UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Form 10-Q

       (Mark One)

FOR THE QUARTERLY PERIOD ENDED MARCH 27, 2004

OR

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

FOR THE TRANSITION PERIOD FROM         TO

Commission File Number 0-27975

eLoyalty Corporation

150 Field Drive
Suite 250
Lake Forest, Illinois 60045
(847) 582-7000
(Address, Including Zip Code, and Telephone Number, Including Area Code, of
Registrant’s Principal Executive Offices)

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

          Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes o No x

          The number of outstanding shares of the registrant’s common stock, $0.01 par value per share, as of May 6, 2004 was 6,991,410.

TABLE OF CONTENTS

Part I. Financial Information

Item 1. Financial Statements

eLoyalty Corporation
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited and in thousands, except share and per share data)

The accompanying Notes to Condensed Consolidated Financial Statements are an integral part of this financial information.

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eLoyalty Corporation
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited and in thousands, except per share data)

The accompanying Notes to Condensed Consolidated Financial Statements are an integral part of this financial information.

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eLoyalty Corporation
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited and in thousands)

The accompanying Notes to Condensed Consolidated Financial Statements are an integral part of this financial information.

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eLoyalty Corporation
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited and dollars in thousands, except per share data)

Note 1 — General

          In the opinion of management, the accompanying unaudited condensed consolidated financial statements of eLoyalty Corporation (we or eLoyalty) include all normal and recurring adjustments necessary for a fair presentation of our condensed consolidated financial position as of March 27, 2004, the condensed consolidated results of our operations for the three months ended March 27, 2004 and March 29, 2003 and our condensed consolidated cash flows for the three months ended March 27, 2004 and March 29, 2003, and are in conformity with Securities and Exchange Commission (SEC) Rule 10-01 of Regulation S-X.

          The results of operations for any interim period are not necessarily indicative of the results for the full year. The accompanying financial statements should be read in conjunction with the audited consolidated financial statements and the notes thereto in our Annual Report on Form 10-K for the fiscal year ended December 27, 2003.

Note 2 — Severance and Related Costs

          Severance costs are comprised primarily of contractual salary and related fringe benefits over the severance payment period. Facility costs include losses on contractual lease commitments, net of estimated sublease recoveries, and impairment of leasehold improvements and certain office assets. Other costs include laptop costs, other contractual computer lease termination costs, and other employee related expenses.

          In 2003, in response to the business environment and decreased demand for IT consulting services, a number of cost reduction activities were undertaken, principally consisting of personnel reductions. These cost reduction activities were designed to size the workforce to meet eLoyalty’s expected business requirements. During the three months ended March 27, 2004 and March 29, 2003, respectively, eLoyalty recognized pre-tax income of $234 and expense of $1,260. The income recorded in the first quarter of 2004 is primarily related to a favorable settlement of employment litigation in the International segment with former employees who were terminated in prior years. The $1,260 expense in the first quarter of 2003 primarily related to employee severance payments and related costs for the elimination of 22 positions, in both the North America and International segments.

          During the quarter ended March 27, 2004, eLoyalty made cash payments of $1,043 related to cost reduction actions initiated in 2003 and earlier periods. eLoyalty expects substantially all severance and other charges to be paid out by the second quarter of 2004 pursuant to agreements entered into with affected employees. Facility costs related to office space reductions and office closures, reserved for in 2002 and 2001, are to be paid pursuant to contractual lease terms through 2007 and other costs are to be paid pursuant to contractual commitments through the third quarter of 2004.

          The severance and related costs and their utilization for the three months ended March 27, 2004 are as follows:

          Of the $2,358 that remained reserved as of March 27, 2004, $994 related to future lease payments, net of estimated sublease recoveries, is recorded in “Long-term liabilities,” $582 related to employee severance payments is recorded in “Accrued compensation and related costs” and the balance of $782 is recorded in “Other current liabilities.” Of the balance

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in “Other current liabilities,” $619 relates to facility lease payments, net of estimated sublease recoveries, and is expected to be paid over the next twelve months.

Note 3 — Comprehensive Net Loss

          Comprehensive net loss is comprised of the following:

          The accumulated other comprehensive loss, which represents the cumulative effect of foreign currency translation adjustments, was $3.9 million and $3.8 million at March 27, 2004 and December 27, 2003, respectively.

Note 4 — Loss Per Share

          The following table sets forth the computation of the loss and shares used in the calculation of basic and diluted loss per share:

          In periods in which there is a loss, the dilutive effect of common stock equivalents, which is primarily related to the 7% Series B Convertible Preferred Stock, was not included in the diluted loss per share calculation as it was antidilutive. The total number of common share equivalents that would have been included in the computation of diluted loss per share if they had been dilutive was 4,383 and 4,270 for the three months ended March 27, 2004 and March 29, 2003.

Note 5 — Segment Information

          eLoyalty focuses exclusively on providing customer relationship management (“CRM”) related professional services. eLoyalty has two reportable geographic segments: North America (consisting of US and Canada) and International. The following table reflects revenue and operating results by reportable segment for the three months ended March 27, 2004 and March 29, 2003, respectively, and total assets by reportable segment as of March 27, 2004 and December 27, 2003, respectively.

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          Total long-lived assets for US operations are $11,233 and $11,236 at March 27, 2004 and December 27, 2003, respectively. For the three months ended March 27, 2004 and March 29, 2003, Consulting services represented 72% and 77% of total revenue, Managed services represented 19% and 11% of total revenue and sales of third-party software represented 3% and 6% of total revenue, respectively. Reimbursed expenses represented 6% of total revenue for the three months ended March 27, 2004 and March 29, 2003, respectively.

Note 6 — Stock Based Compensation

          eLoyalty accounts for stock-based compensation using Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” whereby compensation cost for stock options is measured as the excess, if any, of the fair market value of a share of the Company’s stock at the date of grant over the amount that must be paid to acquire the stock. Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation” issued subsequent to APB No. 25 and amended by SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure” defines a fair value-based method of accounting for employee stock options but allows companies to continue to measure compensation cost for employee stock options using the intrinsic value-based method described in APB No. 25.

          The following table illustrates the effect on net loss available to common stockholders and net loss per share if eLoyalty had applied the fair value recognition provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” as amended by SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure,” to stock-based employee compensation. No compensation costs have been recognized for the stock option plans. Compensation costs were recognized for restricted and installment awards as expense in the Condensed Consolidated Statements of Operations.

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          There were no stock options granted during the quarter ended March 27, 2004. Assumptions used for valuation of option grants for the quarter ended March 29, 2003 calculated in accordance with SFAS No. 148 are as follows:

Note 7 — Recent Accounting Pronouncements

          In March 2004, Emerging Issues Task Force (“EITF”) reached a consensus on EITF Issue No. 03-6, “Participating Securities and the Two-Class Method under Financial Accounting Standards Board (“FASB”) Statement No. 128, Earnings per Share.” EITF 03-6 clarifies what constitutes a participating security and provides further guidance in applying the two-class method of calculating earnings per share. The consensus reached by the Task Force in this Issue is effective for reporting periods beginning after March 31, 2004. eLoyalty is currently assessing the provisions of EITF 03-6 and the impact on eLoyalty’s financial position or results of operations.

          During 2003, the FASB issued FASB Interpretation No. (“FIN”) 46, “Consolidation of Variable Interest Entities.” This new interpretation requires that companies consolidate a variable interest entity if the company is subject to a majority of the risk of loss from the variable interest entity’s activities, or is entitled to receive a majority of the entity’s residual returns, or both. In December 2003, the FASB issued Interpretation 46R (“FIN 46R”), a revision to FIN 46. FIN 46R clarifies some of the provisions of FIN 46 and exempts certain entities from its requirements. FIN 46R was effective at the end of the first interim period ending after March 15, 2004. The adoption of FIN 46R did not have a material impact on eLoyalty’s financial position or results of operations.

Note 8 — Litigation and Other Contingencies

          eLoyalty, from time to time, has been subject to legal claims arising in connection with its business. While the results of these claims cannot be predicted with certainty, at March 27, 2004 there were no asserted claims against eLoyalty

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that, in the opinion of management, if adversely decided, would have a material effect on eLoyalty’s financial position, results of operations, and cash flows.

          eLoyalty is a party to various agreements, including substantially all major services agreements and intellectual property licensing agreements, under which it may be obligated to indemnify the other party with respect to certain matters, including, but not limited to, indemnification against third party claims of infringement of intellectual property rights with respect to software and other deliverables provided by us in the course of our engagements. These obligations may be subject to various limitations on the remedies available to the other party, including, without limitation, limits on the amounts recoverable and the time during which claims may be made, and may be supported by indemnities given to eLoyalty by applicable third parties. Payment by eLoyalty under these indemnification clauses is generally subject to the other party making a claim that is subject to challenge by eLoyalty and dispute resolution procedures specified in the particular agreement. Historically, eLoyalty has not been obligated to pay any claim for indemnification under its agreements and, as of March 27, 2004, management was not aware of future indemnification payments that it would be obligated to make.

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

Forward-Looking Statements

          The following Management’s Discussion and Analysis and other parts of this Form 10-Q contain forward-looking statements that are based on current management expectations, forecasts and assumptions. These include, without limitation, statements containing the words “believes,” “anticipates,” “estimates,” “expects,” “plans,” “intends,” “projects,” “future” and similar expressions, references to plans, strategies, objectives and anticipated future performance, and other statements that are not strictly historical in nature. These forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those expressed or implied by the forward-looking statements. Such risks, uncertainties and other associated factors that might cause such a difference include, without limitation, those noted under “Factors That May Affect Future Results or Market Price of Stock” included elsewhere in this Form 10-Q.

          Readers are cautioned not to place undue reliance on forward-looking statements. They reflect opinions, assumptions and estimations only as of the date they are made, and, subject to applicable law, eLoyalty Corporation undertakes no obligation to publicly update or revise any forward-looking statements in this Form 10-Q, whether as a result of new information, future events or circumstances, or otherwise.

Background

          eLoyalty is a leading management consulting, systems integration and managed services company focused on optimizing customer interactions. We offer a broad range of customer relationship management (“CRM”) solutions including business strategy, technical architecture, selecting, implementing and integrating appropriate CRM software applications and providing ongoing support for multi-vendor systems. Our revenue across our various service lines is generated from professional services primarily and, to a minor degree, resales of software and hardware. Our Consulting services involve evaluating, selecting, building or integrating CRM systems for clients. Our Managed services involve a range of contact center services from routine maintenance and technology upgrades to the resolution of highly complex issues that involve multiple technology components and vendors. Consulting services are generally billed on a time and materials basis or, periodically, on a fixed-fee basis, where Managed services are generally provided for a contracted price over a specified period. We operate in two primary business segments — North America (consisting of the United States and Canada) and International.

Overview of the Results of Operations and Financial Position

          The following is an overview of our operating results and financial position for the first quarter of 2004, which includes a discussion of business trends, revenue, gross profit margin percentage (total revenue less cost of services divided

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by total revenue), expenses and cash flows for this period. The following table summarizes the major components of our revenue over the last five quarters:

          Our results of operations are affected by general business conditions, levels of economic activity and rates of change in the industry sectors we serve. The pace of technological change and the amount of technology spending by our clients in the areas of marketing, sales and customer service also influence our operating results. eLoyalty’s ability to identify and capitalize on these market and technological changes early in their cycles is a key driver of our performance. In addition, our high level of customer concentration can influence our financial results as large clients can increase or decrease their spending from period to period, which may have a significant impact on our results of operations. Our ability to attract and increase the spending of new customers is also an important driver of our results of operations. In the first quarter of 2004, we added 17 new customers, compared to adding 29 new customers in total for fiscal 2003, and accordingly had 65 customers in the first quarter of 2004 compared to 46 customers in the first quarter of 2003.

          The ability of our employees to develop client relationships, secure contracts for new and existing customers and to deliver solutions and services that add value to our clients is a key driver of revenue. Accordingly, we focus on Services revenue as a key internal measurement, which is summarized in the above table. As illustrated in the table above, Services revenue is comprised of Consulting services and Managed services, and is exclusive of revenue from Software and Reimbursed expenses.

          Services revenue has shown modest growth in each of the last two quarters, driven by strong sequential revenue growth in Managed services. Managed services has experienced sequential revenue growth of 10%, 19% and 15% in each of the last three quarters, respectively. In addition, Managed services grew over 38% in the first quarter of 2004, compared to the first quarter of 2003.

          In the first quarter of 2004, Managed services comprised 20% of our Services revenue. In fiscal 2003, Managed services comprised 15% of our Services revenue. We believe Managed services should continue to experience revenue growth, since it is being positively affected by industry trends to outsource technology to third party providers, as well as the growing adoption by Global 2000 companies of new technologies such as Voice-over-Internet-Protocol (“VoIP”).

          Consulting services has generated approximately $10.5 million of revenue in each of the last three quarters, a significant decrease from the first and second quarters of 2003, primarily due to reduced spending by large clients. Further, the addition of new client accounts and shifts in our customer concentration have impacted the mix of our revenue results.

          For example, our largest customer in fiscal 2003 accounted for approximately 24% of our total revenue. For the five quarters ended March 2004, revenue from this client was $1.0 million, $1.3 million, $3.0 million, $5.1 million and $5.4 million, respectively, illustrating four straight quarters of sequential spending declines by this client. In addition, four of our top six clients in the fourth quarter of 2003 (the top 6 clients in the fourth quarter comprised 57% of total revenue), reduced their total spending by a total of $1.8 million when compared to their spending in the first quarter of 2004. All of these clients continue to do business with eLoyalty today and, we believe, should remain eLoyalty clients for the foreseeable future. We also believe these clients are highly satisfied customers, however their spending patterns can vary significantly from quarter to

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quarter, and in conjunction with new account revenue and changes in other existing client revenue, can create a measure of underlying volatility in our quarterly results due to our size and current customer base of 65 clients.

          Managed services engagements typically involve annual contracts and usually do not have the same underlying revenue volatility as Consulting services. Our growth in Managed services has historically been driven and will continue to be driven for the foreseeable future by new clients, as well as expansion of our services in existing accounts.

          Resale of software, principally sales of third party software, can vary significantly from quarter to quarter due to the variability in the number and size of these transactions in any one quarter. Our primary form of software resale is the sublicensing of software that we license directly from the software manufacturer. In addition, we resell hardware and software purchased from a third party distributor, although such sales have been immaterial. Resale of third party software and hardware is primarily driven by our efforts in selling our Managed services.

          We are presently expecting sequential revenue increases in Consulting services and Managed services in the second quarter of 2004 over the first quarter of 2004. Services revenues in the second quarter of 2004 are presently expected to range from $14.0 million to $15.5 million. A significant add-on project at an existing account late in the first quarter, other existing account growth, as well as new clients, are driving this growth as customers have access to more capital for CRM solutions spending and investment.

          The gross profit margin percentage in the first quarter of 2004 was 24%, which was equal to the level realized in fiscal 2003, although favorable by five percentage points to the gross profit margin percentage earned in the last half of fiscal 2003. An improved average hourly billing rate of $174 an hour and higher utilization of 64% were the primary drivers of a gross profit margin percentage improvement when compared to the 21% gross profit margin percentage realized in the fourth quarter of 2003. Average hourly billing rates are primarily affected by competitive and market conditions. Utilization is affected by the size of our delivery organization and the demand for our services.

          Cost management remains a focus of the organization. Total operating expenses in the first quarter of 2004 were reduced by $2.8 million when compared to the fourth quarter of 2003. In addition, total operating expenses were reduced by $5.9 million, when compared to the first quarter of 2003. However, with an expectation of sequential growth in our Services revenue, we will be adding personnel to serve client business requirements. Accordingly, we presently expect that this will result in an increase in personnel costs in the second quarter of 2004 when compared to the first quarter of 2004. However, we do not presently plan to increase our expenses in areas other than those dedicated to client delivery, sales and service focused on revenue related activities.

          In addition, where appropriate we intend to continue to evaluate opportunities to increase our revenue base through the addition of personnel with proven abilities to enhance and deliver additional client relationships and to leverage our Consulting services and Managed services capabilities and strategies with those opportunities. There can be no assurance, however, that we will be able to successfully execute these strategies.

          In the first quarter of 2004, we used total cash of $3.7 million, primarily to fund the operating loss, the dividend payment related to the 7% Series B Convertible Preferred Stock (“Series B stock”), and both short-term and long-term capital requirements, which were only partially offset by advance payments by clients which are reflected as increases in unearned revenue and long-term unearned revenue. We funded these uses of cash out of our existing cash balances, which in total were $34.1 million at March 27, 2004.

          In 2004, we continue to have cash obligations related to severance and related costs recognized in previous periods, an expectation of Series B stock cash dividends, and modest capital expenditure requirements. We believe that our significant cost reductions through the first quarter of 2004, in conjunction with an expected improvement in utilization, an anticipated abatement in the historical decline of billing rates experienced in fiscal 2003 and prior periods and the addition of new clients will move us closer to or even exceed a cash break-even position (i.e. having cash expenses in a quarter equal quarterly revenue) in 2004. However, the uncertainty with respect to the size of spending by new customers and the anticipated reduced spending of certain existing large clients makes it difficult to predict when future operating performance will

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improve. Notwithstanding these uncertainties, we believe that our significant total cash balances at March 27, 2004, together with other expected internally generated funds, are more than adequate to fund our operations over the next twelve months.

Critical Accounting Policies and Estimates

          Our management’s discussion and analysis of financial condition and results of operations is based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments 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 the costs and timing of completion of client projects, collectibility of customer accounts receivable, the timing and amounts of expected payments associated with cost reduction activities, the realizability of net deferred tax assets and contingencies and litigation. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions.

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

          eLoyalty derives substantially all of its revenue from professional services. Most of this revenue is from professional services that involve integrating or building a system for clients. eLoyalty provides professional services primarily on a time and materials basis and periodically performs projects on a fixed-fee basis. For the integration or the building of a system, eLoyalty recognizes revenue utilizing the percentage-of-completion method as services are performed. Percentage-of-completion estimates are based on the ratio of actual hours incurred to total estimated hours. For all other consulting services, we recognize revenue as the service is performed. Revenue from Managed service contracts are recognized ratably over the contract period as the services are performed. We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments and customers indicating their intention to dispute their obligation to pay for contractual services provided by us. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.

          We have recorded income tax valuation allowances on our net deferred tax assets to account for the unpredictability surrounding the timing of realization of our US and non-US net deferred tax assets due to uncertain economic conditions. The valuation allowances may be reversed at a point in time when management determines realization of these tax assets has become more likely than not, based on an anticipated return to predictable levels of profitability.

          We have recorded accruals for severance and related costs associated with our cost reduction efforts undertaken during 2001 through fiscal year end 2003. A substantial portion of the accruals relate to office space reductions, office closures and associated contractual lease obligations that are based in part on assumptions and estimates of the timing and amount of sublease rentals that are affected by overall economic and local market conditions. That portion of the accruals relating to employee severance represents contractual severance for identified employees and is not subject to a significant revision. To the extent estimates of the success of our sublease efforts change in the future, adjustments increasing or decreasing the related accruals will be recognized.

First Quarter 2004 Compared with First Quarter 2003

     Revenue

          Our revenue decreased $3.3 million, or