital stock of our subsidiaries (but limited to only 65% of the voting stock of first-tier foreign subsidiaries)). For the year ended December 31, 2010, the Company recorded $611 in deferred financing costs in connection with its credit agreements. On August 27, 2012 the Company paid-off the remaining outstanding borrowings under its term and revolver facilities.   

Borrowings under the amended credit agreement are cross-collateralized by a first priority perfected lien on the Company’s assets including, but not limited to, receivables, inventory, equipment, furniture, general intangibles, fixtures, real property and improvements. The amended credit agreement contains various terms and covenants that provide for restrictions on 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. The Company was compliant with its financial covenants at September 30, 2012 and had $34,500 available for borrowing under the revolving line of credit. 

In March 2011 and October 2010 in connection with borrowings of $25,000 and $10,000 under the Term and Revolver Facilities, the Company entered into three interest rate swap agreements. On August 27, 2012 in connection with the repayment of the term and revolver credit facility, the Company terminated its interest rate swap agreements and incurred a termination fee of approximately $237. In connection with the closing of its acquisition by IBM, the Company’s revolving facility will be terminated and will no longer be in effect.

12. Income Taxes

The Company’s tax provision for interim periods is determined using an estimate of its annual effective tax rate which does not include the effect of discrete events that may occur during the year. The effect of any discrete events is reflected in the quarter in which the event occurs. The 2012 effective tax rate is higher than the 35% statutory U.S. Federal rate primarily due to losses in domestic and foreign jurisdictions where we recorded a valuation allowance.  

On January 1, 2007, we adopted FASB ASC 740, “Income Taxes,” which clarifies the accounting for uncertain income tax positions recognized in financial statements and requires the impact of a tax position to be recognized in the financial statements if that position is more likely than not of being sustained by the taxing authority. The Company does not expect that the amount of unrecognized tax benefits will significantly increase or decrease within the next twelve months. Our policy is to recognize interest and penalties on unrecognized tax benefits in the provision for income taxes in the consolidated statements of operations.  Tax years beginning in 2007 are subject to examination by taxing authorities, although net operating loss and credit carryforwards from all years are subject to examinations and adjustments for at least three years following the year in which the attributes are used. 

During the period ended September 30, 2012, the valuation allowance increased to $19,902 from $18,211 at December 31, 2011 due primarily to domestic net operating losses and acquired foreign net operating losses. Management continues to believe, based on the weight of available evidence, that it is more likely than not that some of the deferred tax asset will not be realized.

21

Kenexa Corporation and Subsidiaries

Notes to Consolidated Financial Statements - Unaudited (Continued)

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

13. Commitments and Contingencies

Litigation

Taleo  Litigation 

On June 28, 2011, Kenexa and Taleo Corporation and its subsidiaries (“Taleo”) (together, the “parties”) entered into a settlement agreement and other related documents resolving all outstanding litigations between the parties (“Settlement Agreement”). As a result of the Settlement Agreement, all litigations between the parties have been dismissed with prejudice. The Settlement Agreement also includes a license of certain Kenexa intellectual property to Taleo and a license of certain Taleo intellectual property to Kenexa. A $3,000 net cash settlement to Kenexa for all intellectual property licenses and settlement of litigations was recorded in the second quarter of 2011 as a reduction to legal expenses. 

Genesys Shareholder Suit 

On October 1, 2010, Kenexa completed its acquisition of Salary.com, Inc. which included responsibility for the suit filed on August 13, 2010 by former shareholders and option holders of Genesys Software Systems, Inc. (the “Genesys Parties” and “Genesys,” respectively) against Salary.com, Inc. and Silicon Valley Bank –Trustee Process Defendant in Massachusetts Superior Court. The Genesys Parties asserts claims for breach of contract, breach of implied covenant of good faith and fair dealing, violation of the Massachusetts Unfair Business Practices Act, and declaratory judgment seeking damages of $2,000 in contingent consideration related to the purchase of Genesys by Salary.com, plus other monetary damages and fees. On September 7, 2010, Salary.com filed an answer and counterclaim against the Genesys Parties, and certain former shareholders of Genesys, asserting breach of contract, breach of implied covenants of good faith and fair dealing, fraud, violation of the Massachusetts Unfair Business Practices Act, civil conspiracy, negligent misrepresentation, and declaratory judgment seeking to dismiss the original complaint and unspecified monetary damages. The $2,000 in contingent consideration was accrued for in the financial statements at December 31, 2010. The parties entered into a settlement agreement in September 2011 whereby Kenexa paid $1,780 in contingent consideration. On October 5, 2011, the Court dismissed the action with prejudice. 

Salary.com Appraisal Suit 

On February 2, 2011, Dorno Investment Partners, LLC filed a Petition for Appraisal of Stock in the Court of Chancery of the State of Delaware against Kenexa Compensation, Inc., the new name for the surviving entity subsequent to the all cash, short form merger of Salary.com, Inc. and Spirit Merger Sub, Inc. on October 1, 2010. Dorno was the beneficial owner of 143,610 shares of Salary.com, Inc. common stock on the merger date. It demanded appraisal of the fair value of 140,000 shares pursuant to Delaware law, together with interest from October 1, 2010, costs, attorney’s fees, and other appropriate relief. The parties entered into a settlement agreement in June 2011, and on June 30, 2011, the Court dismissed the action with prejudice. 

The Company is involved in claims, including those identified above, which arise in the ordinary course of business. In the opinion of management, the Company has 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, could have a material adverse effect on the Company’s business, financial condition and operating results. Furthermore, the Company believes that the litigation matters described above, at their current state, are neither probable nor reasonably estimable at the time of filing.

22

Kenexa Corporation and Subsidiaries

Notes to Consolidated Financial Statements - Unaudited (Continued)

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

14.  Equity

On May 25, 2011, the Company completed a public offering of 3,000,000 shares of its common stock at a price to the public of $27.75 per share. Net proceeds to the Company aggregated approximately $79,467 after payment of all offering fees and underwriters’ commission and offering expenses of $245. On May 25, 2011, the underwriters exercised their over-allotment option under the terms of the underwriting agreement to purchase 450,000 additional shares of common stock. Net proceeds to the Company following the sale of the over-allotment shares were $11,957. 

Stock and Voting Rights

Undesignated Preferred Stock

The Company has 10,000,000 shares of $0.01 par value undesignated preferred stock authorized, with no shares issued or outstanding at September 30, 2012 or December 31, 2011. These shares have preferential rights in the event of liquidation and payment of dividends.  

Common Stock

At September 30, 2012 and December 31, 2011, the Company had 100,000,000 authorized shares of common stock. Shares of common stock outstanding were 27,603,010 and 27,124,276 at September 30, 2012 and December 31, 2011, respectively. Each share of common stock has one-for-one voting rights.

15. Stock Plans

Equity Incentive Plan

The Company’s Equity Incentive Plan (the “plan”) provides for the granting of stock options and restricted stock to employees, officers and non-employee directors at the discretion of the Board or a committee of the Board. The purpose of the plan is to recognize past services rendered and to provide additional incentive in furthering the continued success of the Company.  

The Company grants to certain employees and officers stock options and restricted stock unit awards. Stock options granted under the plan expire between the fifth and tenth anniversary of the date of grant and may vest on the third anniversary from the date of grant or may vest twenty-five percent per year over four years. Unexercised stock options may expire up to 90 days after an employee's termination for options granted under the plan. Restricted stock units granted under the plan vest twenty-five percent per year over four years. Under the plan all unvested restricted stock grants are forfeited to the issuer on the date of termination. 

The Company grants to non-employee directors stock options and restricted stock awards. Stock options granted under the plan expire on the fifth anniversary from the date of grant and vest 100% on the day preceding the Company’s annual meeting of Shareholders. Restricted stock awards granted under the plan vest 100% on the day preceding the Company’s annual meeting of Shareholders. In the event a non-employee director ceases to be a director for the Company before the shares are fully vested, the unvested restricted shares will be forfeited to the Company. 

As of September 30, 2012, there were 2,506,561 options to purchase shares of common stock and 273,080 shares of restricted stock and restricted stock units outstanding under the plan. The Company is authorized to issue up to an aggregate of 4,579,036 shares of its common stock under the plan. As of September 30, 2012, a total of 1,799,395 shares of common stock were available for future grants under the plan. Please see note 18 to the consolidated financial statements for a discussion of the treatment of these options and restricted stock upon consummation of the Merger (as defined in that note).      

23

Kenexa Corporation and Subsidiaries

Notes to Consolidated Financial Statements - Unaudited (Continued)

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

Share-based Compensation Expense

The Company accounts for its share-based arrangements in accordance with ASC 718, “Compensation-Stock Compensation.”The compensation expense for share-based awards with a service condition that cliff vest, is recognized on a straight-line basis over the award’s requisite service period based on its fair value on the date of grant. For those awards with a service condition that have graded vesting, compensation expense is calculated using the graded-vesting attribution method. This method entails recognizing compensation expense on a straight-line basis over the requisite service period for each separately vesting portion as if the grant consisted of multiple awards, each with the same service inception date but different requisite service periods. This method accelerates the recognition of compensation expense. In accordance with ASC 718, the pool of excess tax benefits available to absorb tax deficiencies was determined using the alternative transition method. Excess tax benefits, associated with the expense recognized for financial reporting purposes, are presented as a financing cash inflow rather than as a reduction of income taxes paid in our consolidated statement of cash flows and are recognized upon the exercise of stock options and determination of tax deductibility.   

The fair value of market-based, performance vesting share awards is calculated using a Monte Carlo valuation model that simulates various potential outcomes of the option grant and values each outcome using the Black-Scholes valuation model which yields a fair market value of the Company's common stock on the date of the grant (measurement date). This amount is recognized over the vesting period, using the straight-line method. Since the award requires both the completion of four years of service and the share price reaching predetermined levels as defined in the option agreement, compensation cost will be recognized over the four year explicit service period. If the employee terminates prior to the four-year requisite service period, compensation cost will be reversed even if the market condition has been satisfied by that time. The total grant date fair value of the options granted during 2008 using the Monte Carlo valuation model was $1,026. 

The Company records share-based compensation expense in the following categories included in the accompanying consolidated statement of operations: 

	Three months ended   September 30,				Nine months ended   September 30,
	2012		2011		2012		2011
Cost of revenues	$	62	$	69	$	249	$	187
Sales and marketing		451		273		1,161		708
General and administrative		1,657		1,329		4,805		3,335
Research and development		190		136		495		363
Total share-based compensation expense	$	2,360	$	1,807	$	6,710	$	4,593

As of September 30, 2012, there was $11,215 of total unrecognized compensation cost related to unvested share-based compensation arrangements granted under the 2005 Option Plan. That cost is expected to be recognized over a weighted-average period of 1.45 years. 

24

Kenexa Corporation and Subsidiaries

Notes to Consolidated Financial Statements - Unaudited (Continued)

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

Stock Options

The Company estimates the fair value of stock option awards using the Black-Scholes valuation model. Historically, expected volatility was based upon a weighted average of peer companies and the Company’s stock volatility; however, as of the third quarter ended September 30, 2011, expected volatility has been based solely upon 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 for periods commensurate with the expected term at the time of grant.   

The following table provides the assumptions used in determining the fair value of service-based stock option awards: 

	Nine months ended   September 30, 2012
Expected volatility		63.31-63.96	%
Expected dividends		—
Expected term (in years)		3.00 - 6.25
Risk-free rate		0.44-1.49	%

A summary of the activity of stock options under all plans as of September 30, 2012 is presented below: 

	Outstanding Options
		Shares		Wtd. Avg.  Exercise  Price		Wtd. Avg.  remaining contractual life in years			Aggregate Intrinsic Value   (in thousands)
Outstanding at December 31, 2011			2,865,390	$	15.73
Granted			443,996	$	28.80
Exercised			(408,125)	$	16.25			$	6,581
Forfeited or expired			(394,700)	$	34.67
Outstanding at September 30, 2012			2,506,561	$	14.98		6.50	$	77,317
Exercisable at September 30, 2012			890,940	$	13.58		4.64	$	28,736

A summary of the status of the Company’s unvested stock options for the period ended September 30, 2012 is presented below: 

Unvested Shares	Shares		Wtd. Avg.  Grant Date  Fair Value
Unvested at December 31, 2011		1,657,618	$	6.68
Granted		443,996		16.78
Vested		(463,493)		8.11
Forfeited or expired		(22,500)		12.90
Unvested at September 30, 2012		1,615,621	$	8.96

Restricted Stock and Restricted Stock Units

The fair value of restricted stock and restricted stock units is measured based upon the closing price of the Company’s underlying stock as of the date of grant. Restricted stock and restricted stock units are amortized over the vesting period using the straight-line method. Upon vesting, restricted stock units convert into an equivalent number of shares of common stock. A summary of the activity of restricted stock awards and restricted stock units under all plans as of September 30, 2012 is as follows:

25

Kenexa Corporation and Subsidiaries

Notes to Consolidated Financial Statements - Unaudited (Continued)

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

	Restricted Stock Units		Restricted Stock Awards		Wtd. Avg.  Grant Date Fair Value
Outstanding/unvested balance at December 31, 2011		189,650		7,104	$	22.11
Awarded		127,750		6,036	$	28.84
Released/vested		(50,206)		(7,104)	$	21.67
Forfeited/cancelled		(150)		—	$	31.25
Outstanding/unvested balance at September 30, 2012		267,044		6,036	$	25.50

Employee Stock Purchase Plan 

The Employee Stock Purchase Plan, which was approved in May 2006, enables substantially all U.S. and foreign employees to purchase shares of our common stock at a 5% discounted offering price off the closing market price of our common stock on the offering date. The Company has granted rights to purchase up to 500,000 common shares to employees under the Plan. The Plan is not considered a compensatory plan in accordance with ASC 718 and requires no compensation expense to be recognized. As of September 30, 2012, there were 346,821 shares available for issuance pursuant to our 2006 Employee Stock Purchase Plan. Shares of our common stock purchased under the employee stock purchase plan were 16,994 and 23,417 for the nine months ended September 30, 2012 and the year ended December 31, 2011, respectively.

16. 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. For the nine months ended September 30, 2012 and 2011, the Company paid Pepper Hamilton LLP $259 and $526, respectively. The payments in 2012 were primarily for work relating to the Company’s pending merger with IBM, the acquisition of OutStart and general legal matters. The payments in 2011 were primarily for work relating to the Company’s class action shareholder litigation, acquisitions, credit facility and general legal matters. The amount payable to Pepper Hamilton, LLP as of September 30, 2012 and 2011 was $1,268 and $50, respectively.

17. Geographic Information  

The following table summarizes the distribution of revenue by geographic region as determined by billing address for the three and nine months ended September 30, 2012 and 2011.  

		For the three months ended September 30,								For the nine months ended September 30,
		2012				2011				2012				2011
Country		Amount	Percent of Revenues			Amount	Percent of Revenues			Amount	Percent of Revenues			Amount	Percent of Revenues
United States	$	63,743	70.2	%	$	56,235	74.3	%	$	182,473	71.6	%	$	151,197	73.9	%
United Kingdom		10,113	11.1	%		5,715	7.6	%		26,065	10.2	%		17,212	8.4	%
Germany		1,368	1.5	%		1,345	1.8	%		4,149	1.6	%		4,180	2.0	%
Other European Countries		5,577	6.2	%		4,130	5.4	%		14,964	6.0	%		11,688	5.8	%
Canada		2,976	3.3	%		1,989	2.6	%		8,599	3.4	%		5,221	2.5	%
China		2,649	2.9	%		2,445	3.2	%		6,742	2.6	%		6,297	3.1	%
Other		4,322	4.8	%		3,844	5.1	%		11,842	4.6	%		8,901	4.3	%
Total	$	90,748	100.0	%	$	75,703	100.0	%	$	254,834	100.0	%	$	204,696	100.0	%

26

Kenexa Corporation and Subsidiaries

Notes to Consolidated Financial Statements - Unaudited (Continued)

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

The following table summarizes the distribution of assets by geographic region.  

	September 30, 2012					December 31, 2011
Country	Assets		Assets as a percentage of total assets			Assets		Assets as a percentage of total assets
United States	$	315,939		79.1	%	$	338,779		83.5	%
United Kingdom		28,442		7.1	%		25,207		6.2	%
India		9,379		2.4	%		8,449		2.1	%
New Zealand		8,741		2.2	%		7,508		1.9	%
China		8,159		2.0	%		6,676		1.6	%
Germany		9,017		2.3	%		5,663		1.4	%
Other		19,581		4.9	%		13,362		3.3	%
Total	$	399,258		100.0	%	$	405,644		100.0	%

Note 18. Acquisition by IBM

On August 25, 2012, Kenexa entered into a definitive Agreement and Plan of Merger (the “Merger Agreement”) with International Business Machines Corporation (“IBM”) and Jasmine Acquisition Corp. (“Sub”), a wholly owned subsidiary of IBM. Pursuant to the terms of the Merger Agreement, and subject to the conditions thereof, Sub will merge with and into Kenexa, and Kenexa will become a wholly owned subsidiary of IBM (the “Merger”). If the Merger is completed, Kenexa’s shareholders will be entitled to receive $46.00 in cash (the “Merger Consideration”) for each share of Kenexa’s common stock owned by them as of the date of the Merger.  

The consummation of the Merger is subject to certain conditions, including adoption of the Merger Agreement by Kenexa’s shareholders, the continuing accuracy of Kenexa’s and IBM’s respective representations and warranties, and the expiration or termination of any waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended, as well as any similar filings that need to be made in foreign jurisdictions. The date for Kenexa’s shareholder meeting to vote on adoption of the Merger Agreement has been scheduled for November 29, 2012. 

Kenexa has made representations and warranties related to its business and operations and has agreed to specified covenants in the Merger Agreement, including covenants relating to the conduct of Kenexa’s business between the date of the Merger Agreement and the closing of the Merger, restrictions on solicitation of proposals for alternative transactions, holding a meeting of shareholders for the purposes of voting to adopt the Merger Agreement, governmental filings and approvals and public disclosures. The Merger Agreement contains certain termination rights of IBM and Kenexa and provides that, under specified circumstances, upon the termination of the Merger Agreement, Kenexa will be required to pay IBM a termination fee of $52.0 million and reimburse IBM for up to $5.0 million of expenses it incurred in connection with the transaction.  

Under the Merger Agreement, equity awards exercisable or convertible into shares of Kenexa’s common stock will either be cancelled and converted into a right to receive a cash payment or, in some cases, converted into comparable awards for IBM common stock, as described in more detail below.  

27

Kenexa Corporation and Subsidiaries

Notes to Consolidated Financial Statements - Unaudited (Continued)

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

Subject to any provisions to the contrary in an offer letter between an individual employee of Kenexa and IBM (each such agreement, an “Offer Letter”), stock options to acquire Kenexa’s common stock outstanding and unexercised at the effective time of the Merger will be treated in one of the following manners:  

• Each option that either (i) is vested (or will vest in connection with the Merger), (ii) is held by a non-employee director, consultant or independent contractor of Kenexa or any of its subsidiaries or (iii) has an exercise price per share greater than or equal to the Merger Consideration, will be cancelled at the effective time of the Merger, and the holder thereof will be entitled to receive in consideration for such cancellation a cash payment equal to the product of the number of shares subject to such option and the excess, if any, of the Merger Consideration over the exercise price per share of the option, less applicable tax withholdings.

• Any option not described above will be converted into an option to acquire, on substantially the same terms and conditions as were applicable to such option prior to the Merger, shares of IBM common stock. The number of shares of IBM common stock underlying such option will be determined by multiplying the number of shares of Kenexa’s common stock underlying such option by an exchange ratio, which is determined by dividing an amount equal to the Merger Consideration by the average closing price of a share of IBM’s common stock on the 20 trading days immediately prior to the closing of the Merger, rounded down to the nearest whole share of IBM’s common stock. The exercise price per share of such converted option will be determined by dividing the exercise price of such option prior to the Merger by the exchange ratio described above, rounded up to the nearest whole cent.

Subject to the terms of any Offer Letter, restricted stock units that are outstanding and unsettled at the effective time of the Merger will be treated in one of the following manners:  

• Each restricted stock unit that either is (i) vested (or will vest in connection with the Merger) or (ii) held by a non-employee director, consultant or independent contractor of Kenexa or any of its subsidiaries will be cancelled at the effective time of the Merger, and the holder thereof will be entitled to receive in consideration for such cancellation a cash payment equal to the product of the number of shares subject to such restricted stock unit and the Merger Consideration, less applicable tax withholdings.

• Any restricted stock unit not described above will be converted into a restricted stock unit, on substantially the same terms and conditions as were applicable to such restricted stock unit prior to the Merger, with respect to shares of IBM common stock. The number of shares of IBM common stock underlying such restricted stock unit will be determined by multiplying the number of shares of Kenexa’s common stock underlying such restricted stock unit by the exchange ratio described above, rounded down to the nearest whole share of IBM’s common stock.

Each share of restricted stock that is outstanding at the effective time of the Merger will be converted into the right to receive the Merger Consideration.  

Under the Merger Agreement, the 2006 Employee Stock Purchase Plan (the “ESPP”) will be terminated no later than the last trading day before the closing of the Merger, and, if the ESPP remains in effect on the last trading day before the closing of the Merger, amounts credited to the accounts of participants in the ESPP will be distributed to such participants as soon as practicable after the closing of the Merger.

28

Kenexa Corporation and Subsidiaries

Notes to Consolidated Financial Statements - Unaudited (Continued)

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

Note 19. Subsequent Event

Subsequent to the announcement of the Merger, Kenexa’s board of directors received a letter from a law firm representing an alleged shareholder demanding that we institute a lawsuit on behalf of Kenexa to assert claims that our directors failed to comply with their fiduciary duties in connection with the Merger (the “Demand Letter”). 

Kenexa’s board of directors formed a special committee to review, with independent counsel, the claims in the Demand Letter (the “Committee”). On October, 31, 2012, prior to the Committee making any conclusions regarding the allegations in the Demand Letter, the alleged shareholder filed a derivative action and a purported class action complaint in the Court of Common Pleas of Chester County, Pennsylvania, naming Kenexa, the members of our board of directors, IBM, and Sub as defendants (the “Complaint”). The Complaint essentially repeats the claims in the Demand Letter and generally alleges that, in connection with approving the Merger, our directors breached their fiduciary duties owed to Kenexa, and that IBM knowingly acted in concert with our directors in their breaches of their fiduciary duties. The Complaint seeks, among other things, certification of the case as a class action, an injunction against the consummation of the transaction, a judgment against the defendants for damages, and an award of fees, expenses and costs to plaintiffs and their attorneys.  

Since the filing of the Complaint, the Committee concluded its review and investigation of the Demand Letter and also reviewed the Complaint and has adopted a report that concludes that there is no evidence to support the allegations against the board members made by the alleged shareholder in either the Demand Letter or the Complaint and that pursuing the claims would not be in the best interest of the Company or its Shareholders. The Company and the directors intend to vigorously defend the allegations contained in the Complaint. 

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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. These forward-looking statements include, but are not limited to, plans, objectives, expectations and intentions and other statements contained herein that are not historical facts and statements identified by words such as “expects,” “anticipates,” “will,” “intends,” “plans,” “believes,” “seeks,” “estimates” or words of similar meaning. These statements may contain, among other things, guidance as to future revenue and earnings, operations, prospects of the business generally, intellectual property and the development of products. These statements are based on our current beliefs or expectations and are inherently subject to various risks and uncertainties, including risks related to the pending and consummation of our proposed acquisition by IBM, as well as those risks set forth under the caption “Risk Factors” in our most recent Annual Report on Form 10-K as filed with the Securities and Exchange Commission, as amended and supplemented under the caption “Risk Factors” in our subsequent Quarterly Reports on Form 10-Q filed with the Securities and Exchange Commission. Actual results may differ materially from these expectations due to changes in global political, economic, business, competitive, market and regulatory factors, our ability to implement business and acquisition strategies or to complete or integrate acquisitions. We do not undertake any obligation to update any forward-looking statements contained herein as a result of new information, future events or otherwise. 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, India, and other foreign subsidiaries. 

Overview 

We are a leading provider of software-as-a-service, or SaaS, solutions that enable organizations to more effectively recruit, retain and develop employees. Our solutions are built around a suite of easily configurable software applications that automate talent acquisition and employee performance management best practices. We complement our software applications with tailored combinations of proprietary content, outsourcing services and consulting services based on our 25 years of experience assisting customers in addressing their Human Resource (HR) requirements. Together, our software applications, content and services form complete solutions that our customers find more effective than the point technology or service solutions available from other vendors. We believe that these solutions enable our customers 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. 

We derive revenue primarily from two sources, subscription fees for our solutions and fees for discrete professional services. We offer our talent acquisition and employee performance management solutions on a subscription basis and currently generate a significant portion of our revenue from these subscriptions. 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.   

For the three and nine months ended September 30, 2012, subscription revenue represented approximately 71% of our total revenue. Our customers typically purchase multi-year subscriptions, and during the three and nine months ended September 30, 2012 our customers renewed approximately 92% and 89%, respectively, of the aggregate value of multi-year subscriptions for our on-demand talent acquisition and performance management solution contracts subject to renewal for each of those periods. In addition, we recognize subscription revenue ratably over the term of the underlying contract. These aspects of our business model provide us with recurring revenue streams and revenue visibility. We expect non-GAAP subscription revenue will be within a target range of 70% to 75% of our total revenues in 2012. 

We market our solutions primarily to organizations with more than 2,000 employees. As of June 30, 2012, we had a global customer base of approximately 8,500 companies across a number of industries, including financial services and banking, manufacturing, government, life sciences, biotechnology and pharmaceuticals, retail, healthcare, hospitality, call centers, and education, including approximately 286 companies on the Fortune 500 list published in May 2012. Our customer base includes companies that we billed for services during the nine months ended September 30, 2012 and does not necessarily indicate an ongoing relationship with each such customer. Our top 80 customers contributed approximately $43.2 million and $119.0 million, or approximately 47.6% and 46.7% of our total revenue for the three and nine months ended September 30, 2012, respectively. 

On November 14, 2011, we entered into a share purchase agreement with BHI, a provider of talent management solutions, primarily in the hospitality sector based in Frisco, Texas for a purchase price of approximately $14.7 million, including legal, accounting, other professional fees and contingent consideration. We have accrued $2.5 million of contingent consideration, based upon our estimated revenue growth within the hospitality industry. We believe the acquisition of BHI, along with their extensive research on talent management best practices, will add to the Company's existing research and content portfolio. 

30

On February 6, 2012, we acquired substantially all of the outstanding capital stock of OutStart, a leading provider of SaaS e-learning solutions and services, based in Boston, Massachusetts, for a purchase price of approximately $46.4 million, including legal, accounting, other professional fees and adjustments for certain working capital accounts as defined in the purchase agreement. The acquisition of OutStart will expand the Company’s reach into the e-learning market and enable Kenexa to provide a broader and deeper suite of talent management solutions. We will integrate OutStart’s Learning Management Suite, which includes award-winning social and mobile learning solutions, with Kenexa’s Global Talent Management solutions including its Performance Management suite. 

On August 25, 2012, Kenexa entered into a definitive Agreement and Plan of Merger (the “Merger Agreement”) with International Business Machines Corporation (“IBM”) and Jasmine Acquisition Corp. (“Sub”), a wholly owned subsidiary of IBM. Pursuant to the terms of the Merger Agreement, and subject to the conditions thereof, Sub will merge with and into Kenexa, and Kenexa will become a wholly owned subsidiary of IBM (the “Merger”). If the Merger is completed, Kenexa’s shareholders will be entitled to receive $46.00 in cash (the “Merger Consideration”) for each share of Kenexa’s common stock owned by them as of the date of the Merger. The consummation of the Merger is subject to certain conditions, including adoption of the Merger Agreement by Kenexa’s shareholders, the continuing accuracy of Kenexa’s and IBM’s respective representations and warranties, and the expiration or termination of any waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended, as well as any similar filings that need to be made in foreign jurisdictions. The date for Kenexa’s shareholder meeting to vote on adoption of the Merger Agreement has been scheduled for November 29, 2012.  

Sources of Revenue 

We derive revenue primarily from two sources: subscription revenue and other revenue. 

Subscription revenue 

Subscription revenue for our solutions is comprised of subscription fees from customers accessing our on-demand software, proprietary content, outsourcing services and consulting services and from customers purchasing additional support that is not included in the basic license fee. Our customers primarily purchase renewable subscriptions for our solutions. The typical subscription term is one to three years, with some terms extending up to five years or beyond. We generally price our solutions based on the number of software applications and services included and the number of customer employees. Accordingly, subscription fees are generally greater for larger organizations and for those that subscribe to a broader array of software applications and services.  

Consistent with our historical practices, revenue derived from subscription fees is recognized ratably over the term of the subscription agreement. We generally invoice our customers in advance in annual or quarterly installments and typical payment terms provide that our customers pay us within 30 days of invoice. The majority of our subscription agreements are not cancelable for convenience, but our customers have the right to terminate their contracts for cause if we fail to provide the agreed-upon services or otherwise breach the agreement. A customer does not generally have a right to a refund of any advance payments if the contract is cancelled. For the three and nine months ended September 30, 2012 our customers renewed approximately 92% and 89%, respectively, of the aggregate value of multi-year subscriptions for our on-demand talent acquisition and performance management solution contracts subject to renewal. 

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 of September 30, 2012, deferred revenue increased by $8.0 million, or 9.0%, to $96.8 million from $88.8 million at December 31, 2011. The increase in deferred revenue is a result of the increase in bookings and billings for our products, content and services, sales of multiple arrangements and from certain acquisitions. 

Other revenue 

We derive other revenue from the sale of discrete consulting services and translation services, as well as from out-of-pocket expenses. The majority of our other revenue is derived from discrete consulting services, which primarily consist of consulting and training services and success fees. This revenue is recognized differently depending on the type of service provided. Refer to “Revenue Recognition” in the Notes to Consolidated Financial Statements for details.

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Revenue by geographic region 

For the nine months ended September 30, 2012, approximately 71.6% of our total revenue was derived from sales in the United States. Foreign revenue that we generated from customers in the United Kingdom, Canada and China represented approximately 10.2%, 3.4% and 2.6% of our total revenue, respectively. Revenue from other countries amounted to an aggregate of 12.2% of our total revenue. Other than the countries listed, no other country represented more than 2.0% of our total revenue for the nine months ended September 30, 2012. The percentage of revenue derived from sales in the United States for the nine months ended September 30, 2012 decreased slightly compared to the prior year.

Cost of Revenue and Operating Expenses 

Cost of revenue

Our cost of revenue primarily consists of compensation, employee benefits and out-of-pocket travel-related expenses for our employees and independent contractors who provide consulting or other professional services to our customers. Additionally, our application hosting costs, amortization of third-party license royalty costs 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 customer 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 revenues increase, we expect our cost of revenue to increase proportionately, subject to pricing pressure related to economic conditions and influenced by the mix of services and software. To the extent new customers are added, we expect that the cost of services as a percentage of revenue will be greater than the cost of services associated with existing customers. 

Sales and Marketing

Sales and marketing expenses primarily consist 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 are also included. We expense our sales commissions at the time the related revenue is recognized.   

General and Administrative

General and administrative expenses primarily consist of personnel and related costs for our executive, finance and accounting, human resources and administrative personnel. Professional fees, rent and other corporate expenses are also included in general and administrative expense.   

Research and Development

Research and development expenses primarily consist of personnel and related costs, including salaries and employee benefits for software engineers, quality assurance engineers, user experience/interface designers, architects, product managers, project managers, HR-related subject matter experts, and management information systems personnel and third-party consultants. Our research and development efforts have been devoted to the development of new products and new features for our existing products. Investments also include further development, partner integrations, and deeper integrations of Kenexa content in support of its integrated talent management strategy.  

We continue to enhance our 2x product suite which includes Kenexa 2x Recruit®, Kenexa 2x BrassRing®, Kenexa 2x Perform®, Kenexa 2x Onboard® and Kenexa 2x Mobile®, Kenexa 2x Assess™ and Kenexa 2x Compensation™ with increased functionality, module touch points, and performance. Kenexa is beginning work to integrate its learning solutions to be tightly integrated with the 2x suite. Kenexa will continue to invest in new 2x modules. We believe that Kenexa 2x enables customers to improve productivity, increase cost savings, ensure compliance with corporate and legal mandates, and raise employee engagement. 

Depreciation and Amortization

Depreciation costs are related to our capitalized equipment, software, furniture and fixtures, leasehold improvements, and building. Amortization costs are related to our intangible assets. 

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Critical Accounting Policies and Estimates 

Our consolidated financial statements are prepared in accordance with generally accepted accounting principles. 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. There have been no material changes during the nine months ended September 30, 2012 to the critical accounting policies discussed in our Annual Report on Form 10-K for the year ended December 31, 2011.

Key Performance Indicators 

The following is a discussion of the key performance indicators that we consider to be material in managing our business.  The information provided below is stated in thousands (other than percentages). 

Deferred revenue.  We generate revenue primarily from multi-year subscriptions for our on-demand talent acquisition and employee performance management solutions and our compensation module. We recognize revenue from these subscription agreements ratably over the hosting period, which is typically one to three years. We generally invoice our customers in annual, 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 our customers are more willing to pay us in advance for their subscriptions, the amount of deferred revenue on our balance sheet has grown. This trend may vary as business conditions change. 

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

		For the three months ended				For the nine months ended
		September 30,				September 30,
		2012		2011		2012		2011
		(unaudited)		(unaudited)		(unaudited)		(unaudited)
Deferred Revenue at the beginning of the period	$	96,436	$	84,950	$	88,837	$	76,052
Total invoiced subscriptions during the period		64,610		55,843		185,439		160,811
Deferred revenue from acquisition		-		-		4,319		-
Subscription revenue recognized during the period		(64,190)		(53,462)		(181,739)		(149,532)
Deferred revenue at the end of the period	$	96,856	$	87,331	$	96,856	$	87,331

Non-GAAP financial measures.  We believe that non-GAAP measures of financial results provide useful information to management and investors regarding certain financial and business trends relating to our financial condition and results of operations. We use these non-GAAP measures to compare our performance to that of prior periods for trend analyses, for purposes of determining executive incentive compensation, and for budget and planning purposes. These measures are used in monthly financial reports prepared for management and in quarterly financial reports presented to our Board of Directors. We believe that the use of these non-GAAP financial measures provides an additional tool for investors to use in evaluating ongoing operating results and trends and in comparing financial measures with other companies in our industry, many of which present similar non-GAAP financial measures to investors.  

We do not consider these non-GAAP measures in isolation or as an alternative to measures determined in accordance with GAAP. The principal limitation of such non-GAAP financial measures is that they exclude significant expenses that are required to be recorded under GAAP. In addition, they are subject to inherent limitations as they reflect the exercise of judgments by management about which charges are excluded from the non-GAAP financial measures. In order to compensate for these limitations, we present our non-GAAP financial measures in connection with our GAAP results. We urge investors to review the reconciliation of our non-GAAP financial measures to the comparable GAAP financial measures included below, and not to rely on any single financial measure to evaluate our business. 

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The Company’s non-GAAP financial measures as set forth in the tables below may exclude the following:  

Deferred revenue associated with acquisition. Deferred revenue consists of the impact of the write down of the deferred revenue associated with purchase accounting for the Salary.com and OutStart acquisitions. This effect is added back because we believe its inclusion provides a more accurate depiction of total revenue arising from these acquisitions. 

Share-based compensation. Share-based compensation expense consists of expenses for stock options and stock awards recorded in accordance with ASC 718. Share-based compensation expense is excluded in our non-GAAP financial measures because the magnitude of the changes associated with share-based compensation are difficult to forecast as a result of their dependence upon the volume and timing of stock option grants (which are unpredictable and can vary dramatically from period to period) and external factors (such as interest rates and the trading price and volatility of our common stock). We believe that this exclusion provides meaningful supplemental information regarding our operating results because these non-GAAP financial measures facilitate the comparison of results over multiple periods.  

Amortization of intangibles associated with acquisitions. In accordance with GAAP, operating expense includes amortization of acquired intangible assets which are amortized over the estimated useful lives of such assets. Amortization of acquired intangible assets is excluded from our non-GAAP financial measures because we believe that such exclusion facilitates comparisons to our historical operating results and to the results of other companies in the same industry, which have their own unique acquisition histories.

Acquisition-related fees. In accordance with ASC 805, Business Combinations, acquisition-related fees including advisory, legal, accounting and other professional fees are reported as expense in the periods in which the costs are incurred and the services are received. Acquisition-related fees include legal, travel, and other fees not expected to recur from our acquisitions. Acquisition-related fees are excluded in the non-GAAP financial measures because we believe that such exclusion facilitates comparisons to our historical operating results and to the results of other companies in the same industry, which have their own unique acquisition histories. 

Contingent Consideration.In accordance with ASC 805, Business Combinations, contingent consideration adjustments may result from changes in the preliminary earnout calculation or changes in the forecasted projections. Contingent consideration adjustments are excluded in the non-GAAP financial measures because we believe that such exclusion facilitates comparisons to our historical operating results and to the results of other companies in the same industry, which have their own unique acquisition histories.

Taleo settlement and litigation-related fees.Litigation-related activity which includes settlement proceeds and nonrecurring litigation fees, is excluded from our non-GAAP financial measures due to its infrequent and/or unusual nature and are not expected to recur. We believe that excluding these amounts provides meaningful supplemental information regarding our operating results because these non-GAAP financial measures facilitate the comparison of results for future periods with results from past periods.  

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Kenexa Corporation and Subsidiaries
Reconciliation of GAAP to Non-GAAP Financial Measures
(In thousands, except for per share amounts)
		Three Months Ended				Nine Months Ended
		September 30,				September 30,
		2012		2011		2012		2011
		(unaudited)		(unaudited)		(unaudited)		(unaudited)
Revenue and Gross Profit:
GAAP subscription revenue	$	64,190	$	53,462	$	181,739	$	149,532
Deferred revenue associated with acquisitions		1,329		1,525		5,485		6,809
Non-GAAP subscription revenue		65,519		54,987		187,224		156,341
Other revenue		26,558		22,241		73,095		55,164
Non-GAAP revenue	$	92,077	$	77,228	$	260,319	$	211,505
GAAP cost of revenues	$	32,580	$	29,693	$	97,970	$	79,905
Share-based compensation expense		62		69		249		187
Cost of revenue adjustment		62		69		249		187
Non-GAAP gross profit	$	59,559	$	47,604	$	162,598	$	131,787
Expenses:
GAAP operating expenses	$	60,230	$	44,660	$	162,064	$	125,778
Share-based compensation expense		(2,298)		(1,738)		(6,461)		(4,406)
Amortization of acquired intangibles		(5,783)		(3,571)		(16,999)		(10,685)
Acquisition-related fees		(4,686)		-		(4,959)		(159)
BHI contingent consideration adjustment		-		-		224		-
Taleo settlement		-		-		-		3,000
Nonrecurring litigation charges		-		-		-		(1,416)
Total operating expense adjustment		(12,767)		(5,309)		(28,195)		(13,666)
Non-GAAP operating expenses	$	47,463	$	39,351	$	133,869	$	112,112
Results:
GAAP (loss) income from operations	$	(2,062)	$	1,350	$	(5,200)	$	(987)
Deferred revenue associated with acquisitions		1,329		1,525		5,485		6,809
Cost of revenue adjustment		62		69		249		187
Operating expense adjustment		12,767		5,309		28,195		13,666
Non-GAAP income from operations	$	12,096	$	8,253	$	28,729	$	19,675

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Results of Operations 

The following table sets forth certain unaudited condensed consolidated statements of operations data expressed as a percentage of total revenue for the periods indicated. In our Comparison of the three and six months below, we have included two types of tables: period over period changes in income statement line items, and summaries of the key changes in expenses by natural category for each expense line item. Amounts shown are in thousands, except percentages. Period-to-period comparisons of our financial results are not necessarily meaningful and you should not rely on them as an indication of future performance. 

	Three Months Ended		Nine Months Ended
	September 30,		September 30,
	2012	2011	2012	2011
Condensed Consolidated Statement of Operations Data:	(unaudited)	(unaudited)	(unaudited)	(unaudited)
Revenues:
Subscription	70.7%	70.6%	71.3%	73.1%
Other	29.3%	29.4%	28.7%	26.9%
Total revenues	100.0%	100.0%	100.0%	100.0%
Cost of revenues	35.9%	39.2%	38.4%	39.0%
Gross profit	64.1%	60.8%	61.6%	61.0%
Operating expenses:
Sales and marketing	22.6%	21.7%	22.8%	22.6%
General and administrative	22.4%	20.0%	19.2%	20.1%
Research and development	9.0%	6.5%	8.7%	6.9%
Depreciation and amortization	12.4%	10.9%	12.9%	11.8%
Total operating expenses	66.4%	59.1%	63.6%	61.4%
(Loss) income from operations	-2.3%	1.7%	-2.0%	-0.4%
Interest (income) expense, net	-0.3%	0.1%	-0.3%	-0.4%
(Loss) gain on change in fair market value of investments, net	0.0%	-0.1%	0.0%	-0.2%
(Loss) gain before income taxes	-2.6%	1.7%	-2.3%	-1.0%
Income tax (expense) benefit	-2.1%	-2.1%	-1.0%	-1.1%
Net loss	-4.7%	-0.4%	-3.3%	-2.1%
Loss (income) allocated to noncontrolling interest	0.0%	-0.4%	0.1%	-0.2%
Accretion associated with variable interest entity	0.0%	-3.3%	0.0%	-1.5%
Net loss allocable to common shareholders'	-4.7%	-4.1%	-3.2%	-3.8%

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Comparison of the Three and Nine months ended September 30, 2012 and 2011 

Revenues

		For the three months ended September 30,								For the nine months ended September 30,
	2012		2011		Change		Percent			2012		2011		Change		Percent
Revenues:
Subscription	$	64,190	$	53,462	$	10,728		20.1	%	$	181,739	$	149,532	$	32,207		21.5	%
Other		26,558		22,241		4,317		19.4	%		73,095		55,164		17,931		32.5	%
Total revenues	$	90,748	$	75,703	$	15,045		19.9	%	$	254,834	$	204,696	$	50,138		24.5	%

Summary of changes in Revenues

Subscription revenue increased due to large customer wins, successful renewals of existing customers, increased demand across our product and service offerings and from the addition of customers through our acquisitions of Ashbourne in August 2011, BHI in November 2011 and Outstart in February 2012. The increase in other revenue is primarily due to increased success fees received from our recruitment process outsourcing or “RPO” activity, which contributed $1.8 million and $13.1 million to the change for the three and nine months ended September 30, 2012, respectively, compared to the prior year. To a lesser extent, revenue from discrete professional services, which consist of consulting and training services, also contributed to the increase in other revenue. 

We expect our subscription-based and other revenues to continue to increase in 2012 due to the improved business environment for our products, content and service, renewals by existing customers, sales to new customers and new sales of our 2x platform™ and the addition of our learning module obtained with the acquisition of OutStart.  

Cost of Revenues

		For the three months ended September 30,								For the nine months ended September 30,
	2012		2011		Change		Percent			2012		2011		Change		Percent
Cost of revenues	$	32,580	$	29,693	$	2,887		9.7	%	$	97,970	$	79,905	$	18,065		22.6	%

Summary of changes in Cost of Revenues

		Change from 2011 to 2012
		Three months ended	Nine months ended
		September 30,	September 30,
Employee-related	$	3,387	$	18,054
Third-party fees		(46)		(258)
Reimbursed expenses		(447)		208
Share-based compensation		(7)		61
	$	2,887	$	18,065

Employee-related expenses increased as a result of an increase in compensation costs due to hiring activity necessary to support our new and expanded customers’ demand for our solutions and services and merit pay raises and incentive compensation, as well as increased headcount from our acquisitions of Ashbourne in August 2011, BHI in November 2011 and OutStart in February 2012. The decrease in third-party fees for the three months ended September 30, 2012, was due to reduced non-billable travel and other expenses, job postings and outside consultants as we replaced third party implementation consultants with internal resources. The increase in share-based compensation expense for the nine months ended September 30, 2012 resulting from the issuance of new long-term incentive awards in the first two quarters of 2012 combined with an overall increasing trend in our stock price in this period was off-set in part by the full amortization for prior year’s grants which contributed to the overall decrease for the three months ended September 30, 2012. Overall, the combined increased headcount and changes in the mix of other revenue versus subscription revenue increased the cost to deliver our solutions in absolute dollars but decreased as a percentage of revenues.  

We expect cost of revenues to increase in absolute dollars for the remainder of 2012 over the prior year due to increased headcount from our acquisitions and hiring to support increased revenues. We expect cost of revenues to continue to decrease as a percentage of revenues over the course of 2012, compared to the prior year.

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Operating Expenses

		For the three months ended September 30,								For the nine months ended September 30,
	2012		2011		Change		Percent			2012		2011		Change		Percent
Sales and marketing	$	20,474	$	16,390	$	4,084		24.9	%	$	58,214	$	46,353	$	11,861		25.6	%
General and administrative		20,361		15,114		5,247		34.7	%		48,961		41,081		7,880		19.2	%
Research and development		8,148		4,912		3,236		65.9	%		22,126		14,176		7,950		56.1	%
Depreciation and amortization		11,247		8,244		3,003		36.4	%		32,763		24,168		8,595		35.6	%
Total	$	60,230	$	44,660	$	15,570		34.9	%	$	162,064	$	125,778	$	36,286		28.8	%

Summary of changes in Sales and Marketing 

		Change from 2011 to 2012
		Three months ended	Nine months ended
		September 30,	September 30,
Employee-related	$	2,737	$	10,014
Marketing		424		825
Share-based compensation		178		453
Various other expenses		745		569
	$	4,084	$	11,861

Employee-related expenses increased as a result of an increase in compensation costs due to additional hiring to expand our sales and marketing teams, merit pay raises and incentive compensation due to increased sales, as well as headcount from our acquisitions of Ashbourne in August 2011, BHI in November 2011 and OutStart in February 2012. Marketing expense increased as a result of continued investment in our branding and marketing campaigns for all products and timing of various marketing events, including the World Conference versus the prior year. Share-based compensation expense increased as a result of long-term incentive awards issued in the first two quarters of 2012 combined with an overall increasing trend in our stock price in this period. The increase in other expenses was due to increases in travel, bad debt reserve and third-party consultant expenses. 

Consistent with our past practice, we intend to continue to invest in sales and marketing to pursue new customers and expand relationships with existing customers at levels we deem appropriate given current economic conditions. We expect sales and marketing expense to increase in absolute dollars for the remainder of 2012 due to increased staff expenses and continued investment in our branding and marketing campaigns, and remain constant as a percentage of total revenue, compared to the prior year. 

Summary of changes in General and Administrative

		Change from 2011 to 2012
		Three months ended	Nine months ended
		September 30,	September 30,
Employee-related	$	640	$	2,186
Share-based compensation		328		1,471
Professional fees		3,569		3,537
Software and licenses		(97)		326
Rent and utility		494		(17)
Various other expenses		313		377
	$	5,247	$	7,880

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For the three months ended September 30, 2012, employee-related expenses increased as a result of an increase in compensation costs due to additional hiring, as well as increased headcount from our acquisitions of Ashbourne in August 2011, BHI in November 2011 and OutStart in February 2012. Share-based compensation expense increased as a result of long-term incentive awards issued in the first two quarters of 2012 combined with an overall increasing trend in our stock price in this period. Professional fees primarily increased due to the pending merger with IBM. Software and licenses expense decreased due to the full amortization of prior years’ licenses offset by additional maintenance support and licenses needed to support the increased headcount of our general and administrative teams both internally and from our acquisitions. The increase in rent and utility expense resulted from the BHI and OutStart acquisitions and increased telecommunication costs in connection with the pending IBM merger, offset in part by the consolidation of offices in London and Waltham, MA. Other expenses increased due to increases in travel expenses, subscriptions and other taxes offset by decreases in repairs and maintenance expense, and other corporate expenses. 

For the nine month ended September 30, 2012, employee-related expenses increased as a result of an increase in compensation costs due to additional hiring, merit pay raises and incentive compensation offset by a $224 adjustment relating to the BHI earnout, as well as increased headcount from our acquisitions of Ashbourne in August 2011, BHI in November 2011 and OutStart in February 2012. Share-based compensation expense increased as a result of long-term incentive awards issued in the first two quarters of 2012 combined with an overall increasing trend in our stock price in this period. Professional fees primarily increased due to the pending merger with IBM. Software and licenses expense increased due to additional maintenance support and licenses needed to support the increased headcount of our general and administrative teams both internally and from our acquisitions, offset in part from the full amortization of prior years’ licenses. The decrease in rent and utility expense resulted from the consolidation of offices in London and Waltham, MA offset in part by increases in rent and utility expense resulting from the BHI and OutStart acquisitions and increased telecommunication costs in connection with the pending IBM merger. Other expenses increased due to increases in travel expenses, subscriptions and other taxes offset by decreases in repairs and maintenance expense, and other corporate expenses. 

We expect general and administrative expense to increase in absolute dollars for the remainder of 2012 over the prior year due to continued investments in our infrastructure and our recent acquisitions, while decreasing as a percentage of total revenue, compared to the prior year. 

Summary of changes in Research and Development

		Change from 2011 to 2012
		Three months ended	Nine months ended
		September 30,	September 30,
Employee-related	$	2,739	$	6,594
Professional services		432		1,236
Various other expenses		65		120
	$	3,236	$	7,950

Employee-related expenses increased as a result of an increase in compensation costs due to additional hiring to maintain our existing products, merit pay raises and incentive compensation. In addition, costs to further develop and improve feature enhancements not eligible for capitalization contributed to the increase. Professional services increased as a result of additional resources to aid in the development of our products. Other expenses increased due to increases in other R&D costs and share-based compensation expense as a result of long-term incentive awards issued in the first two quarters of 2012 combined with an overall increasing trend in our stock price in this period. 

As we continue to execute on our strategies, including continuing to develop our 2x platform™, we believe that research and development expenses will increase in absolute dollars and remain constant as a percentage of total revenues for the remainder of 2012, compared to the prior year. 

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Summary of changes in Depreciation and Amortization 

		Change from 2011 to 2012
		Three months ended	Nine months ended
		September 30,	September 30,
Depreciation expense	$	790	$	2,280
Amortization expense		2,213		6,315
	$	3,003	$	8,595

Depreciation expense increased due to increases in software development projects qualifying for capitalization being placed into service during the period, offset by decreases in computer and equipment and purchases in other software. Amortization expense increased due to acquired intangibles from our acquisitions of Salary.com in October 2010, Ashbourne in August 2011, BHI in November 2011 and OutStart in February 2012. As we continue to execute on our strategies including our 2x platform™ and continuing to develop feature enhancements, we believe that depreciation and amortization expenses will increase in absolute dollars and remain constant as a percentage of total revenues for the remainder of 2012, compared to the prior year.

Income Tax Expense

		For the three months ended September 30,								For the nine months ended September 30,
	2012		2011		Change		Percent			2012		2011		Change		Percent
Income tax expense	$	1,869	$	1,602	$	267		16.7	%	$	2,529	$	2,172	$	357		16.4	%

The increase in income tax expense for the three months ended September 30, 2012 was primarily due to an increase in income in certain foreign tax jurisdictions before tax compared to the prior period. Our tax provision for interim periods is determined using an estimate of our annual effective tax rate and the tax effect of discrete tax events, if any, that occur during each interim period. The 2012 effective tax rate is higher than the 35% statutory U.S. Federal rate primarily due to losses in domestic and foreign jurisdictions where we recorded a valuation allowance.   

Changes to deferred income taxes are generally based on management's evaluation of our positive and negative evidence bearing upon the realizability of its deferred tax assets and the determination that it is more likely than not that we will realize a portion of the benefits of federal and state tax assets. In assessing the need for a valuation allowance, management considers all available information within each taxing jurisdiction, including past operating results, estimates of future taxable income and the feasibility of tax planning strategies. Any changes in management’s assessment of the amount of deferred tax assets that may be realized will result in an adjustment to its valuation allowance with a corresponding increase or decrease to income tax expense in the period in which such determination is made.

Liquidity and Capital Resources

Historically, our primary sources of liquidity have been from cash generated from operations, proceeds from equity offerings, and revolving credit facilities. In October 2010, we entered into an amended credit agreement with PNC Bank which provides a maximum amount of $60.0 million, comprised of a $35.0 million revolving facility, including a sublimit of up to $5.0 million for letters of credit and a sublimit of up to $2.5 million for swing loans (the “Revolving Facility”), and a $25.0 million term facility (the “Term Facility”). We may request to increase the maximum amount available under the Revolving Facility to $50.0 million. The amended credit agreement will terminate, and all borrowings will become due and payable, on October 19, 2013. On August 27, 2012 we paid-off all outstanding balances under the term and revolver facilities, and expect to terminate such facilities in connection with the closing of the Merger.  

As of September 30, 2012, we had cash and cash equivalents of $57.0 million and short-term investments of $6.8 million. In addition, we have $34.5 million available for borrowing under the revolving line of credit. We believe that our current cash and cash equivalents, investments, revolving credit facility and projected cash from operations will be sufficient to meet our liquidity needs for at least the next twelve months.   

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Cash held in foreign denominated currencies was $21.1 million, or 37.0%, of our total cash balance as of September 30, 2012. A ten percent change in the exchange rate of the underlying currencies would have changed our cash balances by approximately $2.1 million. 

We calculate our quarterly days sales outstanding (“DSO”) as ending net accounts receivable divided by quarterly net revenues multiplied by 90. For the quarters ended September 30, 2012 and 2011, our DSO was 64 and 65, respectively.   

Summary of changes in cash and cash equivalents by activity

	For the nine months ended September 30,
	2012		2011		Change		Percent
Cash provided by operations	$	23,136	$	31,442	$	(8,306)		(26.4)	%
Cash used in investing activities		(10,334)		(97,265)		86,931		89.4	%
Cash (used in) provided by financing activities		(23,321)		71,086		(94,407)		(132.8)	%

Operating Activities

	For the nine months ended September 30,
	2012		2011		Change from 2011 to 2012
Net loss	$	(8,577)	$	(4,275)	$	(4,302)
Non-cash charges to net income
Depreciation and amortization		32,763		24,168		8,595
Share-based compensation expense		6,710		4,593		2,117
Deferred income tax benefit		(1,705)		(546)		(1,159)
Other non-cash charges to net income		428		1,159		(731)
Changes in assets and liabilities
Accounts receivable		(10,778)		(10,580)		(198)
Deferred revenue		3,475		11,037		(7,562)
Other changes in assets and liabilities		820		5,886		(5,066)
Net cash provided by operations	$	23,136	$	31,442	$	(8,306)

Net cash provided by operating activities historically has been affected by changes in operating assets and liabilities, and net income (loss) adjusted for add-backs of non-cash expenses items such as depreciation and amortization, and the expense associated with share-based awards. The increase in non-cash charges to net income during 2012 compared to the same period in 2011 is primarily due to the amortization of intangible assets associated with our acquisitions of Salary.com in October 2010, Ashbourne in August 2011, BHI in November 2011 and OutStart in February 2012 and depreciation expense due to software development projects placed in service during the period offset by decreases in computer and equipment and purchases in other software. Additionally, share-based compensation expense resulting from long-term incentive awards issued in the first two quarters of 2012 combined with an overall increasing trend in our stock price in this period contributed to the increase over the prior period. Changes in other non-cash charges are due primarily from bad debt recoveries offset for add-backs relating to investments. 

Changes in operating assets and liabilities resulted in a net decrease of $12.8 million to operating cash flows in the nine months ended September 30, 2012 compared to the same period in 2011. Changes in account receivable balances fluctuate from period to period, depending on the timing of sales and billing activity, cash collections, and changes to our allowance for doubtful accounts. Changes in deferred revenue fluctuate from the mix of subscription and other billings combined with the timing of billings and recognition of revenue associated with these contracts. Other assets and liabilities reflect changes in prepaid expenses, accounts payable, accrued compensation and other accrued liabilities and fluctuate due to timing of payments and accrual of additional liabilities.  

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Investing Activities

	For the nine months ended   September 30,
	2012		2011
Quorum acquisition	$	(1,135)	$	—
JRA acquisition		—		(6,732)
Talentmine acquisition		—		(2,950)
Ashbourne acquisition		—		(1,838)
OutStart acquisition		(41,101)		—
Capitalized software and purchases of computer hardware		(22,174)		(17,999)
Purchases of available-for-sale securities		(1,469)		(86,076)
Sales of available-for-sale securities		55,545		18,330
Net cash used in investing activities	$	(10,334)	$	(97,265)

Net cash used in investing activities was $10.3 million and $97.3 million for the nine months ended September 30, 2012 and 2011, respectively. Cash used in investing activities in the nine months ended September 30, 2012 resulted primarily from $22.2 million in capital expenditures and software development costs, $41.1 million to complete the acquisition of OutStart and $1.1 million was used for the payment of the Quorum earnout, partially offset by net sales of available-for-sale securities of $54.1 million.

Financing Activities

Net cash used in financing activities for the nine months ended September 30, 2012 totaled $23.3 million and net cash provided by financing activities for the nine months ended September 30, 2011 totaled $71.1 million. Net cash used in financing activities for the nine months ended September 30, 2012 resulted primarily from net proceeds of $7.1 million from stock option exercises and sales of our common stock issued through our employee stock purchase plan. This was offset by net repayments of our term and revolver loans of $30.0 million and repayments of notes payable and capital leases totaling $0.4 million.  

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 three and nine months ended September 30, 2012, approximately 70.2% and 71.6% of our total revenue was comprised of sales to customers 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% increase in the value of the U.S. dollar during 2012, relative to each currency in which our non-U.S. generated sales are denominated, would have resulted in reduced annual revenues of approximately 4.65% for the three months ended September 30, 2012. 

The financial position and operating results of our foreign 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 to shareholders’ equity was a net reduction of $0.4 million during the nine months ended September 30, 2012 and $2.0 million during the year ended December 31, 2011, and are included in accumulated other comprehensive loss. The foreign currency translation adjustment is not adjusted for income taxes because it relates to an indefinite investment in a non-U.S. subsidiary. 

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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 believe that a 10% change in interest rates would not have had a significant effect on our interest income for the nine months ended September 30, 2012. 

ITEM 4. Controls and Procedures   

Under the supervision 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 and procedures 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 and procedures 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. 

No changes in our internal control over financing reporting occurred during the most recent fiscal quarter that materially affected, or are reasonably likely to materially affect our internal control over financial reporting.   

PART II:  OTHER INFORMATION 

Item 1.  Legal Proceedings 

We are involved in claims 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, could have a material adverse effect on our business, financial condition and operating results. Furthermore, the Company believes that the litigation matters described above in Footnote 13 – Commitments and Contingencies in the Notes to Consolidated Financial Statements, due to their current state are neither probable nor reasonably estimable at the time of filing. 

Subsequent to the announcement of the Merger, Kenexa’s board of directors received a letter from a law firm representing an alleged shareholder demanding that we institute a lawsuit on behalf of Kenexa to assert claims that our directors failed to comply with their fiduciary duties in connection with the Merger (the “Demand Letter”).

Kenexa’s board of directors formed a special committee to review, with independent counsel, the claims in the Demand Letter (the “Committee”). On October, 31, 2012, prior to the Committee making any conclusions regarding the allegations in the Demand Letter, the alleged shareholder filed a derivative action and a purported class action complaint in the Court of Common Pleas of Chester County, Pennsylvania, naming Kenexa, the members of our board of directors, IBM, and Sub as defendants (the “Complaint”). The Complaint essentially repeats the claims in the Demand Letter and generally alleges that, in connection with approving the Merger, our directors breached their fiduciary duties owed to Kenexa, and that IBM knowingly acted in concert with our directors in their breaches of their fiduciary duties. The Complaint seeks, among other things, certification of the case as a class action, an injunction against the consummation of the transaction, a judgment against the defendants for damages, and an award of fees, expenses and costs to plaintiffs and their attorneys.

Since the filing of the Complaint, the Committee concluded its review and investigation of the Demand Letter and also reviewed the Complaint and has adopted a report that concludes that there is no evidence to support the allegations against the board members made by the alleged shareholder in either the Demand Letter or the Complaint and that pursuing the claims would not be in the best interest of the Company or its Shareholders. The Company and the directors intend to vigorously defend the allegations contained in the Complaint.

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Item 1A: Risk Factors 

In addition to the other information set forth in this Form 10-Q, you should carefully consider the risk factors discussed below, as well as those risk factors described in Part I, Item 1A “Risk Factors” of our Annual Report on Form 10-K for the year ended December 31, 2011 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, 2011 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. Except as described below, there have been no material changes from the risk factors previously disclosed in Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2011. 

The announcement and pendency of our agreement to be acquired by IBM could adversely affect our business. 

On August 25, 2012, we entered into the Merger Agreement with IBM and Sub, pursuant to which, and subject to the conditions thereof, Sub will merge with and into Kenexa, and Kenexa will become a wholly owned subsidiary of IBM. If the Merger is completed, Kenexa’s stockholders will be entitled to receive $46.00 in cash for each share of Kenexa’s common stock owned by them as of the date of the Merger. The Merger is conditioned upon, among other things, stockholder approval of the transaction, certain regulatory approvals and other customary closing conditions. Although we will continue to operate as a separate entity until the Merger closes, we have made certain representations and warranties related to our business and operations and have agreed to specified covenants in the Merger Agreement, including covenants relating to the conduct of our business between the date of the Merger Agreement and the closing of the Merger, restrictions on solicitation of proposals for alternative transactions, public disclosures and other matters. The announcement and pendency of the Merger, or any significant delay in the consummation of the Merger, could cause disruptions in our business, including affecting our relationship with our customers, vendors and employees, which could have a material adverse effect on our business, financial results and operations. 

The failure to complete the Merger could materially adversely affect our business. 

There is no assurance that our acquisition by IBM will occur. If the proposed Merger or a similar transaction is not completed, the share price of our common stock may decline to the extent that the current market price of our common stock reflects an assumption that a transaction will be completed. In addition, as set forth in the Merger Agreement, we may be required to pay IBM a termination fee of $52 million, and reimburse IBM for up to $5 million of its expenses (the “Termination Fee”) if the Merger Agreement is terminated under certain circumstances. The payment of a Termination Fee may have a material adverse impact on our financial condition. Further, a failure to complete the Merger may result in negative publicity and a negative impression of us in the investment community or with customers, potential customers, partners and vendors. 

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

Not applicable.

Item 3: Defaults Upon Senior Securities

Not applicable. 

Item 4: Mine Safety Disclosures 

Not applicable. 

Item 5: Other Information

Not applicable.  

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Item 6:  Exhibits

The following exhibits are filed herewith: 

2.1	Agreement and Plan of Merger, dated August 25, 2012, by and among IBM, Sub, a wholly owned subsidiary of IBM, and Kenexa (Incorporated by reference to Exhibit 2.1 to the current report on Form 8-K filed with the SEC on August 27, 2012).
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.
101.INS**	XBRL Instance Documents
101.SCH**	XBRL Taxonomy Extension Schema Document.
101.CAL**	XBRL Taxonomy Extension Calculation Linkbase Document.
101.DEF**	XBRL Taxonomy Extension Definition Document
101.LAB**	XBRL Taxonomy Extension Label Linkbase Document
101.PRE**	XBRL Taxonomy Extension Presentation Linkbase Document.
**	Pursuant to applicable securities laws and regulations, we are deemed to have complied with the reporting obligation relating to the submission of interactive data files in such exhibits and are not subject to liability under any anti-fraud provisions of the federal securities laws as long as we have made a good faith attempt to comply with the submission requirements and promptly amend the interactive data files after becoming aware that the interactive data files fail to comply with the submission requirements. Users of this data are advised that, pursuant to Rule 406T, these interactive data files are deemed not filed and otherwise are not subject to liability.

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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 9, 2012 

Kenexa Corporation 

/s/ Nooruddin S. Karsan  

---------------------------- 

   Nooruddin S. Karsan 

   Chairman of the Board and Chief Executive Officer (Principal Executive Officer) 

/s/ Donald F. Volk 

   ----------------- 

   Donald F. Volk 

   Chief Financial Officer (Principal Financial and Accounting Officer) 

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EXHIBIT INDEX  

Exhibit Number	Description of Document
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.
101.INS**	XBRL Instance Documents
101.SCH**	XBRL Taxonomy Extension Schema Document.
101.CAL**	XBRL Taxonomy Extension Calculation Linkbase Document.
101.DEF**	XBRL Taxonomy Extension Definition Document
101.LAB**	XBRL Taxonomy Extension Label Linkbase Document
101.PRE**	XBRL Taxonomy Extension Presentation Linkbase Document.
**	Pursuant to applicable securities laws and regulations, we are deemed to have complied with the reporting obligation relating to the submission of interactive data files in such exhibits and are not subject to liability under any anti-fraud provisions of the federal securities laws as long as we have made a good faith attempt to comply with the submission requirements and promptly amend the interactive data files after becoming aware that the interactive data files fail to comply with the submission requirements. Users of this data are advised that, pursuant to Rule 406T, these interactive data files are deemed not filed and otherwise are not subject to liability.

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