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Business
Company Overview
We provide software, proprietary content and services that enable organizations to more effectively recruit and retain employees. Our solutions are built around a suite of easily configurable software applications that automate talent acquisition and employee performance management best practices. We offer the software applications that form the core of our on-demand solutions, which materially reduce the costs and risks associated with deploying traditional enterprise applications. We complement our software applications with tailored combinations of outsourcing services, proprietary content and consulting services based on our 23 years of experience assisting customers in addressing their Human Resource (HR) requirements. Together, our software applications and services form complete and highly effective solutions available from a single vendor. We believe that these solutions enable our customers to improve the effectiveness of their talent acquisition programs, increase employee productivity and retention, measure key HR metrics and make their talent acquisition and employee performance management programs more efficient.
Customers
As of December 31, 2010, we had a global customer base of approximately 6,800 companies across a number of industries, including financial services and banking, manufacturing, government, life sciences, biotechnology and pharmaceuticals, retail, healthcare, hospitality, call centers, and education, including approximately 255 companies on the Fortune 500 list published in May 2010. Our customer base includes companies that we billed for services during the 12 months ended December 31, 2010 and does not necessarily indicate an ongoing relationship with each such customer. For the year ended December 31, 2010, we provided our talent acquisition and employee performance management solutions on a subscription basis to approximately 6,000 customers, with an average subscription term of two years. The remainder of our customers in 2010 engaged us to provide discrete professional services and may not engage us for future services once a project is completed. No single customer accounted for more than 10% of our revenue in the year ended December 31, 2010.
We derive revenue primarily from two sources, subscription fees for our solutions and fees for discrete professional services. During the years ended December 31, 2010, 2009 and 2008, subscription revenue comprised approximately 78.8%, 84.9% and 80.2%, respectively, of our total revenue. Our top 80 customers contributed approximately 52.7%, 54.9% and 56.3% of our total revenue for the years ended December 31, 2010, 2009 and 2008, respectively. Our customers typically purchase multi-year subscriptions, which provide us with a recurring revenue stream. Historically, our customers have renewed more than 90% of the aggregate value of multi-year subscriptions for our on-demand talent acquisition and performance management solution contracts subject to renewal. Recently however, the economic downturn has adversely impacted this trend, resulting in lower annual renewals. Our customers renewed 84% and 80% of their contracts for each of the years ended December 31, 2010 and 2009, respectively which represented 88% of the aggregate value of multi-year subscriptions for our on-demand talent acquisition and performance management solution contracts up for renewal for each of those years.
Company History
We are a Pennsylvania corporation. We began our operations under predecessor companies Insurance Services, Inc., or ISI, and International Holding Company, Inc., or IHC, in 1987. In December 1999, we reorganized our corporate structure by merging ISI and IHC with and into Raymond Karsan Associates, Inc., or RKA, a Pennsylvania corporation and a wholly owned subsidiary of Raymond Karsan Holdings, Inc., or RKH, a Pennsylvania corporation. Each of RKA and RKH were newly created to consolidate the businesses of ISI and IHC. In April 2000, we changed our name to TalentPoint, Inc. and we changed the name of RKA to TalentPoint Technologies, Inc. In November 2000, we changed our name to Kenexa Corporation, or Kenexa, and we changed the name of TalentPoint Technologies, Inc. to Kenexa Technology, Inc., or Kenexa Technology. Currently, Kenexa transacts business primarily through Kenexa Technology and its wholly owned subsidiaries.
Our principal executive offices are located at 650 East Swedesford Road, Second Floor, Wayne, PA 19087.
Our telephone number is (610) 971-9171. We maintain an Internet website at http://www.kenexa.com. We are not incorporating by reference into this Annual Report on Form 10-K any material from our website. The reference to our website is an inactive textual reference to the uniform resource locator (URL) and is for your reference only.
Recent Events
On June 11, 2009 and July 16, 2009, two putative class actions were filed against Kenexa Corporation and our Chief Executive Officer and Chief Financial Officer in the United States District Court for the Eastern District of Pennsylvania, purportedly on behalf of a class of our investors who purchased our publicly traded securities between May 8, 2007 and November 7, 2007. On September 28, 2010, the court granted Kenexa’s motion to dismiss the complaint filed on June 11, 2009. The plaintiffs filed a motion for reconsideration of the court’s decision on October 12, 2010, which was denied by the court on November 29, 2010. The plaintiffs failed to file a timely appeal, and, as a result, the actions were concluded in Kenexa's favor.
In May 2010, we launched a major upgrade to our product line. Our 2x platform™ includes applications such as Kenexa 2x Recruit™, Kenexa 2x BrassRing®, Kenexa 2x Onboard™ and our first-to-market Kenexa 2x Mobile™ solution. Future modules to the 2x platform include Kenexa 2x Perform™, Kenexa 2x Assess™, Kenexa 2x Analytics™ and Kenexa 2x Survey™. We believe that Kenexa 2x enables customers to improve productivity, increase cost savings, ensure compliance with corporate and legal mandates, and raise employee engagement.
In July 2010, in accordance with our UBS AG agreement, we exercised our right to sell our auction rate securities back to UBS and liquidated our auction rate security portfolio in its entirety. (See Note 3 - Investments to the Consolidated Financial Statements for further details.)
On July 26, 2010, we acquired all of the outstanding stock of The Centre for High Performance Development (Holdings) Limited (“CHPD”) which operates as a leadership development and management training company based in London, England for a purchase price of approximately $4.2 million in cash. The total cost of the acquisition, including estimated legal, accounting, and other professional fees was approximately $4.4 million. We deposited $0.4 million into escrow to cover any claims for indemnification. We acquired all assets and liabilities of CHPD using our existing cash and expect the acquisition of CHPD will enhance our existing research and content portfolio as well as provide our customers with the ability to more efficiently implement the results of their employee engagement surveys.
On August 31, 2010, we entered into a secured credit agreement with PNC Bank, N.A., as administrative agent, in connection with our acquisition of Salary.com. The secured credit agreement included a maximum amount available under the credit facility of $25.0 million including a sublimit of up to $2.0 million for letters of credit and swing loans. Borrowings under the new credit facility were secured by substantially all of the Company’s assets and the assets of its subsidiaries.
On October 1, 2010, we acquired all of the outstanding stock of Salary.com, Inc., a Delaware corporation (“Salary.com”), which provides on-demand compensation software that helps businesses and individuals manage pay and performance, for a purchase price of approximately $78.4 million in cash. The total cost of the acquisition, including estimated legal, accounting, and other professional fees was approximately $82.8 million. We used cash and borrowings against the credit facility to fund the acquisition. We believe there is a significant opportunity to expand Salary.com’s adoption in large organizations and on a global basis because its compensation analysis software is highly synergistic with our current suite of talent acquisition and retention solutions.
In connection with the acquisition of Salary.com, we assumed responsibility for the suit filed on August 13, 2010 by former shareholders and option holders of Genesys Software Systems, Inc. (the “Genesys Parties” and “Genesys,” respectively) against Salary.com, Inc. and Silicon Valley Bank -Trustee Process Defendant in Massachusetts Superior Court. The Genesys Parties asserts claims for breach of contract, breach of implied covenant of good faith and fair dealing, violation of the Massachusetts Unfair Business Practices Act, and declaratory judgment seeking damages of $2.0 million in contingent consideration related to the purchase of Genesys by Salary.com, plus other monetary damages and fees. On September 7, 2010, Salary.com filed an answer and counterclaim against the Genesys Parties, and certain former shareholders of Genesys, asserting breach of contract, breach of implied covenants of good faith and fair dealing, fraud, violation of the Massachusetts Unfair Business Practices Act, civil conspiracy, negligent misrepresentation, and declaratory judgment seeking to dismiss the original complaint and unspecified monetary damages. The $2.0 million in contingent consideration was accrued for in the financial statements at December 31, 2010.
On, October 20, 2010, we terminated and paid all outstanding amounts under our secured credit agreement, dated August 31, 2010, and entered into a senior secured credit agreement (the “amended credit agreement”) with PNC Bank. The maximum amount available under the amended credit agreement is $60.0 million, comprised of a $35.0 million revolving facility, including a sublimit of up to $5.0 million for letters of credit and a sublimit of up to $2.5 million for swing loans (the “Revolving Facility”), and a $25.0 million term facility (the “Term Facility”). We may request to increase the maximum amount available under the Revolving Facility to $50.0 million. The amended credit agreement will terminate, and all borrowings will become due and payable, on October 19, 2013. We and each of our U.S. subsidiaries are guarantors of the obligations under the amended credit agreement. Borrowings under the amended credit agreement are secured by substantially all of our assets (including a pledge of the capital stock of our subsidiaries (but limited to only 65% of the voting stock of first-tier foreign subsidiaries)). As of December 31, 2010 we borrowed $59.5 million under the amended credit agreement in connection with the acquisition of Salary.com and to enhance working capital. In January 2011, we made payments of approximately $25.7 million under the amended credit agreement.
On February 2, 2011, Dorno Investment Partners, LLC filed a Petition for Appraisal of Stock in the Court of Chancery of the State of Delaware against Kenexa Compensation, Inc., the new name for the surviving entity subsequent to the all cash, short form merger of Salary.Com, Inc. and Spirit Merger Sub, Inc. on October 1, 2010. Dorno was the beneficial owner of 143,610 shares of Salary.Com, Inc. common stock on the merger date and demanded and continues to demand appraisal of the fair value of 140,000 shares pursuant to Delaware law. Dorno demands fair value for its shares, interest from October 1, 2010, costs, attorney’s fees, and other appropriate relief.
Customer Support
We believe that superior customer support is critical to our customers. Our customer support group assists our customers by answering questions and troubleshooting issues involving our solutions. Customer support is available 24 hours a day, 7 days a week by telephone and Internet from a member of our customer support team. Members of our customer support team receive comprehensive training and orientation to ensure that our customers receive high-quality support and service. Each of our customers is assigned a single point of contact. When an issue is reported to us, our customer support personnel follow a clearly defined escalation process to ensure that mission-critical issues are resolved to the satisfaction of the customer.
We utilize our talent acquisition and employee performance management solutions to recruit and manage our customer support personnel. We believe that applying these solutions to our customer service department has resulted in a customer support group with superior skills, competencies and aptitude for customer service. As of December 31, 2010, our customer support group consisted of 1,043 employees. The majority of our customer support groups reside in the following locations: Massachusetts, Nebraska, Pennsylvania, Texas, Argentina, China, England, Germany, India, and Poland.
Employees
As of December 31, 2010, we had 1,963 employees, consisting of 315 employees in sales and marketing, 429 employees in development, 1,043 employees in delivery of our solutions and 176 employees in general and administrative positions. As of December 31, 2009, we had 1,459 employees, consisting of 243 employees in sales and marketing, 291 employees in development, 776 employees in delivery of our solutions and 149 employees in general and administrative positions. None of our employees are represented by a union. We consider our relationship with our employees to be good and have not experienced any interruptions of our operations as a result of labor disagreements.
Industry Overview
Talent acquisition is the sourcing, recruiting, screening and assessment of employees. Employee performance management is the systematic process by which an organization tracks, monitors and optimizes employee behavior and productivity, and evaluates performance through employee reviews, appraisals and business metrics.
Drivers of Demand for Talent Acquisition and Employee Performance Management Applications
According to the Bureau of Economic Analysis, an agency of the U.S. Department of Commerce, the amount spent on U.S. labor in 2010 was approximately $6.4 trillion, or approximately 48.6% of the total U.S. gross domestic product. We believe that the drivers for human capital are affected by intense competition for qualified employees as a result of an aging workforce, declining tenure of employees, increased globalization and the growing service component of the U.S. economy.
Over the past two decades, many organizations have implemented software systems that systematize best practices and drive efficiency in most departments, including enterprise resource planning systems (“ERP”), customer relationship management systems and supply chain management systems. These software applications provide a wide array of benefits that both assist revenue growth and eliminate expenses. Based on our experience, however, we believe that the HR departments of many of these organizations have only implemented HR information systems, which track basic employee information for payroll and benefits purposes, or rudimentary applicant tracking systems. Although these systems provide some level of automation, they do little to increase the effectiveness of talent acquisition and employee performance management programs. We believe that few organizations have systematized best practices for talent acquisition and employee performance management or have implemented software applications to support these processes and provide HR professionals with critical analytics and metrics.
Our experience indicates that, presently, many organizations' talent acquisition functions consist of manual, paper-based processes, category software solutions addressing limited aspects of the talent acquisition equation, and ad hoc outsourcing and third-party or custom software applications with limited functionality. As a result, we believe that they suffer from the following shortcomings:
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Inefficiency. Many organizations rely on manual, paper-based processes and they cannot effectively manage the massive number of candidates presented by today's many recruiting resources, including unsolicited inquiries, internal referrals, career fairs, campus recruiting, Internet job boards and third-party referrals, among many others. As a result, they fail to identify high potential candidates or fail to process those candidates in a timely manner.
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Redundancy. Many organizations do not maintain easily searchable databases of processed candidates and they often conduct redundant searches. A candidate who did not meet the criteria for a certain position may meet the criteria for alternative or future positions. Without a centralized, automated, and easily searchable database, a candidate may be overlooked.
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Ineffectiveness. Organizations generally do not employ sophisticated screening and assessment mechanisms. As a result, most hiring decisions are at best loosely based on objective indicators of future success and fail to match high-potential candidates with roles or positions that leverage their unique abilities and experience. This lowers the probability that a new hire will succeed and negatively impacts employee productivity and satisfaction.
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Inconsistency. Many organizations screen applications and resumes based on rudimentary criteria and base hiring decisions primarily on subjective, ad hoc interviews. This process lacks consistency and objectivity. Furthermore, once hired, organizations need auditable processes to ensure that employees are on-boarded consistently, in compliance with government regulations and company procedures. Inconsistencies in these processes not only negatively impact the effectiveness of recruiting programs and subsequent employee success, but also may expose organizations to regulatory liability.
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High cost and inflexibility. As a result of their inflexibility and absence of a variable cost structure, organizations must either maintain larger HR departments or purchase a greater supply of third-party services in order to accomplish their recruiting and on-boarding goals, significantly increasing the costs of their talent acquisition programs.
Similarly, we believe that many organizations have neither automated nor applied best practices to employee performance management. In our experience, most organizations’ employee performance management processes consist of annual performance reviews and informal mentoring programs. We believe that effective employee performance management requires a consistent, systematized process that identifies employee strengths, weaknesses and issues in a timely manner, continually aligns employee goals with the evolving goals of the organization, monitors opportunities for internal advancement and enables management to analyze employee data over time. We believe that the absence of effective employee performance management systems and processes has the following negative implications:
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Failure to retain top performers. The absence of systems and processes to ensure the fulfillment, motivation and internal mobility of key employees negatively impacts an organization's ability to retain its top performing employees. Management may not have the opportunity to rectify problems with valued employees before they depart from the organization without a system to highlight these issues. Reducing employee turnover can have a material, positive impact on an organization’s expenses and bottom line.
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Failure to optimize productivity. Maximum productivity is obtained when employees believe their roles match their evolving skill sets, find their jobs challenging and have confidence in their upward mobility. The absence of strong employee performance management systems contributes to the failure to accomplish these goals, and even if organizations succeed in retaining employees, they may not be able to maintain maximum productivity from their employees.
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Failure to remove poor performers. An employee who does not fulfill his or her role effectively may have a continuing negative impact on an organization. To the extent that a poor performer has managerial responsibility, this negative impact on the organization increases materially. Without systems that identify poor performers, organizations may not be able to address weaknesses within their human capital in a timely manner.
We believe that the failure to employ sophisticated systems in their talent acquisition and employee performance management processes inhibits organizations from leveraging valuable data generated through these functions. This can negatively impact organizations in several ways, including the failure both to identify overall trends that could improve the efficiency and effectiveness of its processes and to quickly identify problems that could lead to employee turnover.
Emergence of On-Demand Applications
Based on our experience, we believe that organizations have become increasingly dissatisfied with traditional enterprise software applications, resulting in the growing adoption of the on-demand model for enterprise software. Historically, organizations have purchased perpetual software licenses and deployed enterprise software applications on-site within their IT environment. This traditional method of purchasing and deploying enterprise software applications has left many organizations questioning whether the benefits of these technologies outweigh the following burdens:
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Expensive and time consuming implementation. A traditional enterprise software application requires an organization to invest in ancillary IT such as hardware systems, application servers, databases, storage, and backup systems. In addition, the organization must employ consultants or additional IT staff to integrate the application into increasingly complicated IT environments and customize the application for specific needs. The ancillary costs of a complex deployment can equal multiples of the perpetual license fee for the software application and deployment itself can take several months or even years to complete.
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Expensive maintenance. Once the software application has been deployed, the organization must make further investments to maintain the application. In addition to the maintenance fee paid to the software vendor, which is typically approximately 20% of the perpetual license fee for all software used in running the application, the organization must retain both an IT staff capable of maintaining and upgrading the software as well as personnel to train new users to operate the applications. Upgrades must be made to all applications required to run the software such as operating system, databases, security patches, etc. We believe that because of the expense that typical application upgrades entail, software upgrades significantly lag behind available technology, denying end users the benefits of new technologies and solution functionalities.
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Limited incentives to ensure customer success. A typical perpetual software license requires the customer to pay up-front a material amount for the license, with a significantly smaller amount, typically approximately 20%, paid annually for basic support and upgrades. This model leaves little incentive for the software vendor to ensure a successful implementation and on-going customer satisfaction.
Developments in technology have enabled software developers to offer enterprise software applications on an on-demand basis. By leveraging the Internet, multi-tiered architectures, advances in security and open standards for application integration, software vendors can offer software applications to their customers as a service, hosting the software on servers operated by the software vendor. Customers, using an Internet browser, access the applications, which are designed to be easily configured and integrated with a customer’s existing applications.
The on-demand model fundamentally changes both the purchasing and deployment of enterprise software from a customer perspective. Rather than making large, up-front investments in perpetual licenses, customers purchase limited term subscriptions for on-demand software applications. Further, because only an Internet browser is required to access on-demand software applications, which can be easily configured to meet the buyer’s specific needs, organizations eliminate the expense of ancillary technology and third-party services required to implement, configure and maintain the enterprise application on-site. Finally, the finite duration of customer subscriptions provides a strong incentive to software vendors to ensure that the software provides the expected benefits to the customer, resulting in consistent customer service. The on-demand model also reduces research and development support costs for the software developer. Because only limited versions of the software exist at any one time, the on-demand model relieves the burden of maintaining and upgrading historical versions of the software so that customers benefit from a steady stream of the most recent features and technologies.
We believe that talent acquisition and employee performance management applications are particularly well-suited to the on-demand model. Talent acquisition and employee performance management applications are generally purchased by an organization’s HR department. Because the HR departments of most organizations have little historical experience making capital expenditures for enterprise software applications, we believe that providing these departments the opportunity to license software applications on a subscription basis eliminates a major impediment to the adoption of talent acquisition and employee performance management applications.
Our Solutions
We are a leading provider of integrated talent management solutions. Our solutions enable organizations to implement systematic talent acquisition and management practices including compensation strategies that ensure the efficient, effective and consistent hiring, on-boarding and development of qualified and talented individuals. Our solutions also provide employee performance management systems that help to ensure that organizations retain and optimize the performance of qualified individuals, identify employees who fail to perform, and identify successors for critical positions. In addition, our solutions help organizations manage learning and assessment opportunities and events to develop employees for both current and desired future jobs. Finally, our solutions enable customers to determine its workforce’s engagement level, and diagnose where changes in behavior (for individual employees, managers and senior leaders) or HR programs will improve organizational performance and business outcomes.
Our solutions are built around a suite of easily configurable software applications that automate and support leading talent management leading practices. We believe that by delivering our products via Software as a Service (SaaS), we materially reduce the costs and risks associated with traditional enterprise software application implementations. We also believe that implementing feature-rich and scalable, highly configurable on a real-time basis, talent acquisition and employee performance management solutions that meet organizations’ specific needs requires a combination of software, services and domain-specific knowledge and expertise. Accordingly, we complement our software applications with consulting services, outsourcing services and proprietary content. Together, these components form solutions that enable our customers to improve the quality of their hiring programs, increase employee productivity and retention, design tailored compensation philosophies, enhance employee learning and development, increase employee engagement, and make their integrated talent management programs more cost-effective.
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More effective and consistent talent acquisition programs. Our talent acquisition solutions are comprised of two major components that enable our customers to increase the consistency and effectiveness of their recruiting programs. The first component is our applicant tracking system, which automates and streamlines the recruiting process. The second component is our testing and assessment solutions, which ensures that candidates have the desired knowledge, skills, behavior and experience necessary to be successful in the desired position. Our talent acquisition solutions enable our customers to:
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expand the pool of qualified applicants;
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accurately communicate a powerful employment brand that draws “best fit” candidates to the organization;
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identify high-potential candidates more quickly;
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accurately measure candidate skills, aptitude and experience;
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create interviews focused on necessary skills and qualities indicative of success;
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increase interview consistency and objectivity;
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identify training needs immediately;
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integrate new hires into the company in a consistent and documented fashion;
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document compliance with regulatory requirements; and
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ensure cultural fit between candidates and the organization.
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Greater employee productivity and retention. Our employee performance management solutions combine software, proprietary content and consulting services to automate and systematize employee performance management leading practices. Specifically, our solutions enable organizations to automate goal setting, performance appraisal, succession planning, career planning, and compensation management activities; manage learning and development events; design and administer effective and consistent employee surveys and implement productive mentoring programs. Our solutions include tools that facilitate the development of action plans to address weaknesses and cultivate strengths identified through these processes. We complement the software components of our solutions with consulting services that help to encourage and manage behavioral change within an organization. As a result, we understand that our customers experience greater employee productivity and improved employee retention after implementing our solutions, and thus directly impact business outcomes.
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Compensation. Compensation plays a key role in an organization’s ability to attract and retain top performers, and our compensation data and software solutions ensure that our customers are offering pay packages that are both externally competitive and internally equitable. With tools to support market pricing, salary range development and merit budget allocation, we help companies optimize investments in their most important resource - people.
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More cost-effective talent acquisition and employee performance management programs. We believe that our solutions increase the cost-effectiveness of talent acquisition and employee performance management programs in three ways. First, our solutions automate these activities, enabling organizations to maintain smaller HR departments and eliminate some third-party services. Second, our solutions enable organizations to more effectively identify high-potential candidates and retain qualified employees. Third, our solutions provide management the opportunity to achieve economies of scale by outsourcing non-core functions while also ensuring the application of best HR practices and leading technology to these functions.
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Application of analytics to talent acquisition and employee performance management programs. Our solutions enable organizations to use the data generated by their talent acquisition and employee performance management programs in order to improve these programs. Specifically, our solutions enable management to identify overall trends that could improve the efficiency and effectiveness of their processes. For example, we enable our customers to identify their most productive recruiting channels, establish criteria indicative of success in various roles and identify problems that could lead to employee turnover.
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Ease of integration, configuration and deployment. We provide the software applications that form the core of our solutions on an on-demand basis, eliminating the material expenses and complexity of traditionally purchased and deployed software applications. We combine this deployment model with an intuitive user interface to facilitate rapid and widespread adoption within the HR department. Our solutions are designed for ease of use by non-technical staffing professionals, managers, candidates and employees. We believe that these aspects of our solutions enable organizations to quickly achieve the anticipated benefits.
Our Strategy
Our objective is to be the leading global provider of human capital management business solutions for global organizations with more than 2,000 employees. Key elements of our strategy include:
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Focus on strategic talent management solutions. Unlike some vendors that provide broad suites of HR administrative software, we have focused on the strategic HR functions that have the greatest potential to build and improve the workforces of our customers. We believe that this focus has enabled us to deliver solutions that meet the unique needs of our customers in these areas. We also believe that this focus has helped us to generate an increasingly recognized brand in these markets, which are expected to grow at a materially faster rate than the broader Human Capital Management (HCM) market over the next five years. We intend to continue to broaden our footprint in the integrated talent management space in order to leverage our increasingly recognized brand in these markets and these positive market dynamics.
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Provide innovative and industry-specific solutions to our customers. During the past three years, we have introduced several new solutions, each in response to the unique needs of the market and our customers. We intend to continue to work closely with our key customers to further develop innovative solutions that increase the effectiveness of their recruiting programs and contribute to greater employee retention and productivity. We have also introduced specific solutions for the following vertical industries: financial services and banking, manufacturing, life sciences, biotechnology and pharmaceuticals, retail, government, healthcare, hospitality, call centers, and education. We intend to develop specific solutions for additional vertical industries.
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Cross-sell additional solutions and further penetrate current customers. During the year ended December 31, 2010, our customers renewed approximately 84% of their contracts which represents 88% of the aggregate value of multi-year subscriptions for our on-demand talent acquisition and performance management solution contracts subject to renewal. This renewal rate provides us with a strong base of recurring revenue. We believe that our strong customer relationships provide us with a meaningful opportunity to cross-sell additional solutions to our existing customers and to achieve greater penetration within an organization. We expect to continue to create innovative programs designed to provide our employees with strong incentives to maximize the value we provide to each of our customers.
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Continue to leverage our global sourcing strategy to provide quality solutions efficiently and deliver solutions from low cost centers of excellence. We established offices in Hyderabad, India in 2003. In January 2008, we completed construction and opened our facility in Vizag, India. We currently have approximately 337 employees working in our offices in Hyderabad and Vizag. We also have approximately 54 employees working in our Argentina office and 44 employees in our Poland office. We believe our sourcing strategy will continue to provide significant benefits to our customers including cost benefits and year round customer service, 24 hours a day, 7 days a week.
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Expand our global presence and customer base. For the year ended December 31, 2010, our global presence includes more than 34 offices in over 20 countries. Although our primary focus has been on the U.S. market, our solutions are also well suited to addressing problems faced by organizations outside the United States. In the future, we intend to expand our distribution efforts in Europe, Latin America, the Middle East and the Asia/Pacific region. Although we have employed a direct sales force in the United States, we intend to expand our international distribution through strategic partnerships. We believe that pursuing a channel strategy enables us to limit the costs associated with international expansion and acknowledges that different geographies present different cultural challenges best addressed by a local sales force.
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Pursue complementary acquisitions. We have completed 30 acquisitions of businesses since 1994. These acquisitions have helped us to adapt our business to the evolving needs of our customers. We believe that the HCM market is significantly fragmented. Many competing companies have strong technology or vertical market expertise but lack the scale to compete with the industry leaders in the long term. We continue to identify similarly situated companies that we believe could broaden the functionality and strength of our existing solutions.
Our Products and Services
We offer unified business solutions that support hiring, retention and performance management for the entire employee lifecycle.
Talent Acquisition Solutions:
Recruitment Technology
We provide complete Recruitment Technology systems for the largest, most complex organizations in the world. Our web-based technology provides everything organizations need to locate and track talented candidates as they move through the hiring process. Built using cutting-edge technologies, our Recruitment Technology solutions deliver comprehensive support of recruiting processes, giving companies visibility and access to critical hiring and retention data.
Onboarding
Our Onboarding solution is built on the belief that every new employee needs to have the right information to be effective. Our solution offers form management for legal documents, workflow and electronic signatures. We help companies extend a positive brand impression through ongoing communication and socialization that reinforces their culture and business practices. This helps organizations reduce the amount of time it takes employees to be fully competent in their jobs-increasing productivity and return on investment as well as providing an auditable on-boarding process.
Employee Assessments
We offer Employee Assessments that help organizations select and retain top performers based on seven key areas that predict individual performance and potential-experience, skills, abilities, personality, motivation, situational judgment and culture fit. Our tools are delivered in the most usable formats-online, interviews and assessment centers. All of our solutions can be used as standalone systems or easily integrated with the quality and efficiency of recruiting and selection processes. They allow organizations to make better hiring and promotion decisions, and ensure that employees are a perfect fit in the organization’s culture.
Skills Tests
We offer skills tests that improve the screening process by helping organizations quickly identify and select the most talented candidates. Easy-to-use and administer, Kenexa Prove It!® System offers more than 1,000 validated assessments for specific job classifications, including software, office/professional, call center, financial, healthcare, industrial, legal and technical positions. Test results are received instantly-ideal for selecting candidates in a fast-paced, competitive environment.
Structured Interviews
We offer structured interviews that assess candidates with greater accuracy, objectivity and consistency, while improving the fit of new hires within each organization's culture. Kenexa Interview Builder® System provides a powerful online structured interview reference library of more than 3,000 questions that increase interviewer confidence, efficiency, accuracy and defensibility. With the ability to custom select behavioral, situational, attitudinal and job knowledge questions, Interview Builder encourages candidates to speak freely about their experiences and provides a broad spectrum of job analysis tools, job description templates, interview guides and competency profiles.
Employment Branding
Our Employment Branding offering applies the same consumer branding principles of attracting and retaining customers to attracting and retaining top employees. It’s a practice built on research that uncovers the strengths, weaknesses and hidden elements of an organization’s culture. Employment Branding integrates seamlessly with every Kenexa solution to create award-winning recruitment campaigns, provide candidates with an engaging career site experience, uncover the right media mix for sourcing, give insight into employee engagement and help retain top performers.
Recruitment Process Outsourcing (“RPO”)
Our RPO offering delivers a higher quality of candidate, fast. With operations around the globe, we use technology and human ability to reach highly qualified candidates and deliver them real-time to recruiters. We understand organizations need us to provide better recruiting for less, and use our global resources to drive cost savings and improve their workforces. Kenexa’s RPO offering provides global recruitment services for the largest companies in the world.
Talent Retention Solutions:
Performance Management
We offer comprehensive Performance Management solutions that integrate performance management, compensation management, career development, goal alignment and succession planning. Our solutions enable companies to increase productivity, streamline processes, increase accountability and enhance employee engagement.
Employee Surveys
We deliver Employee Surveys that provide the measurements needed to further each organization and improve business outcomes. With the industry’s best psychologists and top HR experts, we believe we are the proven leader in survey design, administration, reporting and behavior change. Our depth of experience, proven track record, high client retention rate, industry leading normative data and global footprint make us unique. Our tools and technology are intuitive and customized for each organization, making them easy for survey champions, employees and managers to use.
Learning Management
Our Learning Management solution enables organizations to deliver and track employee learning. Our system is ideal for all types of training, including skills and behavioral learning, new-hire orientation, leadership education and sales training. We help companies tailor the delivery of learning management processes by division, business unit and geography.
Leadership Solutions
We understand that leadership development efforts are not universal-they must be tailored to each organization’s specific metrics and processes. Our Leadership Solutions are designed to address core business needs by increasing the quality of leadership in organizations. We offer Leadership Audit, Leadership Assessments and Leadership Development solutions that align with each company’s business strategies to help drive greater organizational performance and success.
Compensation
Our ComAnalyst® suite of compensation management solutions is designed for use by compensation professionals to ensure that our costumers are offering pay packages that are both externally competitive and internally equitable. CompAnalyst® is built around a core data set of employer-reported market data that is benchmarked and mapped for jobs held by a majority of U.S. employees. Our compensation products allow our global customers on-demand acces to various applications and modules that provide a complete source of data to value jobs, particpate in surveys and analyze pay competitiveness.
Consumer
Our consumer solutions provide individuals with compensation-focused tools and content to help advance their careers. Products consist of free-to-user applications as well as premium products that are sold directly to individuals visiting the Salary.com® website.
Technology, Development and Operations
Technology
We believe that the current market desires integrated talent management solutions that deliver a high degree of business value by linking human capital management solutions more directly to business outcomes. Available in a Software as a Service (SaaS) context, extending a customer’s enterprise, this technology must be easy to use and inexpensive to configure and integrate with the customer enterprise. Our solutions deliver this value by meeting the diverse needs of key stakeholders (Executives, HR, line managers, and employees), by supporting enterprise processes, and by integrating seamlessly with a wide variety of internal and third party applications and services.
Kenexa’s technology strategy focuses on the following areas: i) continued roadmap developments enhancing our products, ii) continued adoption of common services, and iii) continued development of modules on the 2x platform™. Common Services and the Kenexa 2x Products™ include:
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Common Services. Kenexa utilizes a Service Oriented Architecture (SOA) to integrate its applications to other applications, vendors and customers. These common services also include application functionality that can be leveraged across multiple Kenexa applications, enables extension of best-of-breed capabilities, and drives rapid code deployment across applications. The benefit to Kenexa customers is that it enables us to bridge current applications with future needs, and better meet the diverse needs of our customer base.
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Kenexa 2x Products™. This solution set is a Software as a Service (SaaS) and represents the next generation of Kenexa development, via a fully integrated talent management application on a unified data model, security infrastructure, and user experience, with a competency based universal talent record that enables organizations to aggregate all talent data across the enterprise and spanning entire employee life cycles. Kenexa 2x has been architected to use Common Services for various functions and to integrate with Kenexa 2x BrassRing® category applications.
This strategy enables us to meet the needs of our current customer base while developing and deploying future capabilities with little to no customer impact, and thus delivers a high degree of customer care while bringing innovative solutions to market.
Our software is designed to support easy-to-use features such as dynamic workflows, job templates and user configuration that enable customers to adapt the application for their specific requirements. Dynamic workflows are designs that facilitate business processes whereby one step in the process cannot be completed until all prior steps have been completed.
Development
Innovation is an important part of our business. We believe that three primary factors drive our innovation: our employees, our domain experts and our customers. We have a formalized system to cultivate participation from all of our employees in research and development. We also leverage the experience of our research scholars and domain experts, who produce white papers, case studies and thought pieces which form the foundation for our innovation. Our research and development team maintains a repository of ideas, and selected ideas are presented to the market validation team. Market validated ideas progress to the prototype stage. The executive team reviews prototypes and selects those with the highest potential, which then enter the product development phase. In addition to our employees and domain experts, some of the key ideas are generated from customer feedback gathered during user group meetings, customer symposiums, and advisory councils.
We follow a development methodology that we believe allows us to develop projects quickly and then proceed on a predictable, low risk path for high-quality results. We conduct our product development through our global development teams. We are in the process of transitioning from being an ISO 9001:2000 certified organization to the Capability Maturity Model Integration (CMMI) approach. We intend to seek CMMI certification in the coming years.
Operations
Recognizing that socio-political drivers require data to be regionally located and managed, Kenexa’s hosting strategy provides regional data centers. Our data centers in Sterling, Virginia and Blanchardstown, Ireland serve as our hosting facilities for our on-demand solutions. Kenexa is scheduled to open its Shanghai, China hosting facility in late 2011 or early 2012. We also have data centers in Massachusetts, Pennsylvania, Nebraska, England, and India. We seek to adhere to industry standards and best practices in our global operations. Our goal is to deliver world-class hosted solutions that are highly available, scalable and reliable across our suite of Talent Management solutions. We believe that we offer best-in-industry security to our customers and demonstrate this through a number of security related certifications including CyberTrust Enterprise, CyberTrust Application, TRUSTe, and SafeHarbor. We seek to deliver quality service with service level guarantees to customers.
Our Hosting Operations and Security teams include multiple Certified Information Systems Security Professionals, or CISSPs, with training in the latest security and availability threats. Our data centers are continuously and proactively monitored by a comprehensive set of tools, personnel, as well as partnering with a third party intrusion detection vendor, 24 hours a day, 7 days a week. Our hosted data center has built-in power redundancy from multiple power grids with uninterrupted power supplies backed up by N+1 diesel generators designed to provide uninterrupted service to our customers. The hosted infrastructure is designed with a focus on quality, reliability, scalability, privacy and security.
Intellectual Property
Our intellectual property rights are important to our business. We rely on a combination of patents, copyright, trade secret, trademark and other common laws in the United States and other jurisdictions, as well as confidentiality procedures, systems and contractual provisions to protect our proprietary technology, processes and other intellectual property.
Although we rely on patents, copyright, trade secret and trademark law, written agreements and common law, we believe that the following factors are more essential to establishing and maintaining a competitive advantage:
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the technological skills of our research and development personnel;
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the domain expertise of our consultants and outsourcing service professionals;
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frequent enhancements to our solutions;
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continued expansion of our proprietary content; and
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high levels of customer service.
Others may develop products that are similar to our technology. We generally enter into confidentiality and other written agreements with our employees and partners, and through these and other written agreements, we attempt to control access to and distribution of our software, documentation and other proprietary technology and other information. However, despite our efforts to protect our proprietary rights, third parties may, in an unauthorized manner, attempt to use, copy or otherwise obtain and market or distribute our intellectual property rights or technology or otherwise develop a product with the same functionality as our software. Policing unauthorized use of our software and intellectual property rights is difficult, and nearly impossible on a worldwide basis. Therefore, we cannot be certain that the steps we have taken or will take in the future will prevent misappropriation of our technology or intellectual property rights, particularly in foreign countries where we do business or where our software is sold or used, where the laws may not protect proprietary rights as fully as do the laws of the United States or where enforcement of such laws is not common or effective.
Substantial litigation regarding intellectual property rights exists in the software industry. From time to time, in the ordinary course of our business, we are subject to claims relating to our intellectual property rights or those of others, and we expect that third parties may commence legal proceedings or otherwise assert intellectual property claims against us in the future, particularly as we expand the complexity and scope of our business, the number of similar products increases and the functionality of these products further overlap. We cannot be certain that no third party intellectual property rights that exist could result in a claim against us in the future. These actual and potential claims and any resulting litigation could subject us to significant liability for damages. In addition, even if we prevail, litigation could be time consuming and expensive to defend and could affect our business materially and adversely. Any claims or litigation from third parties may also limit our ability to use various business processes, software and hardware, other systems, technologies or intellectual property subject to these claims or litigation, unless we enter into license agreements with the third parties. However, these agreements may be unavailable on commercially reasonable terms or not available at all.
Sales and Marketing
Our target customers are large and medium-sized organizations with complex talent acquisition and employee performance management needs. We sell our solutions to both new and existing customers primarily through our direct sales force, which is comprised of inside sales, telesales and field sales personnel. Our marketing strategy focuses on building Kenexa’s value proposition in the marketplace, increasing the productivity of our sales engine and establishing relationships with industry influencers.
We believe that our customer relationships provide us with a meaningful opportunity to cross-sell additional solutions to our existing customers and to achieve greater penetration within the organizations. We have established a program intended to increase cross-selling into our largest customers, and we expect to continue to create innovative programs designed to incent our employees and maximize the value we provide to each of our customers.
Our marketing initiatives are generally targeted toward specific vertical industries or specific solutions. Our marketing programs primarily consist of:
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participation in and sponsorship of conferences, symposiums, regional user groups, networks, tradeshows and industry events;
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direct marketing campaigns;
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advertising in online media outlets, trade and mainstream publications;
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creation of white papers, case studies, sales materials and thought leadership papers;
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leveraging our website to provide product and company information, podcasts, social media forums, and resources to professionals;
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focusing public relations efforts on building and enhancing our brand in the marketplace; and
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expanding our international distribution through strategic partnerships.
Competition
We have experienced, and expect to continue to experience, intense competition from a number of companies. We compete with niche point solution vendors, some of whom are privately held, such as Peopleclick Authoria, iCIMS, Inc., Global Innovation Corp, Kronos, Pilat HR Solutions, Inc., Previsor, Inc., SHL Group plc, SuccessFactors, Inc., and Taleo Corporation, which offer products that compete with one or more applications in our suite of solutions. In some aspects of our business, we also compete with established vendors of enterprise resource planning software with much greater resources, such as Oracle Corporation (PeopleSoft), SAP AG and Lawson, Inc. To a lesser extent, we compete with vendors of recruitment process outsourcing services and survey services, including Accolo, Inc., Alexander Mann Solutions, The Right Thing and survey services such as The Gallup Organization. We believe the principal competitive factors in our industry include:
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solution breadth and functionality;
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ease of deployment, integration and configuration;
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domain expertise;
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industry-specific expertise;
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service support, including consulting services and outsourcing services;
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solution price;
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breadth of sales infrastructure; and
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breadth of customer support.
We believe that we generally compete favorably with respect to these factors.
We may face future competition in the talent acquisition and employee performance management market from large, established companies, such as Oracle and SAP, as well as from emerging companies. Barriers to entry into our industry are relatively low, new software products are frequently introduced and existing products are continually enhanced. In addition, we expect that there is likely to be consolidation in our industry, which could lead to increased price competition and other forms of competition. Established companies not only may develop their own competitive products, but may also acquire or establish cooperative relationships with current or future competitors, including cooperative relationships between both larger, established and smaller public and private companies.
In addition, our ability to sell our solutions will depend, in part, on the compatibility of our software with software provided by our competitors. Our competitors could alter their products so that they will no longer be compatible with our software or they could deny or delay access by us to advance software releases, which would limit our ability to adapt our software to these new releases. If our competitors were to bundle their products in this manner or make their products non-compatible with ours, our ability to sell our solutions might be harmed which could reduce our gross margins and operating income.
Securities and Exchange Commission Filings
We file annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K and other information with the SEC. Members of the public may read and copy materials that we file with the SEC at the SEC’s Public Reference Room at 100 F Street, N.E., Washington, D.C. 20549. Members of the public may also obtain information on the Public Reference Room by calling the SEC at 1-800-732-0330. The SEC also maintains an Internet web site that contains reports, proxy and information statements and other information regarding issuers, including us, that file electronically with the SEC. The address of that site is www.sec.gov. Our annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K and other information filed by us with the SEC are available, without charge, on our Internet web site, www.kenexa.com as soon as reasonably practicable after they are filed electronically with the SEC.
ITEM 1A.
ITEM 1A.
Risk Factors
We operate in a market environment that involves significant risks, many of which are beyond our control. The following risk factors may adversely impact our results of operations, cash flows and the market price of our common stock. Although we believe that we have identified and discussed below the key risk factors affecting our business, there may be additional risks and uncertainties that are not presently known or that are not currently believed to be significant that may adversely affect our performance or financial condition.
Our business will suffer if our existing customers terminate or do not renew their software subscriptions.
We expect to continue to derive a significant portion of our revenue from renewals of subscriptions for our talent acquisition and employee performance management solutions. Our customers renewed 84% and 80% of their contracts for each of the years ended December 31, 2010 and 2009, respectively which represented 88% of the aggregate value of multi-year subscriptions for our on-demand talent acquisition and performance management solution contracts up for renewal for each of those years., Historically our customers have renewed in excess of 90% of their subscriptions with us. If our customers terminate their agreements, fail to renew their agreements, renew their agreements upon less favorable terms to us, defer existing agreements or fail to purchase new solutions from us, our revenue may decline or our future revenue growth may be constrained.
Maintaining the renewal rate of our existing subscriptions is critical to our future success. Factors that may affect the renewal rate for our solutions include:
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the price, performance and functionality of our solutions;
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the availability, price, performance and functionality of competing products and services;
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the effectiveness of our support services;
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our ability to develop complementary products and services;
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the willingness of our customers to continue to invest their resources in our solutions in light of other demands on those resources; and
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the macroeconomic environment.
Most of our existing customers have entered into subscription agreements with us that expire between one and three years from the initial contract date. Our customers have the right to terminate their contracts under certain circumstances and are not obligated to renew their subscriptions for our solutions after the expiration of the initial terms of their subscription agreements. In addition, our customers may negotiate terms which are less favorable to us upon renewal, or may request that we license our software to them on a perpetual basis, which may reduce recurring revenue from these customers. For example, some of our RPO customers restructured their RPO agreements with us during 2009, in the midst of the economic downturn, to decrease the amount of fixed fee services and increase the amount of variable fee services provided pursuant to the agreement. Our future success also depends in part on our ability to sell new solutions to our existing customers.
If the unemployment rate increases or fails to materially decrease, our business may be harmed.
Demand for our solutions depends in part on our customers’ ability to hire and retain their employees. According to the U.S. Bureau of Labor Statistics, the U.S. unemployment rate in February 2011 was 8.9%. It is unknown whether unemployment will decrease, increase, or remain constant throughout 2011 and beyond as a result of the general downturn in macroeconomic conditions in the U.S. and globally. If the unemployment rate increases our existing and potential new customers may no longer consider improvement of their talent acquisition and employee performance management systems to be a necessity and may have less of a need to hire and retain employees, which could have a material adverse effect on our business, results of operations and financial condition.
If we fail to adequately protect our proprietary rights, our competitive advantage could be impaired, and we may lose valuable assets, experience reduced revenue and incur costly litigation to protect our rights.
Our intellectual property rights are important to our business, and our success is dependent, in part, on protecting our proprietary software and technology and our brand, marks and domain names. We rely on a combination of patent, copyright, trademark, trade secret and other common laws in the United States and other jurisdictions as well as confidentiality procedures and contractual provisions to protect our proprietary technology, processes and other intellectual property. It may be possible for unauthorized third parties to copy our software and use information that we regard as proprietary to create products and services that compete with ours, which could harm our competitive position and cause our revenue to decline.
We have six issued patents and nine pending patent applications. There is no guarantee that the U.S. Patent and Trademark Office will grant these patents, or do so in a manner that gives us the protection that we seek. We will not be able to protect our intellectual property if we are unable to enforce our rights or if we do not detect promptly unauthorized use of our intellectual property. Existing intellectual property laws only afford limited protection.
To the extent that we expand our international activities, our exposure to unauthorized copying and use of our software and proprietary information may increase despite procedures and systems that control information access. Some license provisions protecting against unauthorized use, copying, transfer and disclosure of our licensed products may be unenforceable under the laws of certain jurisdictions and foreign countries in which we operate. Further, the laws of some countries, and in particular India, where we develop much of our intellectual property, do not protect proprietary rights to the same extent as the laws of the United States. For example, companies seeking to enforce proprietary rights in India can experience substantial delays in prosecuting trademarks and in opposition proceedings.
Litigation may be necessary in the future to enforce our intellectual property rights and to protect our trade secrets. Litigation, whether successful or unsuccessful, could result in substantial costs and diversion of management resources, either of which could seriously harm our business. In the event that we are unable to protect our intellectual property rights, especially those rights that we develop in India, our business would be materially and adversely affected.
Reductions in information technology spending could limit our ability to grow our business.
Our operating results may vary based on changes in the information technology spending of our customers. The revenue growth and profitability of our business depend on the overall demand for enterprise application software and services. We sell our solutions primarily to large organizations whose businesses fluctuate with general economic and business conditions. Historically, corporate information technology spending has been one of the first costs that businesses cut, especially during economic downturns. Software for talent acquisition and employee performance management software may be viewed by some of our existing and potential customers as a lower priority and may be among the first expenditures reduced, especially during unfavorable economic conditions. As a result, potential customers may decide to reduce their information technology budgets by deferring or reconsidering product purchases, which would negatively impact our operating results.
Because we recognize revenue from the sale of our solutions ratably over the term of the subscription period, a significant downturn in our business may not be immediately reflected in our operating results.
A decline in new or renewed subscriptions in any one quarter may not impact our financial performance in that quarter, but will negatively affect our revenue in future quarters. If a number of contracts expire and are not renewed in the same quarter, our revenue could decline significantly in that quarter and in subsequent quarters.
For the years ended December 31, 2010, 2009 and 2008, we derived approximately 78.8%, 84.9% and 80.2%, respectively, of our total revenue, from the sale of subscriptions for our solutions and expect that a significant portion of our revenue for the foreseeable future will be derived from those subscriptions. We recognize the associated revenue ratably over the term of the subscription agreement, which is typically between one and three years. As a result, a significant portion of the revenue that we report in each quarter reflects the recognition of deferred revenue from subscription agreements entered into during previous periods. Accordingly, the effect of significant declines in sales and market acceptance of our solutions may not be reflected in our short-term results of operations, making our results less indicative of our future prospects.
Historically, our customers have renewed more than 90% of the aggregate value of multi-year subscriptions for our on-demand talent acquisition and performance management solution contracts subject to renewal. However, our customers renewed 84% and 80% of their contracts for each of the years ended December 31, 2010 and 2009, respectively which represented 88% of the aggregate value of multi-year subscriptions for our on-demand talent acquisition and performance management solution contracts up for renewal for each of those years. We cannot assure you that our renewal rate will return to its historical levels, or that it will not decrease.
If our revenue does not meet our expectations, we may not be able to curtail our spending quickly enough and our cost of revenue, compensation and benefits, and product development would increase as a percentage of revenue. Our subscription model also makes it difficult for us to rapidly increase our revenue through additional sales in any one period, as revenue from new customers is recognized over the applicable subscription term
Our revenue is highly susceptible to changes in general economic conditions, and a recession or other downturn in the U.S. economy, or in any geographic market in which we provide services, could substantially impact sales of our services and overall results of operations.
Our operating results may vary based on changes in the information technology spending of our customers. The revenue growth and profitability of our business depend on the overall demand for enterprise application software and services. We sell our solutions primarily to large organizations whose businesses fluctuate with general economic and business conditions. Our customers may reevaluate their expenditures on enterprise application software and services, and in particular talent acquisition and employee performance management solutions, especially given the recent financial crisis in today's economic environment, which could cause them to cancel all or any portion of our services or delay the payment of their bills for services previously performed by us. As a result, in the event of a prolonged recession or even a less severe downturn in general economic conditions, our results of operations could be negatively impacted as a result of decreased demand for enterprise application software and services, and in particular talent acquisition and employee performance management solutions, and the impact could be more pronounced for us than for those businesses that deliver products or services that customers deem to be a higher priority. In particular, software for talent acquisition and employee performance management software may be viewed by some of our existing and potential customers as a lower priority and may be among the first expenditures reduced as a result of unfavorable economic conditions. As a result, potential customers may decide to reduce their information technology budgets by deferring or reconsidering product purchases, which would negatively impact our operating results. In addition, volatility and disruption of financial markets could limit our customers’ ability to obtain adequate financing or credit to purchase and pay for our services in a timely manner, or to maintain operations, and result in a decrease in demand for our services that could have a negative impact on our overall results of operations.
Our financial performance may be difficult to forecast as a result of our focus on large customers and the long sales cycle associated with our solutions.
Our sales cycles are generally up to nine months and in some cases even longer. This long sales cycle impedes our ability to accurately forecast the timing of sales in a given period which could adversely affect our ability to meet our forecasts for that period. We focus our sales efforts principally on large organizations with complex talent acquisition and employee performance management requirements. Accordingly, in any single quarter the majority of our revenue from sales to new customers may be composed of large sales made to a relatively small number of customers. Our failure to close a sale in any particular quarter may impede revenue growth until the sale closes, if at all. As a result, substantial time and cost may be spent attempting to close a sale that may not be successful. The period between an initial sales contact and a contract signing is relatively long due to several factors, including:
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the need to educate potential customers about the uses and benefits of our solutions and the on-demand delivery model;
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the discretionary nature of our customers’ purchase and budget cycles;
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the competitive evaluation of our solutions;
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fluctuations in the talent acquisition and employee performance management requirements of our prospective customers;
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potential economic downturns and reductions in corporate IT spending;
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announcements or planned introductions of new products or services by us or our competitors; and
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the lengthy purchasing approval processes of our prospective customers.
If our efforts to attract new customers or to sell additional solutions to our existing customers are not successful, our revenue growth will be adversely affected.
To increase our revenue, we must continually add new customers and sell additional solutions to existing customers. If our existing and prospective customers do not perceive our solutions to be of sufficiently high value and quality, we may not be able to attract new customers or to increase sales to existing customers. Our ability to attract new customers and to sell new solutions to existing customers will depend in large part on the success of our sales and marketing efforts. However, our existing and prospective customers may not be familiar with some of our solutions, or may have traditionally used other products and services for some of their talent acquisition and employee performance management requirements. Our existing and prospective customers may develop their own solutions to address their talent acquisition and employee performance management requirements, purchase competitive product offerings or engage third-party providers of outsourced talent acquisition and employee performance management services. These sales challenges may require us to increase our investment in sales efforts, including by hiring additional employees and expanding upon our existing training for our sales force; if we incur these additional costs without achieving a corresponding increase in sales to new and existing customers, then our results of operations may be adversely affected. Additionally, some customers may require that we license our software to them on a perpetual basis or that we allow them the contractual right to convert from a term license to a perpetual license during the contract term, which may reduce recurring revenue from these customers.
Our quarterly operating results may fluctuate significantly, and these fluctuations may cause our stock price to fall.
As a result of fluctuations in our revenue and operating expenses, our quarterly operating results may vary significantly. We may not be able to curtail our spending quickly enough if our revenue falls short of our expectations. We expect that our operating expenses will increase substantially in the future as we expand our selling and marketing activities, increase our new product development efforts and hire additional personnel. Our operating results may fluctuate in the future as a result of the factors described below:
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our ability to renew and increase subscriptions sold to existing customers, attract new customers, cross-sell our solutions and satisfy our customers’ requirements;
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changes in our pricing policies;
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the introduction of new features to our solutions;
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the rate of expansion and effectiveness of our sales force;
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the length of the sales cycle for our solutions;
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new product and service introductions by our competitors;
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concentration of marketing expenses for activities, such as trade shows and advertising campaigns;
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concentration of research and development costs; and
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concentration of expenses associated with commissions earned on sales of subscriptions for our solutions.
We believe that period-to-period comparisons of our results of operations are not necessarily meaningful as our future revenue and results of operations may vary substantially. It is also possible that in future quarters our results of operations will be below the expectations of securities market analysts and investors. In either case, the price of our common stock could decline, possibly materially.
Our business may not continue to grow if the markets for our products do not continue to grow.
Our growth is dependent upon the continued adoption of on-demand software as a key mechanism for delivering solutions in these markets. The rapidly evolving nature of this market reduces our ability to accurately evaluate our future prospects and forecast quarterly or annual performance. The adoption of on-demand talent acquisition and employee performance management solutions, particularly among organizations that have relied upon traditional software applications, requires the acceptance of a new way of conducting business and exchanging and compiling information. Because these markets are new and evolving, it is difficult to predict with any assurance the future growth rate and size of these markets which, in comparison with the overall market for enterprise software applications, is relatively small.
Interruptions or delays in service from our Web hosting facilities could impair the delivery of our service and harm our business.
We provide and manage our service through computer hardware and software that is currently located in a Qwest Web hosting facility in Sterling, VA USA and ServeCentric facility in Blanchardstown, Ireland. All Web hosting facilities are vulnerable to damage or interruption from earthquakes, floods, fires, power loss, telecommunications failures and similar events. Despite security including continuous guards, dedicated cages, etc., these facilities are also subject to break-ins, sabotage, intentional acts of terrorism, vandalism and similar misconduct. Despite precautions that we take at these facilities, the occurrence of a natural disaster, act of terrorism or other unanticipated problem at any of these facilities could result in lengthy interruptions in our service. Interruptions in our service may reduce our revenue, cause us to issue credits or pay penalties, cause customers to terminate their subscriptions and adversely affect our renewal rates. Our business will be harmed if our customers and potential customers believe our service is unreliable or if our Disaster Recovery Plan (DRP) fails to provide adequate disaster recovery capabilities.
If our security measures are breached and unauthorized access is obtained to customer data, we may incur liabilities and customers may curtail or stop their use of our solutions, which would harm our business, operating results and financial condition.
Our solutions involve the storage and transmission of confidential information of customers and their existing and potential employees, and security breaches could expose us to a risk of loss of, or unauthorized access to, this information, resulting in possible litigation and possible liability. Although we have never sustained such a breach, if our security measures were ever breached as a result of third-party action, employee error, malfeasance or otherwise, and, as a result, an unauthorized party obtained access to this confidential data, our reputation could be damaged, our business may suffer and we could incur significant liability. Techniques used to obtain unauthorized access or to sabotage systems change frequently and generally are not discovered until launched against a target. As a result, we may be unable to anticipate these techniques or to implement adequate preventative measures. If an actual or perceived breach of our security occurs, the market perception of our security measures could be harmed and we could lose sales and customers.
If we fail to develop or acquire new products or enhance our existing solutions to meet the needs of our existing and future customers, our revenue may decline.
To remain competitive, we must continually improve and enhance the responsiveness, functionality and features of our existing solutions and develop new solutions that address the talent acquisition and employee performance management requirements of organizations. If we are unable to successfully develop or acquire new solutions or enhance our existing solutions, our revenue may decline and our business and operating results will be adversely affected. If we do not succeed in developing or introducing new or enhanced solutions in a timely manner, they may not achieve the market acceptance necessary to generate significant revenue.
In addition, evolving technology may enable new deployment mechanisms that make our on-demand business model obsolete. To the extent that we are not successful in continuing to develop our solutions in correlation with evolving technology, we may not be successful in establishing or maintaining our customer relationships.
Releases of new solutions and enhancements to existing solutions may cause purchasing delays, which would harm our revenue.
Our practice and the practice in the industry in which we compete is to regularly develop and release new solutions and enhancements to existing solutions. As a result, our future success could be hindered by delays in our introduction of new solutions and/or enhancements of existing solutions, delays in market acceptance of new solutions and/or enhancements of existing solutions, and our, or our competitors’, announcement of new solutions and/or solution enhancements or technologies that could replace or shorten the life cycle of our existing solutions. In addition, clients may delay their purchasing decisions in anticipation of our new or enhanced solutions or new or enhanced solutions of our competitors. Delays in client purchasing decisions could seriously harm our business and operating results. Moreover, significant delays in the general availability of new releases or client dissatisfaction with new releases could have a material adverse effect on our business, results of operations, cash flow and financial condition.
We may not receive significant revenue as a result of our current research and development efforts.
Developing and localizing software is expensive and the investment in product development often involves a long payback cycle. We have made and expect to continue to make significant investments in software research and development and related product opportunities. Accelerated product introductions and short product life cycles require high levels of expenditures for research and development that could adversely affect our operating results if not offset by corresponding revenue increases. We believe that we must continue to dedicate a significant amount of resources to our research and development efforts to maintain our competitive position. However, it is difficult to estimate when, if ever, we will receive significant revenue as a result of these investments.
The use of open source software in our solutions may expose us to additional risks and harm our intellectual property.
Some of our solutions use or incorporate software components that are subject to one or more open source licenses. Open source software is typically freely accessible, usable and modifiable. Certain open source software licenses require a user who intends to distribute the open source software as a component of the user’s software to disclose publicly part or all of the source code in the user’s software. In addition, certain open source software licenses require the user of such software to make any derivative works of the open source code available to others on unfavorable terms or at no cost. This can subject previously proprietary software to open source license terms.
While we monitor the use of all open source software in our solutions, processes and technology and try to ensure that no open source software is used in such a way as to require us to disclose the source code to the related product or solution when we do not wish to do so, such use could inadvertently occur. Additionally, if a third-party software provider has incorporated certain types of open source software into software we license from such third party for our solutions, we could, under certain circumstances, be required to disclose the source code to our solutions. This could harm our intellectual property position and have a material adverse effect on our business, results of operations and financial condition.
Our ability to license our software is highly dependent on the quality of our services offerings, and our failure to offer high quality services could adversely affect our subscription revenue and results of operations.
Once our software has been implemented and deployed, our customers depend on us to provide them with ongoing support and resolution of issues relating to our software. Therefore, a high level of service is critical for the continued marketing and sale of our solutions. If we do not efficiently and effectively implement and deploy our software products, or succeed in helping our customers quickly resolve post-deployment issues, our ability to sell software products to these customers would be adversely affected and our reputation in the marketplace and with potential customers could suffer.
If we encounter barriers to the integration of our software or services with software provided by our competitors or with the software used by our customers, our revenue may decline and our research and development expenses may increase.
In some cases our software or services may need to be integrated with software provided by our competitors. These competitors could alter their products in ways that inhibit integration with our software, or they could deny or delay access by us to such software releases, which would restrict our ability to provide our services or adapt our software to facilitate integration with this software and could result in lost sales opportunities. In addition, our software is designed to be compatible with the most common third-party ERP systems. If the design of these ERP systems changes, integration of our software with new systems would require significant work and substantial allocation of our time and resources and increase our research and development expenses.
Material defects or errors in our software could affect our reputation, result in significant costs to us and impair our ability to sell our solutions, which would harm our business.
The software applications forming part of our solutions may contain material defects or errors, which could materially and adversely affect our reputation, result in significant costs to us and impair our ability to sell our solutions in the future. The costs incurred in correcting any material product defects or errors may be substantial and would adversely affect our operating results. After the release of our products, defects or errors may also be identified from time to time by our internal team and by our customers. Such defects or errors may occur in the future. Any defects that cause interruptions to the availability of our solutions could result in:
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lost or delayed market acceptance and sales of our solutions;
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loss of customers;
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product liability suits against us;
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diversion of development resources;
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injury to our reputation; and
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increased maintenance and warranty costs.
If we are unable to compete effectively with companies offering enterprise talent acquisition and employee performance management solutions, our revenue may decline.
We may not have the resources or expertise to compete successfully in the future. If we are unable to successfully compete, we could lose existing customers, fail to attract new customers and our revenue would decline. The talent acquisition and employee performance management solutions markets are rapidly evolving and highly competitive, and we expect competition in these markets to persist and intensify. Barriers to entry into our industry are low, new software products are frequently introduced and existing products are continually enhanced. We compete with niche point solution vendors such as PeopleClick Authoria, iCIMS, Inc., Global Innovation Corp, Kronos Incorporated, Pilat HR Solutions, Inc., Previsor, Inc., SHL Group plc, SuccessFactors, Inc., and Taleo Corporation that offer products that compete with one or more applications contained in our solutions. In some aspects of our business, we also compete with established vendors of enterprise resource planning, or ERP, software with much greater resources, such as Oracle Corporation (PeopleSoft), SAP AG and Lawson, Inc. To a lesser extent, we compete with vendors of recruitment process outsourcing services, including Accolo, Inc., Alexander Mann Solutions, The Right Thing, and survey services such as The Gallup Organization. In addition, many organizations have developed or may develop internal solutions to address enterprise talent acquisition and employee performance management requirements that may be competitive with our solutions.
Some of our competitors and potential competitors, especially vendors of ERP software, have significantly greater financial, support, technical, development, marketing, sales, service and other resources, larger installed customer bases, longer operating histories, greater name recognition and more established relationships than we have. In addition, ERP software competitors could bundle their products with, or incorporate capabilities in addition to, talent acquisition and employee performance management functions, such as automated payroll and benefits, in products developed by themselves or others. Products with such additional functions may be appealing to some customers because they would reduce the number of different types of software or applications used to run their businesses. Our niche competitors’ products may be more effective than our solutions at performing particular talent acquisition and employee performance management functions or may be more customized for particular customer needs in a given market. Further, our competitors may be able to respond more quickly than we can to changes in customer requirements or regulatory changes.
We may engage in acquisitions or investments which present many risks, and we may not realize the anticipated financial and strategic goals for any of these transactions.
We have focused on developing solutions for the enterprise talent acquisition and employee performance management market. Our market is highly fragmented and in the future we may acquire or make investments in complementary companies, products, services or technologies. Acquisitions and investments, including our recent acquisition of Salary.com, involve a number of difficulties that present risks to our business, including the following:
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we may be unable to achieve the anticipated benefits from the acquisition or investment;
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we may have difficulty integrating the operations and personnel of the acquired business, and may have difficulty retaining the key personnel of the acquired business;
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we may have difficulty incorporating the acquired technologies or products with our existing solutions;
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our ongoing business and management's attention may be disrupted or diverted by transition or integration issues and the complexity of managing geographically and culturally diverse locations;
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we may lose customers of those companies that we acquire for reasons such as a particular customer desiring to have multiple service vendors;
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we may have difficulty maintaining uniform standards, controls, procedures and policies across locations; and
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we may experience significant problems or liabilities associated with product quality, technology and legal contingencies.
The factors noted above could have a material adverse effect on our business, results of operations and financial condition or cash flows, particularly in the case of a larger acquisition or multiple acquisitions in a short period of time. From time to time, we may enter into negotiations for acquisitions or investments that are not ultimately consummated. These negotiations could result in significant diversion of management time, as well as out-of-pocket costs.
The consideration paid for an investment or acquisition may also affect our financial results. If we were to proceed with one or more significant acquisitions in which the consideration included cash, we could be required to use a substantial portion of our available cash or obtain debt or equity financing. To the extent that we issue shares of our capital stock or other rights to purchase shares of our capital stock as consideration for an acquisition or in connection with the financing of an acquisition, including options or other rights, our existing shareholders may be diluted, and our earnings per share may decrease. In addition, acquisitions may result in the incurrence of debt, large one-time write-offs, including write-offs of acquired in-process research and development costs, and restructuring charges. Acquisitions in the future may require us to incur additional indebtedness to finance our working capital and may also result in goodwill and other intangible assets that are subject to impairment tests, which could result in future impairment charges.
Mergers or other strategic transactions involving our competitors could weaken our competitive position or reduce our revenue.
We believe that our industry is highly fragmented and that there is likely to be consolidation, which could lead to increased price competition and other forms of competition. Increased competition may cause pricing pressure and loss of market share, either of which could have a material adverse effect on our business, results of operations and financial condition. Our competitors may establish or strengthen cooperative relationships with business process outsourcing vendors, systems integrators, third-party consulting firms or other parties. Established companies may not only develop their own products but may also merge with or acquire our current competitors. In addition, we may face competition in the future from large established companies, as well as from emerging companies that have not previously entered the markets for talent acquisition and employee performance management solutions or that currently do not have products that directly compete with our solutions. It is also possible that new competitors or alliances among competitors may emerge and rapidly acquire significant market share or sell their products at significantly discounted prices, causing pricing pressure. In addition, our competitors may announce new products, services or enhancements that better meet the price or performance needs of customers or changing industry standards. If any of these events occur, our revenues and profitability could significantly decline.
Because our products collect and analyze applicants’ and employees’ stored personal information, concerns that our products do not adequately protect the privacy of applicants and employees could inhibit sales of our products.
Some of the features of our talent acquisition and employee performance management applications depend on the ability to develop and maintain profiles of applicants and employees for use by our customers. These profiles contain personal information, including job experience, banking information, social security numbers, home address and home telephone number. Typically, our software applications capture this personal information when an applicant creates a profile to apply for a job, is being on-boarded, and an employee completes a performance review. Our software applications augment these profiles over time by capturing additional data and collecting usage data. Although our applications are designed to protect user privacy, privacy concerns nevertheless may cause employees and applicants to resist providing the personal data necessary to support our products. Any inability to adequately address privacy concerns could inhibit sales of our products and seriously harm our business, financial condition and operating results.
Evolving European Union regulations related to confidentiality of personal data may adversely affect our business.
In order to provide our solutions to our customers, we rely in part on our ability to access our customers’ employee and applicant data. The European Union and other jurisdictions have adopted various data protection regulations related to the confidentiality of personal data. To date, these regulations have not restricted our business as we have qualified for a safe harbor available for U.S. companies that collect personal data from areas under the jurisdiction of the European Union. To the extent that these regulations are modified in such a manner that this safe harbor is no longer available, our ability to conduct business in the European Union may be adversely affected
We may face risks associated with our international operations that could impair our ability to grow our revenue.
We generate a significant portion of our revenue outside the United States. For example, for the year ended December 31, 2010 and 2009, the percentage of revenue generated from customers outside the United States was 26.3% and 20.9%, respectively. We intend to continue selling into our existing international markets and to expand into international markets where we currently do not conduct business, which will require significant management attention and financial resources. If we are unable to continue to sell our products effectively in the existing international markets and expand into additional international markets, our ability to grow our business would be adversely affected. Some of the key factors that may affect our ability to maintain and expand our operations and sales in foreign countries include:
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difficulty in staffing and managing foreign operations, including our ability to provide services to our customers;
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building and maintaining a competitive presence in existing and new markets;
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difficulty enforcing contracts and collecting accounts receivable, leading to longer collection periods;
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certification, qualification and compliance requirements and expenses relating to our products and business;
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regulatory requirements, including import and export regulations;
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changes in currency exchange rates;
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dependence on third parties to market our solutions through foreign sales channels;
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reduced protection for intellectual property rights;
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less stringent adherence to ethical and legal standards by prospective customers;
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potentially adverse tax treatment;
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the need to localize products for other languages and country-specific business requirements and regulations;
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difficulty competing with local vendors;
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language and cultural barriers; and
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political and economic instability.
Foreign currency exchange rate risks may adversely affect our results of operations.
Material portions of our revenue and expenses are generated by our operations in foreign countries, and we expect that our foreign operations will account for a material portion of our revenue and expenses in the future. Substantially all of our international expenses and revenue are denominated in foreign currencies, mostly the Indian rupee, British pound, euro and Canadian dollar. For the year ended December 31, 2010, we generated approximately 26.3% of our total revenue and incurred approximately 25.0% of our total costs in foreign currencies. As a result, our financial results could be affected by factors, such as changes in foreign currency exchange rates or weak economic conditions in European markets and other foreign markets in which we have operations. Fluctuations in the value of those currencies in relation to the U.S. dollar have caused and will continue to cause dollar-translated amounts to vary from one period to another. We also incur currency transaction risk whenever one of our operating subsidiaries enters into either a purchase or a sales transaction using a currency other than the local currency in which it receives revenue and pays expenses. Given the volatility of exchange rates, we may not be able to manage effectively our currency translation or transaction risks, which may adversely affect our financial condition and results of operations.
Changes in the regulatory environment and general economic condition in India, China and elsewhere could have a material adverse effect on our business.
The business and regulatory climates in India, China and other developing economies in which we operate are constantly evolving; developments in the regulatory environment in particular are difficult to predict, and enforcement of current and new laws and regulations may not be consistent. Adverse changes in the business or regulatory climate in these countries, including developments that make enforcement of our property rights more challenging or expensive, could have a material adverse effect on our business.
In addition, wages in India, China and other developing economies in which we operate are increasing at a faster rate than in the United States. In the event that wages continue to rise, the cost benefit of operating in India and elsewhere may diminish. India has also experienced significant inflation in the past and has been subject to civil unrest and terrorism. There can be no assurance that these and other factors will not have a material adverse effect on our business and results of operations.
We may not be able to raise capital on terms that are favorable to us.
As of December 31, 2010, we had cash and cash equivalents of $52.5 million. Changes in our operating plans, lower than anticipated revenue, increased expenses or other events, may cause us to seek additional debt or equity financing. Financing may not be available on acceptable terms, or at all, and our failure to raise capital when needed could negatively impact our growth plans and our financial condition and consolidated results of operations. Additional equity financing would be dilutive to the holders of our common stock, and debt financing, if available, may involve significant cash payment obligations and covenants or financial ratios that restrict our ability to operate our business.
Our credit facility contains certain financial covenants, the breach of which may adversely affect our financial condition.
We have a senior secured credit agreement with PNC Bank, N.A., under which we had drawn down $59.5 million as of December 31, 2010. Our agreement with PNC Bank contains financial covenants that require us to maintain certain ratios. If we are not in compliance with our financial covenants, the amounts drawn on the facility may become immediately due and payable. Any requirement to immediately pay outstanding amounts under a credit facility may negatively impact our financial condition and we may be forced by our creditor into actions, which may not be in our best interests. As of December 31, 2010, we were in compliance with our financial covenants.
Our results of operations may be adversely affected if we are subject to a protracted infringement claim or a claim that results in a significant damage award.
We expect that software product developers, such as ourselves, will increasingly be subjected to infringement claims as the numbers of products and competitors grow and the functionality of products in different industry segments overlaps. Our competitors or other third parties may challenge the validity or scope of our intellectual property rights. A claim may also be made relating to technology that we acquire or license from third parties. If we were subject to a claim of infringement, regardless of the merit of the claim or our defenses, the claim could:
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require costly litigation to defend and resolve, and the payment of substantial damages;
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require significant management time and attention;
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cause us to enter into unfavorable royalty or license agreements;
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require us to discontinue the sale of our solutions;
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create negative publicity that adversely affects the demand for our solutions;
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require us to indemnify our customers; and/or
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require us to expend additional development resources to redesign our software.
Litigation could be costly for us to defend, have a negative effect on our operating results and financial condition or require us to devote additional research and development resources to change our software.
Our data is obtained from a variety of sources, some of which may not be available to us in the future.
Our proprietary compensation data sets are comprised of extensive data. We obtain our data from a variety of sources, including major consulting firms and our partners, the SEC and other U.S. government agencies and other third party providers, and through our own research efforts. We generally obtain data on a non-exclusive basis and in a summary form. While we do not generally have an ability to resell such data in its entirety, we use such data internally in generating our proprietary data sets. We cannot assure you that the data we require for our proprietary data sets will be available from these sources in the future or that the cost of such data will not increase. From time to time in the past, third parties have sent us letters asserting that our use of data may have violated our agreement with them or infringed upon their copyright. Although we believe that our purchase and use of all third party surveys complies with copyright law and any applicable license agreements, we cannot assure you that we will prevail in any such claims asserted against us and any litigation, regardless of its validity, may involve significant costs and could divert our management’s time and attention from developing our business.
If any third party successfully asserts a claim that we have violated their copyrights or our license agreements with them, we may be required to remove the applicable data from our data sets and regenerate our data sets without such data. Additionally, we may no longer be able to obtain data from the provider or other providers on reasonable terms, if at all. Any inability to obtain data may have a material adverse effect on our business, financial condition and results of operations.
Further, as we expand our customer base to include customers outside of the United States, we may not be able to obtain sufficient international data on reasonable terms to support our data sets. We plan to obtain data which we believe is sufficient to build proprietary data sets in order to support the development of an international business. We expect to incur substantial expense to build proprietary data sets for international markets. We cannot assure you that we will be able to successfully obtain sufficient data to develop proprietary data sets for international markets.
We employ technology licensed from third parties for use in or with our solutions, and the loss or inability to maintain these licenses on similar terms or errors in the software we license could result in increased costs, or reduced service levels, which would adversely affect our business.
We include in the distribution of our solutions certain technology obtained under licenses from other companies. We anticipate that we will continue to license technology and development tools from third parties in the future. There may not always be commercially reasonable software alternatives to the third-party software that we currently license, or any such alternatives may be more difficult or costly to replace than the third-party software that we currently license. In addition, integration of our software with new third-party software may require significant work and substantial allocation of our time and resources. Also, to the extent we depend upon the successful operation of third-party products in conjunction with our software, any undetected errors in these third-party products could prevent the implementation or impair the functionality of our software, delay new solution introductions and injure our reputation. Our use of additional or alternative third-party software would require us to enter into license agreements with third parties, which could result in higher costs.
If we do not retain our executive officers, our ability to manage our business and continue our growth could be negatively impacted.
We have grown significantly in recent years, and management responsibilities remain concentrated in a small number of executive officers, most of whom have been employed with us for at least five years. Our future success will depend to a significant extent on the continued service of these executive officers, namely Nooruddin S. Karsan, Troy A. Kanter, Donald F. Volk, James P. Restivo, and Archie L. Jones, Jr. as well as our other key employees, software engineers and senior technical and sales personnel. We have not entered into employment agreements with any of our employees. The loss of the services of any of these individuals or group of individuals could have a material adverse effect on our business, financial condition and results of operations. Competition for qualified personnel in the software industry is intense, and we compete for these personnel with other software companies that have greater financial and other resources than we do. If we lose the services of one or more of our executive officers or other key personnel, or if one or more of them decide to join a competitor or otherwise compete directly or indirectly with us, our business could be harmed. Searching for replacements for key personnel could also divert management’s time and attention and result in increased operating expenses.
We will not be able to maintain our revenue growth if we do not attract, train or retain qualified sales personnel.
If we fail to successfully maintain and expand our sales force, our future revenue and profitability will be adversely affected. We depend on our direct sales force for substantially all of our revenue and intend to make significant expenditures in upcoming years to expand our sales force. Our future success will depend in part upon the continued expansion and increased productivity of our sales force. To the extent that we experience attrition in our direct sales force, we will need to hire replacements. We face intense competition for sales personnel in the software industry, and we may not be successful in hiring, training or retaining our sales personnel in accordance with our plans. Even if we hire and train a sufficient number of sales personnel, we may not generate enough additional revenue to exceed the expense of hiring and training the new personnel.
Failure to implement the appropriate controls and procedures to manage our growth could harm our growth, business, operating results and financial condition.
We have and may continue to have periods of growth in our operations, which has placed, and may continue to place, a significant strain on our management, administrative, operational, technical and financial infrastructure. We increased our employee base from 693 employees in 2005 to 1,220 employees in 2006; 1,373 employees in 2007; and 1,535 employees in 2008. In 2009, due to the continued deterioration in the economic environment we experienced a decrease in employees to 1,459. In 2010, we increased our employees to 1,963.
The increase in employees during 2008 was primarily due to the addition of 135 employees that we acquired as a part of our acquisition of Quorum International Holdings Limited (“Quorum”). The increase in employees during 2010 was primarily due to the addition of 333 employees that we acquired as a part of our acquisitions of CHPD and Salary.com.
To manage our growth, we will need to continue to improve our operational, financial and management processes and controls and reporting systems and procedures. This effort may require us to make significant capital expenditures or to incur significant expenses, and may divert the attention of our personnel from our core business operations, any of which may adversely affect our financial performance. If we fail to successfully manage our growth, our business, operating results and financial condition may be adversely affected.
Evolving regulation of the Internet may increase our expenditures related to compliance efforts, which may adversely affect our financial condition.
As Internet commerce continues to evolve, increasing regulation by federal, state and/or foreign agencies becomes more likely. We are particularly sensitive to these risks because the Internet is a critical component of our business model. For example, we believe that increased regulation is likely in the area of data privacy, and laws and regulations applying to the solicitation, collection, processing or use of personal or consumer information could affect our customers’ ability to use and share data, potentially reducing demand for solutions accessed via the Internet and restricting our ability to store, process and share data with our customers via the Internet. In addition, taxation of services provided over the Internet or other charges imposed by government agencies or by private organizations for accessing the Internet may also be imposed. Any regulation imposing greater fees for Internet use or restricting information exchange over the Internet could result in a decline in the use of the Internet and the viability of Internet-based services, which could harm our business.
The failure of our solutions to comply with employment laws may require us to indemnify our customers, which may harm our business.
Some of our customer contracts contain indemnification provisions that require us to indemnify our customers against claims of non-compliance with employment laws related to hiring. To the extent these claims are successful and exceed our insurance coverages, these obligations would have a negative impact on our cash flow, results of operation and financial condition.
Our reported financial results may be adversely affected by changes in generally accepted accounting principles.
Generally accepted accounting principles in the United States are subject to interpretation by the Financial Accounting Standards Board, or FASB, the American Institute of Certified Public Accountants, the SEC, and various bodies formed to promulgate and interpret appropriate accounting principles. A change in these principles or interpretations could have a significant effect on our historical or future financial results. For example, prior to January 1, 2006, we were not required to record share-based compensation charges if the employee’s stock option exercise price was equal to or exceeded the deemed fair value of the underlying security at the date of grant. However, effective January 1, 2006 we are required to record the fair value of stock options as an expense in accordance with new accounting pronouncements.
Anti-takeover provisions of Pennsylvania law and our articles of incorporation and bylaws could delay and discourage takeover attempts that shareholders may consider to be favorable.
Certain provisions of our articles of incorporation and applicable provisions of the Pennsylvania Business Corporation Law may make it more difficult for a third party to, or prevent a third party from, acquiring control of us or effecting a change in our board of directors and management. These provisions include:
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the classification of our board of directors into three classes, with one class elected each year;
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prohibiting cumulative voting in the election of directors;
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the ability of our board of directors to issue preferred stock without shareholder approval;
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our shareholders may only take action at a meeting of our shareholders and not by written consent;
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prohibiting shareholders from calling a special meeting of our shareholders;
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our shareholders must comply with advance notice procedures in order to nominate candidates for election to our board of directors or to place shareholders proposals on the agenda for consideration at any meeting of our shareholders; and
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prohibiting us from engaging in some types of business combinations with holders of 20% or more of our voting securities without prior approval of our board of directors, unless a majority of our disinterested shareholders approve the transaction.
The Pennsylvania Business Corporation Law further provides that because our articles of incorporation provide for a classified board of directors, shareholders may remove directors only for cause. These and other provisions of the Pennsylvania Business Corporation Law and our articles of incorporation and bylaws could delay, defer or prevent us from experiencing a change of control or changes in our board of directors and management and may adversely affect our shareholders’ voting and other rights. Any delay or prevention of a change of control transaction or changes in our board of directors and management could deter potential acquirers or prevent the completion of a transaction in which our shareholders could receive a substantial premium over the then current market price for their shares of our common stock.
From time to time, we have conducted share repurchase programs, which may restrict our funds available for other actions and negatively affect the market price of our securities.
Since November 2007, we have repurchased 3,125,651 shares of our common stock under share repurchase plans at an average price per share of $17.80 and an aggregate cost of $55.8 million. These shares were restored to original status and accordingly are presented as authorized but not issued. Share repurchases may not have the effects anticipated by our board of directors and may instead harm the market price of our securities. Share repurchase plans may use a significant portion of our cash reserves, and could limit our future flexibility to complete acquisition transactions or fund other growth opportunities. In addition, the share repurchases are subject to regulatory requirements. We may become subject to lawsuits regarding the use of our cash for share repurchases or for the failure to follow applicable regulatory requirements in connection with our share repurchase program. Our repurchase plans will also likely result in an increase in the share percentage ownership of our existing shareholders, and such increase may trigger disclosure or other regulatory requirements for our larger shareholders. As a result, certain shareholders may liquidate a portion of their holdings. In addition, our repurchase plans may decrease our public float as shares are repurchased by us on the open market pursuant to the plan and may have a negative effect on our trading volume. Such outcomes may have a negative impact on the liquidity of our common stock, the market price of our common stock and could make it easier for others to acquire a larger percentage of our voting securities. For the years ended, December 31, 2010 and 2009 no repurchases were made under the stock repurchase plan.
The market price of our common stock has been, and may continue to be, volatile, and our shareholders may be unable to resell their shares at a profit.
The market price of our common stock has been subject to significant fluctuations and may continue to fluctuate or decline. From September 2008 through December 31, 2010, our common stock has been particularly volatile as the price of our common stock has ranged from a high of $24.01 to a low of $3.66. In the past several years, technology stocks have experienced high levels of volatility and significant declines in value from their historic highs. Additionally, as a result of the current global credit crisis and the concurrent economic downturn in the U.S. and globally, there have been significant declines in the values of equity securities generally in the U.S. and abroad. Factors that could cause fluctuations in the trading price of our common stock include the following:
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price and volume fluctuations in the overall stock market from time to time;
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significant volatility in the market price and trading volume of software companies in general, and HR software companies in particular;
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actual or anticipated changes in our earnings or fluctuations in our operating results;
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general economic conditions and trends;
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major catastrophic events;
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the timing and magnitude of stock repurchases pursuant to our stock repurchase plan;
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sales of large blocks of our stock; or
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departures of key personnel.
In the past, following periods of volatility in the market price of a company’s securities, securities class action litigation has often been brought against that company. If our stock price is volatile, we may become the target of securities litigation. Securities litigation could result in substantial costs and divert our management’s attention and resources from our business.
Unexpected changes in tax rates and regulations could negatively impact our operating results.
We currently conduct significant activities internationally. Our foreign subsidiaries accounted for 26.3% of our total revenues during the year ended December 31, 2010, and 20.9% of our total revenues during the year ended December 31, 2009. Our financial results may be negatively impacted to the extent tax rates in foreign countries where we operate increase and/or exceed those in the United States and as a result of the imposition of withholding requirements on foreign earnings.
ITEM 1B.
ITEM 1B.
Unresolved Staff Comments.
Not Applicable.
ITEM 2.
ITEM 2.
Properties
We lease our headquarters in Wayne, Pennsylvania. The table below provides information concerning our principal facilities, as of December 31, 2010, including the approximate square footage, the approximate monthly rent and the lease expiration date of each facility. We believe that our facilities are in good operating condition and will adequately serve our needs for at least the next 12 months. We also anticipate that, if required, suitable additional or alternative space will be available on commercially reasonable terms, in office buildings we currently occupy or in space nearby, to accommodate expansion of our operations.
On January 30, 2011, our lease expired and we closed our facility in Needham, Massachusetts. The personnel at our Needham location were relocated to our Waltham facility. We have renewed the lease for our Waltham facility for a term due to expire on April 29, 2018. During April 2011, three of our facilities located in England, including the lease referenced above, will be consolidated and our personnel will be relocated to a new facility in London, England. The lease for the new facility in London, England is through March 2021.
We sublease space in our Wayne, PA and Vizag, India facilities. The total minimum sublease rentals received under noncancelable subleases for the years ended December 31, 2010 and 2009 was $349 and $152, respectively, for Wayne and Vizag. The total minimum sublease rentals to be received under noncancelable subleases through 2014 is estimated at $1,463 for Wayne and Vizag as of December 31, 2010.
ITEM 3.
ITEM 3.
Legal Proceedings
On August 27, 2007, a complaint was filed and served by Kenexa BrassRing, Inc. against Taleo Corporation in the United States District Court for the District of Delaware. Kenexa alleges that Taleo infringed Patent Nos. 5,999,939 and 6,996,561, and seeks monetary damages and an order enjoining Taleo from further infringement. The trial of this matter is currently scheduled to begin on June 27, 2011.
On May 9, 2008, Kenexa BrassRing, Inc. filed a similar lawsuit against Vurv Technology, Inc. in the United States District Court for the District of Delaware, alleging that Vurv has infringed Patent Nos. 5,999,939 and 6,996,561, and seeks monetary damages and an order enjoining further infringement. This lawsuit has been consolidated with the Kenexa BrassRing, Inc. versus Taleo Corporation lawsuit.
On June 25, 2008, Kenexa Technology, Inc. filed suit in the United States District Court of Delaware against Taleo Corporation for tortious interference with contract, unfair competition, unfair trade practices and unjust enrichment. On August 28, 2009, Taleo filed an amended answer and counterclaim against Kenexa BrassRing, Inc. asserting copyright infringement against Kenexa by the users accessing the Taleo system on behalf of Kenexa’s recruitment process outsourcing customers. Kenexa seeks monetary damages and to enjoin the actions of Taleo. Taleo seeks monetary damages and to enjoin the actions of Kenexa.
On November 7, 2008, Vurv Technology LLC, sued Kenexa Corporation, Kenexa Technology, Inc., and two former employees of Vurv, who now work for Kenexa , in the United States District Court for the Northern District of Georgia. In this action, Vurv asserts claims for breach of contract, computer trespass and theft, misappropriation of trade secrets, interference with contract and civil conspiracy. Vurv seeks unspecified monetary damages and injunctive relief. On July 17, 2009, Kenexa BrassRing, Inc. and Kenexa Recruiter, Inc. filed suit against Taleo Corporation, a current Taleo employee and a former Taleo employee in Massachusetts Superior Court. Kenexa amended the complaint on August 27, 2009 and added Vurv Technology LLC, two former employees of Taleo and two current employees of Taleo. Kenexa asserts claims for breach of contract and the implied covenant of good faith and fair dealing, unfair trade practices, computer theft, misappropriation of trade secrets, tortious interference, unfair competition, and unjust enrichment. Kenexa seeks monetary damages and injunctive relief.
Securities Class Actions
On June 11, 2009 and July 16, 2009, two putative class actions were filed against Kenexa Corporation and our Chief Executive Officer and Chief Financial Officer in the United States District Court for the Eastern District of Pennsylvania, purportedly on behalf of a class of our investors who purchased our publicly traded securities between May 8, 2007 and November 7, 2007. The complaint filed on July 16, 2009 has since been voluntarily dismissed. On September 28, 2010, the court granted Kenexa’s motion to dismiss the complaint filed on June 11, 2009 in its entirety. The plaintiffs filed a motion for reconsideration of the court’s decision on October 12, 2010, which was denied by the court on November 29, 2010. The plaintiffs failed to file a timely appeal, and, as a result, the actions were concluded in Kenexa's favor.
Genesys Shareholder Suit
On October 1, 2010, Kenexa completed its acquisition of Salary.com, Inc. which included responsibility for the suit filed on August 13, 2010 by former shareholders and option holders of Genesys Software Systems, Inc. (the “Genesys Parties” and “Genesys,” respectively) against Salary.com, Inc. and Silicon Valley Bank -Trustee Process Defendant in Massachusetts Superior Court. The Genesys Parties asserts claims for breach of contract, breach of implied covenant of good faith and fair dealing, violation of the Massachusetts Unfair Business Practices Act, and declaratory judgment seeking damages of $2.0 million in contingent consideration related to the purchase of Genesys by Salary.com, plus other monetary damages and fees. On September 7, 2010 Salary.com filed an answer and counterclaim against the Genesys Parties, and certain former shareholders of Genesys, asserting breach of contract, breach of implied covenants of good faith and fair dealing, fraud, violation of the Massachusetts Unfair Business Practices Act, civil conspiracy, negligent misrepresentation, and declaratory judgment seeking to dismiss the original complaint and unspecified monetary damages. The $2.0 million in contingent consideration was accrued for in the financial statements at December 31, 2010.
Salary.com Appraisal Suit
On February 2, 2011, Dorno Investment Partners, LLC filed a Petition for Appraisal of Stock in the Court of Chancery of the State of Delaware against Kenexa Compensation, Inc., the new name for the surviving entity subsequent to the all cash, short form merger of Salary.Com, Inc. and Spirit Merger Sub, Inc. on October 1, 2010. Dorno was the beneficial owner of 143,610 shares of Salary.Com, Inc. common stock on the merger date and demanded and continues to demand appraisal of the fair value of 140,000 shares pursuant to Delaware law. Dorno demands fair value for its shares, interest from October 1, 2010, costs, attorney’s fees, and other appropriate relief.
We are involved in claims, including those identified above, which arise in the ordinary course of business. In the opinion of management, we have made adequate provision for potential liabilities, if any, arising from any such matters. However, litigation is inherently unpredictable, and the costs and other effects of pending or future litigation, governmental investigations, legal and administrative cases and proceedings (whether civil or criminal), settlements, judgments and investigations, claims and changes in any such matters, could have a material adverse effect on our business, financial condition and operating results. Furthermore, the Company believes that the litigation matters described above, due to their current state are neither probable nor reasonably estimable at the time of filing.
ITEM 4.
ITEM 4.
Removed and Reserved
PART II
ITEM 5.
ITEM 5.
Market for Registrant’s Common Equity, Related Stockholder Matters And Issuer Purchases of Equity Securities
Market Information and Dividends
Our common stock has been quoted on The Nasdaq Stock Market, LLC under the symbol “KNXA” since June 24, 2005. Prior to that date, there was no public market for our common stock. The following table sets forth, for the periods indicated, the high and low sales prices of our common stock reported by The Nasdaq Stock Market, LLC.
On March 9, 2011, the last reported sale price of our common stock on The Nasdaq Stock Market, LLC was $24.66 per share. As of March 9, 2011, there were approximately 66 holders of record of our common stock.
We have not declared or paid any cash dividends on our common stock since our inception. We intend to retain future earnings, if any, to finance the operation and expansion of our business and do not anticipate paying any cash dividends in the foreseeable future. Consequently, shareholders will need to sell shares of our common stock to realize a return on their investment, if any.
Unregistered Sales of Equity Securities and Use of Proceeds
Not Applicable.
STOCK PERFORMANCE GRAPH AND CUMULATIVE TOTAL RETURN
The following graph shall not be deemed incorporated by reference into any of our filings under the Securities Act of 1933 or the Securities Exchange Act of 1934, except to the extent we specifically incorporate it by reference therein.
Prior to June 24, 2005, we were not publicly traded and there was no public market for our securities. The graph below compares the cumulative total return of our common stock with that of the Nasdaq Composite Index, the Nasdaq Computer & Data Processing Index and the S&P Smallcap 600 Index from December 31, 2005 through December 31, 2010. The graph assumes that you invested $100 at the close of market on December 31, 2005 in shares of our common stock and invested $100 on December 31, 2005 in each of these indexes, and in each case assumes the reinvestment of dividends. The comparisons in this graph are provided in accordance with Securities and Exchange Commission disclosure requirements and are not intended to forecast or be indicative of the future performance of shares of our common stock.
ITEM 6.
ITEM 6. Selected Consolidated Financial Data
SELECTED CONSOLIDATED FINANCIAL DATA
The selected consolidated financial data set forth below are derived from our consolidated financial statements and should be read in conjunction with our consolidated financial statements and related notes appearing elsewhere in this Annual Report on Form 10-K and "Management's Discussion and Analysis of Financial Condition and Results of Operations" section of this Annual Report on Form 10-K. The consolidated statements of operations data for each of the years ended December 31, 2010, 2009 and 2008 and the consolidated balance sheet data as of December 31, 2010 and 2009 are derived from, and qualified by reference to, our audited consolidated financial statements and related notes appearing elsewhere in this filing. The consolidated statements of operations data for each of the years ended December 31, 2007 and 2006 and the consolidated balance sheet data as of December 31, 2008, 2007 and 2006 are derived from our audited consolidated financial statements not included in this filing.
SELECTED CONSOLIDATED FINANCIAL DATA
(1)
Amounts in 2010, 2009 and 2008 consists of ASC 740 income tax liabilities related to uncertain tax positions of $2,515, $1,890 and $1,256, respectively. See Critical Accounting Policies and Estimates, Accounting for Income taxes for further discussion.
ITEM 7.
ITEM 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
You should read the following discussion and analysis of our financial condition and results of operations in conjunction with the “Selected Consolidated Financial Data” section and our consolidated financial statements and related notes appearing elsewhere in this Annual Report on Form 10-K. In addition to historical information, this discussion and analysis contains forward-looking statements based on current expectations that involve risks, uncertainties and assumptions, such as our plans, objectives, expectations and intentions. Our actual results and the timing of events may differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth in the “Item 1A - Risk Factors” section and elsewhere in this Annual Report on Form 10-K.
Overview
We provide business solutions for human resources which include a comprehensive suite of on-demand software applications and complementary services, including outsourcing services and consulting, to help global organizations recruit high performing individuals and increase employee productivity and retention. We employ a large force of organizational and industrial psychologists and statisticians who study the science of human behavior and its impact on business outcomes. This research is the foundation of our suite of software applications and supporting services that enable our customers to improve business results through human resources. Based on our 23 years of experience assisting customers in addressing their human resource requirements we believe our software applications and services form solutions that enable our customers to improve the effectiveness of their talent acquisition programs, increase employee productivity and retention, measure key HR metrics and make their talent acquisition and employee performance management programs more efficient.
Since 1999, we have focused on providing talent acquisition and employee performance management solutions on a subscription basis and currently generate a significant portion of our revenue from these subscriptions. Our customers typically purchase multi-year subscriptions with an average length of approximately two years. For the years ended December 31, 2010 and 2009, subscription revenue represented approximately 78.8% and 84.9% of our total revenue, respectively. We generate the remainder of our revenue from discrete professional services that are not provided as part of an integrated solution on a subscription basis.
We sell our solutions to large and medium-sized organizations through our direct sales force. As of December 31, 2010, we had a global customer base of approximately 6,800 companies, including approximately 255 companies on the Fortune 500 list published in May 2010. Our customer base includes companies that we billed for services during the year ended December 31, 2010 and does not necessarily indicate an ongoing relationship with each such customer. Our top 80 customers contributed approximately $103.5 million, or 52.7%, of our total revenue for the year ended December 31, 2010.
Our customers typically purchase multi-year subscriptions which provide us with a recurring revenue stream. Our customers renewed 84% and 80% of their contracts for each of the years ended December 31, 2010 and 2009, respectively which represented 88% of the aggregate value of multi-year subscriptions for our on-demand talent acquisition and performance management solution contracts up for renewal for each of those years. This renewal rate provides us with a strong base of recurring revenue. We believe that our strong customer relationships provide us with a meaningful opportunity to cross-sell additional solutions to our existing customers and to achieve greater penetration within an organization. As the business environment improves we expect renewal rates to improve to our historical renewal rate in excess of 90%.
In May 2010, we launched a major upgrade to our product line. Our 2x platform™ includes applications such as Kenexa 2x Recruit™, Kenexa 2x BrassRing®, Kenexa 2x Onboard™ and our first-to-market Kenexa 2x Mobile™ solution. Future modules to the 2x platform include Kenexa 2x Perform™, Kenexa 2x Assess™, Kenexa 2x Analytics™ and Kenexa 2x Survey™. We believe that Kenexa 2x enables customers to improve productivity, increase cost savings, ensure compliance with corporate and legal mandates, and raise employee engagement.
As of December 31, 2010 the national unemployment rate dropped 0.5% from the prior year to 9.4% and with the drop we have witnessed a slow but steady improvement in business conditions. The unemployment rate is slowly improving, and recent industry reports suggest that the unemployment rate will continue to improve over the balance of this year and into 2012.
Background
We commenced operations in 1987 as a provider of recruiting services to a wide variety of industries. In 1993, we offered our first automated talent acquisition system and by 1997 we had expanded our business to provide employee research, employee performance management technology and consulting services. In late 1997, responding to a growing demand from our customers, we began to provide comprehensive human capital management services integrated with on-demand software. Between 1994 and 1998, we acquired 15 businesses that collectively enabled us to offer comprehensive Human Capital Management (“HCM”) services integrated with on-demand technology.
Over the past eleven years, we have pursued a strategy designed to focus our business on talent acquisition and employee performance management solutions and reduce our strategic focus on discrete professional services that generated less predictable revenue streams and lower margins. To that end:
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in 1999, we exited our temporary staffing business;
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in 2000 and 2001, we acquired four businesses which enhanced our screening and behavioral assessment solutions and skills testing technologies;
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since 2002, we reduced our strategic focus on position-specific recruiting services;
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in 2003, we discontinued our Oracle implementation business and sold our pharmaceutical training division;
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in 2005, we expanded our presence in North America and enhanced our customer base through our acquisition of Scottworks Solutions, Inc.;
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in 2006, we enhanced our talent acquisition solutions and customer base through our acquisitions of Webhire, Inc.,
Knowledge Workers Inc., Gantz-Wiley Research Consulting Group Inc., Psychometric Services Limited. and BrassRing Inc.;
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in 2007, we enhanced our talent acquisition solutions and customer base through our acquisitions of Strategic
Outsourcing Corporation and HRC Human Resources Consulting GmbH;
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in 2008, we expanded our global footprint in the talent acquisition space through our acquisition of Quorum International Holdings Limited;
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in 2009, we entered into an ownership interest transfer agreement with Shanghai Runjie Management Consulting Company to gain presence in China’s human capital management market; and
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in 2010, we expanded our global footprint and added to our product offerings through our acquisitions of CHPD and Salary.com.
As a result of our shift in strategic focus in 2000, we have focused on providing talent acquisition and employee performance management solutions on a subscription basis and currently generate a significant portion of our revenue from these subscriptions. We generate the remainder of our revenue from discrete professional services that are not provided as part of an integrated solution on a subscription basis. In 2000, revenue derived from subscriptions for these solutions comprised approximately 54.4% of our total revenue. Since 2005, subscription revenue has represented approximately 80% of our total revenue. For the years ended December 2010 and 2009, subscription revenue represented approximately 78.8% and 84.9% of our total revenue, respectively. This shift to subscription-based services has been driven by our customer’s adoption of the on-demand model for software delivery and need for solutions that improve employee recruiting and retention. We expect non-GAAP subscription revenue will be within a target range of 78% to 82% of our total revenues in 2011.
From our inception through 2001, our operations were funded primarily through internally generated cash flows and our line of credit, as well as private placements of our securities to institutional investors. On June 29, 2005, we completed our initial public offering and listed our common stock for trading on the Nasdaq Stock Market.
Recent Events
In July 2010, in accordance with our UBS AG agreement, we exercised our right to sell our auction rate securities back to UBS and liquidated our auction rate security portfolio in its entirety.
On July 26, 2010, we acquired all of the outstanding stock of CHPD which operates as a leadership development and management training company based in London, England for a purchase price of approximately $4.2 million in cash. The total cost of the acquisition including estimated legal, accounting, and other professional fees was approximately $4.4 million. We deposited $0.4 million into escrow to cover any claims for indemnification. We acquired all assets and liabilities of CHPD using our existing cash and expect the acquisition of CHPD will enhance our existing research and content portfolio as well as provide our customers with the ability to more efficiently implement the results of their employee engagement surveys.
On August 31, 2010, we entered into a secured credit agreement with PNC Bank, N.A., in connection with our acquisition of Salary.com. The secured credit agreement included a maximum amount available under the credit facility of $25.0 million, including a sublimit of up to $2.0 million for letters of credit and swing loans. Borrowings under the new credit facility were secured by substantially all of the Company’s assets and the assets of its subsidiaries. Prior to termination of the credit agreement as discussed below, the Company borrowed $25.0 million under the credit agreement in connection with the acquisition of Salary.com.
On October 1, 2010, we acquired all of the outstanding stock of Salary.com, which provides on-demand compensation software that helps businesses and individuals manage pay and performance, for a purchase price of approximately $78.4 million in cash. The total cost of the acquisition including estimated legal, accounting, and other professional fees of $4.4 million, was approximately $82.8 million. We used cash and borrowings against the credit facility to fund the acquisition. We believe there is a significant opportunity to expand Salary.com’s adoption in large organizations and on a global basis because its compensation analysis software is highly synergistic with our current suite of talent acquisition and retention solutions.
On, October 20, 2010, we terminated and paid all outstanding amounts under our secured credit agreement, dated August 31, 2010, and entered into an amended credit agreement with PNC Bank. The maximum amount available under the amended credit agreement is $60.0 million, comprised of a $35.0 million revolving facility, including a sublimit of up to $5.0 million for letters of credit and a sublimit of up to $2.5 million for swing loans (the “Revolving Facility”), and a $25.0 million term facility (the “Term Facility”). We may request to increase the maximum amount available under the Revolving Facility to $50.0 million. The amended credit agreement will terminate, and all borrowings will become due and payable, on October 19, 2013. We and each of our U.S. subsidiaries are guarantors of the obligations under the amended credit agreement. Borrowings under the amended credit agreement are secured by substantially all of our assets (including a pledge of the capital stock of their subsidiaries (but limited to only 65% of the voting stock of first-tier foreign subsidiaries)). As of December 31, 2010 we borrowed $59.5 million under the amended credit agreement in connection with the acquisition of Salary.com and to enhance working capital.
Sources of Revenue
We derive revenue primarily from two sources: (1) subscription revenue for our solutions, which is comprised of subscription fees from customers accessing our on-demand software, consulting services, outsourcing services and proprietary content, and from customers purchasing additional support that is not included in the basic subscription fee; and (2) fees for discrete professional services.
Our customers primarily purchase renewable subscriptions for our solutions. The typical subscription term is one to three years, with some terms extending up to five years. The majority of our subscription agreements are not cancelable for convenience, but our customers have the right to terminate their contracts for cause if we fail to provide the agreed upon services or otherwise breach the agreement. A customer does not generally have a right to a refund of any advance payments if the contract is cancelled. Our customers renewed 84% and 80% of their contracts for each of the years ended December 31, 2010 and 2009, respectively which represented 88% of the aggregate value of multi-year subscriptions for our on-demand talent acquisition and performance management solution contracts up for renewal for each of those years. As the business environment improves we expect renewal rates to improve to our historical renewal rate in excess of 90%.
Consistent with our historical practices, revenue derived from subscription fees is recognized ratably over the term of the subscription agreement. We generally invoice our customers in advance in annual or quarterly installments and typical payment terms provide that our customers pay us within 30 days of invoice. Amounts that have been invoiced are recorded in accounts receivable prior to the receipt of payment and in deferred revenue to the extent revenue recognition criteria have not been met. As of December 31, 2010, deferred revenue increased by $26.1 million or 52.2% to $76.1 million from $50.0 million at December 31, 2009. The increase in deferred revenue is a result of the increase in sales of our multiple elements or bundled arrangements and our acquisition of Salary.com. We generally price our solutions based on the number of software applications and services included and the number of customer employees. Accordingly, subscription fees are generally greater for larger organizations and for those that subscribe for a broader array of software applications and services.
We derive other revenue from the sale of discrete professional services and translation services, as well as from out-of-pocket expenses. The majority of our other revenue is derived from discrete professional services, which primarily consist of consulting and training services and success fees. This revenue is recognized differently depending on the type of service provided, as described in greater detail below under “Critical Accounting Policies and Estimates.”
For the year ended December 31, 2010, approximately 73.7% of our total revenue was derived from sales in the United States. Foreign revenue that we generated from customers in the United Kingdom, Germany and China was approximately 8.3%, 3.4% and 2.7%, respectively. Revenue for other countries amounted to an aggregate of 11.9%. Other than the countries listed, no other country represented more than 2.0% of our total revenue for the year ended December 31, 2010. For the year ended December 31, 2010, the percentage of revenue derived from sales in the United States decreased over the prior year due our emphasis on global expansion.
Cost of Revenue
Our cost of revenue primarily consists of compensation, employee benefits and out-of-pocket travel-related expenses for our employees and independent contractors who provide consulting or other professional services to our customers. Additionally, our application hosting costs, amortization of third-party license royalty costs, technical support personnel costs, overhead allocated based on headcount and reimbursed expenses are also recorded as cost of revenue. Many factors affect our cost of revenue, including changes in the mix of products and services, pricing trends, changes in the amount of reimbursed expenses and fluctuations in our customer base. Because cost as a percentage of revenue is higher for professional services than for software products, an increase in the services component of our solutions or an increase in discrete professional services as a percentage of our total revenue would reduce gross profit as a percentage of total revenue. As our revenues increase, we expect our cost of revenue to increase proportionately, subject to pricing pressure related to economic conditions and influenced by the mix of services and software. To the extent new customers are added, we expect that the cost of services, as a percentage of revenue, will be greater than those services associated with existing customers.
Operating Expenses
We classify our operating expenses as follows:
Sales and Marketing. Sales and marketing expenses primarily consist of personnel and related costs for employees engaged in sales and marketing, including salaries, commissions, and other variable compensation, travel expenses and costs associated with trade shows, advertising and other marketing efforts and allocated overhead. We expense our sales commissions at the time the related revenue is recognized, and we recognize revenue from our subscription agreements ratably over the terms of the agreements. Consistent with our past practice, we intend to continue to invest in sales and marketing to pursue new customers and expand relationships with existing customers at levels we deem appropriate given our current economic conditions. We expect our sales and marketing expense to increase from current levels, mainly due to increased staff expense and continued emphasis on our rebranding effort.
General and Administrative. General and administrative expenses primarily consist of personnel and related costs for our executive, finance, human resources and administrative personnel, professional fees and other corporate expenses and allocated overhead. We expect general and administrative expenses to increase in the short term as we incur additional professional fees in connection with our patent infringement matter. However, in the longer term, based upon the current state of the economy, we believe that general and administrative expenses will remain the same or slightly increase in dollar amount and remain relatively constant or slightly decrease as a percentage of total revenue in 2011.
Research and Development. Research and development expenses primarily consist of personnel and related costs, including salaries, and employee benefits, for software engineers, quality assurance engineers, product managers, technical sales engineers and management information systems personnel and third party consultants. Our research and development efforts have been devoted primarily to the preliminary stages of project development and maintenance and training costs of our existing products. As we continue to execute on our strategies, including rolling out our 2x platform™ and continuing to develop feature enhancements, we believe that research and development expenses will remain flat or increase slightly in dollar amount in 2011.
Key Performance Indicators
The following tables summarize the key performance indicators that we consider to be material in managing our business, in thousands (other than percentages):
The following is a discussion of significant terms used in the tables above.
Non-GAAP financial measures. We believe that non-GAAP measures of financial results provide useful information to management and investors regarding certain financial and business trends relating to our financial condition and results of operations. We use these non-GAAP measures to compare our performance to that of prior periods for trend analyses, for purposes of determining executive incentive compensation, and for budget and planning purposes. These measures are used in monthly financial reports prepared for management and in quarterly financial reports presented to our Board of Directors. We believe that the use of these non-GAAP financial measures provides an additional tool for investors to use in evaluating ongoing operating results and trends and in comparing financial measures with other companies in our industry, many of which present similar non-GAAP financial measures to investors.
We do not consider such non-GAAP measures in isolation or as an alternative to measures determined in accordance with GAAP. The principal limitation of such non-GAAP financial measures is that they exclude significant expenses that are required by GAAP to be recorded. In addition, they are subject to inherent limitations as they reflect the exercise of judgments by management about which charges are excluded from the non-GAAP financial measures.
In order to compensate for these limitations, we present our non-GAAP financial measures in connection with our GAAP results. We urge investors to review the reconciliation of our non-GAAP financial measures to the comparable GAAP financial measures included below, and not to rely on any single financial measure to evaluate our business.
Non-GAAP cash from operations. Non-GAAP cash from operations consists of GAAP cash flows from operations adjusted for non-recurring payments of liabilities associated with our acquisitions and payments of acquisition related fees totaled $9.1 million. These exclusions are made to GAAP cash from operations to facilitate a consistent and more meaningful comparison to the prior year since their effect was not included in our 2009 results.
Non-GAAP revenue. Non-GAAP revenue consists of GAAP revenue, adjusted to reverse the effect of the write down of deferred revenue associated with purchase accounting for the Salary.com acquisition. This effect during the three months ended December 31, 2010 was $3.1 million and is added back to Non-GAAP revenue because we believe its inclusion provides a more accurate depiction of total revenue arising from the Salary.com acquisition.
Non-GAAP subscription revenue as a percentage of total revenue. Non-GAAP subscription revenue as a percentage of total revenue can be derived from our consolidated statements of operations adjusted for the effect of the write down of the deferred revenue associated with purchase accounting for the Salary.com acquisition as described above. We expect that the percentage of non-GAAP subscription revenue will be within a target range of 78% to 82% of our total revenues in 2011.
Non-GAAP income from operations. Non-GAAP income from operations is derived from income (loss) from operations adjusted for noncash or nonrecurring expenses. We believe that measuring our operations, using non-GAAP income from operations provides more useful information to management and investors regarding certain financial and business trends relating to our financial condition and ongoing results. We believe that the use of these non-GAAP financial measures provides an additional tool for investor to use in evaluating ongoing operating results and trends and in comparing our financial measures with other companies in our industry, many of which present similar non-GAAP financial measures to investors.
The Company’s non-GAAP financial measures as set forth in the table above exclude the following:
Share-based compensation. Share-based compensation consists of expenses for stock options and stock awards that we began recording in accordance with ASC 718 during the first quarter of 2006. Share-based compensation was $4.5 million, $5.4 million and $5.8 million for the years ending December 31, 2010, 2009 and 2008, respectively. Share-based compensation expenses are excluded in our non-GAAP financial measures because they are difficult to forecast. This is due in part to the magnitude of the charges, which depends upon the volume and timing of stock option grants that are unpredictable and can vary dramatically from period to period, and external factors such as interest rates and the trading price and volatility of our common stock.
Amortization of intangibles associated with acquisitions. In accordance with GAAP, operating expenses include amortization of acquired intangible assets which are amortized over the estimated useful lives of such assets. Amortization of acquired intangible assets was $5.8 million, $4.5 million and $5.5 million for the years ending December 31, 2010, 2009 and 2008, respectively. Amortization of acquired intangible assets is excluded from our non-GAAP financial measures because we believe that such exclusion facilitates comparisons to our historical operating results and to the results of other companies in the same industry, which have their own unique acquisition histories.
Acquisition-related fees. In accordance with ASC 805, Business Combinations, acquisition-related fees including advisory, legal, accounting and other professional fees are reported as expense in the periods in which the costs are incurred and the services are received. Acquisition-related fees of $4.6 million, for the year ended December 31, 2010 include legal, travel, and other fees not expected to recur from the acquisitions of Salary.com and CHPD. Acquisition-related fees are excluded in the non-GAAP financial measures because we believe that such exclusion facilitates comparisons to our historical operating results and to the results of other companies in the same industry, which have their own unique acquisition histories.
Deferred revenue associated with acquisition. Deferred revenue consists of the effect of the write down of the deferred revenue associated with purchase accounting for the Salary.com acquisition. This effect during the year ended December 31, 2010 was $3.1 million and is added back since we believe its inclusion provides a more accurate depiction of total revenue arising from the Salary.com acquisition.
Professional fees associated with variable interest entity. We incurred professional fees in connection with our Chinese expansion in the amount of $0.7 million during the first quarter of 2009. We believe that such exclusion facilitates comparisons to our historical operating results and to the results of other companies in the same industry, which have their own unique acquisition histories.
Severance expenses. We incurred charges in the amount of $1.2 million in relation to additional severance expenses in the first quarter of 2009. These charges were excluded from non-GAAP income to facilitate a more meaningful comparison to the prior year’s results.
Expenses related to restructuring charges and related legal fees. We incurred charges in the amount of $2.5 million in relation to restructuring in the fourth quarter of 2008. Such charges consisted of severance and outplacement benefit costs of $2.0 million and certain legal fees of $0.5 million in relation to the termination of approximately 200 employees.
Goodwill impairment charge. We recorded a non-cash goodwill impairment charge in the first quarter of 2009 of $33.3 million and $167.0 million in the fourth quarter of 2008 of as a result of a substantial decrease in our stock price, reflecting the impact of the unprecedented turmoil in world economies and the resultant impact on our operations.
Noncontrolling Interest. Noncontrolling interest of $0.1 million includes income from operations due to our variable interest entity partner and is excluded from the calculation of non-GAAP net income from operations because it is unrelated to our ownership in the venture.
Deferred revenue. We generate revenue primarily from multi-year subscriptions for our on-demand talent acquisition and employee performance management solutions and our compensation module. We recognize revenue from these subscription agreements ratably over the hosting period, which is typically one to three years. We generally invoice our customers in annual, quarterly or monthly installments in advance. Deferred revenue, which is included in our consolidated balance sheets, is the amount of invoiced subscriptions in excess of the amount recognized as revenue. Deferred revenue represents, in part, the amount that we will record as revenue in our consolidated statements of operations in future periods. As the subscription component of our revenue has grown and our customer willingness to pay us in advance for their subscriptions has increased, the amount of deferred revenue on our balance sheet has grown. It is possible that this trend may vary as business conditions change.
The following table reconciles beginning and ending deferred revenue for each of the periods shown:
Critical Accounting Policies and Estimates
Our discussion and analysis of our financial condition and consolidated results of operations are based upon our consolidated financial statements, which have been prepared in accordance with generally accepted accounting principles in the United States. The preparation of our consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to uncollectible accounts receivable and accrued expenses. We base these estimates on historical experience and various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Our actual results may differ from these estimates.
We believe that the following critical accounting policies affect our more significant estimates and judgments used in the preparation of our consolidated financial statements:
Revenue Recognition
We derive our revenue from two sources: (1) subscription revenues for solutions, which are comprised of subscription fees from customers accessing our on-demand software, consulting services, outsourcing services and proprietary content, and from customers purchasing additional support beyond the standard support that is included in the basic subscription fee; and (2) other fees for professional services, translation services and reimbursed out-of-pocket expenses. Because we provide our solutions as a service, we follow the provisions of Financial Accounting Standards Board (“FASB”) ASC 605-10, “Revenue Recognition” and FASB ASC 605-25 “Multiple Element Arrangements.” We recognize revenue when all of the following conditions are met:
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there is persuasive evidence of an arrangement;
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the service has been provided to the customer;
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the collection of the fees is probable; and
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the amount of fees to be paid by the customer is fixed or determinable.
We enter into arrangements with customers which may include consulting services, software licenses and data. For sales arrangements that contain multiple deliverables revenue is allocated among the deliverables using the selling price hierarchy established in ASU 2009-13 to determine the selling price of each deliverable. The selling price hierarchy allows for the use of estimated selling price (“ESP”) to determine the allocation of arrangement consideration to a deliverable in a multiple-element arrangement in the absence of vendor specific objective evidence (“VSOE”) or third-party evidence (“TPE”). We determined our ESP of fair value for our application services based on the following:
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We utilize a pricing model for our products which considers market factors such as customer demand for its products, and the geographic regions where the products are sold. In addition, the model considers entity-specific factors such as volume based pricing, discounts for bundled products and total contract commitment. Management approval of the model ensures that all of our selling prices are consistent and within an acceptable range for use with the relative selling price method.
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While the pricing model currently in use captures all critical variables, unforeseen changes due to external market forces may result in revising some of the inputs. These modifications may result in the consideration allocation differing from the one presently in use. Absent a significant change in the pricing inputs or the way in which the industry structures its deals, future changes in the pricing model are not expected to materially affect our allocation of arrangement consideration.
To qualify as a separate unit of accounting, the delivered item must have value to the customer on a standalone basis; and, if the arrangement includes a general right of return relative to the delivered item(s), delivery or performance of the undelivered item(s) is considered probable and substantially in our control. If the arrangement does not meet all criteria above, the entire amount of the transactions is deferred until all elements are delivered.
We determine the selling price in multiple-element arrangements using VSOE or TPE if available. VSOE is determined based on the price charged for the same deliverable when sold separately and TPE is established based on the price charged by our competitors or third parties for the same deliverable. If we are unable to determine the selling price because VSOE or TPE does not exist, we use our ESP.
This change in policy increased our revenues by approximately $2.9 million for the year ending December 31, 2010.
Subscription Fees and Support Revenues. Subscription fees and support revenues are recognized ratably over the lives of the contracts. Amounts that have been invoiced are recorded in accounts receivable and in deferred revenue or revenue, depending on whether the revenue recognition criteria have been met.
In accordance with FASB ASC 605-45, “Principal Agent Considerations,” we record reimbursements received for out-of-pocket expenses as revenue and not netted with the applicable costs. These items primarily include travel, meals and certain telecommunication costs. Reimbursed expenses for the years ended December 31, 2010, 2009 and 2008, totaled $3.3 million, $2.2 million and $4.7 million, respectively.
Allowance for Doubtful Accounts
We maintain an allowance for doubtful accounts for estimated losses resulting from customers’ inability to pay us. The provision is based on our historical experience and for specific customers that, in our opinion, are likely to default on our receivables from them. In order to identify these customers, we perform ongoing reviews of all customers that have breached their payment terms, as well as those that have filed for bankruptcy or for whom information has become available indicating a significant risk of non-recoverability. We rely on historical trends of bad debt as a percentage of total revenue over 90 days past due and apply these percentages to the accounts receivable associated with new customers and evaluate these customers over time. To the extent that our future collections differ from our assumptions based on historical experience, the amount of our bad debt and allowance recorded may be different.
Self-Insurance
We are self-insured for the majority of our health insurance costs, including claims filed and claims incurred but not reported subject to certain stop loss provisions. We estimate our liability based upon management’s judgment and historical experience. We also rely on the advice of consulting administrators in determining an adequate liability for self-insurance claims. Our self-insurance accruals which are reported on a gross basis totaled approximately $0.6 million for each of the periods ended December 31, 2010 and 2009. We continuously review the adequacy of our insurance coverage. Material differences may result in the amount and timing of insurance expense if actual experience differs significantly from management's estimates.
Capitalized Software Development Costs
In accordance with FASB ASC 985, “Software,” and FASB ASC 350, “Intangibles-Goodwill and Other,” costs incurred in the preliminary stages of a development project are expensed as incurred. Once an application has reached the development stage, internal and external costs, if direct and incremental, will be capitalized until the software is substantially complete and ready for its intended use. Capitalization ceases upon completion of all substantial testing. We also capitalize costs related to specific upgrades and enhancements when it is probable the expenditures will result in additional functionality. Maintenance and training cost are expensed as incurred. Internal use software is amortized on a straight-line basis over its estimated useful life, generally three years. Management evaluates the useful lives of these assets on an annual basis and tests for impairments whenever events or changes in circumstances occur that could impact the recoverability of these assets. There were no impairments to internal software in any of the periods covered in this report.
Goodwill and Other Identified Intangible Asset Impairment
Since 2002, we have recorded goodwill in accordance with the provisions of FASB ASC 350, “Intangibles-Goodwill and Other,” which requires us to annually review the carrying value of goodwill for impairment. If goodwill becomes impaired, some or all of the goodwill would be written off as a charge to operations. This comparison is performed annually or more frequently if circumstances change that would more likely than not reduce the fair value of the reporting unit below its carrying amount.
During the quarter ended December 31, 2008 we reevaluated our goodwill, due to adverse changes in the economic climate, a 49.5% decline in our market capitalization from October 1, 2008 (our annual testing date), and a downward revision in our earnings guidance for the quarter and year ended December 31, 2008. These factors signaled a triggering event, which required us to determine whether and to what extent our goodwill may have been impaired as of December 31, 2008. The first step of this analysis requires the estimation of our fair value, as an entity, and is calculated based on the observable market capitalization with a range of estimated control premiums as well as discounted future estimated cash flows. This step yielded an estimated fair value for us which was less than our carrying value including goodwill at December 31, 2008. The next step entails performing an analysis to determine whether the carrying amount of goodwill on our balance sheet exceeds our implied fair value. The implied fair value of our goodwill, for this step was determined in the same manner as goodwill recognized in a business combination. Our estimated fair value was allocated to our assets and liabilities, including any unrecognized identifiable intangible assets, as if we had been acquired in a business combination with our estimated fair value representing the price paid to acquire it. The allocation process performed on the test date was only for purposes of determining the implied fair value of goodwill with neither the write up or write down of any assets or liabilities, nor recording any additional unrecognized identifiable intangible assets as part of this process as of December 31, 2008. Based on the analysis, we determined that the implied fair value of goodwill was $32.4 million, resulting in a goodwill impairment charge of $167.0 million. The goodwill impairment charge had no effect on our cash balances.
During the quarter ended March 31, 2009 we reevaluated our goodwill due to continued adverse changes in the economic climate, a 32.5% decline in our market capitalization from December 31, 2008 through March 31, 2009 and a downward revision in internal projections. These factors signaled a triggering event, which required us to determine whether and to what extent our goodwill may have been impaired as of March 31, 2009. The allocation process performed on the test date was only for purposes of determining the implied fair value of goodwill with no assets or liabilities written up or down, nor any additional unrecognized identifiable intangible assets recorded as part of this process. Based on the analysis, a goodwill impairment charge of $33.3 million was recorded to write off the remaining balance of our goodwill for the quarter ended March 31, 2009. The goodwill impairment charge had no effect on the Company’s cash balances
Accounting for Income Taxes
We are subject to income taxes in the U.S. and various foreign countries. We record an income tax provision for the anticipated tax consequences of operating results reportable to each taxing jurisdiction in compliance with enacted tax legislation. We account for income taxes in accordance with FASB ASC 740, “Income Taxes,” which requires that deferred tax assets and liabilities be recognized using enacted tax rates for the effect of temporary differences between the book and tax basis of recorded assets and liabilities. ASC 740 also requires that deferred tax assets be reduced by a valuation allowance if it is more likely than not that some portion or all of the deferred tax asset will not be realized.
The realization of the deferred tax assets is evaluated quarterly by assessing the valuation allowance and by adjusting the amount of the allowance, if necessary. The factors used to assess the likelihood of realization are the forecast of future taxable income and available tax planning strategies that could be implemented to realize the net deferred tax assets. We have used tax-planning strategies to realize or renew net deferred tax assets in order to avoid the potential loss of future tax benefits. In addition, we operate within multiple taxing jurisdictions and are subject to audit in each jurisdiction. These audits can involve complex issues that may require an extended period of time to resolve. In our opinion, adequate provisions for income taxes have been made for all periods.
Our determination of the level of valuation allowance at December 31, 2010 is based on an estimated forecast of future taxable income which includes many judgments and assumptions primarily related to revenue, margins, operating expenses, tax planning strategies and tax attributes in multiple taxing jurisdictions. Accordingly, it is at least reasonably possible that future changes in one or more of these assumptions may lead to a change in judgment regarding the level of valuation allowance required in future periods.
Accounting for Share-Based Compensation
Share-based compensation expense recognized during the period is based on the value of the number of awards that are expected to vest multiplied by the fair value. We use a Black-Scholes option-pricing model to calculate the fair value of our share-based awards. The calculation of the fair value of the awards using the Black-Scholes option-pricing model is affected by our stock price on the date of grant as well as assumptions regarding the following:
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Volatility is a measure of the amount by which the stock price is expected to fluctuate each year during the expected life of the award and is based on a weighted average of peer companies, comparable indices and our stock volatility. An increase in the volatility would result in an increase in our expense.
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The expected term represents the period of time that awards granted are expected to be outstanding and is currently based upon an average of the contractual life and the vesting period of the options. With the passage of time actual behavioral patterns surrounding the expected term will replace the current methodology. Changes in the future exercise behavior of employees or in the vesting period of the award could result in a change in the expected term. An increase in the expected term would result in an increase to our expense.
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The risk-free interest rate is based on the U.S. Treasury yield curve in effect at time of grant. An increase in the risk-free interest rate would result in an increase in our expense.
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The estimated forfeiture rate is the rate at which awards are expected to expire before they become fully vested and exercisable. An increase in the forfeiture rate would result in a decrease to our expense.
In certain instances where market based, performance share awards are granted, we use the Monte Carlo valuation model to calculate the fair value. This approach utilizes a two-stage process, which first simulates potential outcomes for our shares using the Monte Carlo simulation. The first stage of the Monte Carlo simulation requires a variety of assumptions about both the statistical properties of our shares as well as potential reactions to such share price movements by our management. Such assumptions include the natural logarithm of our stock price, a random log-difference using the Russell 2000 stock index and a random variable using the specific deviations of our returns relative to the returns dictated by the CAPM model. The second stage employs the Black-Scholes model to value the various outcomes predicted by the Monte Carlo simulation. The resulting fair value, on the date of the grant (measurement date), is being recognized over the vesting period using the straight-line method.
Consolidated Results of Operations and Geographic Information
Consolidated Historical Results of Operations
The following table sets forth certain consolidated historical results of operations data and expressed as a percentage of total revenue for the periods indicated. Period-to-period comparisons of our financial results are not necessarily meaningful and you should not rely on them as an indication of future performance.
Geographic Information
The following table summarizes the distribution of revenue by geographic region as determined by billing address for the years ended December 31, 2010, 2009 and 2008.
Comparison of Years Ended December 31, 2010 and 2009
Revenues
Total revenue increased by $38.7 million or 24.5% to $196.4 million, subscription revenue increased by $20.8 million or 15.6% to $154.7 million and other revenue increased by $17.9 million or 74.9% to $41.7 million for the year ended December 31, 2010, compared to the same period in 2009. Subscription revenue represented approximately 78.8% of our total revenue for the year ended December 31, 2010.
The increase in total revenue for the year ended December 31, 2010 is attributable to volume increases in our recruitment process outsourcing and other consulting services, our Chinese variable interest entity, and favorable changes in foreign exchange rates, which contributed $11.9 million, $4.1 million and $0.8 million, respectively, compared to the same period in 2009. In addition, increases form the accounting effects relating to the adoption of ASU 2009-13, an increase in software subscription activity and the revenue from our recent acquisition of Salary.com contributed $2.9 million, $8.7 million and $10.3 million, respectively compared to the same period in 2009. Based upon the current market conditions, we expect our subscription-based and other revenues to continue to increase in 2010 and into 2011 over the prior year due to stabilization in the unemployment rate, improved business environment and continued acceptance of our talent management solutions on-demand model.
Cost of Revenues
Cost of revenue increased by $15.2 million or 28.2% to $68.5 million during the year ended December 31, 2010, compared to the same period in 2009. The $15.2 million increase was due to an increase in staff related expense, third party fees and reimbursable expenses of $11.8 million, $3.0 million and $1.1 million, respectively, partially offset by a reduction in severance expense of $0.7 million. The increase in staff related expense was due to an increase in headcount in our RPO division and our acquisitions of CHPD and Salary.com. As a percentage of revenue, cost of revenue increased by 1.0% to 34.9% for the year ended December 31, 2010, compared to the same period in 2009.
Sales and Marketing
Sales and marketing expense increased by $13.1 million or 36.9% to $48.2 million during the year ended December 31, 2010, compared to the same period in 2009. The $13.1 million increase was due primarily to increased staff and staff related expense of $7.5 million resulting from an increase in staff and additional personnel from our acquisitions of CHPD and Salary.com and $0.8 million in severance expense in connection with our acquisition of Salary.com. In addition, increased expenses relating to marketing, travel, bonus expenses and bad debt reserve contributed $1.8 million, $1.3 million, $0.8 million and $1.4 million to the increase as compared to the same period in 2009, partially offset by a decrease in third party consultants of $0.5 million, respectively. As a percentage of revenue, sales and marketing expense increased by 2.2% to 24.5%, for the year ended December 31, 2010.
General and Administrative
General and administrative expense increased by $7.5 million or 18.8% to $48.4 million during the year ended December 31, 2010, compared to the same period in 2009. The $7.5 million increase was due primarily to increased professional fees and rent and utility expenses contributed $4.0 million and 1.2 million, respectively, to the increase as compared to the same period in 2009. In addition, an increase in staff and staff related expense from our acquisitions, bonus expense and other expenses contributed of $0.5 million, $1.5 million and $0.8 million, respectively, partially offset by a reduction in share-based compensation expense of $0.5 million. The $4.0 million increase in professional fees was primarily due to litigation expenses from our class action and patent infringement suits and consulting fees from our recent acquisitions of approximately $4.6 million, partially offset by a reduction in variable interest entity setup fees of $0.6 million for the year ended December 31, 2010, compared to the same period in 2009. The increase in rent and utilities expense was primarily due to our recent acquisitions. As a percentage of revenue, general and administrative expense decreased by 1.2% to 24.7% for the year ended December 31, 2010, compared to the same period in 2009.
Research and Development
Research and development expense increased by $2.1 million or 22.0% to $11.9 million during for the year ended December 31, 2010, compared to the same period in 2009, due to an increase in staff expense of $2.2 million, partially offset by a reduction in severance expense of $0.1 million. As a percentage of revenue, research and development expense decreased by 0.1% to 6.1% for the year ended December 31, 2010, compared to the same period in 2009.
Capitalized software costs increased by $1.8 million or 18.6% to $11.5 million for the year ended December 31, 2010, compared to the same period in 2009. The remaining R&D activities have been expensed as incurred. Our total capitalized software costs and research and development expense totaled $23.4 million or 11.9% as a percentage of total revenue, for the year ended December 31, 2010. For the year ended December 31, 2009, our total capitalized software costs and research and development expense totaled $19.5 million or 12.4% as a percentage of total revenue.
Depreciation and Amortization
Depreciation and amortization expense increased by $5.4 million or 37.8% to $19.7 million during the year ended December 31, 2010, compared to the same period in 2009. The $5.4 million increase was due primarily to increased depreciation expense associated with our capitalized software and equipment purchases. In the future, we expect depreciation and amortization expense to increase due to recent capital purchases and as we place our software development costs into service. The increase in capitalized software development costs is directly attributable to an increase in the software development projects qualifying for capitalization, pursuant to ASC 350-40, “Internal-Use Software.”
Income Tax Expense
Income tax expense increased by $0.4 million or 21.6% to $2.3 million for year ended December 31, 2010, compared to the same period in 2009. During the year ended 2010, we made elections related to the acquisition of Salary.com under Section 338(g) of the Internal Revenue Code with the effect of increasing the tax basis of certain acquired intangible assets to equal the deemed purchase price of these assets. We are amortizing the increased tax basis of these acquired intangibles over a 15-year period for federal and state income tax purposes. The amortization of these intangibles gives rise to temporary differences between the book basis and tax basis of these assets.
Income tax expense of $1.9 million was recorded on a loss from operations of $29.0 million for the year ended December 31, 2009 as compared with an income tax benefit of $38.1 million for the year ended December 31, 2008. The current year income tax expense is primarily attributable to an increase in the valuation allowance of $7.3 million on federal, state and foreign net operating losses and the recognition of a goodwill impairment loss of $33.3 million that is only partially deductible for U.S. tax purposes.
We recorded a current Federal tax benefit of $1.7 million for 2010 based primarily on a domestic loss of $8.4 million which may be carried back to a previous year. Current state taxes of $0.4 million have been provided on taxable income recognized by certain domestic affiliated companies. Current foreign income tax expense of $1.6 million has been provided on foreign taxable income of $9.1 million. Deferred federal, foreign and state tax expense (benefit) of $1.3 million, ($0.2) million and $0.9 million, respectively, have been provided on changes in the difference between the book and tax basis of assets.
Webhire and BrassRing were two domestic companies which we acquired in 2006. During the year ended December 31, 2007, Webhire and BrassRing each made retroactive elections under Section 338(g) of the Internal Revenue Code with the effect of increasing the tax basis of certain acquired intangible assets to equal the deemed purchase price of these assets. We are amortizing the increased tax basis of these acquired intangibles over a 15-year period for federal and state income tax purposes. The amortization of these intangibles gives rise to temporary differences between the book basis and tax basis of these assets.
The goodwill impairment loss claimed in 2009 included certain intangible assets recorded by Webhire and BrassRing during their respective acquisitions. These intangibles are characterized as component-1 goodwill as we expect to recognize tax deductions as we amortize the tax basis of these assets over their remaining useful lives. The portion of impaired goodwill that has no tax basis is considered to be component-2 goodwill. We have allocated the impairment charge of $33.3 million between component-1 goodwill ($20.3 million) and component-2 goodwill ($13.0 million) and recorded a deferred tax asset computed on the difference between the book and tax bases of component-1 goodwill.
Changes to deferred income taxes are generally based on management's evaluation of our positive and negative evidence bearing upon the realizability of its deferred tax assets and the determination that it is more likely than not that we will realize a portion of the benefits of federal and state tax assets. In assessing the need for a valuation allowance, management considers all available information within each taxing jurisdiction, including past operating results, estimates of future taxable income and the feasibility of tax planning strategies. Any changes in management’s assessment of the amount of deferred tax assets that may be realized will result in an adjustment to its valuation allowance with a corresponding increase or decrease to income tax expense in the period in which such determination is made.
Comparison of Years Ended December 31, 2009 and 2008
Revenues
Total revenue decreased by $46.0 million or 22.6% to $157.7 million for the year ended December 31, 2009 from $203.7 million for the year ended December 31, 2008. Our subscription revenue decreased by $29.5 million to $133.9 million for the year ended December 31, 2009 from $163.4 million for the year ended December 31, 2008. Subscription revenue represented approximately 84.9% of our total revenue for the year ended December 31, 2009 compared to 80.2% of our total revenue for the year ended December 31, 2008. The decrease in revenue is attributable primarily to the effects of the global economic recession, increased pricing pressures, high unemployment, and reduced demand for our products and services and the effects of delayed revenue recognition associated with sales of our multiple element or bundled arrangements.
Cost of Revenues
Cost of revenue decreased by $8.2 million or 13.3% to $53.4 million for the year ended December 31, 2009 from $61.6 million for the year ended December 31, 2008. As a percentage of revenue, cost of revenue increased 3.7% to 33.9% for the year ended December 31, 2009 compared to 30.2% for the year ended December 31, 2008 due to decreased revenues in 2009. The $8.2 million decrease in the cost of revenue was primarily due to reduced staff expense, reimbursable expense and third party fees, including marketing and agency costs, of approximately $5.0 million, $2.5 million and $0.7 million, respectively, compared to the same period in 2008.
Sales and Marketing
Sales and marketing expense decreased by $5.7 million or 13.7% to $35.1 million for the year ended December 31, 2009 compared to $40.8 million for the year ended December 31, 2008. The $5.7 million decrease was primarily due to reduced staff related expense, commissions, travel expenses and reserve for bad debt of approximately $0.7 million, $1.4 million, $1.1 million, and $3.1 million, respectively, partially offset by an increase in other expenses of $0.6 million, compared to the same period in 2008. As a percentage of total revenue, sales and marketing expense increased by 2.3% to 22.3% for the year ended December 31, 2009 from 20.0% for the year ended December 31, 2008 due to decreased revenue.
General and Administrative
General and administrative expense decreased by $8.1 million or 16.5% to $40.8 million for the year ended December 31, 2009 compared to $48.9 million for the year ended December 31, 2008. The $8.1 million decrease was primarily due to reduced staff related expense, bonus, share-based compensation and travel expenses of approximately $2.8 million, $1.7 million, $0.6 million and $1.4 million, respectively. In addition, phone, entertainment and infrastructure expenses such as supplies, insurance and other expenses contributed approximately $0.5 million, $0.4 million, and $0.7 million, respectively, of the decrease in expense compared to the same period in 2008. As a percentage of total revenue, general and administrative expense increased by 1.9% to 25.9% for the year ended December 31, 2009 compared to 24.0% for the year ended December 31, 2008 due to decreased revenues in 2009.
Research and Development
Research and development expense decreased by $5.8 million or 37.3% to $9.8 million for the year ended December 31, 2009 compared to $15.6 million for the year ended December 31, 2008. The $5.8 million decrease in research and development expense was primarily due to reduced staff related expense and an increase in capitalized software development costs. Capitalized software development costs increased by $1.5 million or 18.3% to $9.7 million for the year ended December 31, 2009 from $8.2 million for the year ended December 31, 2008. The increase in capitalized software development costs was directly attributable to an increase in the software development projects qualifying for capitalization, pursuant to ASC 350-40, “Internal-Use Software”, and a decrease of research and development expenses. The increase in capitalized software development costs was due in part to greater use of third party software developers. As a percentage of total revenue, research and development expense decreased 1.4% to 6.2% for the year ended December 31, 2009 compared to 7.6% the year ended December 31, 2008. A small portion of our research and development expense relates to the efforts of our Kenexa Research Institute scientists, which is more fixed in nature. This cost structure will result in future research and development expense being more constant. .
Depreciation and Amortization
Depreciation and amortization expense increased $2.3 million or 18.0% to $14.3 million for the year ended December 31, 2009 compared to $12.0 million for the year ended December 31, 2008. The $2.3 million increase was due in part to increased amortization expense associated with our acquisitions and increased depreciation expense associated with our capitalized software and our capital purchases including our building in Vizag, India.
Goodwill Impairment
During the quarter ended March 31, 2009 we reevaluated our goodwill due to continued adverse changes in the economic climate, a 32.5% decline in our market capitalization from December 31, 2008 through March 31, 2009 and a downward revision in internal projections. These factors signaled a triggering event, which required us to determine whether and to what extent our goodwill may have been impaired as of March 31, 2009. We reviewed our goodwill by comparing the carrying values to the estimated fair values of the enterprise. Fair value is based on our estimate of the future discounted cash flows to be generated by the enterprise and our market capitalization. Such cash flows consider factors such as future operating income, historical trends, as well as demand and competition. Comparable company multiples are based upon public companies in sectors relevant to our business based on our knowledge of the industry. Changes in the underlying business could affect these estimates, which in turn could affect our assessment of the recoverability of goodwill. Based on the analysis a goodwill impairment charge of $33.3 million for was recorded to write off the remaining balance of our goodwill for the quarter ended March 31, 2009. The goodwill impairment charge had no effect on our cash balances. See Critical Accounting Policies and Estimates for additional details.
Interest Income
Net interest expense was less than $0.1 million for the year ended December 31, 2009 compared to $1.4 million net interest income for the year ended December 31, 2008. The $1.4 million decrease is due primarily to significantly lower rates of interest in 2009 and 2008 and the write off of deferred financing fees as a result of the termination of our Credit Agreement with PNC Bank.
Income Tax Expense
An income tax expense of $1.9 million was recorded on a loss from operations of $29.0 million for the year ended December 31, 2009 as compared with an income tax benefit of $38.1 million for the year ended December 31, 2008. The current year income tax expense is primarily attributable to an increase in the valuation allowance of $7.0 million on federal, state and foreign net operating losses and the recognition of a goodwill impairment loss of $33.3 million that is only partially deductible for U.S. tax purposes.
Webhire and BrassRing were two domestic companies which we acquired in 2006. During the year ended December 31, 2007, Webhire and BrassRing each made retroactive elections under Section 338(g) of the Internal Revenue Code with the effect of increasing the tax basis of certain acquired intangible assets to equal the deemed purchase price of these assets. We are amortizing the increased tax basis of these acquired intangibles over a 15-year period for federal and state income tax purposes. The amortization of these intangibles gives rise to temporary differences between the book basis and tax basis of these assets.
The goodwill impairment loss claimed in 2009 included certain intangible assets recorded by Webhire and BrassRing during their respective acquisitions. These intangibles are characterized as component-1 goodwill as we expect to recognize tax deductions as we amortize the tax basis of these assets over their remaining useful lives. The portion of impaired goodwill that has no tax basis is considered to be component-2 goodwill. We have allocated the impairment charge of $33.3 million between component-1 goodwill ($20.3 million) and component-2 goodwill ($13.0 million) and recorded a deferred tax asset computed on the difference between the book and tax bases of component-1 goodwill.
Changes to deferred income taxes are generally based on management's evaluation of our positive and negative evidence bearing upon the realizability of its deferred tax assets and the determination that it is more likely than not that we will realize a portion of the benefits of federal and state tax assets. In assessing the need for a valuation allowance, management considers all available information within each taxing jurisdiction, including past operating results, estimates of future taxable income and the feasibility of tax planning strategies. Any changes in management’s assessment of the amount of deferred tax assets that may be realized will result in an adjustment to its valuation allowance with a corresponding increase or decrease to income tax expense in the period in which such determination is made.
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Liquidity and Capital Resources
Since we were formed in 1987, we have financed our operations primarily through internally generated cash flows, our revolving credit facilities and the issuance of equity. As of December 31, 2010, we had cash and cash equivalents of $52.5 million. In addition, we had borrowings of $59.5 million from our credit and term loans in connection with our acquisition of Salary.com and enhance working capital and $0.3 million in capital equipment leases. Cash held in foreign denominated currencies was $10.9 million or 20.7% of our total cash balance as of December 31, 2010. A ten percent change in the exchange rate of the underlying currencies would not have a material impact on our foreign denominated cash balances on our statement of cash flows.
Our cash provided from operations was $25.9 million, $35.5 million and $32.5 million for the years ended December 31, 2010, 2009 and 2008, respectively. Cash used in investing activities was $63.1 million, $28.2 million and $18.1 million for the years ended December 31, 2010, 2009 and 2008, respectively. Cash provided by and (used in) financing activities was $60.4 million, $(0.2) million and $(29.7) million for the years ended December 31, 2010, 2009 and 2008, respectively. All of these effects in 2010 resulted in an increase in our cash and cash equivalents of $23.2 million for the year ended December 31, 2010. We expect positive cash flow from operations to continue in future periods.
We calculate our quarterly days sales outstanding (“DSO”) as ending net accounts receivable divided by quarterly net revenues multiplied by 90. In 2010, our DSO ranged from 59 to 67, and 61 to 67 in 2009.
During the quarter ended September 30, 2010 the Company exercised its right to sell the remaining auction rate securities back to UBS at par value realizing $6.6 million in proceeds, effectively liquidating its $13.9 million investment at December 31, 2009. Additionally, during the quarter ended September 30, 2010, in anticipation of the Salary.com acquisition (as discussed in Footnote 4 - Acquisitions of the Notes to the Consolidated Financial Statements) the Company liquidated the remaining balance of its municipal bonds, which totaled $15.6 million at December 31, 2009. (See Note 3 - Investments to our Consolidated Financial Statements included in this Annual Report on Form 10-K for more information).
On July 26, 2010, we acquired CHPD which operates as a leadership development and management training company based in London, England for a purchase price of approximately $4.2 million in cash. The total cost of the acquisition, including estimated legal, accounting, and other professional fees was approximately $4.4 million.
On October 1, 2010, we acquired Salary.com, a provider of on-demand compensation software that helps businesses and individuals manage pay and performance, for approximately $78.4 million in cash. The total cost of the acquisition, including legal, accounting, and other professional fees of $4.4 million, was approximately $82.8 million. As part of the Salary.com transaction we were required to repay approximately $2.5 million of Salary.com debt during the fourth quarter of 2010.
On, October 20, 2010, we terminated and paid all outstanding amounts under our secured Credit Agreement, dated August 31, 2010, and entered into an amended credit agreement with PNC Bank. The maximum amount available under the amended credit agreement is $60.0 million, comprised of a $35.0 million revolving facility, including a sublimit of up to $5.0 million for letters of credit and a sublimit of up to $2.5 million for swing loans (the “Revolving Facility”), and a $25.0 million term facility (the “Term Facility”). We may request to increase the maximum amount available under the Revolving Facility to $50.0 million. The amended credit agreement will terminate, and all borrowings will become due and payable, on October 19, 2013. We and each of our U.S. subsidiaries are guarantors of the obligations under the amended credit agreement. Borrowings under the amended credit agreement are secured by substantially all of our assets (including a pledge of the capital stock of their subsidiaries (but limited to only 65% of the voting stock of first-tier foreign subsidiaries)). As of December 31, 2010 we borrowed $59.5 million under the Credit Agreement in connection with the acquisition of Salary.com and to enhance working capital.
Operating Activities
Historically, our largest source of operating cash flows was cash collections from our customers following the purchase and renewal of their software subscriptions. Payments from customers for subscription agreements are generally received quarterly in advance of providing services. We also generate significant cash from our recruitment process outsourcing services, and to a lesser extent, our consulting services. Our primary uses of cash from operating activities are for personnel related expenditures as well as payments related to taxes and leased facilities.
Net cash provided by operating activities was $25.9 million, $35.5 million and $32.5 million for the years ended December 31, 2010, 2009 and 2008, respectively.
Net cash provided by operating activities for the year ended December 31, 2010 resulted primarily from a net loss of approximately $3.0 million, changes in working capital of $2.9 million and in increase in accounts receivables of $9.2 million offset by non-cash charges to net income of $25.7 million, an increase in deferred revenue of $12.1 million and a decrease in deferred tax benefits of $3.2 million.
Net cash provided by operating activities for the year ended December 31, 2009 resulted primarily from a net loss of approximately $31.0 million, an increase in deferred tax benefits of $0.4 million and other changes in working capital of $5.0 million, offset by a non-cash charge to goodwill impairment of $33.3 million, other non-cash charges of $19.6 million, accounts and unbilled receivables of $7.8 million and deferred revenue of $11.2 million.
Net cash provided by operating activities for the year ended December 31, 2008 resulted primarily from a net loss of approximately $104.7 million, an increase in deferred tax benefits of $46.5 million and other changes in working capital of $8.4 million, partially offset by a non-cash charge to goodwill impairment of $167.0 million, other non-cash charges of $20.9 million, and deferred revenue of $4.2 million.
During 2008, we completed a restructuring plan to decrease costs by reducing our workforce across our organization and by consolidating facilities where the workforce reductions resulted in excess office space. This restructuring plan was designed to decrease costs by reducing our workforce throughout the company of approximately 200 employees. We recorded restructuring and other charges and made payments of $2.0 million during fiscal 2008. As a result of the continued deterioration in the economic environment during the first quarter of 2009, we executed an additional reduction in force resulting in the elimination of approximately 159 employees, as a result we incurred severance and outplacement benefit costs totaling $1.2 million.
Investing Activities
Net cash used in investing activities was $63.1 million, $28.2 million and $18.1 million for the years ended December 31, 2010, 2009 and 2008, respectively. Cash flows used in investing activities consisted primarily of adjustments for acquisitions, escrow payments, earnouts, securities and additional capital equipment and developed software as follows:
Financing Activities
Net cash provided by financing activities was $60.4 million for the year ended December 31, 2010. Net cash used in financing activities was $0.2 million and $29.7 million for the years ended December 31, 2009 and 2008, respectively.
For the year ended December 31, 2010, net cash provided by financing activity resulted primarily from net proceeds from borrowing under our revolving credit line and term loan of $59.5 million, net proceeds from stock option exercises of $3.9 million, and share issuance from our employee stock purchase plan of $0.4 million, partially offset by deferred financing costs of $0.6 million, repayments of borrowings under our revolving credit line of $2.5 million, repayments of capital lease obligations of $0.2 million, and net repayments of notes payable of $0.1 million.
For the year ended December 31, 2009, net cash used in financing activity resulted primarily from our variable interest entity of $0.2 million, repayments of capital lease obligations and notes payable of $0.4 million, partially offset by net proceeds from stock option exercises of $0.1 million, and share issuance from our employee stock purchase plan of $0.3 million.
For the year ended December 31, 2008, net cash used in financing activity resulted primarily from repurchases of our common shares of $30.3 million and repayments of capital lease obligations and notes payable of $0.3 million, partially offset by net proceeds from stock option exercises of $0.4 million, excess tax benefits from share-based payment arrangements of $0.2 million, and share issuance from our employee stock purchase plan of $0.3 million.
Unaudited Quarterly Statements of Operations
The following tables present our unaudited quarterly results of operations for each of the eight quarters in the period ended December 31, 2010 and our unaudited quarterly results of operations expressed as a percentage of our total revenue for the same periods. You should read the following tables in conjunction with our audited consolidated financial statements and related notes appearing in this annual report on Form 10-K. We have prepared the unaudited information on a basis consistent with our audited consolidated financial statements and have included all adjustments, which, in the opinion of management, are necessary to fairly present our operating results for the quarters presented. Our historical unaudited quarterly results of operations are not necessarily indicative of results for any future quarter or for a full year.
Comparison of Unaudited Quarterly Results
Revenues
Subscription-based and other revenues increased slightly or remained flat during 2009 due to a greater number of customers delaying or revising the terms and conditions of our service agreements, the strengthening US dollar, the loss of RPO customers, and a loss of consulting engagements. Total revenue increased throughout 2010 over the prior year due to purchases of our solutions by new customers, purchases of additional solutions by existing customers, contract renewals, increase in RPO services and positive economic conditions.
Cost of Revenues
Cost of revenue for the quarters presented has fluctuated between 32.6% and 35.4% based on the mix of sales between subscription revenue and other revenue. Cost of revenue was highest as a percentage of total revenue for the three months ended December 31, 2010. As our overall revenue fluctuates, we expect our cost of revenue to change proportionately, subject to pricing pressure related to economic conditions and slightly influenced by the mix of services and software. To the extent new customers are added, the cost of services, as a percentage of revenue, will be greater than those services associated with existing customers.
Sales and Marketing
Following our acquisitions in 2010 and our rebranding initiatives in 2009 sales and marketing increased from approximately 20.9% in 2009 to 25.6% in 2010 of our total revenues for those periods. During 2010, sales and marketing expenses increased in terms of absolute dollars as a result of increased marketing programs, variable compensation programs and our recent acquisition of CHPD and Salary.com. During 2009, based on economic conditions we reduced our sales and marketing expenditures to adjust for expected lower rates of growth projections. In the future, we intend to invest in sales and marketing to pursue new customers, expand relationships with existing customers and market and advertise our new brand to existing and potential customers at levels we deem appropriate given our current economic conditions.
General and Administrative
General and administrative expenses for the quarters presented have fluctuated as a percentage of revenues between 23.7% and 28.0% due to our professional fees in connection with our patent infringement matter and our recent acquisitions. In 2010 our general and administrative expense decreased as a percentage of revenues from the prior year due to increased revenue, but increased in the fourth quarter of 2010 due to increased professional fees and rent expense. In the longer term based upon the current state of the economy, we believe that general and administrative expenses will remain the same or slightly increase in dollar amount and remain constant or decrease as a percentage of total revenue in 2011.
Research and Development
Research and development expenses for the quarters presented have fluctuated as a percentage of revenues from 4.8% to 6.9% due to increases in capitalized software development costs during 2010 and 2009. The increase in capitalized software development costs was due in part to continued development and enhancements of our 2x platform™ and enhancement and upgrades our existing products.
Goodwill Impairment
During the three months ended March 31, 2009 we reviewed the carrying values of goodwill by comparing the carrying values to the estimated fair values of the enterprise. The fair value is based on management’s estimate of the future discounted cash flows to be generated by the enterprise and our market capitalization. Such cash flows consider factors such as future operating income, historical trends, as well as demand and competition. Comparable company multiples are based upon public companies in sectors relevant to our business based on our knowledge of the industry. Changes in the underlying business could affect these estimates, which in turn could affect our assessment of the recoverability of goodwill. Due to adverse changes in the economic climate, a decline in our market capitalization from October 1, 2008, and a downward revision in earnings guidance, we reevaluated our goodwill impairment analysis. Based on the analysis, a goodwill impairment charge of $33.3 million for the three months ended March 31, 2009 was recorded. The goodwill impairment charge had no effect on our cash balances.
Contractual Obligations and Commitments
The following table summarizes our contractual obligations at December 31, 2010:
The amounts listed above for put option represent the amounts based upon the December 31, 2010 accretion calculation whereby the sellers (noncontrolling interests) can enforce its put option at anytime to the Company.
The amounts listed above for credit facility represents the payments that we are required to make for borrowings under our amended credit agreement.
The amounts listed above for capital lease obligations represent payments that we are required to make for equipment. If we fail to remain current with our obligations for any of these capital leases, we would be in default, and our continued failure to cure such a default would cause our remaining obligations under the defaulted capital lease to become immediately due.
The amounts listed above for operating leases represent our leases for office space, copiers and other operating obligations. If we fail to make rent payments on any of these operating leases when due, we will be required to pay all remaining rent payments on the leases.
We had no off-balance sheet arrangements for the periods presented in this Annual Report on Form 10-K.
Recently Adopted Accounting Pronouncements
In December 2007, the FASB issued ASC 810-10, “Consolidation-Overall,” and ASC 805, “Business Combinations.” Changes for business combination transactions pursuant to ASC 805 include, among others, expensing of acquisition-related transaction costs as incurred, the recognition of contingent consideration arrangements at their acquisition date fair value and capitalization of in-process research and development assets acquired at their acquisition date fair value. Changes in accounting for noncontrolling (minority) interests pursuant to ASC 810-10 include, among others, the classification of noncontrolling interest as a component of consolidated shareholders’ equity and the elimination of "minority interest" accounting in results of operations. ASC 805 is required to be adopted and was effective for fiscal years beginning on or after December 15, 2008. The adoption of ASC 805 and ASC 810-10 impacted our accounting related to the consolidation of its variable interest entity in 2009 and impacted the accounting for our current acquisition.
In June 2009, the FASB issued new accounting guidance for variable interest entities. This guidance was codified under ASU 2009-17 in December 2009 and includes: (1) the elimination of the exemption from consolidation for qualifying special purpose entities, (2) a new approach for determining the primary beneficiary of a variable interest entity (“VIE”), which requires that the primary beneficiary have both (i) the power to control the most significant activities of the VIE and (ii) either the obligation to absorb losses or the right to receive benefits that could potentially be significant to the VIE, and (3) the requirement to continually reassess who should consolidate a VIE. The new guidance is effective for annual reporting periods that begin after November 15, 2009 and applies to all existing and new VIEs. We adopted ASU 2009-17 on January 1, 2010 and the adoption did not have a material impact on our financial statements.
In January 2010, we adopted the Accounting Standards Update (“ASU”) No. 2009-13, “Revenue Recognition: Multiple-Deliverable Revenue Arrangements - a consensus of the FASB Emerging Issues Task Force,” which eliminates the use of the residual method for allocating consideration, as well as the criteria that requires objective and reliable evidence of fair value of undelivered elements in order to separate the elements in a multiple-element arrangement. By removing the criterion requiring the use of objective and reliable evidence of fair value in separately accounting for deliverables, the recognition of revenue will more closely align with certain revenue arrangements. The standard also will replace the term "fair value" in the revenue allocation guidance with “selling price” to clarify that the allocation of revenue is based on entity-specific assumptions rather than assumptions of a marketplace participant. ASU No. 2009-13 is effective for revenue arrangements entered or materially modified in fiscal years beginning on or after June 15, 2010. The adoption did not have a material impact on the Company’s financial statements. See “Revenue Recognition” above for further details, including financial impact.
Recent Accounting Pronouncements
In December 2010, the FASB issued ASU 2010-28, “Intangibles - Goodwill and Other (Topic 350): When to Perform Step 2 of the Goodwill Impairment Test for Reporting Units with Zero or Negative Carrying Amounts.” For reporting units with zero or negative carrying amounts, if it is more likely than not that a goodwill impairment exists, ASU 2010-28 requires performance of an additional test to determine whether goodwill has been impaired and to calculate the amount of impairment. In determining whether it is more likely than not that a goodwill impairment exists, an entity should consider whether there are any adverse qualitative factors indicating that an impairment may exist. ASU 2010-28 is effective for fiscal years and interim periods within those years beginning after December 15, 2010. We will adopt ASU 2009-28 in the first quarter of 2011. The impact of adopting ASU 2010-28 will not be known until we perform our evaluations of goodwill impairment.
In December 2010, the FASB issued ASU 2010-29, “Business Combinations (Topic 805): Disclosure of Supplementary Pro Forma Information for Business Combinations.” ASU 2010-29 specifies that, for material business combinations when comparative financial statements are presented, revenue and earnings of the combined entity should be disclosed as though the business combination had occurred as of the beginning of the comparable prior annual reporting period. ASU 2010-09 also expands the supplemental pro forma disclosures to include a description of the nature and amount of material, nonrecurring pro forma adjustments directly attributable to the business combination included in the reported pro forma revenue and earnings. ASU 2010-09 is effective prospectively for business combinations with an acquisition date on or after the beginning of the first annual reporting period after December 15, 2010. We will adopt this standard for acquisitions in 2011.
ITEM 7A.
ITEM 7A. Quantitative and Qualitative Disclosures About Market Risk
Market risk represents the risk of loss that may impact our financial position due to adverse changes in financial market prices and rates. Our market risk exposure is primarily a result of fluctuations in interest rates and foreign currency exchange rates. We do not hold or issue financial instruments for trading purposes.
Foreign Currency Exchange Risk
In 2010, approximately 73.7% of our total revenue was comprised of sales to customers in the United States. A key component of our business strategy is to expand our international sales efforts, which will expose us to foreign currency exchange rate fluctuations. A 10% increase in the value of the U.S. dollar during 2010, relative to each currency in which our non-U.S. generated sales are denominated would have resulted in reduced annual revenues of approximately 3.4% for the year ended December 31, 2010.
The financial position and operating results of our foreign operations are consolidated using the local currency as the functional currency. Local currency assets and liabilities are translated at the rate of exchange to the U.S. dollar on the balance sheet date, and the local currency revenue and expenses are translated at average rates of exchange to the U.S. dollar during the period. The related translation adjustments to shareholders’ equity were a decrease of $0.6 million and $0.9 million during 2010 and 2009, respectively, and are included in other comprehensive income (loss). The foreign currency translation adjustment is not adjusted for income taxes because it relates to an indefinite investment in a non-U.S. subsidiary.
Interest Rate Risk
The primary objective of our investment activities is to preserve principal while maximizing income without significantly increasing risk. Some of the securities in which we invest may be subject to market risk. This means that a change in prevailing interest rates may cause the principal amount of the investment to fluctuate. To minimize this risk in the future, we intend to maintain our portfolio of cash equivalents and short-term investments in a variety of securities, including commercial paper, money market funds, government and non-government debt securities and certificates of deposit. Our cash equivalents, which consist solely of money market funds, are not subject to market risk because the interest paid on these funds fluctuates with the prevailing interest rate. We believe that a 10% change in interest rates would not have had a significant effect on our interest income for the year ended December 31, 2010.
We also have a $59.5 million loan with PNC Bank N.A., of which $12.5 million is subject to an interest rate swap, which we used to partially fund our acquisition of Salary.com in the third quarter of 2010. We performed a sensitivity analysis on the outstanding variable portion of this loan as of December 31, 2010. The analysis is based on an estimate of the hypothetical changes in annual interest expense that would result from an immediate increase/decrease in interest rates.
ITEM 8.
ITEM 8. Financial Statements and Supplementary Data
Page
Report of Independent Registered Public Accounting Firm
Consolidated Financial Statements:
Consolidated Balance Sheets as of December 31, 2010 and 2009
Consolidated Statements of Operations for the years ended December 31, 2010, 2009 and 2008
Consolidated Statements of Shareholders’ Equity for the years ended December 31, 2010, 2009 and 2008
Consolidated Statements of Cash Flows for the years ended December 31, 2010, 2009 and 2008
Notes to Consolidated Financial Statements
Report of Independent Registered Public Accounting Firm
Board of Directors and Shareholders
Kenexa Corporation
We have audited the accompanying consolidated balance sheets of Kenexa Corporation and Subsidiaries (collectively, Kenexa Corporation) (a Pennsylvania corporation) as of December 31, 2010 and 2009, and the related consolidated statements of operations, shareholders’ equity, comprehensive income (loss), and cash flows for each of the three years in the period ended December 31, 2010. These financial statements are the responsibility of the Kenexa Corporation’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Kenexa Corporation and Subsidiaries as of December 31, 2010 and 2009, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2010, in conformity with accounting principles generally accepted in the United States of America.
As discussed in Note 2 to the consolidated financial statements, the Company has adopted the new accounting guidance related to revenue recognition for multiple-element arrangements.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Kenexa Corporation’s internal control over financial reporting as of December 31, 2010, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated March 16, 2011 expressed an unqualified opinion.
/s/ Grant Thornton LLP
Philadelphia, PA
March 16, 2011
Kenexa Corporation and Subsidiaries
Consolidated Balance Sheets
(in thousands, except share data)
See notes to consolidated financial statements.
Kenexa Corporation and Subsidiaries
Consolidated Statements of Operations
(in thousands, except share and per share data)
See notes to consolidated financial statements.
Kenexa Corporation and Subsidiaries
Consolidated Statements of Shareholders’ Equity
(in thousands)
See notes to consolidated financial statements.
Kenexa Corporation and Subsidiaries
Consolidated Statements of Cash Flows
(in thousands)
See notes to consolidated financial statements.
Kenexa Corporation and Subsidiaries
Notes to Consolidated Financial Statements
(All amounts in thousands, except share and per share data, unless noted otherwise)
1. Organization
Kenexa Corporation and its subsidiaries (collectively the “Company” or “Kenexa”) commenced operations in 1987 as a provider of recruiting services to a wide variety of industries. In 1993, the Company offered its first automated talent management system. Between 1994 and December 31, 2010, the Company acquired 30 businesses that enabled it to offer comprehensive human capital management, or HCM, services integrated with web-based technology. The Company’s business solutions include a comprehensive suite of on-demand software applications and complementary services, including outsourcing services and consulting, to help global organizations recruit high-performing individuals and to foster optimal work environments to increase employee productivity and retention.
The Company began its operations in 1987 under its predecessor companies, Insurance Services, Inc., or ISI, and International Holding Company, Inc., or IHC. In December 1999, the Company reorganized its corporate structure by merging ISI and IHC with and into Raymond Karsan Associates, Inc., or RKA, a Pennsylvania corporation and a wholly-owned subsidiary of Raymond Karsan Holdings, Inc., or RKH, a Pennsylvania corporation. Each of RKA and RKH were newly created to consolidate the businesses of ISI and IHC. In April 2000, the Company changed its name to TalentPoint, Inc. and changed the name of RKA to TalentPoint Technologies, Inc. In November 2000, the Company changed its name to Kenexa Corporation, and changed the name of TalentPoint Technologies, Inc. to Kenexa Technology, Inc., or Kenexa Technology. Currently, Kenexa transacts business primarily through Kenexa Technology. Although the Company has several product lines, our chief decision makers determine resource allocation decisions and assess and evaluate periodic performance under one operating segment.
2. Summary of Significant Accounting Policies
In June 2009, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Codification 2009-01, “Amendments based on Statement of Financial Accounting Standards No. 168 - The FASB Accounting Standards Codification™ and the Hierarchy of Generally Accepted Accounting Principles,” to codify in ASC 105, “Generally Accepted Accounting Principles,” FASB Statement 168, “The FASB Accounting Standards Codification™ and the Hierarchy of Generally Accepted Accounting Principles,” which was issued to establish the Codification as the sole source of authoritative U.S. GAAP recognized by the FASB, excluding SEC guidance, to be applied by nongovernmental entities. The guidance in ASC 105 was effective for financial statements issued for interim and annual periods ending after September 15, 2009. The Company revised its references to pre-Codification GAAP and noted there was no impact on the financial condition or results of operations of the Company.
Use of Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates, and such differences may be material to the Company’s consolidated financial statements.
Principles of Consolidation
The consolidated financial statements of the Company include the accounts of Kenexa Corporation and its subsidiaries and variable interest entity as described in Footnote 5 - Variable Interest Entity in the Notes to Consolidated Financial Statements. All significant intercompany accounts and transactions have been eliminated in consolidation.
Kenexa Corporation and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
(All amounts in thousands, except share and per share data, unless noted otherwise)
2. Summary of Significant Accounting Policies (continued)
Fair Value of Financial Instruments
The carrying amounts of the Company’s financial assets and liabilities, including cash and cash equivalents, restricted cash, accounts receivable, short-term investments and put option, if presented, accounts payable and accrued expenses at December 31, 2010 and 2009 approximate fair value of these instruments due to their short-term nature.
In accordance with ASC 820, the Company uses three levels of inputs to measure fair value:
•
Level 1 - Quoted prices in active markets for identical assets or liabilities.
•
Level 2 - Observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, quoted prices in markets with insufficient volume or infrequent transactions (less active markets), or valuations in which all significant inputs are observable or can be obtained from observable market data.
•
Level 3 - Unobservable inputs to the valuation methodology that are significant to the measurement of the fair value of assets or liabilities.
The Company values its interest rate swap using widely accepted valuation techniques including discounted cash flow analysis on the expected cash flows of each interest rate swap. This analysis reflects the contractual terms of the interest rate swap, including the period to maturity, and uses observable market-based inputs, including interest rate curves and implied volatilities. The fair value of the interest rate swap is determined using the market standard methodology of netting the discounted future fixed cash payments and the discounted expected variable cash receipts. The variable cash receipts are based on an expectation of future interest rates (forward curves) derived from observable market interest rate curves. The Company also incorporates credit valuation adjustments to appropriately reflect both its own nonperformance risk and the respective counterparty’s nonperformance risk in the fair value measurements. In adjusting the fair value of its interest rate swap for the effect of nonperformance risk, the Company has considered the impact of netting and any applicable credit enhancements, such as collateral postings.
Foreign Currency Translation
The financial position and operating results of the Company’s foreign operations are consolidated using the local currency as the functional currency. Local currency assets and liabilities are translated at the rate of exchange to the U.S. dollar on the balance sheet date, and the local currency revenues and expenses are translated at average rates of exchange to the U.S. dollar during the reporting period. The operations of the variable interest entity in China are translated from Chinese Yuan Renminbis, for which the current exchange rate is approximately 6.6 renminbis to one U.S. dollar. The related translation adjustments are reported in the shareholders’ equity section of the balance sheet and resulted in a net reduction in shareholders’ equity of $607, $925 and $3,861 for the years ended December 31, 2010, 2009 and 2008, respectively. The foreign currency translation adjustment is not adjusted for income taxes as it relates to an indefinite investment in a non-U.S. subsidiary. Transaction losses resulting from the Company’s foreign operations totaled $417, $66 and $400 for the years ending December 31, 2001, 2009 and 2008, respectively.
Comprehensive (Loss) Income
Comprehensive (loss) income consists of net gains and losses on foreign currency translation adjustments, net unrealized gains and losses on short-term investments, income allocated to noncontrolling interest accretion associated with noncontrolling interest and net income or loss and is reported on the accompanying consolidated statements of shareholders’ equity. For the years ended December 31, 2010, 2009 and 2008 comprehensive loss was $6,140, $32,161 and $108,520, respectively
Kenexa Corporation and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
(All amounts in thousands, except share and per share data, unless noted otherwise)
2. Summary of Significant Accounting Policies (continued)
Concentration of Credit Risk
Financial instruments which potentially expose the Company to concentration of credit risk consist primarily of accounts receivable. Credit risk arising from receivables is mitigated by the large number of customers comprising the Company's customer base and their dispersion across various industries. The Company does not require collateral. The customers are concentrated primarily in the Company’s U.S. market area. At December 31, 2010 and 2009, there were no customers that represented more than 10% of the net accounts receivable balance. In addition, there were no customers that individually exceeded 10% of the Company's revenues for the years ended December 31, 2010, 2009 and 2008.
As discussed in Footnote 3 - Investments in the Notes to the Consolidated Financial Statements, the Company sold its auction rate securities back to UBS AG in July 2010.
Cash and Cash Equivalents
Cash and cash equivalents consist of highly liquid investments with remaining maturities of three months or less at the time of purchase. Cash which is restricted for lease deposits is included in other assets. Cash balances are maintained at several banks. Cash held in fixed term deposits with original maturities of three months or less at the time of purchase totaled $829 and $322 as of December 31, 2010 and 2009, respectively. Accounts located in the United States are insured by the Federal Deposit Insurance Corporation ("FDIC") up to $100 (which has been temporarily increased to $250 through December 31, 2013). Certain operating cash accounts may periodically exceed the FDIC limits.
Cash and cash equivalents in foreign denominated currencies which are held in foreign banks totaled $10,862 and $7,994 and represented 20.7% and 27.4% of our total cash and cash equivalents balance at December 31, 2010 and 2009, respectively.
Investments
Investments as of December 31, 2009 include floating rate letter of credit backed securities, municipal bonds and auction rate securities. The maturities of these securities may range from one day to approximately one year and are rated A, AA and AAA by various rating agencies. Certain investments are recorded at fair value based on current market rates and are classified as available-for-sale. Changes in the fair value are included in accumulated other comprehensive (loss) income in the accompanying consolidated financial statements. Other investments, including auction rate securities, are recorded at fair value and are classified as trading securities. Changes in the fair value are included in the statement of operations in the accompanying consolidated financial statements. Both the cost and realized gains and losses of these securities are calculated using the specific identification method. During the quarter ended September 30, 2010, the Company sold the remaining balance of its auction rate securities and municipal bonds. See Footnote 3 - Investments in the Notes to Consolidated Financial Statements for further details.
Investment income
Investment income includes changes in the fair value of auction rate securities, put option related to the UBS Settlement Agreement and changes in the fair value of municipal bond securities. See Footnote 3 - Investments in the Notes to Consolidated Financial Statements for further details.
Kenexa Corporation and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
(All amounts in thousands, except share and per share data, unless noted otherwise)
2. Summary of Significant Accounting Policies (continued)
Allowance for Doubtful Accounts
The Company records an allowance for doubtful accounts based on specifically identified amounts that management believes to be uncollectible. The Company also records an additional allowance based on certain percentages of aged receivables, which is determined based on historical experience and management's assessment of the general financial conditions affecting the Company's customer base. If actual collections experience changes, revisions to the allowance may be required. Activity in the allowance for doubtful accounts is as follows:
Prepaid Expenses and Other Assets
Prepaid expenses and other current assets as of December 31, 2010 and 2009 are as follows:
(1)
Deferred implementation costs represent internal payroll and other costs incurred in connection with the configuration of the sites associated with our internet hosting arrangements. Prior to our adoption of ASU 2009-13 on January 1, 2010 (see revenue recognition accounting policy for implementation service revenue), these costs were deferred over the implementation period which preceded the hosting period, typically three to four months, and were expensed ratably when the hosting period commenced, typically four to five years. The deferred costs at December 31, 2010 relate to implementations which commenced prior to the adoption of ASU 2009-13 and will continue to be deferred until such time as the hosting or license period for those specific contracts commences, at which time these costs will be expensed over the hosting period in accordance with our previous accounting policy. Implementation costs for contracts signed or modified after January 1, 2010, our date of adoption of ASU 2009-13, will be expensed as incurred. During the year ended December 31, 2010, approximately $481 of previously deferred costs were expensed as cost of revenues for a certain contract that is now being recognized in accordance with our new revenue recognition policy in connection with a material modification of that contract during the quarter ended March 31, 2010.
Kenexa Corporation and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
(All amounts in thousands, except share and per share data, unless noted otherwise)
2. Summary of Significant Accounting Policies (continued)
Property and Equipment
Property and equipment are stated at cost. Equipment under capital lease is stated at the lower of the fair market value at the date of acquisition or net present value of the minimum lease payments at inception of the lease. Depreciation and amortization expense are recognized on a straight-line basis over the assets' estimated useful lives or, if shorter, the lease terms for leasehold improvements. Estimated useful lives are generally 7 years for office furniture, and 3 to 5 years for computer equipment and software. Reviews are regularly performed if facts and circumstances exist that indicate that the carrying amount of assets may not be recoverable or that the useful life is shorter than originally estimated. Costs of maintenance and repairs are charged to expense as incurred. When property and equipment or leasehold improvements are sold or otherwise disposed of, the fixed asset account and related accumulated depreciation account are relieved and any gain or loss is included in results of operations. Costs of software not yet placed into service are accumulated as software in development. Upon placement into service, the costs of the assets are transferred to software. Construction costs not yet placed into service are accumulated as building construction in progress. Upon placement into service, the costs of the assets are transferred to building. In January 2008, the building in Vizag, India was placed into service and is being depreciated over 30 years. All costs of the building have been transferred out of construction in progress.
Software Developed for Internal Use
The Company applies FASB ASC 350, “Intangibles-Goodwill and Other, Internal-Use Software.” The costs incurred in the preliminary stages of development are expensed as incurred. Once an application has reached the development stage and technological feasibility has been established, internal and external costs, if direct and incremental, are capitalized until the software is substantially complete and ready for its intended use. Capitalization ceases upon completion of all substantial testing. The Company also capitalizes costs related to specific upgrades and enhancements when it is probable the expenditures will result in additional functionality. Maintenance and training costs are expensed as incurred. Internal use software is amortized on a straight-line basis over its estimated useful life, generally three years. Management evaluates the useful lives of these assets on an annual basis and tests for impairments whenever events or changes in circumstances occur that could impact the recoverability of these assets. There were no impairments to internal software in any of the periods covered in these consolidated financial statements.
The Company capitalized internal-use software costs for the years ended December 31, 2010, 2009 and 2008 of $11,515, $9,665 and $8,137, respectively. Amortization of capitalized internal-use software costs for the years ended December 31, 2010, 2009 and 2008 was $7,055, $3,623 and $1,629, respectively.
Other long-term assets
Other long-term assets as of December 31, 2010 and 2009 are as follows:
(1)
Upon completion of the escrow term or settlement of any outstanding claims, all remaining escrow balances are reclassified to additional purchase price consideration for the respective acquisition, for acquisitions that occurred prior to January 1, 2009.
Kenexa Corporation and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
(All amounts in thousands, except share and per share data, unless noted otherwise)
2. Summary of Significant Accounting Policies (continued)
Goodwill
Since 2002, the Company has recorded goodwill in accordance with the provisions of FASB ASC 350, “Intangibles-Goodwill and Other,” which discontinued the amortization of existing goodwill and instead requires the Company to annually review the carrying value of goodwill for impairment. Prior to 2007, the Company evaluated the carrying value of its goodwill under two reporting units within its single reporting segment. During 2007, the Company combined those two reporting units into a single reporting unit to be in alignment with its organizational and management structure, which was evaluated and restructured as part of the integration of our acquired businesses. As a result, in 2007 and 2008, goodwill was evaluated at the enterprise or Company level. Following its investment in the variable interest entity in China in 2009, the Company reverted to evaluating the carrying value of goodwill under two reporting units within a single segment. The Company performs an annual review in the fourth quarter of each year, or more frequently if indicators of potential impairment exist, to determine if the carrying value of the recorded goodwill is impaired.
The Company evaluated its goodwill by comparing to the fair values of its reporting units, based upon management's estimate of the future discounted cash flows to be generated by the business using level three inputs and comparable company multiples, to their carrying values . These cash flows consider factors such as future operating income, historical trends, as well as demand and competition. Comparable company multiples are based upon public companies in sectors relevant to the Company's business based on its knowledge of the industry. Changes in the underlying business could affect these estimates, which in turn could affect the recoverability of goodwill. Management determined that the carrying values of its reporting units did not exceed the fair values and as a result believes that no impairment of goodwill existed at December 31, 2010.
In 2009 and 2008 after completing its analysis management determined the carrying value of its goodwill exceeded the fair value. The next step entailed performing an analysis to determine whether the carrying amount of goodwill on the Company’s balance sheet exceeded its implied fair value. The implied fair value of the Company’s goodwill for this step was determined in a similar manner as goodwill recognized in a business combination. That is, the estimated fair value of the Company was allocated to its assets and liabilities, including any unrecognized identifiable intangible assets, as if the Company had been acquired in a hypothetical business combination with the estimated fair value of the Company representing the price paid to acquire it. The allocation process performed on each test date was only for purposes of determining the implied fair value of goodwill with no assets or liabilities written up or down, nor any additional unrecognized identifiable intangible assets recorded as part of this process. Based on these analyses, management recorded goodwill impairment charges of $167,011 for the quarter and year ended December 31, 2008 and $33,329 for the quarter ended March 31, 2009. The goodwill impairment charges had no effect on the Company’s cash balances.
The changes in the carrying amount of goodwill, which include adjustments for earnouts, taxes, foreign currency, escrow, acquisitions and impairment charges, for the years ended December 31, 2010, 2009 and 2008 are as follows:
Kenexa Corporation and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
(All amounts in thousands, except share and per share data, unless noted otherwise)
2. Summary of Significant Accounting Policies (continued)
Long-Lived Assets
The Company evaluates its long-lived assets, including certain identifiable assets, for impairment whenever events or circumstances indicate that the carrying value of such assets may not be recoverable. In connection with the Company’s goodwill impairment analysis for each of the periods ended December 31, 2009 and 2008, the Company evaluated its long-lived assets, including certain identifiable intangible assets, for potential impairment by comparing the carrying amount of the asset to future net cash flows expected to be generated by the asset, pursuant to FASB ASC 360-10-35, “Impairment or Disposal of Long-Lived Assets,” and determined that no such assets were impaired. Given the general current economic climate, it is possible that the estimated future cash flows of the asset groupings will be reduced, which may result in an impairment in future periods. If such assets are considered to be impaired, the impairment is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets.
Intangible Assets
Intangible assets consist of intellectual property, non-compete agreements, customer lists and trademarks. Intellectual property, non-compete agreements and trademarks are amortized on a straight-line basis over their estimated useful lives or contract periods, generally ranging from 3 to 20 years. Customer lists are amortized based on the attrition rate of our customers. The amounts were based, in part, on an analysis of the incremental cash flows expected to be derived from the customer lists using historic retention rates and an appropriate discount rate. Amortization expense related to these intangible assets was $5,753, $4,475 and $5,168 for 2010, 2009 and 2008, respectively.
Intangible Assets subject to amortization at December 31, 2010 and 2009 consist of the following:
Intangible Assets estimated amortization expense for each of the next five years is as follows:
Kenexa Corporation and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
(All amounts in thousands, except share and per share data, unless noted otherwise)
2. Summary of Significant Accounting Policies (continued)
Self-Insurance
The Company is self-insured for the majority of its health insurance costs, including claims filed and claims incurred but not reported subject to certain stop loss provisions. The Company estimates the liability based upon management’s judgment and historical experience and reports the amount on a gross basis. At December 31, 2010 and 2009, self-insurance accruals totaled $595 and $556, and stop loss recoveries totaled $205 and $43, respectively. Management continuously reviews the adequacy of the Company’s stop loss insurance coverage. Material differences may result in the amount and timing of health insurance claims if actual experience differs significantly from management’s estimates.
Interest Rate Swap Agreements
The variable-rate debt obligations expose the Company to variability in interest payments due to changes in interest rates. To limit the variability of a portion of its interest payments, the Company has entered into interest rate swap agreements to manage fluctuations in cash flows resulting from interest rate risk. This swap changed the variable-rate cash flow exposure on the debt obligations to fixed cash flows. Under the terms of the interest rate swap, the Company received variable interest rate payments and made fixed interest rate payments, thereby creating the equivalent of fixed-rate debt. See Footnote 8 - Line of Credit in the Notes to Consolidated Financial Statements for further details.
Revenue Recognition
The Company derives its revenue from two sources: (1) subscription revenue for solutions, which is comprised of subscription fees from customers accessing the Company’s on-demand software (application services), consulting services, outsourcing services and proprietary content, and from customers purchasing additional support beyond the standard support that is included in the basic subscription fee; and (2) other fees for discrete professional services. Because the Company provides its solutions as a service, the Company follows the provisions of FASB ASC 605-10, “Revenue Recognition” and FASB ASC 605-25 “Multiple Elements Arrangements.” We recognize revenue when all of the following conditions are met:
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There is persuasive evidence of an arrangement;
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The service has been provided to the customer;
•
The collection of the fees is probable; and
•
The amount of fees to be paid by the customer is fixed or determinable.
Subscription fees and support revenues are recognized on a monthly basis over the lives of the contracts. Amounts that have been invoiced are recorded in accounts receivable and in deferred revenue or revenue, depending on whether the revenue recognition criteria have been met.
Prior to its adoption of Accounting Standards Update 2009-13 (“ASU 2009-13”), “Multiple Deliverable Revenue Arrangements,” the Company separated certain arrangements only if the professional services, provided at the outset of the engagement, had value to the customer on a stand-alone basis and there was objective and reliable evidence of fair value of the undelivered service elements. All other multi-element arrangements were treated as one unit of accounting, since the undelivered element lacked objective and reliable evidence of fair value. In such instances both the initial professional services and subsequent subscription services were recognized ratably over the term of the license and estimated customer relationship period. When offered by itself, professional services are recognized based upon proportional performance as value is delivered to the customer.
Prior to its adoption of ASU 2009-13, in determining whether revenues from professional services could be accounted for separately from subscription revenue, the Company considered the following factors for each agreement: availability from other vendors, whether objective and reliable evidence of fair value exists of the undelivered elements, the nature and the timing of when the agreement was signed in comparison to the subscription agreement start date and the contractual dependence of the subscription service on the customer's satisfaction with the other services.
Kenexa Corporation and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
(All amounts in thousands, except share and per share data, unless noted otherwise)
2. Summary of Significant Accounting Policies (continued)
Revenue Recognition (continued)
Deferred revenue represents payments received or accounts receivable from the Company's customers for amounts billed in advance of subscription services being provided.
The Company records expenses billed to customers in accordance with FASB ASC 605-45, “Revenue Recognition-Principal Agent Considerations,” which requires that reimbursements received for out-of-pocket expenses be classified as revenues and not as cost reductions. These items primarily include travel, meals and certain telecommunication costs. For the years ended December 31, 2010, 2009 and 2008 reimbursed expenses totaled $3,327, $2,218 and $4,700, respectively.
Pursuant to the transition rules contained in ASU 2009-13, the Company elected to early adopt the provisions included in the amendment effective January 1, 2010.
The Company’s arrangements with customers may include consulting services, software licenses and data. For arrangements that contain multiple deliverables, the selling price hierarchy established in ASU 2009-13 is used to determine the selling price of each deliverable. The selling price hierarchy allows for the use of an estimated selling price (“ESP”) to determine the allocation of arrangement consideration to each deliverable in a multiple-element arrangement in the absence of vendor specific objective evidence (“VSOE”) or third-party evidence (“TPE”).
To qualify as a separate unit of accounting, deliverable items must have value to the customer on a standalone basis and, if the arrangement includes a general right of return relative to the delivered item(s), delivery or performance of the undelivered item(s) is considered probable and substantially in our control. If the arrangement does not meet all criteria above, the entire amount of the transactions is deferred until all elements are delivered.
The Company determines the selling price in multiple-element arrangements using VSOE or TPE, if available. VSOE is determined based on the price charged for the same deliverable when sold separately and TPE is established based on the price charged by our competitors or third parties for the same deliverable. If the Company is unable to determine the selling price because VSOE or TPE does not exist, the ESP is used.
The Company determined its ESP for its application services and license fees based on the following:
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The Company utilizes a pricing model for its products which considers market factors such as customer demand for its products and the geographic regions where the products are sold. In addition, the model considers entity-specific factors such as volume based pricing, discounts for bundled products and total contract commitment. Management approval of the model ensures that all of the Company’s selling prices are consistent and within an acceptable range for use with the relative selling price method.
▪
While the pricing model currently in use captures all critical variables, unforeseen changes due to external market forces may result in the Company revising some of its inputs. These modifications may result in the consideration allocation in future periods differing from the one presently in use. Absent a significant change in the pricing inputs or the way in which the industry structures its deals, future changes in the pricing model are not expected to materially affect the Company’s allocation of arrangement consideration.
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The company determined the ESP for consulting services based on sales of those services sold separetely or on consulting rates estimated based on the nature of the services being provided.
Kenexa Corporation and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
(All amounts in thousands, except share and per share data, unless noted otherwise)
2. Summary of Significant Accounting Policies (continued)
Revenue Recognition (continued)
The Company determined that the adoption of ASU 2009-13 did not have a material impact on the financial statements following the initial adoption. This conclusion is based in part on the following facts:
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Revenue that would have been recognized if the related arrangements entered into or materially modified after the effective date were subject to the measurement requirements of FASB ASC 605-25, “Multiple Element Arrangements,” would have been $2,916 or 1.5% less than currently reported revenue of $196,353, for twelve months ended December 31, 2010.
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Revenue that would have been recognized in the year before the year of adoption if the arrangements accounted for under ASC 605-25 were subject to the new measurement requirements of ASU 2009-13 would have been $643 or 0.4% greater than the reported revenue of $157,669, for twelve months ended December 31, 2009.
•
Revenue recognized and deferred revenue as of and for the year ended December 31, 2010 from applying ASC 605-25 and ASU 2009-13:
The new revenue guidance contained in ASU 2009-13 modifies the way the Company accounts for certain of its arrangements, by allowing the Company to separate its professional services and corresponding license fees into two separate units of accounting. These two deliverables represent the primary elements in those arrangement and are recognized upon performance or delivery of each service or product, respectively to the end customer. Revenue related to professional services are recognized as obligations are fulfilled on a proportional performance basis and typically earned over a three to six month period, while the license fees may be recognized over a two to five year period. Expenses associated with the delivering of our consulting service are expensed as incurred. These arrangements usually do not contain cancellation or refund-type provisions and may include termination for convenience clauses following a stated period of time or the failure to meet performance level commitments.
Multiple element arrangements consisting of multiple products are impacted by the new revenue guidance. Under ASU 2009-13, total consideration for an arrangement is allocated to each product using the hierarchy of VSOE, third party evidence or the relative selling price method and is recognized as each product is delivered to the customer. Consistent with current practice, revenue may be deferred if the arrangement includes any unusual terms including extended payment terms, specified acceptance terms, or hold backs payable upon final acceptance of the product.
Advertising
Advertising costs are expensed when incurred. Advertising costs for the years ended December 31, 2010, 2009 and 2008 were $803, $373 and $670, respectively.
401(k) Plan
The Company sponsors a 401(k) defined contribution plan which is available for participation to all eligible employees. Company contributions to the plan are subject to the board of director's election to make a contribution each year. Company contributions, if elected by the board of directors, are allocated to the participants' accounts based upon the percentage of each participant's contributions to the plan during the given year to the total of all participant contributions. For the years ended December 31, 2010 and 2009, the Company's board of directors elected to make a matching contribution of $282 and $298, respectively or 10% for each year of employee contributions. For the year ended December 31, 2008, a matching contribution was not elected.
Kenexa Corporation and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
(All amounts in thousands, except share and per share data, unless noted otherwise)
2. Summary of Significant Accounting Policies (continued)
Share-based Compensation Expense
The Company accounts for its share-based arrangements in accordance with FASB ASC 718, "Compensation-Stock Compensation." The compensation expense for share-based awards with a service condition that cliff vest, is recognized on a straight-line basis over the award’s requisite service period based on their fair value on the date of grant. For those awards with a service condition that have graded vesting, compensation expense is calculated using the graded-vesting attribution method. This method entails recognizing compensation expense on a straight-line basis over the requisite service period for each separately vesting portion as if the grant consisted of multiple awards, each with the same service inception date but different requisite service periods. This method accelerates the recognition of compensation expense. In accordance with FASB ASC 718, the pool of excess tax benefits available to absorb tax deficiencies was determined using the alternative transition method.
The fair value of market based, performance vesting share awards granted is calculated using a Monte Carlo valuation model that results in a factor applied to the fair market value of the Company's common stock on the date of the grant (measurement date), and is recognized over a four year explicit service period using the straight-line method. Since the award requires both the completion of four years of service and the share price reaching predetermined levels as defined in the option agreement, compensation cost will be recognized over the four year explicit service period. If the employee terminates prior to the four-year requisite service period, compensation cost will be reversed even if the market condition has been satisfied by that time.
Income Taxes
The Company files a consolidated income tax return with its subsidiaries for federal tax purposes and on various bases depending on applicable taxing statutes for state and local as well as foreign tax purposes. Deferred income taxes are provided using the asset and liability method for temporary differences between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. Valuation allowances are established when necessary to reduce net deferred tax assets to the amounts which are more likely than not expected to be realized.
Other Taxes
Non-income taxes such as sales and value-added taxes are presented on a net basis within general and administrative expense, on the statement of operations.
Guarantees
Company’s software license agreements typically provide for indemnifications of customers for intellectual property infringement claims. The Company also warrants to customers, when requested, that the Company’s software products operate substantially in accordance with standard specifications for a limited period of time. The Company has not incurred significant obligations under customer indemnification or warranty provisions historically, and does not expect to incur significant obligations in the future. Accordingly, the Company does not maintain accruals for potential customer indemnification or warranty-related obligations.
Kenexa Corporation and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
(All amounts in thousands, except share and per share data, unless noted otherwise)
2. Summary of Significant Accounting Policies (continued)
Loss Per Share
The Company follows FASB ASC 260, “Earnings Per Share,” which requires companies that are publicly held or have complex capital structures to present basic and diluted earnings per share on the face of the statement of operations. Earnings (loss) per share is based on the weighted average number of shares and common stock equivalents outstanding during the period. In the calculation of diluted earnings per share, shares outstanding are adjusted to assume conversion of the exercise of options if they are dilutive. In the calculation of basic earnings per share, weighted average numbers of shares outstanding are used as the denominator. Also, commencing in 2009 as a result of the variable interest entity and its corresponding put option, the Company uses the two-class method of calculating earnings per share as the put feature was issued by the Company and requires adjustments to the carrying value of the noncontrolling interest and the income allocable to common shareholders. Certain common stock equivalents of stock options and restricted stock issued and outstanding other than the options included in the table below were excluded in the computation of diluted earnings per share for the years ended December 31, 2010, 2009 and 2008 since their effect was antidilutive. A summary of the computation is presented in the table below.
Basic and diluted loss per share are computed as follows:
Kenexa Corporation and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
(All amounts in thousands, except share and per share data, unless noted otherwise)
2. Summary of Significant Accounting Policies (continued)
Recently Adopted Accounting Pronouncements
In December 2007, the FASB issued ASC 810-10, “Consolidation-Overall,” and ASC 805, “Business Combinations.” Changes for business combination transactions pursuant to ASC 805 include, among others, expensing of acquisition-related transaction costs as incurred, the recognition of contingent consideration arrangements at their acquisition date fair value and capitalization of in-process research and development assets acquired at their acquisition date fair value. Changes in accounting for noncontrolling (minority) interests pursuant to ASC 810-10 include, among others, the classification of noncontrolling interest as a component of consolidated shareholders’ equity and the elimination of “minority interest” accounting in results of operations. ASC 805 is required to be adopted and was effective for fiscal years beginning on or after December 15, 2008. The adoption of ASC 805 and ASC 810-10 impacted the Company’s accounting related to the consolidation of its variable interest entity in 2009 and impacted the accounting for the Company's current acquisition.
In June 2009, the FASB issued new accounting guidance for variable interest entities. This guidance was codified under ASU 2009-17 in December 2009 and includes: (1) the elimination of the exemption from consolidation for qualifying special purpose entities, (2) a new approach for determining the primary beneficiary of a variable interest entity (“VIE”), which requires that the primary beneficiary have both (i) the power to control the most significant activities of the VIE and (ii) either the obligation to absorb losses or the right to receive benefits that could potentially be significant to the VIE, and (3) the requirement to continually reassess who should consolidate a VIE. The new guidance is effective for annual reporting periods that begin after November 15, 2009 and applies to all existing and new VIEs. The Company adopted ASU 2009-17 on January 1, 2010 and the adoption did not have a material impact on the Company’s financial statements.
In January 2010, the Company adopted the Accounting Standards Update (“ASU”) No. 2009-13, “Revenue Recognition: Multiple-Deliverable Revenue Arrangements - a consensus of the FASB Emerging Issues Task Force,” which eliminates the use of the residual method for allocating consideration, as well as the criteria that requires objective and reliable evidence of fair value of undelivered elements in order to separate the elements in a multiple-element arrangement. By removing the criterion requiring the use of objective and reliable evidence of fair value in separately accounting for deliverables, the recognition of revenue will more closely align with certain revenue arrangements. The standard also will replace the term “fair value” in the revenue allocation guidance with “selling price” to clarify that the allocation of revenue is based on entity-specific assumptions rather than assumptions of a marketplace participant. ASU No. 2009-13 is effective for revenue arrangements entered or materially modified in fiscal years beginning on or after June 15, 2010. The adoption did not have a material impact on the Company’s financial statements. See “Revenue Recognition” above for further details, including financial impact.
Recent Accounting Pronouncements
In December 2010, the FASB issued ASU 2010-28, “Intangibles - Goodwill and Other (Topic 350): When to Perform Step 2 of the Goodwill Impairment Test for Reporting Units with Zero or Negative Carrying Amounts.” For reporting units with zero or negative carrying amounts, if it is more likely than not that a goodwill impairment exists, ASU 2010-28 requires performance of an additional test to determine whether goodwill has been impaired and to calculate the amount of impairment. In determining whether it is more likely than not that a goodwill impairment exists, an entity should consider whether there are any adverse qualitative factors indicating that an impairment may exist. ASU 2010-28 is effective for fiscal years and interim periods within those years beginning after December 15, 2010. The Company will adopt ASU 2009-28 in the first quarter of 2011 and the impact of adopting ASU 2010-28 will not be known until evaluations for goodwill impairment are performed at our annual impairment testing date.
In December 2010, the FASB issued ASU 2010-29, “Business Combinations (Topic 805): Disclosure of Supplementary Pro Forma Information for Business Combinations. ASU 2010-29” specifies that, for material business combinations when comparative financial statements are presented, revenue and earnings of the combined entity should be disclosed as though the business combination had occurred as of the beginning of the comparable prior annual reporting period. ASU 2010-09 also expands the supplemental pro forma disclosures to include a description of the nature and amount of material, nonrecurring pro forma adjustments directly attributable to the business combination included in the reported pro forma revenue and earnings. ASU 2010-09 is effective prospectively for business combinations with an acquisition date on or after the beginning of the first annual reporting period after December 15, 2010. The Company will adopt this standard for acquisitions in 2011.
Kenexa Corporation and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
(All amounts in thousands, except share and per share data, unless noted otherwise)
3. Investments
The following is a summary of our short-term investments at December 31, 2009:
During the twelve months ended December 31, 2010, the Company completed the liquidation of its entire auction rate securities (“ARS”) portfolio for $15,291 through periodic redemptions, which included $1,377 of realized gains. As of December 31, 2009, the Company’s ARS issues had a fair value of $13,914 and were included in its short-term investments due to the ability to liquidate the ARS issues within a year. These securities continued to accrue interest at the contractual rate.
Due to the failure of the auction rate market in early 2008, UBS AG and other major banks entered into discussions with government agencies to provide liquidity to owners of auction rate securities. In November 2008, the Company entered into an agreement (the “UBS Settlement Agreement”) with UBS AG which provided (1) the Company with a “no net cost” loan up to the par value of Eligible auction rate securities until June 30, 2010, and (2) the Company, the right to sell these auction rate securities back to UBS AG at par, at the Company’s sole discretion, anytime during the period from June 30, 2010 through July 2, 2012, and (3) UBS AG the right to purchase these auction rate securities or sell them on the Company’s behalf at par anytime through July 2, 2012. Following the execution of the UBS Settlement Agreement, the Company determined that it no longer had the intent to hold the auction rate securities until either the maturity or recovery of the auction rate security market. Based upon this unusual circumstance related to the execution of the UBS Settlement Agreement, the Company transferred these investments from available-for-sale to trading securities and began recording the change in fair value of the auction rate securities as gains or losses in current statements of operations.
Contemporaneous with the determination to transfer the auction rate securities to trading securities, the Company elected to measure the value of its option to put the securities (“put option”) to UBS AG under the fair value option of ASC 825, “Financial Instruments.” As a result, the Company recorded a non-operating gain representing the estimated fair value of the put option and a corresponding long-term asset of approximately $2,219 at December 31, 2008. At December 31, 2009, the put option’s estimated fair value decreased to $1,374 and by June 30, 2010, the put option’s estimated fair value decreased to zero.
Based upon the results of the discounted cash flow analysis, the Company determined that the fair value of its investment in auction rate securities should be discounted approximately $2,219 to $16,513 at December 31, 2008, with any other-than temporary impairment in the fair value of the auction rate securities offset substantially by the fair value recognized for the rights provided in the settlement agreement. The Company recorded a non-operating gain for its trading securities for the year ended December 31, 2010 and 2009 of approximately $1,377 and $833, respectively. The recording of the loss relating to the decrease in the fair value of the put option and the corresponding recognition of the gain in the auction rate securities resulted in an overall net gain and loss in 2010 and 2009 of approximately $3 and $12, respectively for the twelve months ended December 31.
In anticipation of the Salary.com acquisition (as discussed in Footnote 4 - Acquisitions in the Notes to the Consolidated Financial Statements) the Company liquidated the remaining balance of its municipal bonds during 2010, which totaled $15,656 at December 31, 2009, resulting in a realized loss of $382. At December 31, 2009, contractual maturities of our short-term investments were one year or less.
Kenexa Corporation and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
(All amounts in thousands, except share and per share data, unless noted otherwise)
3. Investments (continued)
The Company adjusted the fair value of its ARS investment portfolio using a discounted cash flow model to determine the estimated fair value of its ARS investments as of December 31, 2009. The ranges of assumptions used in preparing the discounted cash flow model include level three inputs, as defined in ASC 825, and are presented in the following table:
The Company adopted the provisions of ASC 820-10 effective January 1, 2008, which defines fair value as price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.
The Company’s investments are valued in accordance with the provisions of ASC 820, “Fair Value Measurements and Disclosure.” Under this standard, fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. ASC 820, Fair Value Measurements and Disclosure establishes a hierarchy for inputs used in measuring fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that the most observable inputs be used when available. The hierarchy is broken down into three levels based on the reliability of inputs as follows:
•
Level 1 - Valuations based on quoted prices in active markets for identical assets that the Company has the ability to access.
•
Level 2 - Valuations based inputs on other than quoted prices included within level 1, for which all significant inputs are observable, either directly or indirectly.
•
Level 3 - Valuations based on inputs that are unobservable and significant to the overall fair value measurement.
The estimated fair value of the Company’s municipal bond securities on December 31, 2009 of $15,656 was determined based upon quoted prices in active markets for identical assets or Level 1 inputs. On December 31, 2009, the estimated fair value of the Company’s auction rate securities was $13,914 based upon significant unobservable inputs or Level 3 inputs.
A reconciliation of the beginning and ending balances for the auction rate securities using significant unobservable inputs (Level 3) for the period ended December 31, 2009 and 2010 is presented below:
Kenexa Corporation and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
(All amounts in thousands, except share and per share data, unless noted otherwise)
4. Acquisitions
Quorum International Holdings Limited
On April 2, 2008, the Company acquired all of the outstanding stock of Quorum International Holdings Limited (“Quorum”), a provider of recruitment process outsourcing services based in London, England, for a purchase price of approximately $27,950, in cash, of which $19,753 was paid in April 2008 and $8,197 was paid in July 2008. The total cost of the acquisition, including legal, accounting, other professional fees and additional consideration of $2,873, was approximately $30,823, including acquired intangibles of $8,633, with estimated useful lives between 3 and 10 years. In addition, the acquisition agreement contains an earnout provision which provides for the payment of additional consideration by the Company based upon the gross profit of Quorum for the twelve month period ending June 30, 2009 and June 30, 2010. Formulaically, the earnout is 3.86 times Quorum’s gross profit less the amount of base consideration, as defined in the agreement. Pursuant to FASB ASC 805, "Business Combinations" for acquisitions prior to June 1, 2009, the Company accrues contingent purchase consideration when the outcome of the contingency is determinable beyond a reasonable doubt. Based upon the results for the twelve month period through June 30, 2009, it was determined that an earnout payment was due to the former shareholders of Quorum and as such, the additional consideration of $1,167 was accrued for in the financial statements at December 31, 2009. During the first quarter of 2010 additional consideration of $468 was determined payable. The total consideration of $1,635 was paid in cash during the first quarter of 2010. In addition, based upon the results for the twelve month period through June 30, 2010 no earnout payment was determined to be earned. The Company evaluates the earnout provisions contained in the acquisition agreement at each financial statement reporting date. In connection with the acquisition, €500 or approximately $687, of the purchase price was deposited into an escrow account and recorded in other long-term assets, to cover any claims for indemnification made by the Company against Quorum under the acquisition agreement. Although, the escrow agreement expired approximately two years from the acquisition date, the Company is currently evaluating the status of any claims and the amounts to be withheld from the escrow account. The Company expects that the acquisition of Quorum will broaden its presence in the global recruitment market. The purchase price has been allocated to the assets acquired and liabilities assumed based upon management’s best estimate of fair value with any excess over the net tangible and intangible assets acquired allocated to goodwill. Quorum’s results of operations were included in the Company’s consolidated financial statements beginning on April 2, 2008.
Centre for High Performance Development (Holdings) Limited
On July 26, 2010, the Company acquired all of the outstanding stock of The Centre for High Performance Development (Holdings) Limited (“CHPD”) which operates as a leadership development and management training company based in London, England for a purchase price of approximately $4,233 in cash. The total cost of the acquisition, including legal, accounting, and other professional fees of $215, was approximately $4,448, including acquired intangibles of $2,467, with estimated useful lives between 3 and 15 years. The Company deposited €314 or approximately $428 into escrow to cover any claims for indemnification made by the Company or CHPD. The Company used its cash to acquire all the outstanding stock of CHPD. The Company expects the acquisition of CHPD will enhance its existing research and content portfolio as well as provide our customers with the ability to more efficiently implement the results of their employee engagement surveys. The purchase price has been allocated to the assets acquired and liabilities assumed based upon management’s best estimate of fair value with any excess over the net tangible and intangible assets acquired allocated to goodwill. CHPD’s results of operations were included in the Company’s consolidated financial statements beginning on July 26, 2010.
Salary.com
On October 1, 2010, the Company acquired Salary.com, a provider of on-demand compensation software that helps businesses and individuals manage pay and performance, for approximately $78,375 in cash. The total cost of the acquisition, including legal, accounting, and other professional fees of $4,372, was approximately $82,747, including acquired intangibles of $62,700, with estimated useful lives between 3 and 10 years. As part of the Salary.com transaction The Company was required to repay approximately $2,525 of Salary.com’s debt during the fourth quarter of 2010. The Company believes there is a significant opportunity to expand the adoption of Salary.com’s product line in large global organizations because its compensation analysis software is highly synergistic with our current suite of talent acquisition and retention solutions. Salary.com’s results of operations were included in the Company’s consolidated financial statements beginning on October 1, 2010.
Kenexa Corporation and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
(All amounts in thousands, except share and per share data, unless noted otherwise)
4. Acquisitions (continued)
The purchase price was allocated as follows:
The purchase price has been allocated on to the assets acquired and liabilities assumed based upon management’s best estimate of fair value with any excess over the net tangible and intangible assets acquired allocated to goodwill. The fair value of deferred revenue was determined based upon the estimated direct cost of fulfilling the obligation to the customer plus a normal profit margin. The estimated fair values of the intangibles assets are further described below. Contract-related assets and technology-related assets are being amortized over their estimated useful lives. Goodwill is not amortized but is periodically evaluated for impairment. During the three month period ending December 31, 2010, severance payments totaled $2,626, resulting in an ending accrued severance balance of $631 as of December 31, 2010.
The valuation of the identified intangibles including contract-related, content, software and trade name assets totaling of $62,700, which relates to Salary.com’s operations, was determined based upon estimated discounted incremental future cash flow to be received as a result of these relationships.
Goodwill from the acquisition resulted from our belief that the compensation products developed by Salary.com will be complementary to our Kenexa 2x platform™ and will help us remain competitive in the talent acquisition market. As a result of an election made in 2010 pursuant to I.R.S. Section 338(g), the goodwill and related intangible assets from the Salary.com acquisition are being amortized for tax purposes over a fifteen year period.
Unaudited pro forma results of operations to reflect the acquisition as if it had occurred on the first date of all periods presented are shown below.
Kenexa Corporation and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
(All amounts in thousands, except share and per share data, unless noted otherwise)
5. Variable Interest Entity
On January 20, 2009, the Company entered into an ownership interest transfer agreement (“the agreement”) with Shanghai Runjie Management Consulting Company, (“R and J”) in Shanghai, China. In conjunction with the agreement, the Company paid $1,337 as an initial equity contribution and to compensate the former owners of R and J, who transferred their existing business into a new entity, Shanghai Kenexa Human Resources Consulting Co., Ltd., (the “variable interest entity”). The initial payment provided the Company with a 46% ownership in the variable interest entity, and a presence in China’s human capital management market. The former owners of R and J are required to transfer 1% additional ownership interests (in 1% increments up to 49% over a two year period), with consideration to be paid by the Company based upon adjusted EBITDA, as defined in the agreement. In 2010 and 2009, based upon the preceding year’s operating results for R and J, the Company paid an additional $31 and $206, respectively for an additional 1% ownership interest, for each year, in the variable interest entity. At December 31, 2010, the Company had a 48% ownership interest in the variable interest entity.
Consideration for the ownership interest transfer in 2010 was determined as the greater of 1) the amount of registered capital attributable to a 1% ownership interest or 2) an amount denominated in Chinese Yuan Renminbi (“RMB¥”) equal to the result of 47% times four and one half times the Adjusted EBITDA of the variable interest entity for the calendar year ended December 31, 2009, plus 1% of the variable interest entity’s free cash as of December 31, 2009, minus the amount of the initial investment or RMB¥ 8,145 or $1,224. The additional transfer of ownership interests for 2011 will be determined formulaically the same as above and will be adjusted only for an increase in actual ownership percentage by the Company.
Under the terms of the variable interest entity agreement, the Company has the right to acquire R and J’s remaining interest in the variable interest entity at any time after the earlier of the termination of the general manager’s employment by the variable interest entity or during the first three months of any calendar year beginning on or after January 1, 2013 (call rights). The purchase price for the remaining ownership interest is based upon the outstanding ownership interest multiplied by the sum of the amount of free cash flow plus four and one half times the Adjusted EBITDA, as defined in the agreement. R and J may also require the Company to purchase its interest in the variable interest entity at any time after the earlier of the Company’s acquisition of more than fifty percent of the variable interest entity or January 1, 2011 (put rights).
In accordance with ASC 810, “Variable Interest Entities,” the new entity qualified for consolidation as it was determined to be a variable interest entity and the Company as its primary beneficiary. The determination of the primary beneficiary was based, in part, upon a qualitative assessment which included the Company’s commitment to finance the variable interest entity’s ongoing operations, the level of involvement in the variable interest entity’s operations, the use of the Company’s brand by the variable interest entity, and the lack of equity “at risk” by R and J given its put rights. The variable interest entity is consolidated in the Company’s financial statements because of the Company’s implicit guarantee to provide financing as well as its significant involvement in the day-to-day operations. The equity interests of R and J not owned by the Company are reported as a noncontrolling interest in the Company’s December 31, 2010 and 2009 accompanying consolidated balance sheets. All inter-company transactions are eliminated. See Footnote 2 - Summary of Significant Accounting Policies Principles of Consolidation for additional details.
The noncontrolling interest related to the variable interest entity is subject to periodic adjustments in its carrying amount based on the put rights contained in the agreement. For the year ended December 31, 2010, the Company accreted $2,202 based upon a calculation of the actual operating results of the variable interest entity for the twelve month period ended December 31, 2010.
The variable interest entity was financed with $307 in initial equity contributions from the Company and R and J, and has no borrowings for which R and J’s assets would be used as collateral. Following the formation of the variable interest entity, the Company completed a valuation of the variable interest entity, which resulted in the recording of net tangible assets, intangible assets and goodwill of $314, $1,100 and $1,512, respectively in the consolidated balance sheet. On September 30, 2009, the Company provided $160 of financing for the variable interest entity in the form of an intercompany loan. The creditors of the variable interest entity do not have recourse to other assets of the Company.
Pursuant to ASC 480 “Distinguishing Liabilities from Equity,” (formerly Emerging Issues Task Force Abstracts Topic No. D-98, “Classification and Measurement of Redeemable Securities,”) due to the put rights included in the agreement, the Company has presented the estimated fair value of R and J’s 52% ownership interest and the calculated value of the put right in the variable interest entity amounting to $4,052 and $1,330 at December 31, 2010 and 2009, respectively, in noncontrolling interest and classified the amount as temporary equity on the consolidated balance sheet.
Kenexa Corporation and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
(All amounts in thousands, except share and per share data, unless noted otherwise)
6. Property, Equipment and Software
A summary of property, equipment and capitalized software and related accumulated depreciation and amortization as of December 31, 2010 and 2009 is as follows:
Depreciation and amortization expense is excluded from cost of revenues. Equipment and office furniture and fixtures included gross assets under capital leases totaling $2,254 and $2,621 at December 31, 2010 and 2009, respectively. Depreciation and amortization expense, including amortization of assets under capital leases, was $13,908, $9,789 and $6,920 for the years ended December 31, 2010, 2009 and 2008, respectively.
Pursuant to FASB ASC 360, “Property, Plant and Equipment,” the Company reviewed its fixed assets and determined that the fair value exceeded the carrying value, and therefore did not record any fixed asset impairment as of December 31, 2010.
7. Other Accrued Liabilities
Other accrued liabilities consist of the following:
Kenexa Corporation and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
(All amounts in thousands, except share and per share data, unless noted otherwise)
8. Line of Credit
On August 31, 2010, the Company entered into a secured credit agreement with PNC Bank, N.A., as administrative agent, in connection with its acquisition of Salary.com, as discussed in Footnote 4 - Acquisitions to the Notes of the Consolidated Financial Statements. The secured credit agreement included a maximum amount available under the credit facility of $25,000 including a sublimit of up to $2,000 for letters of credit and swing loans. Borrowings under the new credit facility were secured by substantially all of the Company’s assets and the assets of its subsidiaries. As of September 30, 2010 the Company borrowed $25,000 under the secured credit agreement in connection with the acquisition of Salary.com.
On, October 20, 2010, the Company terminated and paid all outstanding amounts under its secured credit agreement, dated August 31, 2010, and entered into a senior secured credit agreement (the “amended credit agreement”) with PNC Bank. The maximum amount available under the amended credit agreement is $60,000, comprised of a $35,000 revolving facility, including a sublimit of up to $5,000 for letters of credit and a sublimit of up to $2,500 for swing loans (the “Revolving Facility”), and a $25,000 term facility (the “Term Facility”). The Company may request to increase the maximum amount available under the Revolving Facility to $50,000. The amended credit agreement will terminate, and all borrowings will become due and payable, on October 19, 2013. The Company and each of its U.S. subsidiaries are guarantors of the obligations under the amended credit agreement. Borrowings under the amended credit agreement are secured by substantially all of the Company’s assets (including a pledge of the capital stock of our subsidiaries (but limited to only 65% of the voting stock of first-tier foreign subsidiaries)). For the year ended December 31, 2010, the Company recorded $611 in deferred financing costs in connection with its credit agreements. As of December 31, 2010, the Company borrowed $59,500 under the amended credit agreement in connection with the acquisition of Salary.com and to enhance working capital. In January 2011, we made payments of approximately $25,750 under the amended credit agreement.
The Company’s borrowings under the Revolving Facility and Term Facility bear interest at either (i) the adjusted London Interbank Offered Rate for U.S. Dollar deposits, or LIBOR Rate, plus the applicable margin or (ii) the Base Rate-the greater of the Agent’s prime rate, the Federal Funds Open Rate plus ½ of 1.0%, and the LIBOR rate plus 100 basis points-plus the applicable margin. The applicable margin, ranging from 275 to 325 basis points for LIBOR Rate loans and from 175 to 225 basis points for Base Rate loans, depends on the fixed coverage ratio of Kenexa and its consolidated subsidiaries.
As of December 31, 2010, the Company had borrowings of $34,500 and $25,000 under the Revolver and Term facility both with an average interest rate of 3.54%, and issued an irrevocable standby letter of credit for $500 in connection with an office lease in Waltham, Massachusetts.
Borrowings under the amended credit agreement are cross collateralized by a first priority perfected lien on the Company’s assets including, but not limited to, receivables, inventory, equipment, furniture, general intangibles, fixtures, real property and improvements. The amended credit agreement contains various terms and covenants that provide for restrictions on payment of dividends, dispositions of assets, investments and acquisitions and require the Company, among other things, to maintain minimum levels of tangible net worth, net income and fixed charge coverage. The Company was compliant with its financial covenants at December 31, 2010.
In October 2010 in connection with the issuance of the $25,000 Term Facility, the Company entered into an interest rate swap with a notional amount of $12,500 under which, it pays a fixed rate of 0.93%. This swap expires in October 2013. The Company entered into this swap as it believed interest rates would increase from their current rates, thus allowing it to reduce its overall interest expense related to the term debt.
The Company has not designated its interest rate swap as a hedge. The Company records interest rate swap on its balance sheet at fair market value with the changes in fair value recorded as gain on interest rate swap, net, in its Consolidated Statement of Operations. During the year ended December 31, 2010, the Company recorded a gain of $16 for the change in the fair value of its interest rate swap. See Summary of Significant Accounting Policies - Fair Value of Financial Instruments for information on the fair value of the Company’s interest rate swap.
Kenexa Corporation and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
(All amounts in thousands, except share and per share data, unless noted otherwise)
9. Income Taxes
The components of income tax expense (benefit) consisted of the following:
A reconciliation of the Company’s effective income tax rate to the U.S. statutory federal income tax rate of 35% is as follows:
Kenexa Corporation and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
(All amounts in thousands, except share and per share data, unless noted otherwise)
9. Income Taxes (continued)
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amount of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Components of the Company’s net deferred tax assets and liabilities as of December 31, 2010 and 2009 were as follows:
Kenexa Corporation and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
(All amounts in thousands, except share and per share data, unless noted otherwise)
9. Income Taxes (continued)
At December 2010, the Company has remaining Federal net operating loss carryforwards from acquisitions of $1,664 with an expiration date of 2025. These acquired operating loss carryovers are subject to Internal Revenue Code section 382 loss limitations. The Company also has $33,666 of state net operating loss carryovers available from domestic affiliates and $14,587 of net operating loss carryovers available from foreign affiliates. These state losses have various expiration dates not in excess of 20 years while the foreign losses have no expiration date, except for those relating to India which expire in eight years. Based on the uncertainty of fully utilizing these NOLs the Company has recorded valuation allowances as of December 31, 2010 of $6,435, $2,554 and $3,154 for federal, state and foreign purposes, respectively.
At December 2009, the Company has remaining Federal net operating loss carryforwards from acquisitions of $2,021 with an expiration date of 2025. These acquired operating loss carryovers are subject to Internal Revenue Code section 382 loss limitations. The Company also has $11,342 of state net operating loss carryovers available from domestic affiliates and $8,546 of net operating loss carryovers available from foreign affiliates. These state losses have various expiration dates not in excess of 20 years while the foreign losses have no expiration date, except for those relating to India which expire in eight years. Based on the uncertainty of fully utilizing these NOLs the Company has recorded valuation allowances as of December 31, 2009 of $4,567, $1,561 and $1,332 for Federal, state and foreign purposes, respectively. In 2009, the Company released $838 of its foreign valuation allowance and simultaneously wrote off a fully reserved acquired foreign net operating loss that was determined to be nondeductible.
At December 2008, the Company has remaining Federal net operating loss carryforwards from acquisitions of $2,253 with an expiration date of 2025. The Company also has net operating loss carryforwards available from foreign acquisitions of $7,731. These losses have no expiration date, except for those relating to India which expire in eight years. Based on the uncertainty of fully utilizing these NOLs the Company has recorded a valuation allowance as of December 31, 2008 of $4,417. The Company also has state NOL carryforwards of $2,266.
Activity in the valuation allowance account for the years ended December 31, 2010, 2009 and 2008 is presented in the table below:
The determination of the level of valuation allowance at December 31, 2010 is based on an estimated forecast of future taxable income which includes many judgments and assumptions primarily related to revenue, margins, operating expenses, tax planning strategies and tax attributes in multiple taxing jurisdictions. Accordingly, it is at least reasonably possible that future changes in one or more of these assumptions may lead to a change in judgment regarding the level of valuation allowance required in future periods.
In 2005, the Company was granted a tax holiday from the government of India for its development center located in Hyderabad, India. This tax holiday was granted for a five year period, was subsequently extended via statute for two additional years and is scheduled to expire in March, 2011. The income tax benefit on this holiday is $73, $83 and $65 in 2010, 2009 and 2008, respectively. In 2008, the Company was granted a separate tax holiday from the Indian government covering the activities of its new development center in Vizag, India. This tax holiday was granted for a period of 10 years and will expire in 2018. The income tax benefit on this holiday is $356, $236 and $309 in 2010, 2009 and 2008, respectively.
9. Income Taxes (continued)
The Company does not provide for U.S. deferred income taxes or tax benefits on the undistributed earnings or losses of its non-U.S. subsidiaries because earnings are permanently reinvested and, in the opinion of management, will continue to be reinvested indefinitely. At December 31, 2010, the Company had not provided for deferred income tax expense for cumulative income of individual international subsidiaries of $16,840.
Should these earnings be distributed in the form of dividends or otherwise, the Company would be subject to both U.S. income taxes and withholding taxes in various international jurisdictions. Determination of the related amount of unrecognized deferred U.S. income tax liability is not practicable because of the complexities associated with its hypothetical calculation. In the event of the repatriation of foreign earnings, the Company believes that it would be in a position to claim sufficient foreign tax credits for U.S. federal income taxes purposes to offset a significant amount of potential tax liability.
During the third quarter of 2009, the Internal Revenue Service completed its examination of the Company’s federal income tax returns for the years 2006 and 2007 and issued a final Revenue Agent’s Report (RAR.) The Company agreed with all of the adjustments contained in the RAR and during the fourth quarter of 2009, received written notification from the IRS that the final examination report had been accepted. The resolution of the examination resulted in the disallowance of tax credits previously claimed by the Company, the loss of which did not have a material impact on the financial condition of the Company.
During 2007, the Company filed separate elections under Section 338(g) of the Internal Revenue Code to treat the acquisitions of Webhire and BrassRing as the purchase of assets for tax purposes. These elections allow the tax basis in acquired assets to be valued at their relative fair market values on the respective dates of purchase. As a result of these elections, certain deferred tax assets of Webhire and BrassRing totaling $2,942 and $342, respectively were reduced and reclassified to goodwill following the elimination of certain tax attributes, including previously recorded net operating loss carryforwards.
The amount of unrecognized tax benefits as of December 31, 2010, determined in accordance with the provisions of ASC 740 increased by $625. A reconciliation of the beginning and ending amounts of unrecognized tax benefits is as follows:
The additions to the unrecognized tax benefits related to the current and prior years are primarily attributable to various transfer pricing and related valuation matters, certain tax incentives and credits, acquisition matters, apportionment of state taxable income and other foreign matters. The settlements and reductions to the unrecognized tax benefits for tax positions of prior years are primarily attributable to the conclusion of the IRS examination. The liability of $2,515 can be reduced by $574 of offsetting tax benefits associated with the correlative effects of potential transfer pricing adjustments, state income taxes and timing adjustments. The net amount of $1,941, if recognized, would have a favorable impact on the Company’s effective tax rate.
Our policy is to recognize interest and penalties on unrecognized tax benefits in the provision for income taxes in the consolidated statements of operations. During the year ended December 31, 2010, the Company recognized $299 in interest and penalties, and in 2009, the Company recognized $69 in interest and penalties.
With certain limited exceptions, the Company is no longer subject to U.S. federal income tax audits for tax years through 2007 and state and local or non-U.S. income tax audits by taxing authorities for tax years through 2005. However, net operating loss and tax credit carryovers from all years continue to be subject to examinations and adjustments for at least three years following the year in which the attributes are used. The Company is currently under examination by certain state taxing authorities for tax years 2006 and 2007. Although the outcome of tax audits is difficult to predict with certainty, the Company believes that adequate amounts of tax and interest have been provided for any adjustments that may result from tax examinations.
Kenexa Corporation and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
(All amounts in thousands, except share and per share data, unless noted otherwise)
10. Commitments and Contingencies
Leasing Arrangements
The Company leases certain of its facilities and equipment under various operating and capital leases. Current assets under capital leases consist primarily of computer equipment. These leases generally have terms of three to five years, bear interest up to 6.2% per annum and are collateralized by the underlying equipment. Operating leases primarily consist of leases for office space and equipment. Future minimum lease payments for each of the following five years are:
Rent expense was $8,565, $7,496 and $7,174 for the years ended December 31, 2010, 2009 and 2008, respectively. Most of the Company’s capital and operating leases contain automatic renewal terms, bargain purchase options or escalation clauses but the leases are expensed on a straight-line basis. The Company subleases space in its Wayne, PA and Vizag, India facilities. The total minimum sublease rentals to be received under noncancelable subleases through 2014 is estimated at $345 for Wayne and $1,118 for Vizag as of December 31, 2010.
Severance arrangement
On November 26, 2006, the Company entered into a separation agreement and general release with its former Chief Operating Officer who resigned from his positions as an officer and a director of the Company and each of its subsidiaries, effective on the close of business on November 30, 2006. The separation agreement provided that the Company continue to pay the former officer his base salary of $250 per year through November 29, 2008. In addition, through May 29, 2010, the Company provided the former officer with continued participation in the medical insurance coverage plans of the Company, or the economic equivalent of the employer portion of the premium for such plans. Pursuant to the separation agreement, the former officer received $397 under the Company’s 2006 bonus plan. In addition, previously unvested options to purchase 28,333 shares of the Company’s common stock held by the former officer became immediately exercisable, and all other unvested stock options granted to the former officer by the Company were forfeited on the separation date. The former officer also provided the Company and its subsidiaries and affiliates with a general release, and the former officer agreed to certain restrictive covenants, including confidentiality and non-disparagement, and non-competition and non-solicitation for a period of two years after the separation date, as such, the company recognized the severance expense over the non compete term.
Kenexa Corporation and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
(All amounts in thousands, except share and per share data, unless noted otherwise)
10. Commitments and Contingencies (continued)
Litigation
On August 27, 2007, a complaint was filed and served by Kenexa BrassRing, Inc. against Taleo Corporation in the United States District Court for the District of Delaware. Kenexa alleges that Taleo infringed Patent Nos. 5,999,939 and 6,996,561, and seeks monetary damages and an order enjoining Taleo from further infringement. The trial of this matter is currently scheduled to begin on June 27, 2011.
On May 9, 2008, Kenexa BrassRing, Inc. filed a similar lawsuit against Vurv Technology, Inc. in the United States District Court for the District of Delaware, alleging that Vurv has infringed Patent Nos. 5,999,939 and 6,996,561, and seeks monetary damages and an order enjoining further infringement. This lawsuit has been consolidated with the Kenexa BrassRing, Inc. versus Taleo Corporation lawsuit.
On June 25, 2008, Kenexa Technology, Inc. filed suit in the United States District Court of Delaware against Taleo Corporation for tortious interference with contract, unfair competition, unfair trade practices and unjust enrichment. On August 28, 2009, Taleo filed an amended answer and counterclaim against Kenexa BrassRing, Inc. asserting copyright infringement against Kenexa by the users accessing the Taleo system on behalf of Kenexa’s recruitment process outsourcing customers. Kenexa seeks monetary damages and to enjoin the actions of Taleo. Taleo seeks monetary damages and to enjoin the actions of Kenexa.
On November 7, 2008, Vurv Technology LLC, sued Kenexa Corporation, Kenexa Technology, Inc., and two former employees of Vurv, who now work for Kenexa , in the United States District Court for the Northern District of Georgia. In this action, Vurv asserts claims for breach of contract, computer trespass and theft, misappropriation of trade secrets, interference with contract and civil conspiracy. Vurv seeks unspecified monetary damages and injunctive relief.
On July 17, 2009, Kenexa BrassRing, Inc. and Kenexa Recruiter, Inc. filed suit against Taleo Corporation, a current Taleo employee and a former Taleo employee in Massachusetts Superior Court. Kenexa amended the complaint on August 27, 2009 and added Vurv Technology LLC, two former employees of Taleo and two current employees of Taleo. Kenexa asserts claims for breach of contract and the implied covenant of good faith and fair dealing, unfair trade practices, computer theft, misappropriation of trade secrets, tortious interference, unfair competition, and unjust enrichment. Kenexa seeks monetary damages and injunctive relief.
Securities Class Actions
On June 11, 2009 and July 16, 2009, two putative class actions were filed against Kenexa Corporation and our Chief Executive Officer and Chief Financial Officer in the United States District Court for the Eastern District of Pennsylvania, purportedly on behalf of a class of our investors who purchased our publicly traded securities between May 8, 2007 and November 7, 2007. The complaint filed on July 16, 2009 has since been voluntarily dismissed. On September 28, 2010, the court granted Kenexa’s motion to dismiss the complaint filed on June 11, 2009 in its entirety. The plaintiffs filed a motion for reconsideration of the court’s decision on October 12, 2010, which was denied by the court on November 29, 2010. The plaintiffs failed to file a timely appeal, and, as a result, the actions were concluded in Kenexa's favor.
Genesys Shareholder Suit
On October 1, 2010, Kenexa completed its acquisition of Salary.com, Inc. which included responsibility for the suit filed on August 13, 2010 by former shareholders and option holders of Genesys Software Systems, Inc. (the “Genesys Parties” and “Genesys,” respectively) against Salary.com, Inc. and Silicon Valley Bank -Trustee Process Defendant in Massachusetts Superior Court. The Genesys Parties asserts claims for breach of contract, breach of implied covenant of good faith and fair dealing, violation of the Massachusetts Unfair Business Practices Act, and declaratory judgment seeking damages of $2,000 in contingent consideration related to the purchase of Genesys by Salary.com, plus other monetary damages and fees. On September 7, 2010 Salary.com filed an answer and counterclaim against the Genesys Parties, and certain former shareholders of Genesys, asserting breach of contract, breach of implied covenants of good faith and fair dealing, fraud, violation of the Massachusetts Unfair Business Practices Act, civil conspiracy, negligent misrepresentation, and declaratory judgment seeking to dismiss the original complaint and unspecified monetary damages. The $2,000 in contingent consideration was accrued for in the financial statements at December 31, 2010.
Kenexa Corporation and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
(All amounts in thousands, except share and per share data, unless noted otherwise)
10. Commitments and Contingencies (continued)
Litigation (continued)
Salary.com Appraisal Suit
On February 2, 2011, Dorno Investment Partners, LLC filed a Petition for Appraisal of Stock in the Court of Chancery of the State of Delaware against Kenexa Compensation, Inc., the new name for the surviving entity subsequent to the all cash, short form merger of Salary.Com, Inc. and Spirit Merger Sub, Inc. on October 1, 2010. Dorno was the beneficial owner of 143,610 shares of Salary.Com, Inc. common stock on the merger date and demanded and continues to demand appraisal of the fair value of 140,000 shares pursuant to Delaware law. Dorno demands fair value for its shares, interest from October 1, 2010, costs, attorney’s fees, and other appropriate relief.
The Company is involved in claims, including those identified above, which arise in the ordinary course of business. In the opinion of management, the Company has made adequate provision for potential liabilities, if any, arising from any such matters. However, litigation is inherently unpredictable, and the costs and other effects of pending or future litigation, governmental investigations, legal and administrative cases and proceedings (whether civil or criminal), settlements, judgments and investigations, claims and changes in any such matters, could have a material adverse effect on the Company’s business, financial condition and operating results. Furthermore, the Company believes that the litigation matters described above, at their current state, are neither probable nor reasonably estimable at the time of filing.
11. Equity
Rollforward of Shares
The Company’s common shares issued and repurchased during the years ended December 31, 2010, 2009 and 2008 are as follows:
Refer to the accompanying consolidated statements of shareholders’ equity and this note for further discussion.
Kenexa Corporation and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
(All amounts in thousands, except share and per share data, unless noted otherwise)
11. Equity (continued)
Stock and Voting Rights
Undesignated Preferred Stock
The Company has 10,000,000 shares of $0.01 par value undesignated preferred stock authorized, with no shares issued or outstanding at December 31, 2010 or 2009. These shares have preferential rights in the event of liquidation and payment of dividends.
Common Stock
At December 31, 2010 and 2009, the Company had 100,000,000 authorized shares of common stock. Shares of common stock outstanding were 22,900,253 and 22,561,883 at December 31, 2010 and 2009, respectively. Each share of common stock has one-for-one voting rights.
Authorized but not issued shares
On February 20, 2008, our board of directors authorized a stock repurchase plan providing for the repurchase of up to 3,000,000 shares of the Company’s common stock, of which 1,125,651 shares were repurchased at an aggregate cost of $20,429 as of December 31, 2008. These shares were restored to original status prior to December 31, 2008 and accordingly are presented as authorized but not issued. The timing, price and volume of repurchases were based on market conditions, relevant securities laws and other factors. As of December 31, 2008 the amount of shares available for repurchase under the stock repurchase plan was 1,874,349. For the years ended, December 31, 2010 and 2009 no repurchases were made under the stock repurchase plan.
12. Stock Plans
Equity Incentive Plan
The Company’s 2005 Equity Incentive Plan (the “2005 Option Plan”), which was adopted by the Company’s Board of Directors (the “Board”) in March 2005 and was approved by the Company’s shareholders in June 2005, provides for the granting of stock options and restricted stock to employees and directors at the discretion of the Board or a committee of the Board. The 2005 Option Plan replaced the Company’s 2000 Stock Option Plan (the “2000 Option Plan”). The purpose of stock options is to recognize past services rendered and to provide additional incentive in furthering the continued success of the Company. Stock options granted under the 2005 Option Plan expires between the fifth and tenth anniversary of the date of grant and may vest on the third anniversary of the date of grant or may vest twenty-five percent per year for four years. Unexercised stock options may expire up to 90 days after an employee's termination for options granted under the 2000 and 2005 Option Plans. As of December 31, 2010, there were options to purchase 73,310 shares of common stock outstanding under the 2000 Option Plan.
As of December 31, 2010, there were options to purchase and restricted stock of 3,314,532 and 111,558, respectively, shares of common stock outstanding under the 2000 and 2005 Option Plan. The Company is authorized to issue up to an aggregate of 4,842,910 shares of its common stock pursuant to stock options granted under the 2005 Option Plan. As of December 31, 2010, there were a total of 475,641 shares of common stock not subject to outstanding options and restricted stock and available for issuance under the 2005 Option Plan.
FASB ASC 718, “Compensation-Stock Compensation,” requires companies to estimate the fair value of share-based payment awards on the date of grant using an option-pricing model. The fair value of each grant was estimated using the Black-Scholes valuation model. Expected volatility was based upon a weighted average of peer companies and the Company’s stock volatility. The expected life was determined based upon an average of the contractual life and vesting period of the options. The estimated forfeiture rate was based upon an analysis of historical data. The risk-free rate was based on U.S. Treasury zero coupon bond yields for periods commensurate with the expected term at the time of grant.
Kenexa Corporation and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
(All amounts in thousands, except share and per share data, unless noted otherwise)
12. Stock Plans (continued)
Compensation expense, for awards with a service condition that cliff vest, is recognized on a straight-line basis over the award’s requisite service period. For those awards with a service condition that have a graded vest, compensation expense is calculated using the graded-vesting attribution method. This method entails recognizing expense on a straight-line basis over the requisite service period for each separately vesting portion as if the grant consisted of multiple awards, each with the same service inception date but different requisite service periods. This method accelerates the recognition of compensation expense.
The fair value of market based, performance vesting share awards granted is calculated using a Monte Carlo valuation model that simulates various potential outcomes of the option grant and values each outcome using the Black-Scholes valuation model which yields a fair market value of the Company's common stock on the date of the grant (measurement date). This amount is recognized over the vesting period, using the straight-line method. Since the award requires both the completion of 4 years of service and the share price reaching predetermined levels as defined in the option agreement, compensation cost will be recognized over the 4 year explicit service period. If the employee terminates prior to the four-year requisite service period, compensation cost will be reversed even if the market condition has been satisfied by that time. The total grant date fair value of the options granted during 2008 using the Monte Carlo valuation model was $1,026.
The following table provides the assumptions used in determining the fair value of the market and service based awards for the year ended December 31, 2010, 2009 and 2008, respectively.
A summary of the status of the Company’s stock options as of December 31, 2010 and 2009 and changes during the period then ended is as follows:
Kenexa Corporation and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
(All amounts in thousands, except share and per share data, unless noted otherwise)
12. Stock Plans (continued)
The total intrinsic value of options and restricted stock outstanding, exercised and exercisable as of and for the period ended December 31, 2010 was $34,605, $1,571 and $9,611, respectively. The weighted average fair value for options and restricted stock granted during the period ended December 31, 2010, 2009 and 2008 was $7.16, $3.50 and $5.67, respectively. The weighted-average remaining contractual term of options and restricted stock outstanding and exercisable at December 31, 2010 was 5.56 and 3.21, respectively.
Between January 1, 2010 and December 31, 2010, the Company granted to certain employees, officers and non-employee directors options to purchase an aggregate of 549,322 shares of the Company's common stock at prevailing market price of $10.50 to $19.53 per share. During the fourth quarter of 2010, the Company granted to certain employees, restricted stock units in aggregate of 12,800 shares, which will vest 25% per year. The grant date fair value of the restricted stock was $19.53 per share.
On February 17, 2010, the Company granted to certain executive officers shares of restricted stock units in aggregate of 85,000 shares, which will vest 25% on each anniversary date of the grant through 2014. In the event the certain executive officer ceases to be an employee before these shares are fully vested, the unvested restricted shares units will be forfeited to the Company. The grant date fair value of the restricted stock was $10.50 per share.
On May 19, 2010, the Company granted to certain non-employee directors shares of restricted stock awards in aggregate of 13,758 shares, which will vest 100% on the day preceding the Company’s 2011 annual meeting of Shareholders. In the event the certain non-employee director ceases to be a director for the Company before these shares are fully vested, the unvested restricted shares units will be forfeited to the Company. The grant date fair value of the restricted stock was $14.39 per share.
Between January 1, 2009 and December 31, 2009, the Company granted options to certain employees to purchase an aggregate of 756,000 shares of the Company's common stock at a weighted exercise price of $6.12 per share. The Company granted the options at prevailing market prices ranging from $4.74 to $13.38 per share.
Between January 1, 2008 and December 31, 2008, the Company granted options to certain employees to purchase an aggregate of 1,084,600 shares of the Company's common stock at a weighted exercise price of $11.87 per share. The Company granted the options at prevailing market prices ranging from $5.11 to $21.80 per share.
The following table summarizes information about stock options outstanding at December 31, 2010:
Kenexa Corporation and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
(All amounts in thousands, except share and per share data, unless noted otherwise)
12. Stock Plans (continued)
A summary of the status of the Company’s unvested share options and restricted stock as of December 31, 2010 and 2009 is presented below:
The following table shows total share-based compensation expense included in the accompanying Consolidated Statement of Operations:
In accordance with FASB ASC 718, “Compensation-Stock Compensation,” excess tax benefits, associated with the expense recognized for financial reporting purposes, realized upon the exercise of stock options are presented as a financing cash inflow rather than as a reduction of income taxes paid in our consolidated statement of cash flows. In addition, the Company classifies share-based compensation within cost of revenues, sales and marketing, general and administrative expenses and research and development corresponding to the same line as the cash compensation paid to respective employees, officers and non-employee directors. For the year ended December 31, 2010, the Company had an unrecognized tax benefit of $1,196.
As of December 31, 2010, there was $3,978 of total unrecognized compensation cost related to unvested share-based compensation arrangements granted under the 2005 Option Plan. That cost is expected to be recognized over a weighted-average period of 1.51 years.
Employee Stock Purchase Plan
The Employee Stock Purchase Plan, which was approved in May 2006, enables substantially all U.S. and foreign employees to purchase shares of our common stock at a 5% discounted offering price off the closing market price of our common stock on the Nasdaq National Market, LLC on the offering date. We have granted rights to purchase up to 500,000 common shares to our employees under the Plan. The Plan is not considered a compensatory plan in accordance with FASB ASC 718 and requires no compensation expense to be recognized. As of December 31, 2010, there were 387,232 shares available for issuance pursuant to our 2006 Employee Stock Purchase Plan. Shares of our common stock purchased under the employee stock purchase plan were 33,263, 42,212 and 27,141 for the years ended December 31, 2010, 2009 and 2008, respectively.
Kenexa Corporation and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
(All amounts in thousands, except share and per share data, unless noted otherwise)
13. Geographic Information
The following table summarizes the distribution of revenue by geographic region as determined by billing address for the years ended December 31, 2010, 2009 and 2008.
The following table summarizes the distribution of assets by geographic region as of December 31, 2010 and 2009.
Kenexa Corporation and Subsidiaries
Notes to Consolidated Financial Statements (Continued)
(All amounts in thousands, except share and per share data, unless noted otherwise)
14. Related Party
In 2006, the Company purchased certain intangibles and property, plant and equipment for $300 from a software development consulting company previously managed by our current Chief Knowledge Officer, James P. Restivo. The assets in connection with the purchase were amortized and depreciated over a two year period ending in 2008.
One of the Company's directors, Barry M. Abelson, is a partner in the law firm of Pepper Hamilton LLP. This firm has represented the Company since 1997. For the years ended December 31, 2010, 2009 and 2008, the Company paid Pepper Hamilton LLP net of insurance coverage $1,153, $258 and $389, respectively, for general legal matters. The increase in payments to Pepper Hamilton LLP for the year ended 2010 as compared to the previous years resulted from an increase in activity from our class action shareholders litigation, our recent acquisitions of CHPD and Salary.com, and credit facility. The amount payable to Pepper Hamilton as of December 31, 2010 and 2009 was $177 and $202, respectively.
15. Subsequent Events
Talentmine
On January 11, 2011, the Company acquired substantially all of the assets and assumed selected liabilities of Talentmine, LLC, (“Talentmine”) a global performance-based talent assessment and development system with real-time analytics and reports to help employers improve service quality, employee retention and business results, based in Lincoln, Nebraska, for a purchase price of approximately $3,000 in cash. In addition, the former shareholder for Talentmine is eligible to receive an Earnout payment in an amount not to exceed $2,000 based upon meeting certain benchmarks in calendar year 2011. The acquisition of Talentmine will provide the Company with valuable intellectual property and key talent in the assessment market. The purchase price will be allocated to the assets acquired and liabilities assumed based upon management’s best estimate of fair value with any excess over the net tangible and intangible assets acquired allocated to goodwill. Talentmine’s results of operations will be included in the Company’s consolidated financial statements beginning on January 11, 2011.
JRA Technology Ltd.
On February 14, 2011, the Company entered into a share purchase agreement with JRA Technology Ltd. (“JRA”), a leading provider of employee climate/culture and related surveys based in Auckland, New Zealand, for a purchase price of approximately NZD 8,973 or $6,859 in cash with an adjustment for certain working capital accounts as defined. The total cost of the acquisition, including legal, accounting, and other professional fees of $14, was approximately $6,873. In connection with the acquisition, $675 of the cash portion of the purchase price was deposited into an escrow account to cover any claims for indemnification made by the Company against JRA under the acquisition agreement. The escrow agreement will remain in place for approximately two years from the acquisition date, and any funds remaining in the escrow account at the end of the two year period will be distributed to the former stockholders of JRA. The acquisition of JRA will enhance the Company’s global position in the survey market by broadening our solution suite and increasing our geographic reach. The purchase price will be allocated to the assets acquired and liabilities assumed based upon management’s best estimate of fair value with any excess over the net tangible and intangible assets acquired allocated to goodwill. JRA’s results of operations will be included in the Company’s consolidated financial statements beginning on February 14, 2011.
ITEM 9.
ITEM 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None
ITEM 9A.
ITEM 9A. Controls and Procedures
Disclosure Controls
Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 as of the end of the period covered by this report, or the Evaluation Date. Based upon the evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures were effective as of the Evaluation Date. Disclosure controls and procedures are controls and procedures designed to reasonably ensure that information required to be disclosed in our reports filed under the Exchange Act, such as this report, is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms. Disclosure controls and procedures include controls and procedures designed to reasonably ensure that such information is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate to allow timely decisions regarding required disclosure.
Internal Control over Financial Reporting
(a)
Management’s Annual Report on Internal Control over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting to provide reasonable assurance regarding the reliability of our financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of our assets, (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with authorizations of our management and directors, and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on the financial statements.
Management assessed our internal control over financial reporting as of December 31, 2010, the end of our fiscal year. Management based its assessment on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Management’s assessment included evaluation of such elements as the design and operating effectiveness of key financial reporting controls, process documentation, accounting policies, and our overall control environment.
We excluded from the scope of our assessment of internal control over financial reporting the operations and related assets of the following acquisitions completed in 2010, as permitted by the rules and regulations of the Securities and Exchange Commission. Expressed as a percentage of our total revenues, income before taxes and our total assets as of and for the year ended December 31, 2010 these exclusions included the following entities:
Based on its assessment, management has concluded that our internal control over financial reporting was effective as of the end of the fiscal year to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external reporting purposes in accordance with generally accepted accounting principles. The results of management’s assessment were reviewed with the Audit Committee of the Board of Directors.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. No evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within Kenexa have been detected. The design of any system of controls is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.
Grant Thornton, LLP independently assessed the effectiveness of our internal control over financial reporting and has issued its opinion, which is included below.
(b) Report of Independent Registered Public Accounting Firm
Report of Independent Registered Public Accounting Firm
On Internal Control over Financial Reporting
Board of Directors and Shareholders
Kenexa Corporation
We have audited Kenexa Corporation and Subsidiaries’ (collectively, Kenexa Corporation) (a Pennsylvania corporation) internal control over financial reporting as of December 31, 2010, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Kenexa Corporation’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on Kenexa Corporation’s internal control over financial reporting based on our audit. Our audit of, and opinion on, Kenexa Corporation's internal control over financial reporting does not include internal control over financial reporting of Salary.com a wholly owned subsidiary, whose financial statements reflect total assets and revenues constituting 32 percent and 4 percent, respectively, of the related consolidated financial statement amounts as of and for the year ended December 31, 2010. As indicated in Management's Report, Salary.com was acquired during 2010 and therefore, management's assertion on the effectiveness of Kenexa Corporation's internal control over financial reporting excluded internal control over financial reporting of Salary.com.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, Kenexa Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2010, based on criteria established in Internal Control-Integrated Framework issued by COSO.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Kenexa Corporation and Subsidiaries, as of December 31, 2010 and 2009 and the related consolidated statements of operations, shareholders’ equity, comprehensive income (loss) and cash flows for each of the three years in the period ended December 31, 2010 and our report dated March 16, 2011 expressed an unqualified opinion.
/s/ Grant Thornton LLP
Philadelphia, Pennsylvania
March 16, 2011
(c) Change in Internal Control over Financial Reporting
There have been no changes in internal control over financial reporting identified in connection with management’s evaluation that occurred during the last fiscal quarter ended December 31, 2010, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
ITEM 9B.
ITEM 9B. Other Information
Not Applicable
PART III
ITEM 10.
ITEM 10. Directors, Executive Officers and Corporate Governance
We incorporate by reference the information contained under the captions “Board of Directors”, “Structure and Practices of the Board of Directors”, “Section 16(a) Beneficial Ownership Reporting Compliance” and “Executive Compensation and Executive Officers” in our Definitive Proxy Statement for our 2010 annual meeting of shareholders, to be filed within 120 days after the end of the year covered by this Report pursuant to Regulation 14A under the Securities Exchange Act of 1934, as amended (the “2011 Proxy Statement”).
We have adopted a written code of business conduct and ethics, known as our Corporate Code of Conduct, which applies to all of our directors, officers and employees, including our principal executive officer and our principal financial and accounting officer. Our Corporate Code of Conduct is available on our Internet website, www.kenexa.com. Any amendments to our Corporate Code of Conduct or waivers from the provisions of the Corporate Code of Conduct for our principal executive officer and our principal financial and accounting officer will be disclosed on our Internet website within four business days following the date of such amendment or waiver.
ITEM 11.
ITEM 11. Executive Compensation
We incorporate by reference the information contained under the captions “Executive Compensation and Executive Officers”, “Compensation Committee Report” and “Structure and Practices of the Board of Directors” in our 2011 Proxy Statement.
ITEM 12.
ITEM 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
We incorporate by reference the information contained under the caption “Security Ownership of Certain Beneficial Owners and Management” in our 2011 Proxy Statement.
Equity Compensation Plan Information as of December 31, 2010.
The following table sets forth, as of December 31, 2010, information concerning equity compensation plans under which our securities are authorized for issuance. The table does not reflect grants, awards, exercises, terminations or expirations since that date. The following table excludes 500,000 shares of our common stock which were issued or are available for issuance pursuant to our 2006 Employee Stock Purchase Plan, which was approved by our shareholders in May 2006. As of December 31, 2010, there were 387,232 shares available for issuance pursuant to our 2006 Employee Stock Purchase Plan. All share amounts and exercise prices have been adjusted to reflect stock splits that occurred after the date on which any particular underlying plan was adopted to the extent applicable. All of the equity compensation plans pursuant to which we are currently granting equity awards have been approved by our shareholders.
(1)
Excludes number of securities to be issued upon exercise of outstanding options.
For a description of the material features of our equity compensation plans, see Note 11 to our consolidated financial statements.
ITEM 13.
ITEM 13. Certain Relationships, Related Transactions and Director Independence
We incorporate by reference the information contained under the caption “Certain Relationships and Related Party Transactions” and “Structure and Practices of the Board of Directors” in our 2011 Proxy Statement.
ITEM 14.
ITEM 14. Principal Accountant Fees and Services
We incorporate by reference the information contained under the caption Proposal No. 5 “Ratification of Selection of Independent Registered Public Accounting Firm” in our 2011 Proxy Statement.
PART IV
ITEM 15.
ITEM 15. Exhibits and Financial Statement Schedules
(a) Documents filed as part of this report:
1. Financial Statements. The financial statements as set forth under Item 8 of this Annual Report on Form 10-K are incorporated herein.
2. Financial Statement Schedules. All financial statement schedules have been omitted because they are not applicable, not required, or the information is shown in the financial statements or related notes.
3. Exhibits. See (b) below.
(b) Exhibits:
Exhibit Number
Description of Document
2.1
Agreement and Plan of Merger, dated as of December 21, 2005, among Kenexa Corporation, Kenexa Technology, Inc., Kenexa Acquisition Corp., Webhire, Inc., and Gazaway L. Crittenden, solely as the representative of the Equityholders (incorporated by reference to Exhibit 2.1 filed with the Company’s Current Report on Form 8-K dated December 22, 2005)
2.2
Equity Purchase Agreement and Agreement and Plan of Merger, dated as of October 5, 2006, among Kenexa Corporation, Kenexa Technology, Inc., Birmingham Acquisition Corp., BrassRing LLC, BrassRing Inc., Gannett Satellite Information Network, Inc., BRLLC Holdings Inc., Tribune National Marketing Company, Accel VI L.P., Accel Internet Fund II, L.P., Accel Keiretsu VI L.P., Accel Investors ‘98 L.P., Accel VI-S L.P., Accel Investors ‘98-S L.P., James W. Breyer, and Gerald M. Rosberg solely as the representative of the stockholders of BRINC and the selling members of BRLLC (incorporated by reference to Exhibit 2.1 filed with the Company’s Current Report on Form 8-K dated October 6, 2006)
2.3
Agreement and Plan of Merger, dated as of August 31, 2010, among Kenexa Corporation, Spirit Merger Sub, Inc. and Salary.com, Inc. (incorporated by reference to Exhibit 2.1 filed with the Company’s Current Report on Form 8-K dated September 1, 2010).
3.1
Amended and Restated Articles of Incorporation of Kenexa Corporation (incorporated by reference to Exhibit 3.1 filed with the Company’s Quarterly Report on Form 10-Q dated November 9, 2007)
3.2
Amended and Restated Bylaws of Kenexa Corporation (incorporated by reference to Exhibit 3.2 filed with the Company’s Quarterly Report on Form 10-Q dated November 9, 2007)
4.1
Form of Specimen Common Stock Certificate of Kenexa Corporation (incorporated by reference to Exhibit 4.1 filed with Amendment No. 4 to the Company’s Registration Statement on Form S-1 dated June 20, 2005, Registration No. 333-124028)
4.2
Form of Indenture (incorporated by reference to Exhibit 4.2 filed with the Company’s Registration Statement on Form S-3 dated March 9, 2010, Registration No. 333-165371)
10.1*
Kenexa Corporation 2000 Stock Option Plan (incorporated by reference to Exhibit 10.1 filed with the Company’s Registration Statement on Form S-1 dated April 12, 2005, Registration No. 333-124028)
10.2*
Form of Non-Qualified Stock Option Agreement under the Kenexa Corporation 2000 Stock Option Plan (incorporated by reference to Exhibit 10.2 filed with the Company’s Registration Statement on Form S-1 dated April 12, 2005, Registration No. 333-124028)
10.3*
Kenexa Corporation 2005 Equity Incentive Plan (incorporated by reference to Exhibit 10.3 filed with the Company’s Registration Statement on Form S-1 dated April 12, 2005, Registration No. 333-124028)
10.4*
Form of Non-Qualified Stock Option Award Agreement under the 2005 Equity Incentive Plan (Director) (incorporated by reference to Exhibit 10.4 filed with the Company’s Registration Statement on Form S-1 dated April 12, 2005, Registration No. 333-124028)
10.5*
Form of Non-Qualified Stock Option Award Agreement under the 2005 Equity Incentive Plan (Employee) (incorporated by reference to Exhibit 10.5 filed with the Company’s Registration Statement on Form S-1 dated April 12, 2005, Registration No. 333-124028)
* Management contracts and compensatory plans and arrangements required to be filed as exhibits pursuant to Item 15(a)(3) of this Annual Report on Form 10-K.
Exhibit Number Description of Document
10.6*
Kenexa Corporation Amended and Restated 2006 Employee Stock Purchase Plan (incorporated by reference to Exhibit 10.1 filed with the Company’s Current Report on Form 8-K dated October 20, 2006)
10.7
Agreement of Lease between Liberty Property Limited Partnership and Raymond Karsan Associates dated July 1, 1996 (incorporated by reference to Exhibit 10.10 filed with the Company’s Registration Statement on Form S-1 dated April 12, 2005, Registration No. 333-124028)
10.8
First Amendment to Agreement of Lease dated August 14, 2002 between Liberty Property Limited Partnership and Kenexa Corporation (incorporated by reference to Exhibit 10.11 filed with the Company’s Registration Statement on Form S-1 dated April 12, 2005, Registration No. 333-124028)
10.9
Second Amendment to Agreement of Lease dated November 8, 2002 between Liberty Property Limited Partnership and Kenexa Corporation (incorporated by reference to Exhibit 10.12 filed with the Company’s Registration Statement on Form S-1 dated April 12, 2005, Registration No. 333-124028)
10.10
Form of Indemnification Agreements between Kenexa Corporation and each of its directors and certain officers (incorporated by reference to Exhibit 10.23 filed with the Company’s Registration Statement on Form S-1 dated April 12, 2005, Registration No. 333-124028)
10.11*
Form of Restricted Stock Award Agreement under the 2005 Equity Incentive Plan (Non-Employee Director) (incorporated by reference to Exhibit 10.1 filed with the Company’s Current Report on Form 8-K dated August 14, 2007.)
10.12
Form of Tender and Support Agreement, dated as of August 31, 2010, by and among Kenexa Corporation, Spirit Merger Sub, Inc., and certain Salary.com stockholders (incorporated by reference to Exhibit 10.1 filed with the Company’s Current Report on Form 8-K dated September 1, 2010).
10.13
Non-Competition and Non-Solicitation Agreement, dated as of August 31, 2010, by and between Kenexa Corporation and Paul Daoust (incorporated by reference to Exhibit 10.2 filed with the Company’s Current Report on Form 8-K dated September 1, 2010).
10.14
Credit Agreement, dated as of August 31, 2010, by and among Kenexa Technology, Inc., PNC Bank, National Association, as administrative agent, and the lenders party thereto (incorporated by reference to Exhibit 10.3 filed with the Company’s Current Report on Form 8-K dated September 1, 2010).
10.15
Credit Agreement, by and among Kenexa Technology, Inc., PNC Bank, National Association, as administrative agent, and the lenders party thereto, dated as of October 20, 2010 (incorporated by reference to Exhibit 10.1 filed with the Company’s Current Report on Form 8-K dated October 22, 2010)
21.1
Subsidiaries of Kenexa Corporation
23.1
Consent of Grant Thornton LLP
31.1
Certification by Chief Executive Officer Pursuant to Rule 13a-14(a)/15d-14(a)
31.2
Certification by Chief Financial Officer Pursuant to Rule 13a-14(a)/15d-14(a)
32.1
Certification Furnished Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
* Management contracts and compensatory plans and arrangements required to be filed as exhibits pursuant to Item 15(a)(3) of this Annual Report on Form 10-K.
(c) None.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on March 16, 2011.
Kenexa Corporation
/s/ Nooruddin S. Karsan
----------------------------
Nooruddin S. Karsan
Chairman of the Board and Chief Executive Officer (Principal Executive Officer)
/s/ Donald F. Volk
-----------------
Donald F. Volk
Chief Financial Officer (Principal Financial and Accounting Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this report has been signed by the following persons on March 16, 2011 in the capacities indicated:
Signature
Title
/s/ Nooruddin S. Karsan
Nooruddin S. Karsan
Chairman of the Board and Chief Executive Officer and Director (Principal Executive Officer)
/s/ Donald F. Volk
Donald F. Volk
Chief Financial Officer (Principal Financial and Accounting Officer)
/s/ Troy A. Kanter
Troy A. Kanter
President, Chief Operating Officer and Director
/s/ Barry M. Abelson
Barry M. Abelson
Director
/s/ Renee B. Booth
Renee B. Booth
Director
/s/ Joseph A. Konen
Joseph A. Konen
Director
/s/ John A. Nies
John A. Nies
Director
/s/ Richard J. Pinola
Richard J. Pinola
Director
/s/ Rebecca Maddox
Rebecca Maddox
Director
EXHIBIT INDEX
Exhibit Number
Description of Document
21.1
Subsidiaries of Kenexa Corporation
23.1
Consent of Grant Thornton LLP
31.1
Certification by Chief Executive Officer Pursuant to Rule 13a-14(a)/15d-14(a)
31.2
Certification by Chief Financial Officer Pursuant to Rule 13a-14(a)/15d-14(a)
32.1
Certification Furnished Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002