UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

 

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

For the transition period from                   to                  

 

Commission File Number 000-27385

 

INTERACTIVE INTELLIGENCE, INC.

(Exact name of registrant as specified in its charter)

 

 

Indicate by checkmark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

 

Yes ý   No o

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

 

Yes o   No ý

 

The number of shares of common stock outstanding on April 30, 2004 was 15,836,663.

 

 

TABLE OF CONTENTS

 

PART I. FINANCIAL INFORMATION
Item 1.	Condensed Consolidated Balance Sheets as of March 31, 2004 (unaudited) and December 31, 2003
	Condensed Consolidated Statements of Operations for the three months ended March 31, 2004 and 2003 (unaudited)
	Condensed Consolidated Statement of Shareholders’ Equity for the three months ended March 31, 2004 (unaudited)
	Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2004 and 2003 (unaudited)
	Notes to Condensed Consolidated Financial Statements (unaudited)
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.	Quantitative and Qualitative Disclosures About Market Risk
Item 4.	Controls and Procedures
PART II. OTHER INFORMATION
Item 1.	Legal Proceedings
Item 6.	Exhibits and Reports on Form 8-K
SIGNATURES

 

2

 

PART I. FINANCIAL INFORMATION

 

Item 1. Condensed Consolidated Financial Statements and Footnotes.

 

Interactive Intelligence, Inc.

 

Condensed Consolidated Balance Sheets

(in thousands, except share amounts)

 

		March 31, 2004			December 31, 2003
		(unaudited)
Assets
Current assets:
Cash and cash equivalents		$	15,123		$	12,461
Short-term investments		—			3,008
Account receivable, net of allowance for doubtful accounts of $404 in 2004 and $354 in 2003		7,346			8,956
Prepaid expenses		2,260			1,958
Other current assets		527			418
Total current assets		25,256			26,801
Property and equipment, net		5,348			5,857
Other assets, net		641			601
Total assets		$	31,245		$	33,259
Liabilities and Shareholders’ Equity
Current liabilities:
Line of credit		$	1,200		$	2,800
Accounts payable and accrued liabilities		4,532			4,544
Accrued compensation and related expenses		1,426			1,349
Deferred software revenues		8,250			8,745
Deferred services revenues		11,879			12,030
Total current liabilities		27,287			29,468
Shareholders’ equity:
Preferred stock, no par value: 10,000,000 authorized; no shares issued and outstanding		—			—
Common stock, $0.01 par value; 100,000,000 authorized; 15,816,666 issued and outstanding at March 31, 2004, 15,755,477 issued and outstanding at December 31, 2003		158			157
Additional paid-in capital		64,854			64,696
Accumulated other comprehensive income		168			280
Accumulated deficit		(61,222		)	(61,342		)
Total shareholders’ equity		3,958			3,791
Total liabilities and shareholders’ equity		$	31,245		$	33,259

 

See Notes to Condensed Consolidated Financial Statements

 

3

 

Interactive Intelligence, Inc.

 

Condensed Consolidated Statements of Operations (unaudited)

(in thousands, except per share amounts)

 

		Three Months Ended March 31,
		2004			2003
Revenues:
Software		$	6,993		$	8,621
Services		6,713			5,763
Total revenues		13,706			14,384
Cost of revenues:
Software		493			292
Services		2,855			3,186
Total cost of revenues		3,348			3,478
Gross profit		10,358			10,906
Operating expenses:
Sales and marketing		5,028			5,207
Research and development		3,278			3,495
General and administrative		1,871			1,456
Restructuring and other charges		16			448
Total operating expenses		10,193			10,606
Operating income		165			300
Interest income, net		7			53
Income before income taxes		172			353
Income taxes		52			53
Net income		$	120		$	300
Net income per share:
Basic		$	0.01		$	0.02
Diluted		0.01			0.02
Shares used to compute net income per share:
Basic		15,806			15,565
Diluted		16,700			15,947

 

See Notes to Condensed Consolidated Financial Statements

 

4

 

Interactive Intelligence, Inc.

 

Condensed Consolidated Statement of Shareholders’ Equity (unaudited)

(in thousands)

 

							Additional			Accum. Other
		Common Stock					Paid-in			Comprehensive			Accumulated
		Shares		Amount			Capital			Income (loss)			Deficit			Total
Balances, December 31, 2003		15,755		$	157		$	64,696		$	280		$	(61,342	)	$	3,791
Issuances of common stock		30		—			72			—			—			72
Exercise of stock options		32		1			83			—			—			84
Amortization of deferred stock-based compensation		—		—			3			—			—			3
Comprehensive income (loss):
Unrealized loss on foreign currency		—		—			—			(112		)	—			(112		)
Net income		—		—			—			—			120			120
Total comprehensive income (loss)		—		—			—			(112		)	120			8
Balances, March 31, 2004		15,817		$	158		$	64,854		$	168		$	(61,222	)	$	3,958

 

See Notes to Condensed Consolidated Financial Statements

 

5

 

Interactive Intelligence, Inc.

 

Condensed Consolidated Statements of Cash Flows (unaudited)

(in thousands)

 

		Three Months Ended March 31,
		2004			2003
Operating activities:
Net income		$	120		$	300
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation		873			1,278
Amortization		3			24
Changes in operating assets and liabilities:
Accounts receivable		1,610			(1,829		)
Prepaid expenses		(302		)	168
Other current assets		(221		)	(23		)
Other assets		(40		)	4
Accounts payable and accrued liabilities		(12		)	131
Accrued compensation and related expenses		77			289
Deferred software revenues		(495		)	(417		)
Deferred services revenues		(151		)	2,445
Net cash provided by operating activities		1,462			2,370
Investing activities:
Purchases of property and equipment		(364		)	(1,182		)
Sales of available-for-sale investments		3,008			5,502
Net cash provided by investing activities		2,644			4,320
Financing activities:
Repayments on line of credit, net		(1,600		)	—
Proceeds from issuance of common stock		72			91
Proceeds from stock options exercised		84			—
Net cash provided (used) by financing activities		(1,444		)	91
Net increase in cash and cash equivalents		2,662			6,781
Cash and cash equivalents, beginning of period		12,461			5,913
Cash and cash equivalents, end of period		$	15,123		$	12,694
Cash paid for interest		$	13		$	6
Cash paid for taxes			3			1

 

See Notes to Condensed Consolidated Financial Statements

 

6

 

1.              Description of Business and Basis of Presentation

 

Interactive Intelligence, Inc. (the “Company”) is a leading provider of software applications for contact centers and is leveraging that leadership position to provide mission critical voice over Internet protocol (VoIP) applications to enterprises. The Company sells into four distinct markets, all of whose needs are increasing for VoIP-based systems:

 

•                  Contact Centers

•                  Enterprise IP Telephony

•                  Unified Communications, and

•                  Self-service Automation.

 

The Company’s principal competitors are hardware vendors who offer proprietary approaches using a combination of phone systems, call distributors, voicemail systems, and interactive voice response (IVR) systems equipment. The Company offers a software solution based on Microsoft Windows that resides on a customer’s network and uses an open Session Initiation Protocol (SIP) for VoIP networking. This open approach typically results in lower overall costs for phone devices, system maintenance, and customer networking. The Company’s software applications are also pre-integrated into many popular business applications such as financial, customer relationship management (CRM) and enterprise resource planning (ERP) software, thereby automating and tracking business transactions to customer interactions. The Company is best known for its bundled suite of contact center applications that includes multi-media customer contact for phone calls, Web chat, Web callback, e-mail queuing, customer defined queues, and integrated speech recognition applications.

 

Principal operations of the Company commenced during 1997. Since then, the Company has established wholly-owned subsidiaries in Australia, France, the Netherlands and the United Kingdom. The Company also currently has branch offices in Canada, Germany, Hong Kong, Japan, Korea, Malaysia, Singapore, Spain and Sweden. The Company markets its software applications in North America, Central America, South America, Europe, Asia/Pacific, Australia and South Africa.

 

The accompanying unaudited financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America for interim financial information and with the instructions for Form 10-Q and Article 10 of Regulation S-X. Accordingly, certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed, or omitted, pursuant to the rules and regulations of the Securities and Exchange Commission. In our opinion, the statements include all adjustments necessary (which are of a normal and recurring nature) for the fair presentation of the results of the interim periods presented.

 

The balance sheet at December 31, 2003 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements.

 

These financial statements should be read in conjunction with our audited consolidated financial statements for the year ended December 31, 2003, included in the Company’s Form 10-K for the year ended December 31, 2003, filed with the Securities and Exchange Commission on March 25, 2004. Our results of operations for any interim period are not necessarily indicative of the results of operations for any other interim period or for a full fiscal year.

 

2.              Net Income Per Common Share

 

Basic net income per share is calculated based on the weighted-average number of outstanding common shares in accordance with Financial Accounting Standards Board (FASB) Statement No. 28, Earnings per Share. Diluted net income per share is calculated based on the weighted-average number of outstanding common shares plus the effect of dilutive potential common shares.

 

7

 

The following table presents the calculation of basic and diluted net income per share (in thousands, except per share amounts):

 

		Three Months Ended March 31,
		2004			2003
Net income (A)		$	120		$	300
Weighted average outstanding shares of common stock (B)		15,806			15,565
Dilutive effect of options to purchase common stock		894			382
Common stock and common stock equivalent shares (C)		16,700			15,947
Net income per share:
Basic (A/B)		$	0.01		$	0.02
Diluted (A/C)			0.01			0.02

 

The Company’s calculation of diluted net income per share for the three months ended March 31, 2004 and March 31, 2003, respectively, excludes 2.1 million and 2.4 million options to purchase common stock with exercise prices ranging from $5.53 to $50.50 and $3.06 to $50.50 as their effect was antidilutive.

 

3.              Stock-Based Compensation

 

The Company applies the intrinsic-value-based method of accounting prescribed by Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations including FASB Interpretation No. 44, Accounting for Certain Transactions involving Stock Compensation, an interpretation of APB Opinion No. 25, to account for its fixed-plan stock options. Under this method, compensation expense is recorded on the date of grant only if the current market price of the underlying stock exceeds the exercise price. FASB Statement No. 123, Accounting for Stock-Based Compensation and FASB Statement No. 148, Accounting for Stock-Based Compensation – Transition and Disclosure - an amendment of FASB Statement No. 123, established accounting and disclosure requirements using a fair-value-based method of accounting for stock-based employee compensation plans. As permitted by existing accounting standards, the Company has elected to continue to apply the intrinsic-value-based method of accounting described above, and has adopted only the disclosure requirements of FASB Statement No. 123, as amended.

 

For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense on a straight-line basis over the options’ vesting period. The table included below illustrates the effect on net income and net income per share if the Company had applied the fair value recognition provisions of FASB Statement No. 123 to stock-based employee compensation (in thousands except per share amounts).

 

		Three Months Ended March 31,
		2004			2003
Net income, as reported		$	120		$	300
Add: Stock-based compensation expense included in reported net income, net of related tax effects		3			23
Deduct: Total stock-based compensation expense determined under fair value based method for all awards, net of related tax effect		(769		)	(1,389		)
Pro forma net loss		$	(646	)	$	(1,066	)
Net income (loss) per share:
Basic – as reported		$	0.01		$	0.02
Diluted – as reported		0.01			0.02
Basic – pro forma		(0.04		)	(0.07		)
Diluted – pro forma			(0.04	)		(0.07	)

 

8

 

4.              Concentration of Credit Risk

 

One reseller represented 17% of accounts receivable as of March 31, 2004 and one customer represented approximately 16% of total revenues and 29% of accounts receivable for the three months ended March 31, 2003.

 

5.              Contingencies

 

From time to time the Company has received claims from competitors and other technology providers claiming that the Company’s technology infringes their respective proprietary rights. One such claim has resulted in a legal proceeding being filed against the Company, which is described below. In addition, the Company is involved in certain legal proceedings in the ordinary course of conducting its business.  The Company believes these claims and legal proceedings can be resolved without a material adverse effect on its business, financial condition or results of operations; however, the Company cannot provide assurance as to the outcome.  Litigation in general, and intellectual property litigation in particular, can be expensive and disruptive to normal business operations. Moreover, the results of complex legal proceedings are difficult to predict.

 

In 2002, the Company received a letter from a consulting firm that has been retained by a telecommunication technology provider to develop and implement a licensing program based on the technology provider’s patents. The consulting firm believes that the Company has infringed on the technology provider’s propriety rights and therefore feels that a licensing agreement between the Company and the technology provider is appropriate. The Company believes that the technology subject to this claim is not significant to the software it licenses. There is on-going communication between the Company and the consulting firm to resolve this matter.  The Company believes that this matter can be resolved without a material adverse effect on its business, financial condition or results of operations; however, the Company cannot provide assurance as to the outcome.

 

In 2002, the Company received a letter from one of its resellers requesting indemnification related to a request that the reseller had received for indemnification from a customer. The customer had received a letter from a third party indicating that the customer may be infringing patents held by the third party. To date, the Company’s patent counsel has not determined the validity or the applicability of these patents as they relate to the Company’s products or whether the reseller is entitled to indemnification. The Company believes that this matter can be resolved without a material adverse effect on its business, financial condition or results of operations; however, the Company cannot provide assurance as to the outcome.

 

On September 30, 2003, Recursion Software, Inc. filed suit in Dallas County Court in Dallas, Texas against the Company alleging breach of contract and money due under claims of quantum meruit, unjust enrichment and infringement. Recursion claims that the Company incorporated Recursion Software into one of its products in breach of the underlying license. No dollar amount has been stated in the action. The Company believes that it has strong defenses to the claims and intends to vigorously defend against the action. The Company believes that this matter can be resolved without a material adverse effect on its business, financial condition or results of operations; however, the Company cannot provide assurance as to the outcome.

 

In 2002, the Company received a notification from the French government as a result of a tax audit that had been conducted encompassing the years 1998, 1999, 2000 and 2001. These assessments claim various taxes are owed related to Value Added Tax (“VAT”) and corporation taxes in addition to what has previously been paid and accrued. As of March 31, 2004, the assessment related to VAT was approximately $2.8 million and the assessment related to corporation taxes was approximately $366,000. The Company’s tax counsel has assessed the possibility of the Company paying the assessment related to VAT as remote and the assessment related to corporation taxes as reasonably possible; the Company has not accrued for these amounts. The Company is appealing the assessments, but cannot assure you that these matters will be resolved without litigation or that it will not have to pay some or all of the assessments.

 

9

 

6.              Restructuring Charges

 

In February 2003, the Company announced its plan to downsize and reorganize resources in Europe, the Middle East, and the African (“EMEA”) region. The French office was significantly affected, with most positions moved or eliminated. The Company determined that the severance payments and related legal fees incurred qualified as restructuring costs in accordance with FASB Statement No. 146, Accounting for Costs Associated with Exit or Disposal Activities.

 

Effective April 1, 2003, the Company moved its worldwide headquarters to a new building in Indianapolis, Indiana and all Indianapolis-based employees, equipment and furniture were relocated to the new facility. The majority of the lease on the previous headquarters has expired, however the Company continues to owe lease payments on a small portion of the previous headquarters through February 12, 2005. The Company determined that the remaining lease payments as of April 1, 2003 for the previous headquarters, net of sublease income, qualified as an exit cost and was recognized in accordance with SFAS 146 as restructuring charges. The Company does not anticipate additional restructuring charges related to the relocation of its worldwide headquarters.

 

The Company has ten former employees from its French office with whom it has not reached agreement regarding severance. The Company has recorded a liability for the estimated severance for those employees in accordance with FASB Statement No. 146. The Company could incur additional expenses related to these employees for legal fees and for additional severance costs when a settlement is reached.

 

The Company recognized restructuring charges in accordance with FASB Statement No. 146 of $16,000 and $448,000 for the three months ended March 31, 2004 and March, 31 2003, respectively.

 

A summary of the beginning accrued restructuring charges, expensed amount, cash payments and the ending accrued restructuring  charges for the three months ended March 31, 2004 is presented below (in thousands).

 

		Beginning Balance			Expense			Cash Payments			Ending Balance
EMEA restructuring		$	549		$	16		$	(132	)	$	433
Headquarters		267			—			(252		)	15
Total		$	816		$	16		$	(384	)	$	448

 

7.              Recent Accounting Pronouncements

 

In May 2003, the FASB issued FASB Statement No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. This Statement establishes standards for classification and measurement of certain financial instruments with characteristics of both liabilities and equity. The Statement also includes required disclosures for financial instruments within its scope. For the Company, the Statement was effective for financial instruments entered into or modified after May 31, 2003, and otherwise was effective as of January 1, 2004, except for mandatorily redeemable financial instruments. For certain mandatorily redeemable financial instruments, the Statement will be effective for the Company on January 1, 2005. The effective date has been deferred indefinitely for certain other types of mandatorily redeemable financial instruments. The Company currently does not have any financial instruments that are within the scope of this Statement.

 

10

 

In December 2003, the FASB issued FASB Interpretation No. 46 (revised December 2003), Consolidation of Variable Interest Entities, which addresses how a business enterprise should evaluate whether it has a controlling  financial interest in an entity through means other than voting rights and accordingly should consolidate the entity. FASB Interpretation No. 46R replaces FASB Interpretation No. 46, Consolidation of Variable Interest Entities, which was issued in January 2003. The Company will be required to apply FASB Interpretation No. 46R to interests in variable interest entities (VIEs) created after December 31, 2003. For variable interests in VIEs created before January 1, 2004, the Interpretation was applied beginning on January 1, 2004. For any VIEs that must be consolidated under FASB Interpretation No. 46R that were created before January 1, 2004, the assets, liabilities and noncontrolling interests of the VIE initially would be measured at their carrying amounts with any difference between the net amount added to the balance sheet and any previously recognized interest being recognized as the cumulative effect of an accounting change. If determining the carrying amounts is not practicable, fair value at the date FASB Interpretation No. 46R first applies may be used to measure the assets, liabilities and noncontrolling interest of the VIE. The Company does not hold any interests in VIEs.

 

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

 

Forward-Looking Information

 

Certain statements in this Form 10-Q contain “forward-looking” information (as defined in Section 27A of the Securities Act of 1933, as amended and Section 21E of the Securities Exchange Act of 1934, as amended) that involve risks and uncertainties which may cause actual results to differ materially from those predicted in the forward-looking statements. Forward-looking statements can often be identified by their use of such verbs as “expects,” “anticipates,” and “believes” or similar verbs or conjugations of such verbs. If any of our assumptions on which the statements are based prove incorrect or should unanticipated circumstances arise, our actual results could materially differ from those anticipated by such forward-looking statements. The differences could be caused by a number of factors or combination of factors, including, but not limited to, the “Factors that may affect our future operating results” described herein and the Risk Factors described in our Securities and Exchange Commission filings, including the Form 10-K filing for the year ended December 31, 2003.

 

Overview

 

We are a leading provider of software applications for contact centers and hope to leverage that leadership position to provide mission critical VoIP applications to enterprises. Our customers are in a wide variety of fields including financial institutions, government, healthcare and retail, among others. We are a global software provider with presence in North America, EMEA and Asia/Pacific.

 

Financial Highlights

 

In the initial years after we began licensing our software applications, our revenue growth was substantial. In 2002 and 2003, we saw a decrease in worldwide spending on technology given the global economic slowdown, and as a result, our revenue growth has diminished.

 

We believe that during the economic downturn and resulting decrease in technology spending, it became harder to market our products to new customers. Companies delayed changes to their systems and continued to use technology that they had in place. However, we believe that once companies have implemented our software and the personnel at these companies experience the capabilities and efficiencies of our software, these companies are increasing their technology spending for our software. Future licensing to new customers is dependent on the economy and whether companies will allocate their resources to upgrade their systems.

 

Revenue recognized in the first three months of 2004 is the second highest quarterly revenue since inception. The information below shows our total revenues and percentage growth from the previous year since sales commenced (revenues in millions).

 

11

 

Year			Revenues			% Growth
2004 (through March 31, 2004)			$	13.7		6	%(1)
2003			51.5			8
2002			47.8			0
2001			47.9			76
2000			27.3			43
1999			19.1			112
1998			9.0			467
1997			1.6			n/a

 

(1)  Percent growth shown is for the three months ended March 31, 2004 compared to the three months ended December 31, 2003.

 

Operating expenses decreased approximately $400,000 for the three months ended March 31, 2004 compared to the three months ended March 31, 2003. The improvement was a result of cost reduction and containment efforts that included staff reductions.

 

We had approximately $15.1 million of cash and short-term investments as of March 31, 2004. We had borrowings from a line of credit as of March 31, 2004 of $1.2 million, but have since repaid the line in full. We believe that as our revenues grow and our expenses remain controlled, we will increase our liquidity and position ourselves for growth in the future. If revenues remain stagnant or decrease, our liquidity position may weaken, which would result in the need to raise capital, either through the capital markets or debt financings.

 

Historical Results of Operations

 

The following table presents certain financial data, derived from our unaudited statements of operations, as a percentage of total revenues for the periods indicated. The operating results for the three months ended March 31, 2004 and 2003 are not necessarily indicative of the results that may be expected for the full year or for any future period.

 

		Three Months Ended March 31,
		2004		2003
Revenues:
Software		51	%	60	%
Services		49		40
Total revenues		100		100
Cost of revenues:
Software		3		2
Services		21		22
Total cost of revenues		24		24
Gross Profit		76		76
Operating expenses:
Sales and marketing		37		37
Research and development		24		24
General and administrative		14		10
Restructuring and other charges		—		3
Total operating expenses		75		74
Operating income		1		2
Interest income, net		—		—
Income before income taxes		1		2
Income taxes		—		—
Net income		1	%	2	%

 

12

 

Comparison of Three Months Ended March 31, 2004 and 2003

 

Revenues

 

Software Revenues

 

		Three Months Ended March 31,
		2004			2003
		($ in thousands)
Software revenues		$	6,993		$	8,621
Change from prior year		(19		)%	14		%
Percentage of total revenues		51		%	60		%

 

The decrease in software revenues and percent of software revenues to total revenues is related primarily to a perpetual license agreement with one customer, which accounted for 27% of software revenues in the three months ended March 31, 2003. Without this license agreement in 2003, software revenues would have increased slightly for the first three months of 2004 compared to the first three months of 2003.

 

Beginning in the fourth quarter of 2003, we began offering perpetual licenses to our new customers and therefore the recognition of revenue on new contracts signed in 2004 was accelerated compared to how revenue was recognized under annually renewable licenses in 2003. Some customers prefer a perpetual license, therefore the decision to offer customers perpetual licenses was a part of other actions designed to improve our customer licensing process and may result in the acceleration of revenue recognition.

 

Services Revenues

 

		Three Months Ended March 31,
		2004			2003
		($ in thousands)
Services revenues		$	6,713		$	5,763
Change from prior year		16		%	32		%
Percentage of total revenues		49		%	40		%

 

The increase in services revenues was primarily due to increases in our growing installed base of customers and related payments of annual license renewal fees and ongoing maintenance from perpetual licenses. As we sign and install new customers, our services revenues should grow, if existing customers continue to renew licenses and pay for maintenance on our software applications. The percent of services revenues to total revenues grew due to the decrease in software revenues (as described above) coupled with the increasing services revenues.

 

Cost of Revenues

 

		Three Months Ended March 31,
		2004			2003
		($ in thousands)
Cost of revenues:
Software		$	493		$	292
Services		2,855			3,186
Total cost of revenues		$	3,348		$	3,478
Total change from prior year		(4		)%	6		%
Software costs as a% of software revenues		7		%	3		%
Services costs as a% of services revenues		43		%	55		%

 

Costs of software consist primarily of product and software royalties paid to third parties for the use of their technologies in our products and, to a lesser extent, software packaging costs, which include product media, duplication and documentation. Costs of software can fluctuate depending on which software applications are licensed to our customers, and the third party technology, if any, which is licensed. The

 

13

 

increase in the software costs as a percent of related software revenues for the three months ended March 31, 2004 compared to the three months ended March 31, 2003 was due to increased royalties for third party software.

 

Costs of services consist primarily of compensation expenses for technical support, education and professional services personnel and other costs associated with supporting our resellers and customers. The decrease in costs of services as a percent of related services revenues was a result of our focus on cost control and increases in the related services revenues.

 

Gross Profit

 

		Three Months Ended March 31,
		2004			2003
		($ in thousands)
Gross profit		$	10,358		$	10,906
Change from prior year		(5		)%	26		%
Percentage of total revenues		76		%	76		%

 

Gross profit decreased slightly for the three months ended March 31, 2004 compared to the three months ended March 31, 2003. This was a result of a decrease in total revenues due to one large perpetual license agreement recognized in 2003, offset by a reduction in cost of revenues resulting from our focus on cost control, as described above.

 

Operating Expenses

 

Sales and Marketing

 

		Three Months Ended March 31,
		2004			2003
		($ in thousands)
Sales and marketing expenses		$	5,028		$	5,207
Change from prior year		(3		)%	(6		)%
Percentage of total revenues		37		%	37		%
Percentage of software revenues		72		%	60		%

 

Research and Development

 

		Three Months Ended March 31,
		2004			2003
		($ in thousands)
Research and development expenses		$	3,278		$	3,495
Change from prior year		(6		)%	(11		)%
Percentage of total revenues		24		%	24		%

 

Sales and marketing and research and development expenses are comprised primarily of compensation expenses. We initiated cost control efforts including staff reductions in 2002 and 2003, which resulted in lower compensation expenses for the three months ended March 31, 2004 compared to the three months ended March 31, 2003. Sales and marketing expenses as a percentage of software revenues increased for the three months ended March 31, 2004 due mainly to a decrease in software revenues in 2004 as described above.

 

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General and Administrative

 

		Three Months Ended March 31,
		2004			2003
		($ in thousands)
General and administrative expenses		$	1,871		$	1,456
Change from prior year		29		%	(3		)%
Percentage of total revenues		14		%	10		%

 

General and administrative expenses are comprised of compensation expense and non-allocable expenses including bad debt, legal and other professional service fees. General and administrative expenses increased for the three months ended March 31, 2004 compared to the three months ended March 31, 2003. This increase is principally the result of hiring general counsel in the third quarter of 2003, which increased compensation expense, and an increase in outside legal expenses due to increased efforts to resolve litigation and other claims against the Company. See Note 5 of Notes to Condensed Consolidated Financial Statements.

 

Restructuring and Other Charges

 

		Three Months Ended March 31,
		2004			2003
		($ in thousands)
Restructuring and other charges		$	16		$	448
Change from prior year		(96		)%	100		%
Percentage of total revenues		—			3		%

 

Restructuring and other charges for the three months ended March 31, 2004 and 2003 relate primarily to staff reductions in our European operations which occurred in 2003. We expect to incur some additional expenses related to the restructuring of international operations in 2004; however, at this time, we do not expect the amount to be significant. See Note 6 of Notes to Condensed Consolidated Financial Statements. Although we do not currently believe that we will need to further reduce staff, the state of the economy and resulting technology spending by businesses, among other factors, could result in further reductions.

 

Interest Income, Net

 

The majority of interest income, net is made up of interest earned from investments and interest-bearing cash accounts. Interest expense, which is not material for any periods reported, is also included in interest income, net. We have experienced decreased interest earnings as shown below.

 

		Three Months Ended March 31,
		2004			2003
		($ in thousands)
Cash, cash equivalents and short-term investments (average)		$	15,296		$	15,907
Interest income		20			59
Return on investment		.5		%	1.5		%

 

The decrease in interest income for the three months ended March 31, 2004 from the three months ended March 31, 2003 was related mainly to a decrease in interest rates and partially to the mix of investments. In 2003, short-term investments were a greater proportion of the total, while in 2004 all cash was held in cash and cash equivalents accounts. Cash and cash equivalents earn a lower rate of return than short-term investments. We opted to invest in this more liquid mix of investments in 2004 in order to ensure the availability of our cash.

 

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Liquidity and Capital Resources

 

In 1999 we raised cash through an initial public offering that provided net proceeds of $34.9 million. In 2001 we received an equity investment that yielded $15 million in cash. In addition, we generate cash from the collections we receive related to licensing our application software and to annual license renewals, maintenance and other services revenues. We also have in place a $3 million line of credit, of which we had utilized $1.2 million as of March 31, 2004. We use cash primarily for paying our employees (including salaries, commissions, benefits and severance), leasing office space, reimbursing travel expenses, paying insurance premiums, remitting applicable taxes and paying vendors for services rendered and supplies purchased. In addition, we purchase property and equipment, including furnishing our new worldwide headquarters and in-house technology purchases.

 

We determine liquidity by combining cash and cash equivalents and short-term investments net of our line of credit borrowings as shown in the table below. Our total liquidity position improved as of March 31, 2004 compared with our position as of December 31, 2003 and we believe that when combined with our anticipated cash flows from operations, will be sufficient to satisfy our cash needs over the next 12 months. If cash flows from operations are less than anticipated or we have additional cash needs (such as an unfavorable outcome in legal proceedings), our liquidity may not be sufficient to cover our needs. In this case, we may be forced to raise additional capital, either through the capital markets or debt financings. We may not be able to receive favorable terms in raising this capital.

 

		March 31, 2004			December 31, 2003
		($ in thousands )
Cash and cash equivalents		$	15,123		$	12,461
Short-term investments		—			3,008
Line of credit		(1,200		)	(2,800		)
Total liquidity		$	13,923		$	12,669

 

Our operating activities resulted in a net cash inflow of $1.6 million for the three months ended March 31, 2004 compared with a net cash inflow of $2.4 million for the three months ended March 31, 2003. These inflows consisted mainly of net income and non-cash items such as depreciation. In addition, accounts receivable decreased $1.6 million as of March 31, 2004 and deferred services revenues increased $2.4 million as of March 31, 2003, which both had positive impacts on cash provided by operating activities. Depreciation was $873,000 and $1.3 million for the three months ended March 31, 2004 and 2003, respectively.

 

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

 

We purchased property and equipment with a cost of $364,000 and $1.2 million in the three months ended March 31, 2004 and 2003, respectively.

 

The net repayment on our line of credit resulted in a $1.6 million use of cash for the three months ended March 31, 2004 because we borrowed less on our line of credit as compared to December 31, 2003.

 

Critical Accounting Policies and Estimates

 

We believe there are three accounting policies that are important to understanding our historical and future performance, as these policies affect the reported amounts of revenues and expenses and are the more significant areas involving management’s judgments and estimates. These critical accounting policies and estimates relate to revenue recognition, the allowance for doubtful accounts receivable and research and development. These policies, and our procedures related to these policies, are described below.

 

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Sources of Revenues and Revenue Recognition Policy

 

We generate software revenues from licensing the right to use our software applications and generate services revenues primarily from annual renewal fees, annual maintenance fees, educational services and professional services. We believe both of these sources of revenues are critical to our financial statements because of their materiality to our statements as a whole and because of the judgment required in determining if revenue recognition criteria have been met.

 

Software Revenues

 

Our software license agreements are either annually renewable or perpetual. For any revenues to be recognized from a software license agreement, the following criteria must be met:

 

•                  persuasive evidence of an arrangement exists;

•                  the fee is fixed or determinable;

•                  collection is probable; and

•                  delivery has occurred.

 

For an annually renewable software license agreement, upon meeting the revenue recognition criteria above, we recognize a majority of the initial license fees under these agreements as software revenues ratably over the initial license period, which is generally 12 months, and the remainder of the initial license fees are recognized as services revenues over the same time period.

 

For a perpetual software license agreement, upon meeting the revenue recognition criteria above, we immediately recognize as software revenues the amount of initial license fees if sufficient vendor specific objective evidence exists to support allocating a portion of the total fee to the undelivered elements of the arrangement. If sufficient vendor specific objective evidence of the fair value of the undelivered elements does not exist, we recognize the initial license fee as software revenues ratably over the initial term of the maintenance agreement, which is generally 12 months.

 

Services Revenues

 

Services revenues are recognized for annually renewable software license agreements and perpetual software license agreements. For annually renewable software license agreements, the allocation of the initial order between software revenues and services revenues is based on actual renewal fee rates. After the initial license period, our customers may renew their license agreement for an additional period, typically 12 months, by paying a renewal fee. Under perpetual software license agreements, we recognize annual maintenance fees as services revenues ratably over the post-contract maintenance period, which is typically 12 months.

 

We also generate services revenues from other services that we provide to our resellers and customers. These additional services revenues include fees for educational services and professional services. Revenues from educational services, which consist of training courses for resellers and customers, and professional services, which include implementing and customizing our products for a customer, are typically recognized as the related services are performed.

 

Allowance for Doubtful Accounts Receivable

 

We adjust our allowance for doubtful accounts for each reporting period based on a detailed analysis of our accounts receivable at the end of that period. In estimating the allowance for doubtful accounts, we primarily consider the age of the reseller’s or customer’s receivable and also consider the creditworthiness of the reseller or customer, the economic conditions of the customer’s industry, and general economic conditions, among other factors. If payment is not made timely, we contact the customer or reseller to try to obtain payment. If this is not successful, we institute other collection practices such as generating collection letters, involving our sales representatives and ultimately terminating the customer’s license(s) and/or the customer’s and reseller’s access to future upgrades, licenses and customer support. Once all collection efforts are exhausted, the receivable is written off against the allowance for doubtful accounts.

 

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Research and Development

 

Research and development expenditures are generally expensed as incurred. Based on our product development process and technological feasibility, the date at which capitalization of development costs may begin is established upon completion of a working model. Costs incurred between completion of the working model and the point at which the product is ready for general release have been insignificant. Through March 31, 2004, all research and development costs have been expensed.

 

Recently Issued Accounting Standards

 

In May 2003, the FASB issued FASB Statement No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. This Statement establishes standards for classification and measurement of certain financial instruments with characteristics of both liabilities and equity. The Statement also includes required disclosures for financial instruments within its scope. For us, the Statement was effective for financial instruments entered into or modified after May 31, 2003, and otherwise was effective as of January 1, 2004, except for mandatorily redeemable financial instruments. For certain mandatorily redeemable financial instruments, the Statement will be effective for us on January 1, 2005. The effective date has been deferred indefinitely for certain other types of mandatorily redeemable financial instruments. We currently do not have any financial instruments that are within the scope of this Statement.

 

In December 2003, the FASB issued FASB Interpretation No. 46 (revised December 2003), Consolidation of Variable Interest Entities, which addresses how a business enterprise should evaluate whether it has a controlling  financial interest in an entity through means other than voting rights and accordingly should consolidate the entity. FASB Interpretation No. 46R replaces FASB Interpretation No. 46, Consolidation of Variable Interest Entities, which was issued in January 2003. We will be required to apply FASB Interpretation No. 46R to interests in variable interest entities (VIEs) created after December 31, 2003. For variable interests in VIEs created before January 1, 2004, the Interpretation was applied beginning on January 1, 2004. For any VIEs that must be consolidated under FASB Interpretation No. 46R that were created before January 1, 2004, the assets, liabilities and noncontrolling interests of the VIE initially would be measured at their carrying amounts with any difference between the net amount added to the balance sheet and any previously recognized interest being recognized as the cumulative effect of an accounting change. If determining the carrying amounts is not practicable, fair value at the date FASB Interpretation No. 46R first applies may be used to measure the assets, liabilities and noncontrolling interest of the VIE. We do not hold any interests in VIEs.

 

Factors that may affect our future operating results are set forth below:

 

THE OVERALL ECONOMIC CLIMATE MAY BE WEAK

 

Our products typically represent substantial capital commitments by customers and  involve a potentially long sales cycle. As a result, customer purchase decisions may be significantly affected by a variety of factors, including general economic trends in the allocation of capital spending budgets to communication software, services and systems, lengthened sales cycles, customer approval processes, and market conditions, which have resulted in many of our customers delaying and/or reducing their capital spending related to information systems. If the economy is weak, demand for our products could decrease, resulting in lower revenues.

 

WE HAVE HISTORICALLY INCURRED LOSSES AND WE MAY NOT SUSTAIN PROFITABILITY

 

Since inception, the first quarters of 2004 and 2003 were the only quarters we have been profitable. We incurred net income of $120,000 in the quarter ended March 31, 2004 and net losses of $5.9 million, $7.7 million and $11.0 million for the years ended December 31, 2003, 2002 and 2001, respectively. At March 31, 2004, we had accumulated net losses since inception of $61.2 million. We intend to continue to make significant investments in our research and development, marketing, services and sales operations.

 

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Certain of these expenses will precede generation of revenues. As a result, we may continue to experience losses and/or negative cash flow from operations in future quarters.

 

OUR QUARTERLY OPERATING RESULTS HAVE VARIED SIGNIFICANTLY

 

Our operating results have varied significantly from quarter to quarter and may continue to do so in the future depending on a number of factors affecting us or our industry, including many that are beyond our control. As a result, we believe that period-to-period comparisons of our operating results are not necessarily meaningful, and you should not rely on them as an indication of our future performance. In addition, our operating results in a future quarter or quarters may fall below expectations of securities analysts or investors and, as a result, the price of our common stock may fluctuate.

 

Because we do not know if or when our potential customers will place orders and finalize licenses, and because it is difficult to predict the mix of annually renewable licenses and perpetual licenses in a quarter, we cannot accurately forecast our licensing activity, our revenues and our operating results for future quarters. We recognize revenues from different licenses over different periods depending on the satisfaction of the requirements of relevant accounting literature, including AICPA Statement of Position 97-2, Statement of Position 98-9, SEC Staff Accounting Bulletin (SAB) 101, and all related AICPA Technical Practice Aids (5100.38 - 5100.76). As a result, our quarterly revenues and operating results depend on many factors, including the type of license, the size, quantity and timing of orders received for our products during each quarter, the delivery of the related software and our expectations regarding collection. If a large number of orders or several large orders do not occur or are deferred or delayed, our revenues in a quarter could be substantially reduced. This risk is heightened by the significant investment and executive level decision-making typically involved in our customers’ decisions to license our products. Since a large portion of our operating expenses, including salaries and rent, is fixed and difficult to reduce or modify in a short time period, our business, financial condition or results of operations could be materially adversely affected if revenues do not meet our expectations.

 

Our limited number of products, changes in pricing policies, the timing of development completion, and announcement and sale of new or upgraded versions of our products are some of the additional factors that could cause our revenues and operating results to vary significantly from quarter to quarter.

 

WE HAVE A LENGTHY PRODUCT SALES CYCLE WHICH HAS CONTRIBUTED AND MAY CONTINUE TO CONTRIBUTE TO THE VARIABILITY OF QUARTERLY OPERATING RESULTS

 

We have generally experienced a lengthy product sales cycle, averaging approximately six to nine months. The lengthy sales cycle is one of the factors that has caused, and may in the future continue to cause, our software revenues and operating results to vary significantly from quarter to quarter, which could affect the market price of our common stock. The lengthy sales cycle also makes it difficult for us to forecast product license revenues. Because of the unique characteristics of our products, our prospective customers’ decisions to license our products often require significant investment and executive-level decision making. We believe that many companies currently are not aware of the benefits of interaction management software of the type that we license or of our products and capabilities. For this reason, we must provide a significant level of education to prospective customers about the use and benefits of our products, which can cause potential customers to take many months to make these decisions. As a result, sales cycles for customer orders vary substantially from customer to customer. Excessive delay in product sales could materially adversely affect our business, financial condition or results of operations.

 

The length of the sales cycle for customer orders depends on a number of other factors over which we have little or no control, including:

 

•                  a customer’s budgetary constraints;

•                  the timing of a customer’s budget cycles;

•                  concerns by customers about the introduction of new products by us or our competitors; and

 

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•                  downturns in general economic conditions, including reductions in demand for contact center services.

 

The sales cycle for our products in international markets has been, and is expected to continue to be, longer than the sales cycle in the United States. The average sales cycle for our products may lengthen as we continue to expand internationally.

 

OUR INABILITY TO SUCCESSFULLY MANAGE OUR INCREASINGLY COMPLEX THIRD PARTY RELATIONSHIPS COULD ADVERSELY AFFECT US

 

As the complexity of our product technology and our reseller and other third party relationships have increased, the management of those relationships and the negotiation of contractual terms sufficient to protect our rights and limit our potential liabilities have become more complicated, and we expect this trend to continue in the future. As a result, our inability to successfully manage these relationships or negotiate sufficient contractual terms could have a material adverse effect on us.

 

WE FACE COMPETITIVE PRESSURES, WHICH MAY HAVE A MATERIAL ADVERSE EFFECT ON US

 

The market for our software applications is highly competitive and, because there are relatively low barriers to entry in the software market, we expect competition to increase in the future. In addition, because our industry is evolving and characterized by rapid technological change, it is difficult for us to predict whether, when and by whom new competing technologies or new competitors may be introduced into our markets. Currently, our competition comes from several different market segments, including computer telephony platform developers, computer telephony applications software developers and telecommunications equipment vendors. We cannot assure you that we will be able to compete effectively against current and future competitors. In addition, increased competition or other competitive pressures may result in price reductions, reduced margins or loss of market share, any of which could have a material adverse effect on our business, financial condition or results of operations.

 

Many of our current and potential competitors have longer operating histories, significantly greater financial, technical, marketing, customer service and other resources, greater name recognition and a larger installed base of customers than we do. As a result, these competitors may be able to respond to new or emerging technologies and changes in customer requirements faster and more effectively than we can, or to devote greater resources to the development, promotion and sale of products than we can. Current and potential competitors have established, and may in the future establish, cooperative relationships among themselves or with third parties, including mergers or acquisitions, to increase the ability of their products to address the needs of our current or prospective customers. If these competitors were to acquire significant market share, it could have a material adverse effect on our business, financial condition or results of operations.

 

WE MAY NOT BE ABLE TO GROW OUR BUSINESS IF WE DO NOT MAINTAIN SUCCESSFUL RELATIONSHIPS WITH OUR RESELLERS AND OEM PARTNERS AND CONTINUE TO RECRUIT AND DEVELOP ADDITIONAL SUCCESSFUL RESELLERS AND OEM PARTNERS

 

Our ability to achieve revenue growth in the future will depend in part on our success in maintaining successful relationships with our existing and future resellers and OEM partners and in recruiting and training additional resellers and OEM partners. We rely primarily on resellers to market and support our products and plan on continuing to rely heavily on such partners in the future. We are still developing our reseller and OEM distribution networks and may be unable to attract additional resellers with both voice and data expertise or appropriate OEM partners that will be able to market our products effectively and that will be qualified to provide timely and cost-effective customer support and service. We generally do not have long-term or exclusive agreements with our resellers or OEM partners, and the loss of specific larger

 

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resellers or OEM partners or a significant number of resellers or OEM partners could materially adversely affect our business, financial condition or results of operations.

 

OUR MARKETS ARE CHARACTERIZED BY RAPID TECHNOLOGICAL CHANGE WHICH MAY CAUSE US TO INCUR SIGNIFICANT DEVELOPMENT COSTS AND PREVENT US FROM ATTRACTING NEW CUSTOMERS

 

The market for our products is characterized by rapid technological change, frequent new product introductions and enhancements, uncertain product life cycles and changing customer demands. The introduction of products embodying new technologies and the emergence of new industry standards could render existing products obsolete or unmarketable and cause us to incur significant development costs and prevent us from attracting new customers.

 

OUR BUSINESS WILL BE ADVERSELY AFFECTED IF WEB-BASED ELECTRONIC BUSINESS SOLUTIONS ARE NOT WIDELY UTILIZED

 

Our products address a market for Web-based, interactive electronic business solutions. Therefore, our future success depends on the widespread adoption of the Web as a primary medium for commerce and business applications. The failure of this market to expand, or a delay in the development of this market, could have a material adverse effect on our business, financial condition or results of operations. The Web has experienced, and is expected to continue to experience, significant user and traffic growth, which has, at times, caused user frustration with slow access and download times. The Web infrastructure may not be able to support the demands placed on it by the continued growth on which our success depends. Moreover, critical issues concerning the commercial use of the Web, such as security, reliability, cost, accessibility and quality of service, remain unresolved and may negatively affect the growth of Web use or the attractiveness of commerce and business communication over the Web. In addition, the Web could lose its viability due to delays in the development or adoption of new standards and protocols to handle increased activity or due to increased government regulation or taxation of Internet commerce.

 

A DECLINE IN MARKET ACCEPTANCE FOR MICROSOFT TECHNOLOGIES ON WHICH OUR PRODUCTS RELY COULD HAVE A MATERIAL ADVERSE EFFECT ON US

 

Our products currently run only on Microsoft Windows operating systems. In addition, our products use other Microsoft technologies, including Microsoft Exchange Server and Microsoft SQL Server. A decline in market acceptance for Microsoft technologies or the increased acceptance of other server technologies could cause us to incur significant development costs and could have a material adverse effect on our ability to market our current products. Although we believe that Microsoft technologies will continue to be widely used by businesses, we cannot assure you that businesses will adopt these technologies as anticipated or will not in the future migrate to other computing technologies that we do not currently support. In addition, our products and technologies must continue to be compatible with new developments in Microsoft technologies.

 

OUR FUTURE BUSINESS PROSPECTS DEPEND IN PART ON OUR ABILITY TO MAINTAIN AND IMPROVE OUR CURRENT PRODUCTS AND DEVELOP NEW PRODUCTS

 

We believe that our future business prospects depend in large part on our ability to maintain and improve our current software applications and to develop new software applications on a timely basis. Our software applications will have to continue to achieve market acceptance, maintain technological competitiveness and meet an expanding range of customer requirements. As a result of the complexities inherent in our applications, major new applications and application enhancements require long development and testing periods. We may not be successful in developing and marketing, on a timely and cost effective basis, application enhancements or new software applications that respond to technological change, evolving industry standards or customer requirements. We may also experience difficulties that could delay or prevent the successful development, introduction or marketing of application enhancements, and our new applications and application enhancements may not achieve market acceptance. Significant

 

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delays in the general availability of new releases of our software applications or significant problems in the installation or implementation of new releases of our applications could have a material adverse effect on our business, financial condition or results of operations.

 

SLOW GROWTH, OR A DECLINE IN DEMAND FOR INTERACTION MANAGEMENT SOFTWARE OF THE TYPE WE LICENSE, COULD MATERIALLY ADVERSELY AFFECT OUR FINANCIAL RESULTS AND GROWTH PROSPECTS

 

If the demand for interaction management software of the type we license does not grow within each of our four targeted markets, our financial results and ability to grow our business could be materially adversely affected. All of our revenues have been generated from licenses of our Interaction Center Platform software or complementary products, and related support, educational and professional services. We expect these products and services to account for the majority of our revenues for the foreseeable future. Although we believe demand for the functions performed by our products is high, the market for our products and services is still emerging. Further, our growth plans require us to successfully attract enterprise and service provider customers in significantly larger numbers than we have historically achieved.

 

IF OUR CUSTOMERS DO NOT PERCEIVE OUR PRODUCTS OR THE RELATED SERVICES PROVIDED BY US OR OUR RESELLERS OR OEM PARTNERS TO BE EFFECTIVE OR OF HIGH QUALITY, OUR BRAND AND NAME RECOGNITION WILL SUFFER

 

We believe that establishing and maintaining brand and name recognition is critical for attracting, retaining and expanding customers in our target markets. We also believe that the importance of reputation and name recognition will increase as competition in our market increases. Promotion and enhancement of our name will depend on the effectiveness of our marketing and advertising efforts and on our success in providing high-quality products and related services, neither of which can be assured. If our customers do not perceive our products or related services to be effective or of high quality, our brand and name recognition would suffer which could have a material adverse effect on our business, financial condition or results of operations.

 

WE MAY NOT BE ABLE TO PROTECT OUR PROPRIETARY RIGHTS ADEQUATELY, WHICH COULD ALLOW THIRD PARTIES TO COPY OR OTHERWISE OBTAIN AND USE OUR TECHNOLOGY WITHOUT AUTHORIZATION

 

We regard our software products as proprietary. In an effort to protect our proprietary rights, we rely primarily on a combination of copyright, trademark and trade secret laws, as well as patents, licensing and other agreements with consultants, suppliers, strategic and OEM partners, resellers and customers, and employee and third-party non-disclosure agreements. These laws and agreements provide only limited protection of our proprietary rights. It may be possible for a third party to copy or otherwise obtain and use our technology without authorization. A third party could also develop similar technology independently. In addition, the laws of some countries in which we sell our products do not protect our software and intellectual property rights to the same extent as the laws of the United States. Unauthorized copying, use or reverse engineering of our products could materially adversely affect our business, results of operations or financial condition.

 

We license technology that is embedded in our products. If one or more of these licenses terminates or cannot be renewed on satisfactory terms, we would have to modify the affected products to use alternative technology or eliminate the affected product function, either of which could have a material adverse effect on us.

 

INFRINGEMENT CLAIMS COULD ADVERSELY AFFECT US

 

Third parties have claimed or may in the future claim that our technology infringes their proprietary rights. As the number of software products in our target markets increases and the functionality of these

 

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products overlap, we believe that software developers may face additional infringement claims. See Note 5 of Notes to the Condensed Consolidated Financial Statements for a description of contingencies.

 

Infringement claims, even if without merit, can be time consuming and expensive to defend. A third party asserting infringement claims against us or our customers with respect to our current or future products may require us to enter into costly royalty arrangements or litigation, or otherwise materially adversely affect us.

 

WE DEPEND ON KEY PERSONNEL AND WILL NEED TO RETAIN AND RECRUIT SKILLED PERSONNEL, FOR WHICH COMPETITION IS INTENSE, TO CONDUCT AND GROW OUR BUSINESS EFFECTIVELY

 

Our success depends in large part on the continued service of our key personnel, particularly Dr. Donald E. Brown, our Chief Executive Officer and principal stockholder. The loss of the services of Dr. Donald E. Brown or other key personnel could have a material adverse effect on our business, financial condition or results of operations. Our future success also depends on our ability to attract, train, assimilate and retain additional qualified personnel. Competition for persons with skills in the software industry is intense, particularly for those with relevant technical and/or sales experience. We cannot assure you that we will be able to retain our key employees or that we can attract, train, assimilate or retain other highly qualified personnel in the future.

 

Also, in connection with our effort to streamline operations, reduce costs and rationalize our staffing and structure, we initiated headcount reductions in both 2001 and 2002 of approximately 10% to12% each year. There were substantial costs associated with the workforce reductions related to severance and other employee-related costs, and our restructuring plans may still yield unanticipated consequences, such as attrition beyond our implemented headcount reductions. As a result, our ability to respond to unexpected challenges may be impaired and we may be unable to take advantage of new opportunities. These reductions in workforce may reduce employee morale and may create concern among existing employees about job security, which may lead to increased turnover. These reductions in headcount may still subject us to the risk of litigation. As a result of these factors, our remaining personnel may seek employment with larger, more established companies or companies they perceive as having a greater potential for stock price appreciation.

 

WE MAY PURSUE ACQUISITIONS THAT BY THEIR NATURE PRESENT RISKS AND THAT MAY NOT BE SUCCESSFUL

 

In the future we may pursue acquisitions to diversify our product offerings and customer base or for other strategic purposes. We have no prior history of making material acquisitions and we cannot assure you that any future acquisitions will be successful. The following are some of the risks associated with acquisitions that could have a material adverse effect on our business, financial condition or results of operations:

 

•                  We cannot assure that any acquired businesses will achieve anticipated revenues, earnings or cash flow.

•                  We may be unable to integrate acquired businesses successfully and realize anticipated economic, operational and other benefits in a timely manner, particularly if we acquire a business in a market in which we have limited or no current expertise, or with a corporate culture different from our own. If we are unable to integrate acquired businesses successfully, we could incur substantial costs and delays or other operational, technical or financial problems.

•                  Acquisitions could disrupt our ongoing business, distract management, divert resources and make it difficult to maintain our current business standards, controls and procedures.

•                  We may finance future acquisitions by issuing common stock for some or all of the purchase price. This could dilute the ownership interests of our stockholders. We may also incur

 

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additional debt or be required to recognize expense related to intangible assets recorded in future acquisitions.

•                  We may be competing with other firms, many of which have greater financial and other resources, to acquire attractive companies, making it more difficult to acquire suitable companies on acceptable terms.

 

OUR INTERNATIONAL OPERATIONS INVOLVE FINANCIAL AND OPERATIONAL RISKS

 

Our international operations require significant management attention and financial resources to establish and operate, including hiring appropriate personnel and recruiting effective international resellers. Non-North American revenues accounted for 20%, 13%, 19% and 22% of our total revenues for the three months ended March 31, 2004 and the years ended December 31, 2003, 2002, and 2001, respectively. To date, our products have been licensed outside North America primarily in Western Europe, South Africa, and Australia. We also have marketing efforts in Japan, Korea, China and Central and South America. We intend to continue to emphasize our international operations and we may enter additional international markets. Revenues from international operations may be inadequate to cover the expenses of those operations. In addition to foreign currency fluctuation risks, other risks inherent in our international business activities may include the following:

 

•                  economic and political instability;

•                  unexpected changes in foreign regulatory requirements and laws;

•                  tariffs and other trade barriers;

•                  timing, cost and potential difficulty of adapting our software products to the local language in those foreign countries that do not use the alphabet that English uses, such as Japan, Korea and China;

•                  lack of acceptance of our products in foreign countries;

•                  longer sales cycles and accounts receivable payment cycles;

•                  potentially adverse tax consequences;

•                  restrictions on the repatriation of funds;

•                  acts of terrorism; and

•                  increased government regulations related to increasing or reducing business activity in various countries.

 

FLUCTUATIONS IN THE VALUE OF FOREIGN CURRENCIES COULD RESULT IN LOSSES

 

Our international revenues are generally denominated in U.S. dollars with the exception of some European resellers and customers located in countries who have adopted the Euro as their official currency. Our international expenses are generally denominated in local foreign currencies. Although foreign currency translation gains and losses have been immaterial to date, fluctuations in exchange rates between the U.S. dollar and other currencies could have a material adverse effect on our business, financial condition or results of operations, and particularly on our operating margins. To date, we have minimally sought to hedge the risks associated with fluctuations in exchange rates, but we may more actively undertake to do so in the future. Any hedging techniques we implement in the future may not be successful. Exchange rate fluctuations could also make our products more expensive than competitive products not subject to these fluctuations, which could adversely affect our revenues and profitability in international markets.

 

OUR PRODUCTS COULD HAVE DEFECTS FOR WHICH WE ARE POTENTIALLY LIABLE AND WHICH COULD RESULT IN LOSS OF REVENUE, INCREASED COSTS OR LOSS OF OUR CREDIBILITY OR DELAY IN ACCEPTANCE OF OUR PRODUCTS IN THE MARKET

 

Our products, including components supplied by others, may contain errors or defects, especially when first introduced or when new versions are released. Despite internal product testing, we have in the past discovered software errors in some of our products after their introduction. Errors in new products or releases could be found after commencement of commercial shipments, and this could result in additional

 

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development costs, diversion of technical and other resources from our other development efforts, or the loss of credibility with current or future customers. This could result in a loss of revenue or delay in market acceptance of our products, which could have a material adverse effect on our business, financial condition or results of operations.

 

Our license agreements with our customers typically contain provisions designed to limit our exposure to potential product liability and some contract claims. However, not all of these agreements contain these types of provisions and, where present, these provisions vary as to their terms and may not be effective under the laws of some jurisdictions. A product liability, warranty, or other claim brought against us could have a material adverse effect on our business, financial condition or results of operations.

 

Because our solution currently consists of our software running on a Windows 2000 server and voice processing boards operating in a complex network environment with database servers, email servers and other third party systems, it may be more prone to performance interruptions for our customers than traditional hardware-based products. Performance interruptions at our customer sites, most of which currently do not have back-up systems, could affect demand for our products or give rise to claims against us.

 

WE MAY NOT BE ABLE TO OBTAIN ADEQUATE FINANCING TO IMPLEMENT OUR STRATEGY

 

Successful implementation of our strategy may require continued access to capital. If we do not generate sufficient cash from operations, our growth could be limited unless we are able to obtain capital through additional debt or equity financings. We cannot assure you that debt or equity financings will be available as required for acquisitions or other needs. Even if financing is available, it may not be on terms that are favorable to us or sufficient for our needs. If we are unable to obtain sufficient financing, we may be unable to fully implement our growth strategy.

 

OUR STOCK PRICE HAS BEEN AND COULD CONTINUE TO BE HIGHLY VOLATILE

 

Our stock price has been and could continue to be highly volatile due to a number of factors, including:

 

•                  actual or anticipated fluctuations in our operating results;

•                  announcements by us, our competitors or our customers;

•                  changes in financial estimates of securities analysts or investors regarding us, our industry or our competitors;

•                  technological innovations by others;

•                  the operating and stock price performance of other comparable companies or of our competitors;

•                  the low number of our shares typically traded in any trading session;

•                  the availability for future sale, or sales, of a substantial number of shares of our common stock in the public market; and

•                  general market or economic conditions.

 

This risk may be heightened because our industry is new and evolving, characterized by rapid technological change and susceptible to the introduction of new competing technologies or competitors.

 

In addition, the stock market has experienced significant price and volume fluctuations that have particularly affected the trading prices of equity securities of many technology companies, including us. These price and volume fluctuations often have been unrelated to the operating performance of the affected companies. In the past, following periods of volatility in the market price of a company’s securities, securities class action litigation has often been instituted against that company. This type of litigation, regardless of the outcome, could result in substantial costs and a diversion of management’s attention and resources, which could materially and adversely affect our business, financial condition or results of operations.

 

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OUR COMMON STOCK IS SUBJECT TO VARIOUS LISTING REQUIREMENTS

 

The various markets operated by The NASDAQ Stock Market have quantitative maintenance criteria for continued listing of common stock. We may be delisted from one or more NASDAQ markets if we fail to comply with the criteria. While we believe that we currently meet criteria for listing on a market operated by The NASDAQ Stock Market, we can offer no assurance that our common stock will continue to meet the various criteria for continued listing on any market operated by The NASDAQ Stock Market. Any delisting may result in a reduction in the liquidity of our common stock, which may have a material adverse effect on the price of our common stock.

 

REGULATORY CHANGES MADE TO ACCOUNTING PRINCIPLES GENERALLY ACCEPTED IN THE UNITED STATES OF AMERICA OR CORPORATE GOVERNANCE MATTERS MAY IMPACT OUR BUSINESS

 

Revisions to accounting principles generally accepted in the United States of America will require us to review our accounting and financial reporting procedures in order to ensure continued compliance with required policies. From time to time, such changes may have a short-term impact on our reporting, and these changes may impact market perception of our financial condition. In addition, legislative changes, and the perception these changes create, can have a material, adverse effect on our business. For example:

 

•                  pending or new legislation may lead to an increase in our costs related to audits in particular and regulatory compliance generally; and

•                  changes in the legal climate may lead to additional liability concerns which may result in increased insurance costs.

 

OUR EXECUTIVE OFFICERS AND DIRECTORS CONTROL US AND MAY MAKE DECISIONS THAT SHAREHOLDERS DO NOT CONSIDER TO BE IN THEIR BEST INTERESTS

 

Our current directors and executive officers together beneficially own more than 50% of our outstanding common stock. Accordingly, these shareholders are able to control us through their ability to determine the outcome of the election of our directors, amend our Restated Articles of Incorporation and By-Laws and take other actions requiring the vote or consent of shareholders, including mergers, going private transactions and other extraordinary transactions, and the terms of any of these transactions. The ownership position of these shareholders may have the effect of delaying, deterring or preventing a change in control or a change in the composition of our board of directors.

 

ANTI-TAKEOVER PROVISIONS IN OUR ORGANIZATIONAL DOCUMENTS AND INDIANA LAW MAKE ANY CHANGE IN CONTROL OF US MORE DIFFICULT, MAY DISCOURAGE BIDS AT A PREMIUM OVER THE MARKET PRICE AND MAY ADVERSELY AFFECT THE MARKET PRICE OF OUR STOCK

 

Our Restated Articles of Incorporation and By-Laws contain provisions that may have the effect of delaying, deferring or preventing a change in control of us, may discourage bids at a premium over the market price of our common stock and may adversely affect the market price of our common stock, and the voting and other rights of the holders of our common stock. These provisions include:

 

•                  the division of our board of directors into three classes serving staggered three-year terms;

•                  removal of directors only for cause and only upon a 66 2/3% shareholder vote;

•                  prohibiting shareholders from calling a special meeting of shareholders;

•                  the ability to issue additional shares of our common stock or preferred stock without shareholders’ approval; and

•                  advance notice requirements for raising business or making nominations at shareholders’ meetings.

 

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The Indiana corporation law contains business combination provisions that, in general, prohibit for five years any business combination with a beneficial owner of 10% or more of our common stock unless the holder’s acquisition of the stock was approved in advance by our board of directors. The Indiana corporation law also contains control share acquisition provisions that limit the ability of certain shareholders to vote their shares unless their control share acquisition was approved in advance.

 

WE CANNOT PREDICT EVERY EVENT AND CIRCUMSTANCE THAT MAY IMPACT OUR BUSINESS AND, THEREFORE, THE RISKS AND UNCERTAINTIES DISCUSSED ABOVE MAY NOT BE THE ONLY ONES YOU SHOULD CONSIDER

 

The risks and uncertainties discussed above are in addition to those that apply to most businesses generally. In addition, as we continue to grow our business, we may encounter other risks of which we are not aware at this time. These additional risks may cause serious damage to our business in the future, the impact of which we cannot estimate at this time.

 

Item 3. Quantitative and Qualitative Disclosures about Market Risk.

 

We develop products in the United States and sell licenses in North America, Europe, the Asia/Pacific region, South Africa, and Central and South America. As a result, our financial results could be affected by various factors, including changes in foreign currency exchange rates or weak economic conditions in foreign markets. As most sales are currently made in U.S. dollars, a strengthening of the dollar could make our products less competitive in foreign markets. Additionally, as our business matures in foreign markets, we may offer our products and services in certain other local currencies. As a result, we will be subject to foreign currency fluctuations which may have an adverse affect on our company.

 

We manage our interest rate risk by maintaining an investment portfolio with debt instruments of high credit quality and relatively short average maturities. We also manage interest rate risk by maintaining sufficient cash and cash equivalent balances such that we are typically able to hold our investments to maturity. We have a line of credit with a variable interest rate based upon the bank’s prime rate on which we will incur interest expense if the line is utilized.

 

Item 4. Controls and Procedures

 

We maintain a set of disclosure controls and procedures that are designed to ensure that information required to be disclosed by us in the reports filed by us under the Securities Exchange Act of 1934, as amended (“Exchange Act”) is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. We carried out an evaluation, under the supervision and with the participation of our management, including our President and Chief Executive Officer and our Chief Financial Officer and Treasurer, of the effectiveness of the design and operation of our disclosure controls and procedures as of March 31, 2004 pursuant to Rule 13a-15(b) of the Exchange Act. Based on that evaluation, our President and Chief Executive Officer and our Chief Financial Officer and Treasurer concluded that our disclosure controls and procedures are effective.

 

There have been no changes in our internal control over financial reporting that occurred during the quarter ended March 31, 2004 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

PART II. OTHER INFORMATION

 

Item 1. Legal Proceedings.

 

From time to time we have received claims from competitors and other technology providers claiming that our technology infringes their respective proprietary rights. One such claim has resulted in a legal proceeding being filed against us, which is described below. In addition, we are involved in certain legal proceedings in the ordinary course of conducting our business.  We believe these claims and legal proceedings can be resolved without

 

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a material adverse effect on our business, financial condition or results of operations; however, we cannot provide assurance as to the outcome. Litigation in general, and intellectual property litigation in particular, can be expensive and disruptive to normal business operations. Moreover, the results of complex legal proceedings are difficult to predict.

 

In 2002, we received a letter from a consulting firm that has been retained by a telecommunication technology provider to develop and implement a licensing program based on the technology provider’s patents. The consulting firm believes that we have infringed on the technology provider’s propriety rights and therefore feels that a licensing agreement between us and the technology provider is appropriate. We believe that the technology subject to this claim is not significant to the software we license. There is on-going communication between us and the consulting firm to resolve this matter.  We believe that this matter can be resolved without a material adverse effect on our business, financial condition or results of operations; however, we cannot provide assurance as to the outcome.

 

In 2002, we received a letter from one of our resellers requesting indemnification related to a request that the reseller had received for indemnification from a customer. The customer had received a letter from a third party indicating that the customer may be infringing patents held by the third party. To date, our patent counsel has not determined the validity or the applicability of these patents as they relate to our products or whether the reseller is entitled to indemnification. We believe that this matter can be resolved without a material adverse effect on our business, financial condition or results of operations; however, we cannot provide assurance as to the outcome.

 

On September 30, 2003, Recursion Software, Inc. filed suit in Dallas County Court in Dallas, Texas against us alleging breach of contract and money due under claims of quantum meruit, unjust enrichment and infringement. Recursion claims that we incorporated Recursion Software into one of our products in breach of the underlying license. No dollar amount has been stated in the action. We believe that we have strong defenses to the claims and intend to vigorously defend against the action. We believe that this matter can be resolved without a material adverse effect on our business, financial condition or results of operations; however, we cannot provide assurance as to the outcome.

 

In 2002, we received a notification from the French government as a result of a tax audit that had been conducted encompassing the years 1998, 1999, 2000 and 2001. These assessments claim various taxes are owed related to Value Added Tax (“VAT”) and corporation taxes in addition to what has previously been paid and accrued. As of March 31, 2004, the assessment related to VAT was approximately $2.8 million and the assessment related to corporation taxes was approximately $366,000. Our tax counsel has assessed the possibility of us paying the assessment related to VAT as remote and the assessment related to corporation taxes as reasonably possible; we have not accrued for these amounts. We are appealing the assessments, but cannot assure you that these matters will be resolved without litigation or that we will not have to pay some or all of the assessments.

 

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Item 6. Exhibits and Reports on Form 8-K.

 

(a)          Exhibits

 

10.13  Employment Agreement between the Company and Pamela J. Hynes dated November 4, 1996 and the First Amendment to Employment Agreement between the Company and Pamela J. Hynes dated February 23, 2000

 

31.1  Certification of the Chief Executive Officer pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

 

31.2  Certification of the Chief Financial Officer pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

 

32.1 Certification of Donald E. Brown, M.D., CEO, pursuant to 18 U. S. C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 

32.2 Certification of Stephen R. Head, CFO, pursuant to 18 U. S. C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 

(b)         Reports on Form 8-K

 

1. On April 20, 2004, the Company furnished, not filed, a Form 8-K attaching a press release describing its results of operations for the quarter ended March 31, 2004.

 

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SIGNATURES

 

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

 

	Interactive Intelligence, Inc.
	(Registrant)
Date: May 12, 2004	By	/s/ Stephen R. Head
	Stephen R. Head
	Chief Financial Officer, Vice President of Finance and Administration, Secretary and Treasurer (Principal Financial Officer and Principal Accounting Officer)

 

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