Interactive Intelligence 10-Q 2012 Q2 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

____________

FORM 10-Q

(Mark One)

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

For the quarterly period ended June 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: 000-54450

INTERACTIVE INTELLIGENCE GROUP, INC.

(Exact name of registrant as specified in its charter)

Indiana (State or other jurisdiction of incorporation or organization)	45-1505676 (I.R.S. Employer Identification No.)
7601 Interactive Way Indianapolis, IN 46278 (Address of principal executive offices, including zip code)
(317) 872-3000 (Registrant’s telephone number, including area code)
Not Applicable
(Former name, former address and former fiscal year, if changed since last report)

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 RNo ¨

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     R 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 the definitions 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 R Non-accelerated filer (Do not check if a smaller reporting company) ¨ 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¨NoR

As of July 31, 2012, there were 19,279,989 shares outstanding of the registrant’s common stock, $0.01 par value.

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TABLE OF CONTENTS

PART I. FINANCIAL INFORMATION		Page
Item 1.	Financial Statements.
	Condensed Consolidated Balance Sheets as of June 30, 2012 and December 31, 2011	4
	Condensed Consolidated Statements of Operations and Comprehensive Income (Loss) for the Three and Six Months Ended June 30, 2012 and 2011	5
	Condensed Consolidated Statement of Shareholders’ Equity for the Six Months Ended June 30, 2012	6
	Condensed Consolidated Statements of Cash Flows for the Six Months Ended June, 2012 and 2011	7
	Notes to Condensed Consolidated Financial Statements	8
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations.	23
Item 3.	Quantitative and Qualitative Disclosures About Market Risk.	37
Item 4.	Controls and Procedures.	37
PART II. OTHER INFORMATION
Item 1.	Legal Proceedings.	38
Item 1A.	Risk Factors.	38
Item 6.	Exhibits.	39
SIGNATURE		39

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PART I. FINANCIAL INFORMATION

Item 1. Condensed Consolidated Financial Statements and Notes to Condensed Consolidated Financial Statements.

Interactive Intelligence Group, Inc.

Condensed Consolidated Balance Sheet

As of June 30, 2012 and December 31, 2011

(in thousands, except share amounts)

	June 30,		December 31,
	2012		2011
Assets	(unaudited)
Current assets:
Cash and cash equivalents	$	23,940	$	28,465
Short-term investments		40,828		40,589
Accounts receivable, net of allowance for doubtful accounts of $1,858
at June 30, 2012 and  $1,718 at December 31, 2011		52,678		56,331
Deferred tax assets, net		9,562		8,952
Prepaid expenses		13,644		11,474
Other current assets		5,144		4,966
Total current assets		145,796		150,777
Long-term investments		19,739		23,415
Property and equipment, net		21,923		18,304
Goodwill		30,623		22,696
Intangible assets, net		17,860		15,029
Other assets, net		2,777		2,581
Total assets	$	238,718	$	232,802
Liabilities and Shareholders' Equity
Current liabilities:
Accounts payable and accrued liabilities	$	16,638	$	16,545
Accrued compensation and related expenses		7,549		8,870
Deferred product revenues		4,921		3,870
Deferred services revenues		58,688		57,423
Total current liabilities		87,796		86,708
Deferred revenue		15,177		14,141
Deferred tax liabilities, net		1,056		1,688
Other long-term liabilities		247		291
Total liabilities		104,276		102,828
Shareholders' equity:
Preferred stock,  no par value;  10,000,000 authorized; no shares
issued and outstanding		-		-
Common stock, $0.01 par value; 100,000,000 authorized;
19,253,282 issued and outstanding at June 30, 2012 and
18,961,497 issued and outstanding at December 31, 2011		193		190
Additional paid-in capital		125,629		119,644
Accumulated other comprehensive loss		(794)		(193)
Retained earnings		9,414		10,333
Total shareholders' equity		134,442		129,974
Total liabilities and shareholders' equity	$	238,718	$	232,802

See Accompanying Notes to Condensed Consolidated Financial Statements

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Interactive Intelligence Group, Inc.

Condensed Consolidated Statements of Operations and Comprehensive Income (Loss)

For the Three and Six Months Ended June 30, 2012 and 2011

(in thousands, except per share amounts)

(unaudited)

	Three Months Ended				Six Months Ended
	June 30,				June 30,
	2012		2011		2012		2011
Revenues:
Product	$	19,662	$	24,208	$	39,097	$	44,632
Recurring revenue		28,398		22,330		56,037		43,418
Services		6,721		5,443		12,415		11,661
Total revenues		54,781		51,981		107,549		99,711
Costs of revenues:
Costs of product		6,000		6,392		11,651		12,588
Costs of recurring revenue		7,838		5,813		15,079		11,095
Costs of services		5,200		3,919		9,775		7,631
Amortization of intangible assets		35		35		70		70
Total costs of revenues		19,073		16,159		36,575		31,384
Gross profit		35,708		35,822		70,974		68,327
Operating expenses:
Sales and marketing		19,256		15,320		36,677		29,477
Research and development		10,966		8,714		21,345		16,861
General and administrative		6,943		6,024		13,832		11,119
Amortization of intangible assets		350		274		651		458
Total operating expenses		37,515		30,332		72,505		57,915
Operating income (loss)		(1,807)		5,490		(1,531)		10,412
Other income:
Interest income, net		167		92		348		135
Other income (expense)		92		256		(92)		90
Total other income		259		348		256		225
Income (loss) before income taxes		(1,548)		5,838		(1,275)		10,637
Income tax expense (benefit)		(440)		2,011		(356)		3,715
Net income (loss)	$	(1,108)	$	3,827	$	(919)	$	6,922
Other comprehensive income (loss):
Foreign currency translation adjustment		(1,164)		-		(783)		-
Net unrealized investment gain (loss)		(50)		(98)		182		(43)
Comprehensive income (loss)	$	(2,322)	$	3,729	$	(1,520)	$	6,879
Net income (loss) per share:
Basic	$	(0.06)	$	0.20	$	(0.05)	$	0.37
Diluted		(0.06)		0.19		(0.05)		0.35
Shares used to compute net income (loss) per share:
Basic		19,213		18,707		19,156		18,563
Diluted		19,213		19,933		19,156		19,860

See Accompanying Notes to Condensed Consolidated Financial Statements

5

Interactive Intelligence Group, Inc.

Condensed Consolidated Statement of Shareholders’ Equity

For the Six Months Ended June 30, 2012

(in thousands)

(unaudited)

				Additional		Accumulated Other
	Common Stock			Paid-in		Comprehensive		Retained
	Shares	Amount		Capital		Loss		Earnings		Total
Balances, December 31, 2011	18,961	$	190	$	119,644	$	(193)	$	10,333	$	129,974
Stock-based compensation expense	-		-		3,294		-		-		3,294
Exercise of stock options	260		3		2,480		-		-		2,483
Issuances of common stock	13		-		320		-		-		320
Issuance of restricted stock units	19		-		(253)		-		-		(253)
Tax benefits from stock-based payment arrangements	-		-		144		-		-		144
Net loss	-		-		-		-		(919)		(919)
Foreign currency translation adjustment	-		-		-		(783)		-		(783)
Net unrealized investment gain	-		-		-		182		-		182
Balances, June 30, 2012	19,253	$	193	$	125,629	$	(794)	$	9,414	$	134,442

See Accompanying Notes to Condensed Consolidated Financial Statements

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Interactive Intelligence Group, Inc.

Condensed Consolidated Statements of Cash Flows

For the Six Months Ended June 30, 2012 and 2011

(in thousands)

(unaudited)

	Six Months Ended
	June 30,
	2012		2011
Operating activities:
Net income (loss)	$	(919)	$	6,922
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation, amortization and other non-cash items		3,768		3,080
Stock-based compensation expense		3,294		2,593
Tax benefits from stock-based payment arrangements		(144)		(1,240)
Deferred income tax		(2,224)		1,517
Accretion of investment income		294		(1,660)
Gain on disposal of fixed assets		25		-
Changes in operating assets and liabilities:
Accounts receivable		5,264		(7,470)
Prepaid expenses		(2,102)		(1,646)
Other current assets		(178)		1,296
Other assets		(196)		(133)
Accounts payable and accrued liabilities		680		46
Accrued compensation and related expenses		(1,507)		(667)
Deferred product revenues		970		2,128
Deferred services revenues		552		5,659
Net cash provided by operating activities		7,577		10,425
Investing activities:
Sales of available-for-sale investments		27,487		40,279
Purchases of available-for-sale investments		(24,161)		(66,465)
Purchases of property and equipment		(6,799)		(5,625)
Acquisitions, net of cash		(11,322)		(4,111)
Unrealized gain (loss) on investment		(1)		40
Net cash used in investing activities		(14,796)		(35,882)
Financing activities:
Proceeds from stock options exercised		2,483		4,708
Proceeds from issuance of common stock		320		258
Employee taxes withheld for restricted stock units		(253)		-
Tax benefits from stock-based payment arrangements		144		1,240
Net cash provided by financing activities		2,694		6,206
Net decrease in cash and cash equivalents		(4,525)		(19,251)
Cash and cash equivalents, beginning of period		28,465		48,300
Cash and cash equivalents, end of period	$	23,940	$	29,049
Cash paid during the year for:
Interest	$	4	$	2
Income taxes		86		1,106
Other non-cash item:
Purchase of property and equipment payable at end of period	$	(174)	$	(7)

See Accompanying Notes to Condensed Consolidated Financial Statements

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Interactive Intelligence Group, Inc.

Notes to Condensed Consolidated Financial Statements

June 30, 2012 and 2011 (unaudited)

1.FINANCIAL STATEMENT PRESENTATION

Effective July 1, 2011, Interactive Intelligence Group, Inc. (“Interactive Intelligence”) became the successor reporting company to Interactive Intelligence, Inc. (“ININ Inc.”), pursuant to a corporate reorganization approved by the shareholders of ININ Inc. at its 2011 annual meeting of shareholders (the “Reorganization”). Interactive Intelligence is conducting the business previously conducted by ININ Inc. in substantially the same manner. In these Notes to Condensed Consolidated Financial Statements, the term the “Company” means ININ Inc. and its wholly-owned subsidiaries for the periods through and including June 30, 2011, and Interactive Intelligence and its wholly-owned subsidiaries for the periods after June 30, 2011.

The accompanying unaudited condensed consolidated financial statements of the Company have been prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”) and with the instructions for Form 10-Q and Article 10 of Regulation S-X for interim financial information.  Accordingly, certain information and note disclosures normally included in the Company’s financial statements prepared in accordance with GAAP have been condensed, or omitted, pursuant to the rules and regulations of the United States Securities and Exchange Commission (the “SEC”). 

The preparation of the Company’s condensed consolidated financial statements requires management to make estimates and assumptions that affect reported amounts of assets and liabilities, at the respective balance sheet dates, and the reported amounts of revenues and expenses during the respective reporting periods. Despite management’s best effort to establish good faith estimates and assumptions, actual results could differ from these estimates. In management’s opinion, the Company’s accompanying condensed consolidated financial statements include all adjustments necessary (which are of a normal and recurring nature, except as otherwise noted) for the fair presentation of the results of the interim periods presented.

The Company’s accompanying condensed consolidated financial statements as of December 31, 2011 have been derived from the Company’s audited consolidated financial statements at that date but do not include all of the information and notes required by GAAP for complete financial statements. These accompanying condensed consolidated financial statements should be read in conjunction with the Company’s audited consolidated financial statements for the year ended December 31, 2011, included in the Company’s most recent Annual Report on Form 10-K as filed with the SEC on March 15, 2012. The Company’s results of operations for any interim period are not necessarily indicative of the results of operations for any other interim period or for a full fiscal year.

Principles of Consolidation

The accompanying condensed consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries after elimination of all significant intercompany accounts and transactions.

Reclassification and Adjustments

Effective January 1, 2012, the Company reclassified certain subscription revenues which were included in product revenues in prior periods as recurring revenues. In prior years, these revenues were not significant; however, as we have signed additional agreements with increasing revenues, we concluded that it is appropriate to report these revenues as recurring. For the three and six months ended June 30, 2011, $287,000 and $629,680, respectively, have been reclassified as recurring revenues based on this new revenue presentation. The reclassification did not have any impact on the overall results previously reported.

2.SUMMARY OF CERTAIN ACCOUNTING POLICIES AND RECENT ACCOUNTING
PRONOUNCEMENTS

The Company’s interim critical accounting policies and estimates include the recognition of income taxes using an estimated annual effective tax rate.  For a complete summary of the Company’s other significant accounting policies and other critical accounting estimates, refer to Note 2 of Notes to Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011.  

In May 2011, the Financial Accounting Standards Board (“FASB”) issued FASB Accounting Standards Update (“ASU”) 2011-04, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and International Financial Reporting Standards (“IFRS”), which amends FASB Accounting Standards Codification (“ASC”) Topic 820,  Fair Value Measurements and Disclosures (“FASB ASC 820”). This updated guidance clarifies the FASB’s intent about the application of existing fair value measurement and disclosure requirements. In order to develop common requirements in accordance with GAAP and IFRS, this update also provides changes to particular principles or requirements for measuring fair value or for disclosing information about fair value measurements. This guidance became effective for public entities prospectively for interim and annual periods beginning after December 15, 2011. Early adoption was not permitted. The Company adopted this guidance on January 1, 2012 and there was no material impact on its consolidated financial statements upon adoption.

In June 2011, the FASB issued FASB ASU 2011-05, Presentation of Comprehensive Income, which amends FASB ASC Topic 220, Comprehensive Income. This updated guidance requires companies to report comprehensive income in either a single statement or in two consecutive statements reporting net income and other comprehensive income. The updated guidance does not change what items are reported in other comprehensive income or the GAAP requirement to report reclassification of items from other comprehensive income to net income. The guidance became effective for public entities with fiscal years and interim periods beginning after December 15, 2011. The Company adopted this guidance on January 1, 2012 and there was no material impact on its consolidated financial statements upon adoption.

In December 2011, the FASB issued FASB ASU 2011-12, Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05, which defers the presentation requirements for reclassification adjustments out of accumulated other comprehensive income. This update was issued to allow the FASB more time to decide whether companies should present on the face of the financial statements the effects of reclassifications out of accumulated other comprehensive income on the components of net income and other comprehensive income for all periods presented.  All other requirements under FASB ASU 2011-05 were not impacted by this update. The Company will continue to monitor the status of this updated guidance.

During the six months ended June 30, 2012, there were no material changes to the Company’s significant accounting policies or critical accounting estimates.

3.INVESTMENTS

FASB ASC 820, as amended, defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. FASB ASC 820 also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes the following three levels of inputs that may be used to measure fair value:

· Level 1 - Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities.

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· Level 2 - Observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.  

· Level 3 - Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.

The Company’s short-term investments all mature in less than one year and its long-term investments all mature within three years. Both short-term and long-term investments are considered available for sale. The Company’s assets that are measured at fair value on a recurring basis are classified within Level 1 or Level 2 of the fair value hierarchy. The types of instruments valued based on quoted market prices in active markets include money market securities. Such instruments are classified within Level 1 of the fair value hierarchy. The Company invests in money market funds that are traded daily and does not adjust the quoted price for such instruments. The types of instruments valued based on quoted prices in less active markets, broker or dealer quotations, or alternative pricing sources with reasonable levels of price transparency include corporate notes, agency bonds, commercial paper, certificates of deposit, and international government bonds. Such instruments are classified within Level 2 of the fair value hierarchy. The Company uses consensus pricing, which is based on multiple pricing sources, to value its fixed income investments. 

The following table sets forth a summary of the Company’s financial assets, classified as cash and cash equivalents, short-term investments and long-term investments on its condensed consolidated balance sheet, measured at fair value as of June 30, 2012 and December 31, 2011 (in thousands):

	Fair Value Measurements at June 30, 2012 Using
				Quoted Prices in		Significant		Significant
				Active Markets for		Other Observable		Unobservable
				Identical Assets		Inputs		Inputs
Description		Total		(Level 1)		(Level 2)		(Level 3)
Cash & cash equivalents:
Money market funds	$	470	$	470	$	-	$	-
Cash		3,314		3,314		-		-
Total	$	3,784	$	3,784	$	-	$	-
Short-term investments:
Corporate notes	$	27,225	$	-	$	27,225	$	-
Agency bonds		3,001		-		3,001		-
Commercial paper		8,491		-		8,491		-
Certificates of deposit		1,100		-		1,100		-
International government bonds		1,011		-		1,011		-
Total	$	40,828	$	-	$	40,828	$	-
Long-term investments:
Corporate notes	$	17,718	$	-	$	17,718	$	-
Agency bonds		2,021		-		2,021		-
Total	$	19,739	$	-	$	19,739	$	-

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	Fair Value Measurements at December 31, 2011 Using
				Quoted Prices in		Significant		Significant
				Active Markets for		Other Observable		Unobservable
				Identical Assets		Inputs		Inputs
Description		Total		(Level 1)		(Level 2)		(Level 3)
Cash & cash equivalents:
Money market funds	$	3,027	$	3,027	$	-	$	-
Cash		384		384		-		-
Total	$	3,411	$	3,411	$	-	$	-
Short-term investments:
Corporate notes	$	29,084	$	-	$	29,084	$	-
Agency bonds		5,409		-		5,409		-
Commercial paper		4,997		-		4,997		-
Certificates of deposit		1,099		-		1,099		-
Total	$	40,589	$	-	$	40,589	$	-
Long-term investments:
Corporate notes	$	21,395	$	-	$	21,395	$	-
Agency bonds		2,020		-		2,020		-
Total	$	23,415	$	-	$	23,415	$	-

4.NET INCOME (LOSS) PER SHARE

Basic net income (loss) per share is calculated based on the weighted-average number of common shares outstanding in accordance with FASB ASC Topic 260, Earnings per Share. Diluted net income per share is calculated based on the weighted-average number of common shares outstanding plus the effect of dilutive potential common shares. Potential common shares consist of shares of common stock issuable upon the exercise of stock options and vesting of restricted stock units (“RSUs”). The calculation of diluted net income per share excludes shares underlying stock options outstanding that would be anti-dilutive. When the Company reports a net loss, the calculation of diluted net loss per share excludes potential common shares as the effect would be anti-dilutive. The following table sets forth the calculation of basic and diluted net income (loss) per share (in thousands, except per share amounts):

	Three Months Ended				Six Months Ended
	June 30,				June 30,
	2012		2011		2012		2011
Net income (loss), as reported (A)	$	(1,108)	$	3,827	$	(919)	$	6,922
Weighted average shares of common stock outstanding and RSUs (B)		19,213		18,707		19,156		18,563
Dilutive effect of employee stock options		-		1,226		-		1,297
Common stock and common stock equivalents (C)		19,213		19,933		19,156		19,860
Net income (loss) per share:
Basic (A/B)	$	(0.06)	$	0.20	$	(0.05)	$	0.37
Diluted (A/C)		(0.06)		0.19		(0.05)		0.35

The Company’s calculation of diluted net income per share for the three and six months ended June 30, 2011 excludes stock options to purchase approximately 320,000 and 915,000 shares of the Company’s common stock, respectively, as their effect would be anti-dilutive.

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5. STOCK-BASED COMPENSATION

Stock Option Plans

The Company’s stock option plans, adopted in 1995, 1999 and 2006, authorize the Board of Directors or the Compensation Committee, as applicable, to grant incentive and nonqualified stock options, and, in the case of the 2006 Equity Incentive Plan, as amended and as assumed by Interactive Intelligence (the “2006 Plan”), stock appreciation rights, restricted stock, RSUs, performance shares, performance units and other stock-based awards. After adoption of the 2006 Plan by the Company’s shareholders in May 2006, the Company may no longer make any grants under previous plans, but any shares subject to awards under the 1999 Stock Option and Incentive Plan and the Outside Directors Stock Option Plan (collectively, the “1999 Plans”) that are cancelled are added to shares available under the 2006 Plan. A maximum of 7,050,933 shares are available for delivery under the 2006 Plan, which consists of (i) 3,350,000 shares, plus (ii) 320,000 shares available for issuance under the 1999 Plans, but not underlying any outstanding stock options or other awards under the 1999 Plans, plus (iii) up to 3,380,933 shares subject to outstanding stock options or other awards under the 1999 Plans that expire, are forfeited or otherwise terminate unexercised on or after May 18, 2006. The number of shares available under the 2006 Plan is subject to adjustment for certain changes in the Company’s capital structure. The exercise price of options granted under the 2006 Plan is equal to the closing price of the Company’s common stock, as reported by The NASDAQ Global Select Market, on the business day immediately preceding the date of grant.

The Company grants RSUs and three types of stock options. The first type of stock option is non-performance-based subject only to time-based vesting, and these stock options are granted by the Company as annual grants to executives, to certain new employees and to newly-elected non-employee directors.  These stock options vest in four equal annual installments beginning one year after the grant date.  The fair value of these option grants is determined on the date of grant and the related compensation expense is recognized for the entire award on a straight-line basis over the requisite service period.  

The second type of stock option granted by the Company is performance-based subject to cancellation if the specified performance targets are not met. If the applicable performance targets have been achieved, the options will vest in four equal annual installments beginning one year after the performance-related period has ended.  The fair value of these stock option grants is determined on the date of grant and the related compensation expense is recognized over the requisite service period, including the initial period for which the specified performance targets must be met.

The third type of stock option granted by the Company is director options granted to non-employee directors annually. These options are similar to the non-performance-based options described above except that the director options vest one year after the grant date. The fair value of these option grants is determined on the date of the grant and the related compensation expense is recognized over one year. The director options are generally granted at the Company’s Annual Meeting of Shareholders during the second quarter of a fiscal year.

Commencing in January 2011, the Company began granting RSUs to certain key employees and certain new employees. The fair value of the RSUs is determined on the date of grant and the RSUs vest in four equal annual installments beginning one year after the grant date. RSUs are not included in issued and outstanding common stock until the shares are vested and settlement has occurred.

The plans may be terminated by the Company’s Board of Directors at any time.

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Stock-Based Compensation Expense Information

The following table summarizes the allocation of stock-based compensation expense related to employee and director stock options and RSUs under FASB ASC Topic 718,  Compensation – Stock Compensation for the three and six months ended June 30, 2012 and 2011 (in thousands):

	Three Months Ended				Six Months Ended
	June 30,				June 30,
	2012		2011		2012		2011
Stock-based compensation expense by category:
Costs of recurring revenues	$	130	$	103	$	253	$	208
Costs of services revenues		42		11		76		36
Sales and marketing		569		433		1,101		825
Research and development		473		395		870		803
General and administrative		500		333		993		721
Total stock-based compensation expense	$	1,714	$	1,275	$	3,293	$	2,593

Stock Option and RSU Valuation

The Company estimated the fair value of stock options using the Black-Scholes valuation model. There were no material changes in the way the assumptions were calculated as previously disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011. Non-performance based options can be granted to all employees throughout the year, while performance-based options are only granted to sales and marketing employees during the first quarter of each year and option grants to directors only occur during the second quarter of each year. The weighted-average estimated per option value of each category of options granted during the six months ended June 30, 2012 and 2011 used the following assumptions:

	Six Months Ended
	June 30,
Valuation assumptions for non-performance-based options:	2012		2011
Dividend yield	-	%	-	%
Expected volatility	59.65 - 64.68	%	62.42 - 63.10	%
Risk-free interest rate	0.57 - 0.71	%	1.25 - 1.74	%
Expected life of option (in years)	4.25		4.25
	Six Months Ended
	June 30,
Valuation assumptions for performance-based options:	2012		2011
Dividend yield	-	%	-	%
Expected volatility	63.23	%	65.55	%
Risk-free interest rate	0.79	%	1.97	%
Expected life of option (in years)	4.75		4.75
	Six Months Ended
	June 30,
Valuation assumptions for directors	2012		2011
Dividend yield	-	%	-	%
Expected volatility	57.10	%	64.38	%
Risk-free interest rate	0.49	%	0.93	%
Expected life of option (in years)	3.50		3.50

RSUs are valued using the fair market value of the Company’s stock on the date of grant and expense is recognized on a straight line basis taking into account an estimated forfeiture rate.   

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Stock Option and RSU Activity

The following table sets forth a summary of stock option activity for the six months ended June 30, 2012:

			Weighted-
			Average
			Exercise
		Options	Price
Balances, beginning of year		2,665,654	$	15.16
Options granted		405,000		24.79
Options exercised		(260,055)		9.54
Options cancelled, forfeited or expired		(2,750)		16.11
Options outstanding		2,807,849		17.07
Option price range	$	2.59 - 37.76
Weighted-average fair value of options granted	$	12.20
Options exercisable		1,719,821		13.36

The following table sets forth information regarding the Company’s stock options outstanding and exercisable at June 30, 2012:

					Options Outstanding				Options Exercisable
						Weighted-
						Average	Weighted-			Weighted-
						Remaining	Average			Average
Range of Exercise						Contractual	Exercise			Exercise
Prices					Number	Life	Price		Number	Price
$	2.59	-	$	5.61	305,030	1.66	$	4.51	305,030	$	4.51
$	5.72	-	$	6.03	190,405	1.93		5.83	190,405		5.83
$	6.66	-	$	6.66	324,059	2.63		6.66	214,184		6.66
$	6.70	-	$	14.79	288,214	1.72		13.15	276,309		13.34
$	14.86	-	$	19.13	312,550	2.27		17.48	265,677		17.52
$	19.19	-	$	19.66	456,779	3.61		19.65	198,904		19.65
$	19.77	-	$	22.92	176,312	1.06		20.67	161,312		20.53
$	24.50	-	$	24.50	325,000	5.71		24.50	-		-
$	25.00	-	$	37.76	429,500	4.93		31.29	108,000		32.38
Total shares/average price					2,807,849	3.11		17.07	1,719,821		13.36

The total intrinsic value of options exercised during quarter ended June 30, 2012 was $4.6 million. The aggregate intrinsic value of options outstanding as of June 30, 2012 was $32.8 million and the aggregate intrinsic value of options currently exercisable as of June 30, 2012 was $26.0 million. The aggregate intrinsic value represents the total intrinsic value, based on the Company’s closing stock price per share of $28.21 as of June 29, 2012, which would have been realized by the option holders had all option holders exercised their options as of that date. The total number of in-the-money options exercisable as of June 30, 2012 represented 1.7 million shares with a weighted average exercise price of $13.36.

As of June 30, 2012, there was $16.4 million of total unrecognized compensation cost related to non-vested stock options. These costs are expected to be recognized over the weighted average remaining vesting period of 2.33 years.

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The following table sets forth a summary of RSU activity for the six months ended June 30, 2012:

		Weighted-
		Average Grant
	Awards	Date Price
Balances, beginning of year	116,340	$	32.33
RSUs granted	136,700		28.39
RSUs vested	(28,869)		32.48
RSUs forfeited	(7,082)		32.60
RSUs outstanding	217,089

As of June 30, 2012, there were 758,983 shares of stock available for issuance for equity compensation awards under the 2006 Plan.

6.CONCENTRATION OF CREDIT RISK

No customer or partner accounted for more than 10% of the Company’s accounts receivable as of June 30, 2012 or December 31, 2011 or revenues for the three and six months ended June 30, 2012 or 2011. No country accounted for more than 10% of the Company’s revenues except for the United States, which accounted for 73% of the Company’s revenues in each of the three and six months ended June 30, 2012, and 56% and 59% of the Company’s revenues in the three and six months ended June 30, 2011, respectively.

7.COMMITMENTS AND CONTINGENCIES

Legal Proceedings

From time to time, the Company has received notification from competitors and other technology providers claiming that the Company’s technology infringes their proprietary rights. The Company cannot provide assurance that these matters can be resolved amicably without litigation, or that the Company will be able to enter into licensing arrangements on terms and conditions that would not have a material adverse effect on its business, financial condition or results of operations.

From time to time, the Company is also involved in certain legal proceedings in the ordinary course of conducting its business. While the ultimate liability pursuant to these actions cannot currently be determined, the Company believes these legal proceedings will not have a material adverse effect on its financial position or results of operations. Litigation, in general, and intellectual property litigation, in particular, can be expensive and disruptive to normal business operations. Moreover, the results of complex legal proceedings are difficult to predict.

Guarantees

The Company provides indemnifications of varying scope and amount to certain customers against claims of intellectual property infringement made by third parties arising from the use of its products.The Company’s direct software license agreements, in accordance with FASB ASC Topic 460, Guarantees, include certain provisions for indemnifying customers, in material compliance with their license agreement, against liabilities if the Company’s software products infringe upon a third party's intellectual property rights, over the life of the agreement. There is no maximum potential amount of future payments set under the guarantee. However, the Company may at any time and at its option and expense:  (i) procure the right of the customer to continue to use the Company’s software that may infringe a third party’s rights; (ii) modify its software so as to avoid infringement; or (iii) require the customer to return its software and refund the customer the fee actually paid by the customer for its software less depreciation based on a five-year straight-line depreciation schedule. The customer’s failure to provide timely notice or reasonable assistance will relieve the Company of its obligations under this indemnification to the extent that it has been actually and materially prejudiced by such failure. To date, the Company has not incurred, nor does it expect to incur, any material related costs and, therefore, has not reserved for such liabilities.

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The Company’s software license agreements also include a warranty that its software products will substantially conform to its software user documentation for a period of one year, provided the customer is in material compliance with the software license agreement. To date, the Company has not incurred any material costs associated with these product warranties, and as such, has not reserved for any such warranty liabilities in its operating results.

Lease Commitments

The Company leases space for its world headquarters in Indianapolis, Indiana under an operating lease agreement and amendments which expire on March 31, 2018. The Company also has multiple leases for offices and other space throughout the world. The office space for sales, services, development and international offices and a product distribution center located in Indianapolis, Indiana are rented under operating leases and expire at various times through 2016. In accordance with FASB ASC Topic 840, Leases, rental expense is recognized ratably over the lease period, including those leases containing escalation clauses. 

Other Contingencies

The Company has received and may continue to receive certain payroll tax credits and real estate tax abatements that were granted to the Company based upon certain growth projections.  If the Company’s actual results are less than those projections, the Company may be subject to repayment of some or all of the tax credits or payment of additional real estate taxes in the case of the abatements.  The Company does not believe that it will be subject to payment of any money related to these taxes; however, the Company cannot provide assurance as to the outcome.

8. INCOME TAXES

The Company’s tax provision for interim periods is determined using an estimate of its annual effective tax rate, adjusted for the settlement of prior period amounts (“discrete items”) arising in that quarter.  The Company’s effective tax rates for the three and six months ended June 30, 2012 decreased to 28.8% and 27.9%, respectively, compared to 34.4% and 35.0%, respectively, for the same periods in 2011. The decrease was a result of the discrete items, partially offset by the federal research and development tax credits which were enacted in 2011 but have yet to be extended for 2012. Without the effect of the discrete items, the Company’s effective tax rate for the three and six months ended June 30, 2012 would have been 36.7% and 37.3%, respectively.

Additionally, the Company’s effective tax rates for the three and six months ended June 30, 2012 were lower than the federal statutory tax rate of 35% primarily due to the discrete items recorded during the three months ended June 30, 2012 and various non-deductible expenses.  

The Company’s quarterly tax provision and its quarterly estimate of its annual effective tax rate are subject to significant volatility due to several factors, including the Company’s ability to accurately predict its pre-tax income and loss in multiple jurisdictions.

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9.  OTHER COMPREHENSIVE INCOME (LOSS)

Other comprehensive income (loss), net of related tax effects, consisted of the following (in thousands):

	Three Months Ended				Six Months Ended
	June 30,				June 30,
	2012		2011		2012		2011
Foreign currency translation adjustment,
net of tax expense of $427 and $292, for the three and six months ended June 30, 2012, respectively	$	(737)	$	-	$	(491)	$	-
Net unrealized investment gain,
net of tax benefit (expense) of $(18) and $68, for the three and six months ended June 30, 2012, respectively, and $(34) and $(15) for the same periods in 2011, respectively		(32)		(64)		114		(28)
Other comprehensive income (loss), net of tax	$	(769)	$	(64)	$	(377)	$	(28)

10.  ACQUISITIONS

Brightware Acquisition

The Company entered into a stock purchase agreement, dated as of April 1, 2012, with Brightware B.V. (“Brightware”), a reseller offering sales, deployment and integration services focused on the contact center market. Pursuant to the terms of the stock purchase agreement, the Company purchased 100% of Brightware’s outstanding capital stock for an aggregate purchase price of $6.4 million, funded with cash-on-hand. The Company deposited $461,800 of the purchase price into an escrow account to ensure funds are available to pay indemnification claims, if any. The Company acquired Brightware as a continued part of its strategy for growing existing operations in key international markets. The acquisition was accounted for using the acquisition method of accounting in accordance with FASB ASC Topic 805,  Business Combinations (“FASB ASC 805”). The results of Brightware’s operations resulting from the acquisition date were included in the Company’s condensed consolidated financial statements for the three and six months ended June 30, 2012.  

The preliminary purchase price allocations for the Company’s acquisition of Brightware are based on a third-party valuation report which was prepared in accordance with the provisions of FASB ASC 805. The following table summarizes the fair value of the intangible and other assets acquired and liabilities assumed at the date of the acquisition (in thousands):

	April 1,
	2012
Cash and cash equivalents	$	2,143
Accounts receivable		579
Prepaid expenses		28
Property and equipment, net		196
Intangible assets		1,456
Goodwill		3,347
Total assets acquired		7,749
Accounts payable and accrued liabilities		313
Accrued compensation and related expenses		(22)
Deferred tax liability		(983)
Deferred service revenue		(678)
Net assets acquired	$	6,379

The fair value of financial assets acquired includes accounts receivable with a fair and a contractual value of $579,000. The receivables consist of amounts due from customers for products sold and/or services rendered. 

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Professional fees recognized as of June 30, 2012 totaled approximately $96,000, with approximately $32,000 recognized during the second quarter of 2012, and included transaction costs such as legal, accounting, and valuation services, which were expensed as incurred. These costs are included within general and administrative expenses on the condensed consolidated statements of income.

The premium paid over the fair value of the net assets acquired in the purchase, or goodwill, was primarily attributed to Brightware’s existing client base. Included within goodwill is the assembled workforce, comprised of 14 employees, which does not qualify for separate recognition. None of the goodwill is expected to be deductible for tax purposes.

Customer relationships are amortized based upon historical patterns in which the economic benefits are expected to be realized. Other finite-lived identifiable intangible assets are amortized on a straight-line basis. The following sets forth the customer relationships acquired and their economic useful life at the date of acquisition (dollars in thousands):

	As of June 30, 2012
							Economic
			Accumulated				Useful Life
	Gross Amount		Amortization		Net Amount		(in years)
Customer relationships	$	1,457	$	19	$	1,438	10

ATIO Acquisition

On January 5, 2012, the Company closed its acquisition of certain assets of ATIO Corporation (Pty) Ltd. (“ATIO”), a reseller of its multichannel contact center solutions based in South Africa.  Pursuant to the terms of the asset purchase agreement, the Company purchased certain contact center assets of ATIO for approximately $7 million, funded with cash-on-hand.  The Company deposited $704,000 of the purchase price into an escrow account to ensure funds are available to pay indemnification claims, if any. The Company acquired the assets of ATIO as a continued part of its growth strategy to accelerate business in key international markets.   The acquisition was accounted for using the acquisition method of accounting in accordance with FASB ASC 805. The results of ATIO’s operations related to the acquired assets from the acquisition date were included in the Company’s condensed consolidated financial statements for the three and six months ended June 30, 2012.

The preliminary purchase price allocations for the ATIO transaction are based on a third-party valuation report which was prepared in accordance with the provisions of FASB ASC 805. The following table summarizes the fair value of the intangible and other assets acquired and liabilities assumed at the date of the acquisition (in thousands):

	January 5,
	2012
Accounts receivable	$	1,119
Property and equipment, net		539
Prepaid expenses		42
Intangible assets, net		1,472
Goodwill		5,269
Total assets acquired		8,441
Accrued compensation and related expenses		(174)
Deferred services revenues		(1,225)
Net assets acquired	$	7,042

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The fair value of financial assets acquired includes accounts receivable with a fair and a contractual value of $1.1 million. The receivables consist of amounts due from customers for products sold and/or services rendered. 

Professional fees recognized as of June 30, 2012 totaled approximately $33,000 and included transaction costs such as legal, accounting, and valuation services, which were expensed as incurred. These costs are included within general and administrative expenses on the condensed consolidated statements of income.

The premium paid over the fair value of the net assets acquired in the purchase, or goodwill, was primarily attributed to ATIO’s existing client base. Included within goodwill is the assembled workforce, comprised of 40 employees, which does not qualify for separate recognition. None of the goodwill is expected to be deductible for tax purposes.

During the second quarter of 2012, the Company recorded a $920,000 adjustment to true up the intangible assets acquired as a result of the Company’s ongoing valuation analysis of the ATIO assets. The valuation is expected to be completed during the third quarter of 2012. 

Customer relationships are amortized based upon historical patterns in which the economic benefits are expected to be realized. Other finite-lived identifiable intangible assets are amortized on a straight-line basis. The following sets forth the customer relationships acquired and their economic useful life at the date of acquisition (dollars in thousands):

	As of June 30, 2012
							Economic
			Accumulated				Useful Life
	Gross Amount		Amortization		Net Amount		(in years)
Customer relationships	$	1,400	$	38	$	1,362	18

CallTime Acquisition

The Company entered into a stock purchase agreement, dated as of July 1, 2011, with CallTime Technology Sdn. Bnd., the ultimate parent company of CallTime Solutions Ltd. (“CallTime”). CallTime is based in Australia and New Zealand, and is an exclusive reseller of the Company’s solutions. Pursuant to the terms of the stock purchase agreement, the Company purchased 100% of CallTime’s outstanding capital stock for an aggregate purchase price of $11.4 million, funded with cash-on-hand. The Company deposited $2.1 million of the purchase price into an escrow account to ensure funds would be available to pay any indemnification claims. This escrow amount was released in four equal installments, with first the installment released on October 1, 2011 and the last installment released on July 1, 2012. The Company acquired CallTime as part of its growth strategy of accelerating business in key international markets. CallTime was the Company’s largest revenue-producing reseller in Australia and New Zealand from 2008 through 2010. The acquisition was accounted for using the acquisition method of accounting in accordance with FASB ASC 805. The results of CallTime’s operations were included in the Company’s consolidated financial statements commencing on the July 2011 acquisition date.

The purchase price allocations for the Company’s acquisition of CallTime are based on a third-party valuation report which was prepared in accordance with the provisions of FASB ASC 805. The following table summarizes the fair value of the intangible and other assets acquired and liabilities assumed at the date of the acquisition (in thousands):

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	July 1,
	2011
Cash and cash equivalents	$	2,106
Accounts receivable		5,790
Property and equipment, net		419
Prepaid expenses		842
Intangible assets, net		2,410
Goodwill		9,197
Total assets acquired		20,764
Accounts payable and accrued liabilities		(3,537)
Accrued compensation and related expenses		(3,133)
Other liability, net		(329)
Deferred tax liability		(723)
Deferred service revenue		(1,671)
Net assets acquired	$	11,371

The fair value of financial assets acquired includes accounts receivable with a fair and a contractual value of $5.8 million. The receivables consist of amounts due from customers for products sold and/or services rendered.

The Company has recorded a deferred tax liability of $723,000 associated with the intangible asset recorded in connection with the CallTime acquisition. This resulted in a corresponding adjustment recorded to goodwill.

Professional fees recognized as of June 30, 2012 totaled approximately $186,000 and included transaction costs such as legal, accounting, valuation and other professional services, which were expensed as incurred. These costs are included within general and administrative expenses on the condensed consolidated statements of income.

The premium paid over the fair value of the net assets acquired in the purchase, or goodwill, was primarily attributed to CallTime’s existing client base. Included within goodwill is the assembled workforce, comprised of 21 employees, which does not qualify for separate recognition. None of the goodwill is expected to be deductible for tax purposes.

Customer relationships are amortized based upon historical patterns in which the economic benefits are expected to be realized. Other finite-lived identifiable intangible assets are amortized on a straight-line basis. The following sets forth the customer relationships acquired and their economic useful life at the date of acquisition (dollars in thousands):

	As of June 30, 2012
							Economic
			Accumulated				Useful Life
	Gross Amount		Amortization		Net Amount		(in years)
Customer relationships	$	2,410	$	199	$	2,211	12

Agori Acquisition

The Company entered into a stock purchase agreement, dated as of February 28, 2011, with Agori Communications, GmbH (“Agori”), a Frankfurt, Germany-based reseller of the Company’s solutions. Pursuant to the terms of the stock purchase agreement, the Company purchased 100% of Agori’s outstanding capital stock for an aggregate purchase price of $4.9 million, including $808,000 related to the working capital of Agori, funded with cash-on-hand. The Company deposited $493,000 of the purchase price into an escrow account to ensure funds would be available to pay any indemnification claims. These funds were distributed to the former shareholders in February 2012. The Company acquired Agori as part of its growth strategy of accelerating business in key international markets, including Germany, which is currently the fourth largest economy in the world and the Company’s largest market in Europe, the Middle East and Africa. The acquisition was accounted for using the

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acquisition method of accounting in accordance with FASB ASC 805, and the results of Agori’s operations were included in the Company’s condensed consolidated financial statements commencing on the February 2011 acquisition date.  

The purchase price allocations for the Company’s acquisition of Agori are based on a third-party valuation report which was prepared in accordance with the provisions of FASB ASC 805. The following table summarizes the fair value of the intangible and other assets acquired and liabilities assumed at the date of the acquisition (in thousands):

	February 28,
	2011
Cash and cash equivalents	$	815
Accounts receivable		1,098
Prepaid expenses		288
Property and equipment, net		123
Other assets, net		221
Intangible assets, net		2,670
Goodwill		2,344
Total assets acquired		7,559
Accounts payable and accrued liabilities		(812)
Accrued compensation and related expenses		(102)
Contingent liability		(370)
Deferred tax liability		(801)
Deferred services revenues		(548)
Net assets acquired	$	4,926

The fair value of financial assets acquired includes accounts receivable with a fair and a  contractual value of $1.1 million. The receivables consist of amounts due from customers for products sold and/or services rendered.

The Company has recorded a reversal of the deferred tax liability of $800,000, which resulted in a corresponding adjustment recorded to goodwill.

Professional fees recognized as of June 30, 2012 totaled approximately $391,000 and included transaction costs such as legal, accounting, valuation and other professional services, which were expensed as incurred. These costs are included within general and administrative expenses on the condensed consolidated statements of income.

The premium paid over the fair value of the net assets acquired in the purchase, or goodwill, was primarily attributed to Agori’s existing client base. Included within goodwill is the assembled workforce, comprised of 16 employees, which does not qualify for separate recognition. None of the goodwill is expected to be deductible for tax purposes.

Customer relationships are amortized based upon historical patterns in which the economic benefits are expected to be realized. Other finite-lived identifiable intangible assets are amortized on a straight-line basis. The following sets forth the customer relationships acquired and their economic useful live at the date of acquisition (dollars in thousands):  

	As of June 30, 2012
							Economic
			Accumulated				Useful Life
	Gross Amount		Amortization		Net Amount		(in years)
Customer relationships	$	2,670	$	327	$	2,343	10

In accordance with the stock purchase agreement with Agori, the Company agreed to make contingent earn-out payments based upon pre-defined terms. The Company estimates the earn-out payments will total

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approximately $370,000 and will be paid over the next two and a half years. A corresponding liability has been recorded for this amount. A payment of approximately $100,000 was paid in January 2012 related to this earn-out.  In connection with FASB ASC 805, the fair value of any contingent consideration is established at the acquisition date and included in the total purchase price. The contingent consideration is then adjusted to fair value as an increase or decrease in current earnings in each reporting period.  

Pro Forma Results

We have not furnished pro forma financial information related to our Brightware, ATIO, CallTime or Agori acquisitions because such information is not material individually or in the aggregate to the overall financial results of the Company.

11. SUBSEQUENT EVENT

The Company entered into a stock purchase agreement, effective August 1, 2012, with Bay Bridge Decision Technologies Inc. (“Bay Bridge”), a privately-held Maryland-based company. Pursuant to the terms of the stock purchase agreement, the Company purchased 100% of Bay Bridge’s outstanding capital stock for an aggregate purchase price of $12.9 million, funded with cash-on-hand. The Company deposited $1.3 million of the purchase price into an escrow account to ensure funds are available to pay indemnification claims, if any. The Company acquired Bay Bridge to broaden its workforce optimization (WFO) portfolio of applications and to add advanced, long-term contact center capacity planning and strategic analytics capabilities that supplement Interaction Optimizer^®’s workforce management functionality.The allocation of the purchase price was not completed as of the date of this Quarterly Report on Form 10-Q and the results of Bay Bridge’s operations were not included in the Company’s condensed consolidated financial statements for the three and six months ended June 30, 2012.  The acquisition will be accounted for using the acquisition method of accounting in accordance with FASB ASC 805.

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

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations is intended to provide our investors with an understanding of our past performance, our financial condition and our prospects and should be read in conjunction with other sections of this Quarterly Report on Form 10-Q. Investors should carefully review the information contained in this report under Part II, Item 1A “Risk Factors” and in the Part I, Item 1A “Risk Factors” section of our Annual Report on Form 10-K for the fiscal year ended December 31, 2011. The following will be discussed and analyzed:

· Forward-Looking Information

· Overview

· Financial Highlights 

· Historical Results of Operations

· Comparison of Three and Six Months Ended June 30, 2012 and 2011

· Liquidity and Capital Resources

· Critical Accounting Policies and Estimates

Forward-Looking Information

Certain statements in this Quarterly Report on Form 10-Q contain “forward-looking” information (as defined in the Private Securities Litigation Reform Act of 1995,Section 27A of the Securities Act of 1933, as amended and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) that involves risks and uncertainties which may cause actual results to differ materially from those predicted in the forward-looking statements. Forward-looking statements can often be identified by the use of such verbs as “expects”,  “anticipates”,  “believes”,  “intend”,  “plan”,  “may”,  “should”,  “will”,  “would”,  “will be”,  “will continue”,  “will likely result”, or similar verbs or conjugations of such verbs. If any of our assumptions on which the statements are based prove incorrect or should unanticipated circumstances arise, our actual results could materially differ from those anticipated by such forward-looking statements. The differences could be caused by a number of factors or combination of factors, including, but not limited to, unstable economic conditions,  rapid technological changes in the industry, our ability to maintain profitability, to manage successfully our growth, to manage successfully our increasingly complex third-party relationships resulting from the software and hardware components being licensed or sold with our solutions, to maintain successful relationships with certain suppliers which may be impacted by competition in the technology industry, to maintain successful relationships with our current and any new partners, to maintain and improve our current products, to develop new products, to protect our proprietary rights adequately, to successfully integrate acquired businesses and other factors set forth in our Securities and Exchange Commission (“SEC”) filings.

Overview

We are a recognized leader in the global market for contact center and business communications solutions, offering a suite of applications that can be deployed as a cloud-based or on-premise multi-channel communications platform. This platform is also the foundation of our solutions for unified communications and business process automation.  Our solutions are used by businesses and organizations across a wide range of industries, including teleservices, insurance, banking, accounts receivable management, utilities, healthcare, retail, technology, government and business services.

In 2011, we completed our organizational transformation into a new holding company structure pursuant to a corporate reorganization whereby Interactive Intelligence Group, Inc. became the successor reporting company to Interactive Intelligence, Inc. (the "Reorganization").  This new structure is intended to provide us with enhanced

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strategic, operational and financial flexibility, improve our ability to determine financial results and profitability of different lines of business, and better manage tax expenses and exposure to liabilities.

We plan to expand our global reach by:

1.  Continuing to gain market share with our contact center and unified communications solutions, particularly through our cloud-based deployment;

2.  Increasing sales of our business process automation offering;

3.  Acquiring complementary applications and distribution channels; and

4.  Leveraging our strategic and distribution partners to further penetrate existing accounts and markets.

For further information on our business and the products and services we offer, refer to the Part I, Item 1 “Business” section of our Annual Report on Form 10-K for the year ended December 31, 2011.

Our management monitors certain key measures to assess our financial results. In particular, we track trends in product orders, contracted professional services, and cloud-based orders from quarter to quarter and in comparison to the prior year actual results and current year projected amounts. We also review leading market indicators to identify trends in economic conditions. In addition to orders and revenues, management reviews costs of revenue and operating expenses and staffing levels to ensure we are managing new expenditures and controlling costs. For additional discussions regarding trends and our expectations for the remainder of 2012, see “Financial Highlights” and “Comparison of Three and Six Months ended June 30, 2012 and 2011” below.

In addition to the above, our management monitors diluted earnings per share (“EPS”), a key measure of performance also used by analysts and investors, based on accounting principles generally accepted in the United States of America (“GAAP”) and on a non-GAAP basis. Management uses non-GAAP EPS, non-GAAP net income and non-GAAP operating income to analyze our business. These non-GAAP measures include revenue which was not recognized on a GAAP basis due to purchase accounting adjustments and exclude non-cash stock-based compensation expense for stock options, the amortization of certain intangible assets related to acquisitions by us, and non-cash income tax expense. These measures are not in accordance with, or an alternative for, GAAP, and may be different from non-GAAP measures used by other companies. Stock-based compensation expense and amortization of intangibles related to acquisitions are non-cash and certain amounts of income tax expense are non-cash. We believe that the presentation of non-GAAP results, when shown in conjunction with corresponding GAAP measures, provides useful information to our management and investors regarding financial and business trends related to our results of operations. Further, our management believes that these non-GAAP measures improve management’s and investors’ ability to compare our financial performance with other companies in the technology industry. Because stock-based compensation expense, amortization of intangibles related to acquisitions and non-cash income tax expense amounts can vary significantly between companies, it is useful to compare results excluding these amounts. Our management also uses financial statements that exclude stock-based compensation expense related to stock options, amortization of intangibles related to acquisitions and non-cash income tax amounts for our internal budgets.

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Reconciliations of these non-GAAP measures to the most directly comparable GAAP measures are included below (in thousands, except per share amounts):

	Three Months Ended				Six Months Ended
	June 30,				June 30,
	2012		2011		2012		2011
Net income (loss), as reported	$	(1,108)	$	3,827	$	(919)	$	6,922
Purchase accounting adjustments:
Increase to revenues:
Recurring		70		39		200		98
Services		-		17		-		48
Reduction of operating expenses:
Customer relationships		305		229		561		368
Technology		35		35		70		70
Non-compete agreements		45		45		90		90
Acquisition costs		29		131		151		332
Total		484		496		1,072		1,006
Non-cash stock-based compensation expense:
Costs of recurring revenues		130		103		253		208
Costs of services revenues		42		11		76		36
Sales and marketing		569		433		1,101		825
Research and development		473		395		870		803
General and administrative		500		333		993		721
Total		1,714		1,275		3,293		2,593
Non-cash income tax expense (benefit)		(510)		727		(1,012)		1,276
Non-GAAP net income	$	580	$	6,325	$	2,434	$	11,797
Operating income (loss), as reported	$	(1,807)	$	5,490	$	(1,531)	$	10,412
Purchase accounting adjustments		484		496		1,072		1,006
Non-cash stock-based compensation expense		1,714		1,275		3,293		2,593
Non-GAAP operating income	$	391	$	7,261	$	2,834	$	14,011
Diluted EPS, as reported	$	(0.06)	$	0.19	$	(0.05)	$	0.35
Purchase accounting adjustments		0.03		0.03		0.06		0.05
Non-cash stock-based compensation expense		0.09		0.06		0.16		0.13
Non-cash income tax expense (benefit)		(0.03)		0.04		(0.05)		0.06
Non-GAAP diluted EPS	$	0.03	$	0.32	$	0.12	$	0.59

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Financial Highlights

The tables below show our total revenues (in millions) for the most recent five quarters and the years ended December 31, 2011, 2010 and 2009 and the percentage change over the previous periods, and also a summary of orders received during the three and six months ended June 30, 2012 and 2011.

			Year-over-
			Year
Period	Revenues		Growth %
Three Months Ended:
June 30 2012	$	54.8	5	%
March 31, 2012		52.8	11
December 31, 2011		57.7	14
September 30, 2011		52.1	25
June 30, 2011		52.0	34
Year Ended December 31:
2011	$	209.5	26	%
2010		166.3	27
2009		131.4	8

Order Summary	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2012			2011			2012			2011
		($ in thousands)
Change from prior year period (total dollar amount)		26	%		44	%		16	%		49	%
Change from prior year period (cloud-based dollar amount)		88	%		86	%		47	%		171	%
Number of new customers (total)		67			81			127			146
Number of new customers (cloud-based)		16			11			27			27

Total revenues increased $2.8 million, or 5%, and $7.8 million, or 8%, during the three and six months ended June 30, 2012, respectively, from the same periods in 2011. These increases were primarily driven by higher sales of our cloud-based offerings, particularly to new customers. These increases were partially offset by a higher percentage of cloud-based orders received, for which revenue recognition is deferred to future periods, compared to the prior year periods. Additionally, more than $7.0 million in product orders were received but not recognized as revenue in the second quarter and first six months of 2012 due to reasons discussed in the product revenues section below.

Deferred revenues increased to $78.8 million and the amount of unbilled future cloud-based revenues increased to $49.7 million as of June 30, 2012 compared to deferred revenues of $62.1 and unbilled future cloud-based revenues of $21.0 as of June 30, 2011.  Because cloud-based orders are deferred and recognized over time, while most premise-based orders are recognized upfront, the mix of orders received affects the amount of revenues recognized. 

Total expenses during the three and six months ended June 30, 2012 increased 23% and 25%, respectively, compared to the previous year periods as a result of the continued planned investment in our operations, specifically sales and marketing and research and development.

The exchange rate for the euro declined during the three and six months ended June 30, 2012, resulting in between a $500,000 and $1 million reduction in revenues, which was partially offset by a corresponding decrease in

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expenses denominated in euro. The net effect on our operating loss was immaterial during the three and six months ended June 30, 2012.

For the full year of 2012, we expect an order growth rate of 20%, with cloud-based order growth of more than 50% and on-premise order growth of 5% to 10%. Additionally, we expect to see cloud-based orders increase to between 30% and 32% of total orders for 2012. Due to the deferral of revenues in the first two quarters and a higher percentage of cloud-based orders received in 2012 than originally expected, we now expect revenues for the year to be in the range of $233 million to $238 million. The mix of orders received during the remainder of 2012 could differ significantly from our expectations, which would impact our recognized revenues for 2012.

Acquisitions

On February 28, 2011, we entered into a stock purchase agreement with the shareholders of Agori Communications GmbH (“Agori”), and acquired 100% of Agori’s outstanding capital stock.  On July 1, 2011, we entered into a stock purchase agreement with CallTime Technology Sdn. Bhd., the ultimate parent company of CallTime Solutions Ltd. (“CallTime”), and acquired 100% of CallTime’s outstanding capital stock.  On January 5, 2012, we entered into an agreement with ATIO Corporation (Pty). Ltd. (“ATIO”), and acquired certain Interactive Intelligence-related contact center assets of ATIO. On April 1, 2012, we entered into a stock purchase agreement with Brightware B.V. (“Brightware”), and acquired 100% of Brightware’s capital stock. Additional details of each acquisition are as follows:

					Working
				Funding of	Capital
	Description of	Purchase		Purchase	Amount		Escrow		# of
Company	Company	Price		Price	Required		Amount		Employees
Agori	Reseller	$	4.9 million	Cash on hand	$	808,000	$	493,000	16
CallTime	Reseller	$	11.4 million	Cash on hand	$	1.4 million	$	2.1 million	21
ATIO	Reseller	$	7.0 million	Cash on hand	$	1.8 million	$	704,000	40
Brightware	Reseller	$	6.4 million	Cash on hand	$	3.0 million	$	461,800	14

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Historical Results of Operations

The following table presents certain financial data derived from our unaudited statements of operations as a percentage of total revenues for the periods indicated. The operating results for the three and six months ended June 30, 2012 and 2011 are not necessarily indicative of the results that may be expected for the full year and for any future periods.

	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2012			2011			2012			2011
Revenues:
Product		36	%		47	%		36	%		45	%
Recurring		52			43			52			43
Services		12			10			12			12
Total revenues		100			100			100			100
Costs of revenues:
Product		11			12			11			13
Recurring revenue		14			11			14			11
Services		9			8			9			8
Total costs of revenues		34			31			34			32
Gross profit		66			69			66			68
Operating expenses:
Sales and marketing		35			29			34			30
Research and development		20			17			20			17
General and administrative		13			12			12			11
Amortization of intangible assets		1			1			1			-
Total operating expenses		69			59			67			58
Operating income (loss)		(3)			10			(1)			10
Other income:
Interest income, net		-			-			-			-
Other income (expense):		-			-			-			-
Total other income		-			-			-			-
Income (loss) before income taxes		(3)			11			(1)			11
Income tax expense (benefit)		(1)			4			-			4
Net income (loss)		(2)	%		7	%		(1)	%		7	%

Comparison of Three and Six Months Ended June 30, 2012 and 2011

Revenues

Primary Sources of Revenues

Our revenues include: (i) product revenues, which include licensing the right to use our software applications and selling hardware as a part of our solutions; (ii) recurring revenues, which include support fees from perpetual license agreements and fees from our cloud-based offerings; and (iii) services revenues, which include professional and educational services fees.  During the first quarter of 2012, we reclassified long-term subscription revenues from product revenues to recurring revenues. Historical amounts have been reclassified based on this new revenue presentation. Our revenues are generated by direct sales to customers and through our partner channels.

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Product Revenues	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2012			2011			2012			2011
	($ in thousands)
Product revenues	$	19,662		$	24,208		$	39,097		$	44,632
Change from prior year period		(19)	%		32	%		(12)	%		31	%
Percentage of total revenues		36	%		47	%		36	%		45	%

Product revenues decreased $4.5 million, or 19%, and $5.5 million, or 12%, during the three and six months ended June 30, 2012, respectively, compared to the same periods in 2011. Product revenues decreased for both periods as a result of more than $7.0 million in product orders that were received during the second quarter of 2012 but not recognized as revenue in the quarter due to the following: extended payment terms on a multi-million dollar order that is part of a major systems deployment; deferral of certain other orders until product components are delivered; and a high percentage of prepaid multi-year product maintenance that was bundled with certain product orders, which is recognized over the related support period. Certain amounts of these orders are expected to be recognized as revenue in the third and fourth quarters of 2012 and a portion of these orders will be recognized over the next three years.

Not all software and hardware product orders are recognized as revenues when the orders are received from the customer because of certain contractual terms or the collection history with particular customers or partners. Consequently, product revenues for any particular period not only reflect the orders received in the current period but also include certain orders received but deferred in previous periods and recognized in the current period. In addition, a portion of product orders are related to maintenance and support, and they are recognized over the maintenance and support period as recurring revenues.

Our geographic mix of revenues has been relatively consistent between the second quarters and first six months of 2012 and 2011. The following table sets forth the percentage of revenues derived from each of our geographic regions for the periods presented:

	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2012			2011			2012			2011
		($ in thousands)
North and Latin America		69	%		71	%		74	%		70	%
Europe, Middle East, and Africa		23			18			19			21
Asia-Pacific		8			11			7			9

Recurring Revenues	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2012			2011			2012			2011
	($ in thousands)
Recurring revenues	$	28,398		$	22,330		$	56,037		$	43,418
Change from prior year period		27	%		37	%		29	%		35	%
Percentage of total revenues		52	%		43	%		52	%		44	%

Recurring revenues include the maintenance and support from perpetual license agreements and revenues from our cloud-based solutions. 

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Breakdown of recurring revenues was as follows:

	Three Months Ended				Six Months Ended
	June 30,				June 30,
	2012		2011		2012		2011
		($ in thousands)
Renewal and support fees	$	23,359	$	19,134	$	46,001	$	37,347
Cloud-based		5,039		3,196		10,035		6,071
Total	$	28,398	$	22,330	$	56,036	$	43,418

Recurring revenues increased $6.1 million, or 27%, and $12.6 million, or 29%, during the three and six months ended June 30, 2012, respectively, from the same periods in 2011. Recurring revenues increased in both periods due to increases in our cloud-based orders, an increase in both the total dollar amount of new customer orders and the average dollar amount of new cloud-based customer orders, as well as an increase in maintenance and support fees due to the continued growth of our installed base of premise customers and recent acquisitions. During the three and six months ended June 30, 2012, the percent of cloud-based orders increased to 24% and 26%, respectively, compared to 16% and 21%, respectively, of total orders in the same periods in 2011. Cloud-based orders are recognized over the contract term, which is typically three to five years, and we invoice customers monthly for the services performed.

Our unrecognized cloud-based revenues were $49.7 and $21.0 million as of June 30, 2012 and 2011, respectively. These amounts represent the remaining minimum value of non-cancellable agreements that have not been invoiced and are not included in deferred revenues. 

Renewal rates for license and support fees in the three and six months ended June 30, 2012 were consistent with the renewal rates in the three and six months ended June 30, 2011.

We believe recurring revenues will continue to grow with further expansion of our installed base of customers and the growing demand for our cloud-based solutions, particularly as we continue to expand our cloud-based offerings worldwide through data centers in Australia, Germany, Japan, the United Kingdom and the United States.  We plan to open an additional data center in Brazil in the third quarter of 2012.

Services Revenues	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2012			2011			2012			2011
	($ in thousands)
Services revenues	$	6,721		$	5,443		$	12,415		$	11,661
Change from prior year period		23	%		30	%		6	%		56	%
Percentage of total revenues		12	%		10	%		12	%		12	%

Services revenues increased $1.3 million, or 23%, and $754,000, or 6%, during the three and six months ended June 30, 2012, respectively, compared to the same periods in 2011 due to increases in the number and scope of professional service engagements and the number of attendees of our educational services. Prior to 2012, professional services revenues related to cloud-based implementations were deferred and recognized over the length of a contract. Beginning in 2012, such revenues are recognized as work is performed.

Services revenues have and will continue to fluctuate based on the product implementation requirements of our customers and partners as well as the number of attendees at our educational classes. We believe services revenues will continue to grow as product and recurring revenues increase, order sizes increase and as we license more of our solutions directly to our customers. 

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Costs of Revenues	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2012			2011			2012			2011
	($ in thousands)
Product	$	6,000		$	6,392		$	11,651		$	12,588
Recurring		7,838			5,813			15,079			11,095
Services		5,200			3,919			9,775			7,631
Total costs of revenues	$	19,038		$	16,124		$	36,505		$	31,314
Change from prior year period		18	%		38	%		17	%		42	%
Product cost as a % of product gross revenues		31	%		26	%		30	%		28	%
Recurring cost as a % of recurring gross revenues		28	%		26	%		27	%		26	%
Services cost as a % of services gross revenues		77	%		72	%		79	%		65	%

Costs of Product Revenues

Costs of product revenues consists of hardware costs (including media servers, Interaction Gateway^® appliances and Interaction SIP Stations^TM that we develop, as well as servers, telephone handsets and gateways that we purchase and resell), royalties for third-party software and other technologies included in our solutions, personnel costs and product distribution facility costs. These costs can fluctuate depending on which software applications are licensed (including third-party software) and the dollar amount of orders for hardware and appliances.

Costs of product revenues decreased $392,000, or 6%, and $937,000, or 7%, in the three and six months ended June 30, 2012, respectively, compared to the same periods in 2011. These decreases were primarily a result of the more than $7.0 million in product orders that were received but not recognized during the second quarter of 2012, as discussed in the product revenues section above.

Costs of Recurring Revenues

Costs of recurring revenues consist primarily of compensation expenses for technical support personnel and costs associated with our cloud-based offerings. 

Costs of recurring revenues increased $2.0 million, or 35%, and $4.1 million, or 36%, during the three and six months ended June 30, 2012, respectively, compared to the same periods in 2011. These higher costs were primarily due to an increase in compensation and other expenses related to staff hired to support our expanding customer base and growing number of cloud-based implementations. In addition, these costs increased due to staff added through acquisitions and additional cloud-based offerings costs including data center and telecommunications costs.

Some costs related to our cloud-based offerings, such as equipment costs, are recognized over time, but others such as salary and travel-related expenses are recognized as incurred.  Some of these costs are fixed while others are variable based on usage and call volume. We expect costs of recurring revenues to increase as new customers are added. We expect operating margins for our cloud-based offerings to improve over time as our business scales. 

Costs of Services Revenues

Costs of services revenues consist primarily of compensation expenses for professional services and educational personnel. 

Costs of services revenues increased by $1.3 million, or 33%, and  $2.1 million, or 28%, during the three and six months ended June 30, 2012, respectively, compared to the same periods in 2011. These higher costs were

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due to an increase in compensation, allocated rent and travel expenses, all resulting from additional staff hired and added through acquisitions. These increases were partially offset by an increase in the amount of professional services costs related to implementation services for cloud-based customers, which are deferred and recognized over the life of the contract. 

Gross Profit	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2012			2011			2012			2011
		($ in thousands)
Gross Profit	$	35,708		$	35,822		$	70,974		$	68,327
Change from prior year period		-	%		32	%		4	%		32	%
Percentage of total revenues		65	%		69	%		66	%		69	%

Gross profit as a percentage of total revenues in any particular period reflects the amount of product, recurring and services revenues recognized and the costs of product, recurring and services revenues incurred.

Gross profit decreased immaterially during three months ended June 30, 2012 and $2.7 million, or 4%, during the six months ended June 30, 2012 compared to the same periods in 2011, due to the impact of the factors discussed above.

Operating Expenses

Sales and Marketing	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2012			2011			2012			2011
		($ in thousands)
Sales and marketing expenses	$	19,256		$	15,320		$	36,677		$	29,477
Change from prior year period		26	%		33	%		24	%		35	%
Percentage of total revenues		35	%		29	%		34	%		30	%

Sales and marketing expenses primarily include compensation, travel, and promotional costs related to our direct sales, marketing, client success and channel management operations for premise and cloud-based deployments.

Sales and marketing expenses increased by $3.9 million, or 26%, and $7.2 million, or 24%, during the three and six months ended June 30, 2012, respectively, compared to the same periods in 2011. The rise in these expenses was primarily due to increases in compensation, travel and allocated rent expenses, all resulting from additional staff hired and added through acquisitions. Additionally, corporate marketing expenses were higher due to increased spending on our annual customer and user conference.

We expect sales and marketing expenses to increase in future periods as we continue expanding our sales organization and increasing our marketing and other promotional efforts. We believe these investments are critical to our future growth, as we continue to grow our market share and as we expand internationally.  In addition, if more customers choose our cloud-based deployment, marketing and sales expenses as a percentage of total revenues may increase because revenues for cloud-based deployments are recognized over time while certain sales and marketing expenses are recognized as incurred.

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Research and Development	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2012			2011			2012			2011
		($ in thousands)
Research and development expense	$	10,966		$	8,714		$	21,345		$	16,861
Change from prior year period		26	%		25	%		27	%		26	%
Percentage of total revenues		20	%		17	%		20	%		17	%

Research and development expenses are comprised primarily of compensation cost, allocated corporate costs and depreciation expenses.

Research and development expenses increased by $2.3 million, or 26%, and  $4.5 million, or 27%, during the three and six months ended June 30, 2012, respectively, compared to the same periods in 2011. The rise in these expenses was due to increased compensation and allocated corporate expenses, such as rent and depreciation, that resulted from additional staff hired.

We believe that continued investment in research and development is critical to our future growth, particularly because our competitive position in the marketplace is directly related to the timely development of new and enhanced solutions. As a result, we expect research and development expenses will continue to increase in future periods.

General and Administrative	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2012			2011			2012			2011
		($ in thousands)
General and administrative expense	$	6,943		$	6,024		$	13,832		$	11,119
Change from prior year period		15	%		50	%		24	%		42	%
Percentage of total revenues		13	%		12	%		13	%		11	%

General and administrative expenses include compensation expense as well as general corporate expenses that are not allocable to other departments, such as legal and other professional fees and bad debt expense. We expect that general and administrative expenses will continue to increase as we acquire additional companies and expand our infrastructure consistent with our growth strategy.

Three Months Ended June 30, 2012 compared to Three Months Ended June 30, 2011

General and administrative expenses increased $919,000, or 15%, primarily due to an increase in compensation and allocated corporate expenses, resulting from additional staff hired.  These expenses were partially offset by a decrease in professional services related to the Reorganization in 2011 as well as a reduction in other legal fees.

Six Months Ended June 30, 2012 compared to Six Months Ended June 30, 2011

General and administrative expenses increased $2.7 million, or 24%, primarily due to an increase in compensation and allocated corporate expenses, resulting from additional staff hired, and an increase in recruiting expenses resulting from the expansion of our staff.

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Other Income (Expense)

Interest Income, net	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2012			2011			2012			2011
	($ in thousands)
Cash, cash equivalents, and investments (average)	$	86,820		$	93,135		$	88,488		$	90,138
Interest income, net		167			92			348			135
Return on investments		0.77	%		0.40	%		0.79	%		0.30	%

Interest income, net, primarily consists of interest earned from investments and interest-bearing cash accounts. Interest expense and fees, which were not material in any years reported, are also included.

Interest earned on investments increased during the three and six months ended June 30, 2012 compared to the same periods in 2011 as a result of increases in investments with maturities between one and three years. These increases were partially offset by lower cash and investment balances. In the first quarter of 2011, we began investing in longer term investments with maturities up to three years to increase our overall yield on investments. We continue to monitor the allocation of funds in which we have invested to maximize our return on investment within our established investment policy. We do not have any investments in subprime assets.

Other Income, Net	Three Months Ended				Six Months Ended
	June 30,				June 30,
	2012		2011		2012		2011
		($ in thousands)
Other income, net	$	259	$	348	$	256	$	225

Other income, net includes foreign currency transaction gains and losses. These gains and losses can fluctuate based on the amount of receivables we generated in certain international currencies, the exchange gain or loss that results from foreign currency disbursements and receipts, and the cash balances and exchange rates at the end of a reporting period.  Other income included $93,000 and $(81,000) of foreign currency gain (losses) for the three and six months ended June 30, 2012, respectively, compared to $256,000 and $90,000 of foreign currency gain for the same periods in 2011. The income was mainly due to the change in value in the euro and Australian dollar.  We enter into foreign currency hedge transactions to mitigate the impact of exchange rate fluctuations.

Income Tax Expense (Benefit)	Three Months Ended				Six Months Ended
	June 30,				June 30,
	2012		2011		2012		2011
		($ in thousands)
Income tax expense (benefit)	$	(440)	$	2,011	$	(356)	$	3,715

Our effective tax rate benefit for the three and six months ended June 30, 2012 was 28.8% and 27.9%, respectively, including the settlement of certain prior period amounts (“discrete items”).  Excluding the discrete items in the second quarter of 2012, our effective tax rate for the three and six months ended June 30, 2012 would have been 36.7% and 37.3%.  Our estimated annual effective tax rate is 39.4%. If the federal research and development tax credit is extended until 2012, our annual effective tax rate is expected to be 32.0%. This tax rate was determined by considering the annual expected federal tax rate, rates in various states and international jurisdictions in which we have operations, and a portion of the amount of stock-based compensation that is not deductible for income tax purposes.

We have historically used a cost plus basis for calculating taxes in most foreign tax jurisdictions in which we operate.  A cost plus tax basis limits the taxes paid in these foreign jurisdictions to a markup of the costs that we incur in these jurisdictions and is not tied to the actual revenues generated. During 2012, three of our foreign

34

subsidiaries changed from the cost plus basis to a reseller basis because of structural changes in our business- two in the first quarter of 2012 and one in the second quarter of 2012. 

Net income (loss) before taxes for our foreign subsidiaries, under both the cost plus and reseller models, for the six months ended June 30, 2012 and 2011 were $(2.1) million and $1.1 million respectively.  The recorded foreign tax benefit (expense) and the related effect on the income tax rates for the six months ended June 30, 2012 and 2011 was $662,000, and $(236,000),  respectively. The decrease in our foreign tax expense for the six months ended June 30, 2012 was due to switching three of our foreign subsidiaries to the reseller model. The impact of the foreign effective income tax rates could become material as we expand our operations in foreign countries and calculate foreign income taxes based on operating results in those countries.

Liquidity and Capital Resources

We generate cash from the collection of payments related to licensing our products as well as from selling hardware, renewals of support agreements, and the delivery of other services.  During the six months ended June 30, 2012, we also received $2.5 million in cash from the exercise of stock options and $320,000 from purchases of common stock under our 2000 Employee Stock Purchase Plan.  We use cash primarily to pay our employees (including salaries, commissions and benefits), lease office space, pay travel expenses, pay for  marketing activities, pay vendors for hardware, other services and supplies, purchase property and equipment, pay research and development costs and fund acquisitions.  We used cash of approximately $7.0 million and cash of approximately $4.2 million, net of the $2.1 million in cash received, for acquisitions in the first and second quarters of 2012, respectively. We continue to be debt free.

We determine liquidity by combining cash and cash equivalents and short-term and long-term investments as shown in the table below. Based on our recent performance and current expectations, we believe that our current liquidity position, when combined with our anticipated cash flows from operations, will be sufficient to satisfy our working capital needs and current or expected obligations associated with our operations over the next 12 months and into the foreseeable future.  Our largest potential capital outlay in the future would be for potential acquisitions. If our liquidity is not sufficient to purchase a targeted company with our existing cash, we may need to raise additional capital, either through the capital markets or debt financings.

	June 30,		December 31,
	2012		2011
	($ in thousands)
Cash and cash equivalents	$	23,940	$	28,465
Short-term investments		40,828		40,589
Long-term investments		19,739		23,415
Total liquidity	$	84,507	$	92,469

The amount that we report as cash and cash equivalents or as short-term investments fluctuates depending on investing decisions in each period. Purchases of short-term investments are reported as a use of cash and the related receipt of proceeds upon maturity of investments is reported as a source of cash.

The majority of cash held in foreign accounts is the property of the Interactive Intelligence. We believe that these funds can be transferred into the U.S. with limited tax consequences. As of June 30, 2012, Interactive Intelligence held a total of $3.1 million in its various foreign bank accounts and our foreign subsidiaries held a total of $10.4 million in their various bank accounts. Our foreign subsidiaries had $6.7 million in undistributed earnings as of June 30, 2012. If we were to repatriate all of those earnings to Interactive Intelligence in the form of dividends, the incremental U.S. federal income tax net of applicable foreign tax credits would be $800,000.

As of June 30, 2012 and December 31, 2011, we had accounts with euro balances of approximately $7.6 million and $7.9 million, respectively, British pound balances of $412,000 and $1.6 million, respectively, Australian dollar balances of $4.6 million and $2.3 million, respectively, South African rand balances of $863,000 and $7.2

35

million, respectively, and balances of nine other foreign currencies totaling $2.2 million and $1.2 million, respectively.

The following table shows cash flows from operating activities, investing activities and financing activities for the stated periods:

	Six Months Ended
	June 30,
	2012		2011
Beginning cash and cash equivalents	$	28,465	$	48,300
Cash provided by operating activities		7,577		10,425
Cash used in investing activities		(14,796)		(35,882)
Cash provided by financing activities		2,694		6,206
Ending cash and cash equivalents	$	23,940	$	29,049

Cash provided by operating activities decreased year-over-year due to routine fluctuations in our operating assets and liabilities. The cash used in investing activities during the first six months of 2012 was primarily due to the purchases of ATIO and Brightware during the first quarter and second quarters of 2012, respectively. Cash provided by financing activities during both periods was primarily due to proceeds from stock options exercised.

Contractual Obligations

As of June 30, 2012,  there have been no material changes to our contractual obligations as set forth in the Contractual Obligations table disclosed in our Annual Report on Form 10-K for the year ended December 31, 2011. 

Off-Balance Sheet Arrangements

Except as set forth in the Contractual Obligations table disclosed in our Annual Report on Form 10-K for the year ended December 31, 2011, we have no off-balance sheet arrangements that have or are reasonably likely to have a current or future material impact on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources as of June 30, 2012.

    We provide indemnifications of varying scope and amount to certain customers against claims of intellectual property infringement made by third parties arising from the use of our products.Our software license agreements, in accordance with FASB ASC Topic 460, Guarantees, include certain provisions for indemnifying customers, in material compliance with their license agreement, against liabilities if our software products infringe upon a third party's intellectual property rights, over the life of the agreement. We are not able to estimate the potential exposure related to the indemnification provisions of our license agreements but have not incurred expenses under these indemnification provisions. We may at any time and at our option and expense:  (i) procure the right of the customer to continue to use our software that may infringe a third party’s rights; (ii) modify our software so as to avoid infringement; or (iii) require the customer to return our software and refund the customer the fee actually paid by the customer for our software less depreciation based on a five-year straight-line depreciation schedule. The customer’s failure to provide timely notice or reasonable assistance will relieve us of our obligations under this indemnification to the extent that we have been actually and materially prejudiced by such failure. To date, we have not incurred, nor do we expect to incur, any material related costs and, therefore, have not reserved for such liabilities. 

Our software license agreements also include a warranty that our software products will substantially conform to our software user documentation for a period of one year, provided the customer is in material compliance with the software license agreement. To date, we have not incurred any material costs associated with these product warranties, and as such, we have not reserved for any such warranty liabilities in our operating results.

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Critical Accounting Policies and Estimates

The preparation of our condensed consolidated financial statements requires us to make estimates and judgments that affect the reported amount of assets, liabilities, revenues and expenses. Actual results may differ from those estimates and judgments under different assumptions or conditions. We have discussed the critical accounting policies that we believe affect our more significant estimates and judgments used in the preparation of our consolidated financial statements in the “Management’s Discussion and Analysis of Financial Condition and Results of the Operations—Critical Accounting Policies and Estimates” section of our Annual Report on Form 10-K for the year ended December 31, 2011 and in Note 2 of Notes to Consolidated Financial Statements included in our Annual Report on Form 10-K for the year ended December 31, 2011. For a further summary of certain accounting policies, see Note 2 of Notes to Condensed Consolidated Financial Statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q.

Item 3. Quantitative and Qualitative Disclosures about Market Risk.

We develop software application products in the United States and license our products worldwide. As a result, our financial results could be affected by market risks, including changes in foreign currency exchange rates, interest rates or weak economic conditions in certain markets. Market risk is the potential of loss arising from unfavorable changes in market rates and prices.

Foreign Currency Exchange Rates

We transact business in certain foreign currencies including the British pound, Canadian dollar, South African rand, Australian dollar and the euro. However, as a majority of the orders we receive are denominated in United States dollars, a strengthening of the dollar could make our products more expensive and less competitive in foreign markets. During 2010, we began hedging both our accounts receivable and cash that are held in euros. As of June 30, 2012, we had hedging arrangements in British pounds, Canadian dollars and the euro. We continue to mitigate our foreign currency risk by generally transacting business and paying salaries in the functional currency of each of the major countries in which we do business, thus creating natural hedges. Additionally, as our business matures in foreign markets, we may offer our products and services in certain other local currencies. If this were to occur, foreign currency fluctuations could have a greater impact on us and may have an adverse effect on our results of operations. For the three and six months ended June 30, 2012, our foreign currency transaction gain (loss) amounted to approximately $92,600 and ($81,000), respectively.

For the three and six months ended June 30, 2012, approximately 13%  and 11% of our revenues and 21%  and 20% of our expenses, respectively, were denominated in a foreign currency. As of June 30, 2012, we had net monetary assets valued in foreign currencies subject to foreign currency transaction gains or losses, consisting primarily of cash and receivables, partially offset by accounts payable, with a carrying value of approximately $15.4 million. A 10% change in foreign currency exchange rates if not hedged would have changed the carrying value of these net assets by approximately $1.5 million as of June 30, 2012, with a corresponding foreign currency gain (loss) recognized in our condensed consolidated statements of income.

Interest Rate Risk

We invest cash balances in excess of operating requirements in securities that have maturities of three years or less and are diversified among security types. The carrying value of these securities approximates market value. These securities bear interest at fixed interest rates. Based on the weighted average maturities of the investments, if market interest rates were to increase by 100 basis points from the level at June 30, 2012, the fair value of our portfolio would decrease by approximately $507,000.

Item 4. Controls and Procedures.

We maintain a set of disclosure controls and procedures that are designed to ensure that information required to be disclosed by us in the reports filed by us under the Exchange Act is (a) recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and (b) accumulated and

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communicated to our management, including our principal executive and principal financial officers, to allow timely decisions regarding required disclosures. We carried out an evaluation, under the supervision and with the participation of our management, including our President and Chief Executive Officer (principal executive officer) and our Chief Financial Officer (principal financial officer), of the effectiveness of the design and operation of our disclosure controls and procedures as of June 30, 2012, pursuant to Rule 13a-15 of the Exchange Act. Based on that evaluation, our President and Chief Executive Officer and our Chief Financial Officer concluded that our disclosure controls and procedures were effective as of June 30, 2012.  

There have been no changes in our internal control over financial reporting that occurred during the quarter ended June 30, 2012 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings.

The information set forth under “Legal Proceedings” in Note 7  of Notes to Condensed Consolidated Financial Statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q is incorporated herein by reference.

Item 1A. Risk Factors.

In addition to the information set forth in this Quarterly Report on Form 10-Q and before deciding to invest in, or retain, shares of our common stock, you also should carefully review and consider the information contained in our other reports and periodic filings that we make with the SEC, including, without limitation, the information contained under the caption Part I, Item 1A “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2011. Those risk factors could materially affect our business, financial condition and results of operations.

The risks that we describe in our public filings are not the only risks that we face. Additional risks and uncertainties not currently known to us, or that we presently deem to be immaterial, also may materially adversely affect our business, financial condition and results of operations. There have been no material changes from the risk factors previously disclosed in our Annual Report on Form 10-K for the year ended December 31, 2011.

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Item 6. Exhibits

(a) Exhibits
			Incorporated by Reference
Exhibit						Filed
Number	Exhibit Description		Form	Exhibit	Filing Date	Herewith
3.1	Articles of Incorporation of the Company, as currently in effect		S-4/A	Annex II to the	4/27/2011
		(Registration No.		Proxy Statement
		333-173435)		/ Prospectus
3.2	Amended By-Laws of the Company, as currently in effect		S-4/A	Annex III to the	4/27/2011
		(Registration No.		Proxy Statement
		333-173435)		/ Prospectus
31.1	Certification of the Chief Executive Officer pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002					X
31.2	Certification of the Chief Financial Officer pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002					X
32.1	Certification of the Chief Executive Officer, pursuant to 18 U. S. C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002					X
32.2	Certification of the Chief Financial Officer, pursuant to 18 U. S. C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002					X
101	The following materials from Interactive Intelligence Group, Inc.’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2012, formatted in XBRL (eXtensible Business Reporting language):  (i) Condensed Consolidated Balance Sheets; (ii) Condensed Consolidated Statements of Operations and Comprehensive Income (Loss); (iii) Condensed Consolidated Statement of Shareholders’ Equity; (iv) Condensed Consolidated Statements of Cash Flows; and (v) Notes to Condensed Consolidated Financial Statements					X

SIGNATURE

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

		Interactive Intelligence Group, Inc. (Registrant)
Date:   August 9, 2012	By:	/s/     Stephen R. Head
		Stephen R. Head Chief Financial Officer, Senior Vice President of Finance and Administration, Secretary and Treasurer (Principal Financial Officer and Principal Accounting Officer)

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