UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

 

____________

 

FORM 10-Q

 

(Mark One)

 

 

For the quarterly period ended June 30, 2014

 

Or

 

 

For the transition period from ____________to____________

 

Commission File Number: 000-54450

 

 

INTERACTIVE INTELLIGENCE GROUP, INC.

(Exact name of registrant as specified in its charter)

 

 

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

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

 

 

 

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

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ☑

 

As of July  31, 2014,  there were 20,973,531 shares outstanding of the registrant’s common stock, $0.01 par value.

 

 

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TABLE OF CONTENTS

 

 

 

 

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PART I. FINANCIAL INFORMATION

 

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

 

 

 

See Accompanying Notes to Condensed Consolidated Financial Statements

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See Accompanying Notes to Condensed Consolidated Financial Statements

 

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See Accompanying Notes to Condensed Consolidated Financial Statements

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See Accompanying Notes to Condensed Consolidated Financial Statements

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Interactive Intelligence Group, Inc.

Notes to Condensed Consolidated Financial Statements

June 30, 2014 and 2013 (unaudited)

 

1.FINANCIAL STATEMENT PRESENTATION

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

 

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

 

The Company’s accompanying condensed consolidated financial statements as of December 31, 2013 have been derived from the Company’s audited consolidated financial statements at that date but do not include all of the information and notes required by GAAP for complete financial statements. These accompanying condensed consolidated financial statements should be read in conjunction with the Company’s audited consolidated financial statements for the year ended December 31, 2013, included in the Company’s most recent Annual Report on Form 10-K as filed with the SEC on March 12, 2014. The Company’s results of operations for any interim period are not necessarily indicative of the results of operations for any other interim period or for a full fiscal year.

 

Principles of Consolidation

 

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

 

Revisions and Adjustments

   

Effective January 1, 2014, the Company revised certain personnel related expenses which were included in cost of recurring revenues in prior periods to sales and marketing expenses. In prior years, these costs were not significant; however, as these costs have continued to increase in line with the Company’s growth strategy related to its cloud offerings, the Company concluded that it is appropriate to report these personnel related expenses as sales and marketing. For the three and six months ended June 30, 2013,  $209,000 and $418,000  have been revised to sales and marketing expenses based on this new expense presentation. The revision did not have any impact on the overall results previously reported.  

 

 

 

2.SUMMARY OF CERTAIN ACCOUNTING POLICIES AND RECENT ACCOUNTING  PRONOUNCEMENTS

 

For a complete summary of the Company’s significant accounting policies and critical accounting estimates, refer to Note 2 of Notes to Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2013.  

 

In July 2013, the Financial Accounting Standards Board (“FASB”) issued FASB Accounting Standards Update (“ASU”) 2013-11, Income Taxes: Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists. This updated guidance requires an entity to present an unrecognized tax benefit as a reduction of a deferred tax asset for a net operating loss (NOL) carryforward, or similar tax loss or tax credit carryforward, rather than as a liability when (1) the uncertain tax position would reduce the NOL or other carryforward under the tax law of the applicable jurisdiction and (2) the entity intends to use the deferred tax asset for that purpose. This ASU does not require new recurring disclosures. The Company adopted this guidance in the first quarter of 2014 and noted no material impact on its consolidated financial statements upon adoption.

 

In May 2014, the FASB issued FASB ASU No. 2014-09, Revenue from Contracts with Customers (“FASB ASU 2014-09”), which requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. FASB ASU No. 2014-09 will replace most existing GAAP revenue recognition guidance when it becomes

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effective. This guidance becomes effective for the Company on January 1, 2017. Early adoption is not permitted. This guidance permits the use of either the retrospective or cumulative effect transition method. The Company is evaluating the effect that FASB ASU 2014-09 will have on its consolidated financial statements and related disclosures. The Company has not yet selected a transition method nor has it determined the effect of the guidance on its ongoing financial reporting.

 

The Company capitalizes costs related to its next generation cloud communication platform and certain projects for internal use in accordance with FASB Accounting Standards Codification (“ASC”) 350-40, Internal Use Software. Once a solution has reached the development stage, internal and external costs, if direct and incremental, are capitalized until the software is substantially complete and ready for its intended use. The capitalization of costs ceases upon completion of all substantial testing. Costs incurred in the preliminary stages of development, maintenance and training costs are expensed as incurred. During the three and six months ended June 30, 2014, the Company capitalized $2.7 million and $4.5 million, respectively, of costs related to the development of its next generation cloud communication platform. The Company will continue to capitalize development costs related to this project and will begin amortizing such costs once the software is released for general availability, which is expected to be in the fourth quarter of 2014.

 

Additionally, in 2013 the Company purchased new business software to meet its internal administrative needs and it has no plans to market such software externally. During the three and six months ended June 30, 2014, the Company capitalized $0.8 million and $1.4 million, respectively, of costs associated with development and implementation of this software. 

 

During the three and six months ended June 30, 2014, there were no other material changes to the Company’s significant accounting policies or critical accounting estimates.

 

 

 

3.NET INCOME (LOSS) PER SHARE 

 

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

 

 

The Company’s calculation of diluted net income (loss) per share for the three and six months ended June 30, 2014 excludes RSUs and stock options to purchase approximately 969,000 and 1.1 million  shares  of the Company’s common stock, respectively, as their effect would be anti-dilutive, compared to 253,000 and 223,000 during the same periods in 2013.  

 

 

4.INVESTMENTS

 

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

 

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

 

The following table sets forth a summary of the Company’s financial assets, classified as cash and cash equivalents, short-term investments and long-term investments on its condensed consolidated balance sheets, measured at fair value as of June 30, 2014 and December 31, 2013 (in thousands):

 

 

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5.ACCOUNTS RECEIVABLE AND CONCENTRATION OF CREDIT RISK

 

The Company records unbilled accounts receivable, which represents amounts recognized as revenues for invoices that have not yet been sent to customers. This balance fluctuates depending on the contractual billing milestones and work performed related to projects specified in the contract. When the work performed is ahead of the billing milestones related to a services engagement, unbilled accounts receivable will be recorded. The balance of unbilled accounts receivable recorded as of June 30, 2014 and December 31, 2013 was $9.4 million and $6.5 million, respectively.

 

No customer or partner accounted for more than 10% of the Company’s accounts receivable as of June 30, 2014 or December 31, 2013 or for more than 10% of the Company’s revenues for the three and six months ended June 30, 2014 or 2013. The Company’s top five customers or partners collectively represented 19% and 27% of the Company’s accounts receivables balance at June 30, 2014 and December 31, 2013, respectively.

 

No individual country accounted for more than 10% of the Company’s revenues except for the United States, which accounted for 62% and 63% of the Company’s revenues in the three and six months ended June 30, 2014, and 64% and 65% of the Company’s revenues in the three and six months ended June 30, 2013, respectively. The Company attributes revenues to countries based on the country in which the customer or partner is located.

 

 

 

Stock Option Plans

 

The Company’s stock option plans, adopted in 1995, 1999 and 2006, authorize the Board of Directors or the Compensation Committee, as applicable, to grant incentive and nonqualified stock options, and, in the case of the 2006 Equity Incentive Plan, as amended and as assumed by the Company (the “2006 Plan”), stock appreciation rights, restricted stock, RSUs, performance shares, performance units and other stock-based awards. After adoption of the 2006 Plan by the Company’s shareholders in May 2006, the Company may no longer make any grants under previous plans, but any shares subject to awards under the 1999 Stock Option and Incentive Plan and the Outside Directors Stock Option Plan (collectively, the “1999 Plans”) that are cancelled are added to shares available under the 2006 Plan. At the Company’s 2013 Annual Meeting of Shareholders held on May 22, 2013, the Company’s shareholders approved an amendment to the 2006 Plan to increase the number of shares available for issuance under the 2006 Plan by 2,000,000 shares. A maximum of 9,050,933 shares are available for delivery under the 2006 Plan, which consists of (i) 5,350,000 shares, plus (ii) 320,000 shares available for issuance under the 1999 Plans, but not underlying any outstanding stock options or other awards under the 1999 Plans, plus (iii) up to 3,380,933 shares subject to outstanding stock options or other awards under the 1999 Plans that expire, are forfeited or otherwise terminate unexercised on or after May 18, 2006. The number of shares available under the 2006 Plan is subject to adjustment for certain changes in the Company’s capital structure. The exercise price of options granted under the 2006 Plan is equal to the closing price of the Company’s common stock, as reported by The NASDAQ Global Select Market, on

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the business day immediately preceding the date of grant. As of June 30, 2014, there were approximately 1.8 million shares of stock available for issuance for equity compensation awards under the 2006 Plan.

 

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

 

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

 

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

 

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

 

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

 

Stock-Based Compensation Expense Information

 

The following table summarizes the allocation of stock-based compensation expense related to employee and director stock options and RSUs under FASB ASC Topic 718,  Compensation – Stock Compensation (“FASB ASC 718”) for the three and six months ended June 30, 2014 and 2013 (in thousands except for per share amounts):

 

Stock Option and RSU Valuation 

 

The Company estimated the fair value of stock options using the Black-Scholes valuation model. During the fourth quarter of 2013, the Company re-evaluated the expected life of its stock options based on historical exercise data by reviewing the exercise, expiration and termination patterns of the Company’s three types of stock options. Based on the results of this analysis: the expected life of performance-based stock options issued in the first quarter of 2014 changed from an expected life of 4.75 years used in 2013 to an expected life of 4.5 years,  the expected life of non-performance-based stock options issued in the first quarter of 2014 changed from an expected life of 4.25 years used in 2013 to an expected life of 4.0 years and the expected life of annual director options issued in the second quarter of 2014 changed from an expected life of 3.5 years used in 2013 to an expected life of 4.0 years.  

 

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Non-performance-based options are granted during the year to newly-elected non-employee directors, if any, during the second quarter of each year to non-employee directors, and during the first quarter of each year to senior management. Performance-based options are only granted to sales employees during the first quarter of each year. The weighted-average estimated per option value of non-performance-based and performance-based options granted under the 2006 Plan during the six months ended June 30, 2014 and 2013 used the following assumptions:

 

 

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

 

Stock Option and RSU Activity

 

The following table sets forth a summary of stock option activity for the six months ended June 30, 2014:

 

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The following table sets forth information regarding the Company’s stock options outstanding and exercisable as of June 30, 2014:

 

 

The total intrinsic value of options exercised during the quarter ended June 30, 2014 was $19.6 million. The aggregate intrinsic value of options outstanding as of June 30, 2014 was $47.1 million and the aggregate intrinsic value of options currently exercisable as of June 30, 2014 was $35.1 million. The aggregate intrinsic value represents the total intrinsic value, based on the Company’s closing stock price per share of $56.13 as of June 30, 2014, which would have been realized by the option holders had all option holders exercised their options as of that date. The total number of in-the-money options exercisable as of June 30, 2014 represented approximately 1.0 million shares with a weighted average exercise price of $21.18.

 

As of June 30, 2014, there was $12.7 million of total unrecognized compensation cost related to non-vested stock options. These costs are expected to be recognized over the weighted average remaining vesting period of 2.30 years.

 

The following table sets forth a summary of RSU activity for the six months ended June 30, 2014:

 

As of June 30, 2014, there was $26.7 million of total unrecognized compensation cost related to unvested RSUs. These costs are expected to be recognized over the weighted average remaining vesting period of 2.66 years.

 

 

 

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The Company’s effective tax rate for the three and six months ended June 30, 2014 was 40.5% and 41.0%, without the effects of discrete tax items, compared to 61.4% and 2.4%, respectively, for the same periods in 2013.  During the six months ended June 30, 2014, the Company recorded a $150,000 credit related to a discrete item. There was no such discrete item recorded in the three months ended June 30, 2014. The Company’s effective tax rate was 40.5% and 42.0% for the three and six months ended June 30, 2014. The Company’s effective tax rate for the six months ended June 30, 2014 was higher than the federal statutory tax rate of 35.0% primarily due to the allocation of book operating results between the United States and foreign entities and the impact of permanent tax differences on pre-tax operating results during the three and six months ended June 30, 2014. 

 

The Company is currently projecting a taxable net operating loss for 2014 to be between $20.0 million and $22.0 million, of which $10.8 million will be carried back to December 31, 2012.  The remaining projected net operating loss carryforward is a result of compensation for tax purposes for stock option exercises.  In accordance with FASB ASC 718, these stock option compensation 

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deductions have not been recognized for financial reporting purposes because they have not yet reduced taxes payable.  The tax benefit of these deductions will be recorded as a credit to additional paid-in-capital if and when realized.

 

 

 

 

 

8.COMMITMENTS AND CONTINGENCIES

Legal Proceedings

 

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

 

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

 

Guarantees

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

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

Lease Commitments

 

The Company’s world headquarters are located in three office buildings in Indianapolis, Indiana, which space was formerly leased pursuant to that certain Office Lease Agreement (the “Office Lease”), dated April 1, 2001, between the Company and Duke Realty Limited Partnership (formerly Duke-Weeks Realty Limited Partnership), as amended.  On May 6, 2014, the Company entered into a lease termination agreement with Duke Realty Limited Partnership, whereby the Office Lease (and the eight amendments thereto) was terminated.  In place of such Office Lease and amendments, on May 6, 2014, the Company entered into new separate lease agreements with Duke Realty Limited Partnership for each of the three office buildings, one of which expires on March 31, 2018 and two of which expire on or after June 30, 2025.

 

On May 6, 2014, the Company also entered into a lease agreement with Duke Construction Limited Partnership to expand its world headquarters to include a fourth, build-to-suit office building in Indianapolis, Indiana.  The target date for completion of construction of the fourth office building is July 1, 2015 and the lease term expires 10 years after construction is completed.

 

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The following amounts set forth in the table are as of June 30, 2014 (in thousands).

 

 

 

As set forth in the Contractual Obligations table, the Company has operating lease obligations and purchase obligations that are not recorded in its consolidated financial statements. The operating lease obligations represent future payments on leases classified as operating leases and disclosed pursuant to FASB ASC Topic 840, Leases. The obligations include the operating leases of the Company’s world headquarters, which extend to the year 2025, and the leases of several other locations for its offices in the United States and 20 other countries with initial lease terms of up to five years. The Company rents office space for sales, services, development and international offices under month-to-month leases. In accordance with FASB ASC Topic 840, Leases, rental expense is recognized ratably over the lease period, including those leases containing escalation clauses.

 

 

Other Contingencies

 

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

 

 

 

OrgSpan Acquisition

 

On May 14, 2014, the Company entered into a stock purchase agreement to acquire OrgSpan, Inc. (“OrgSpan”), a privately held provider of cloud-based enterprise social communications solutions.  The Company purchased OrgSpan’s technology to leverage the modern open source technology and Amazon Web Services,  that will provide efficient deployment of the Company’s next generation multi-tenant cloud communication platform.  As previously disclosed, Donald E. Brown, the Company’s Chairman of the Board, President and Chief Executive Officer, was a founder and majority stockholder of OrgSpan.  The Company purchased OrgSpan for approximately $14.1 million, partially funded with cash on hand, which included the repayment of OrgSpan’s outstanding debt of approximately $8.0 million. OrgSpan’s outstanding debt consisted primarily of operating loans provided by Dr. Brown bearing interest at a rate of 4.25% per annum. Approximately $1.4 million in cash was paid to OrgSpan’s stockholders (other than Dr. Brown) and to holders of vested OrgSpan stock options. In exchange for his shares of OrgSpan stock, Dr. Brown has the right to receive an aggregate of 98,999 restricted shares of the Company’s common stock (the “Restricted Shares”), representing approximately $4.7 million of the purchase price, which Restricted Shares will vest and be issued by the Company upon the achievement of certain performance-based conditions tied to the launch and sales of the Company’s next generation multi-tenant cloud communication platform, which incorporates certain OrgSpan products and technology. The Restricted Shares will be unregistered. The difference between the $15.6 million purchase price previously disclosed in the 8-K filed on May 14, 2014 and the $14.1 million noted above is a result of the change in the value of the 98,999 Restricted Shares received by Dr. Brown. We also retained 38 OrgSpan employees as part of the transaction. 

 

The transaction was negotiated and approved by the Company’s audit committee following its previously disclosed reassessment of the relationship between the Company and OrgSpan. The audit committee retained its own independent valuation consultant and its own independent counsel in connection with the reassessment. The committee’s valuation consultant subsequently provided the audit committee with a fairness opinion concerning the transaction. Following its approval, the audit committee recommended that the acquisition be approved by the Company’s board of directors. The independent members of the Company’s board of directors unanimously approved the transaction, with Dr. Brown recusing himself from all board deliberations related to OrgSpan.

 

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The acquisition was accounted for using the acquisition method of accounting in accordance with FASB ASC Topic 805,  Business Combinations (“FASB ASC 805”).  The results of OrgSpan’s operations were included in the Company’s condensed consolidated financial statements commencing on the acquisition date.

 

The preliminary purchase price allocations for the OrgSpan transaction were prepared by the Company’s management utilizing a third-party valuation report, which was prepared in accordance with the provisions of FASB ASC 805, and other tools available to the Company, including conversations with OrgSpan’s management and historical data from the Company’s other acquisitions. The final valuation of the intangible asset is pending as of June 30, 2014. The following table summarizes the preliminary fair value of the intangible and other assets acquired and liabilities assumed at the date of the acquisition (in thousands):

 

 

 

Professional fees related to this acquisition and recognized as of June 30, 2014 totaled $600,000, all of which were recognized during the second quarter, and included transaction costs such as legal, accounting, and valuation services, which were expensed as incurred. These costs are included within general and administrative expenses on the condensed consolidated statements of operations and comprehensive income (loss).

 

The premium paid over the fair value of the net assets acquired in the purchase, or goodwill, was primarily attributed to OrgSpan’s existing trained workforce. None of the goodwill is expected to be deductible for tax purposes.

 

Intangible assets acquired resulting from this acquisition include technology, which is amortized on a straight-line basis. The following sets forth the technology acquired (dollars in thousands):

 

 

Amtel Acquisition

 

On April 1, 2013, the Company closed its acquisition of certain assets of a New Zealand reseller, Amtel Communications, Ltd. (“Amtel”). Pursuant to the terms of the asset purchase agreement, the Company purchased contact center assets of Amtel for approximately $725,000, funded with cash-on-hand. The Company purchased Amtel’s customer support agreements as a continued part of its growth strategy, which increases the Company’s presence internationally, gives local customers direct access to expanded support services and paves the way for a launch of cloud-based communications services in New Zealand. The acquisition was accounted for using the acquisition method of accounting in accordance with FASB ASC 805. The results of Amtel’s operations related to the acquired assets were included in the Company’s condensed consolidated financial statements commencing on the acquisition date.

 

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The purchase price allocations for the Amtel transaction were prepared by the Company’s management utilizing a third-party valuation report, which was prepared in accordance with the provisions of FASB ASC 805, and other tools available to the Company, including conversations with Amtel’s management and historical data from the Company’s other acquisitions. The following table summarizes the fair value of the intangible and other assets acquired and liabilities assumed at the date of the acquisition (in thousands):

 

 

Professional fees recognized as of June 30, 2014 totaled approximately $21,000 and included transaction costs such as legal, accounting, and valuation services, which were expensed as incurred. These costs are included within general and administrative expenses on the condensed consolidated statements of operations and comprehensive income (loss).

 

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

 

Intangible assets acquired resulting from this acquisition include customer relationships, which are amortized on a straight-line basis. The following sets forth the customer relationships acquired and their economic useful life at the date of acquisition (dollars in thousands):

 

 

 

 

 Pro Forma Results

 

    The Company has not furnished pro forma financial information related to its acquisition of OrgSpan or certain contact center assets of Amtel because such information is not material individually or in the aggregate to the overall financial results of the Company.

 

10.  DERIVATIVES

 

The Company enters into derivative contracts to mitigate its foreign currency risk associated with transacting business internationally.  The Company uses foreign currency forward contracts to hedge the revaluation exposure of its net monetary assets and liabilities including cash, accounts receivable, accounts payable and certain intercompany payables and receivables.  These hedges are not designated under GAAP, and all realized and unrealized gains and losses are recorded as incurred within other income (expense) on the Company’s condensed consolidated statements of operations and comprehensive income (loss).  The objective is to offset the gains and losses on the underlying exposures with the gains and losses from the forward contracts.  The Company’s hedging policy prohibits entering into hedge contracts that are speculative in nature.

 

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   The Company records the fair value of its outstanding hedge contracts in other current assets and accrued liabilities depending upon the market value of the forward contracts at each balance sheet date.  The following table summarizes the notional amount and fair value of the Company’s outstanding currency contracts at June 30, 2014 and December 31, 2013, respectively. 

 

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During the three and six months ended June 30, 2014,  the Company recorded hedging losses of $208,000 and $387,000, respectively, compared to hedging gains of $1.8 million during both periods last year.  

 

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The following Management’s Discussion and Analysis of Financial Condition and Results of Operations is intended to provide our investors with an understanding of our past performance, our financial condition and our prospects and should be read in conjunction with other sections of this Quarterly Report on Form 10-Q. Investors should carefully review the information contained in this report under Part II, Item 1A “Risk Factors” and in the Part I, Item 1A “Risk Factors” section of our Annual Report on Form 10-K for the fiscal year ended December 31, 2013. The following will be discussed and analyzed:

 

 

Forward-Looking Information

 

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

 

Overview

 

We are a global provider of software and services designed to improve the customer experience. Our primary offering is a suite of applications that provides customers with a multichannel communications platform that is deployed on-premises or through the cloud. We are a recognized leader in the worldwide contact center market. Our software applications provide a range of pre-integrated inbound and outbound communications functionality and this same platform provides solutions for unified communications and business process automation. Our solutions are broadly applicable, and are used by businesses and organizations in industries particularly including teleservices, insurance, banking, accounts receivable management, utilities, healthcare, retail, technology, government and business services.

 

For further information on our business and the products and services we offer, refer to the Part I, Item 1 “Business” section of our Annual Report on Form 10-K for the year ended December 31, 2013.

 

Our management monitors certain key measures to assess our financial results. In particular, we track trends in on-premises and cloud-based orders and contracted professional services from quarter to quarter and in comparison to the prior year actual results and current year projected amounts. We also review leading market indicators to identify trends in economic conditions. In addition to orders and revenues, management reviews costs of revenue, operating expenses and staffing levels to ensure we are managing new expenditures and controlling costs. For additional discussions regarding trends, see “Revenue,  Order Trends and Acquisition Highlights” and “Comparison of Three and Six Months Ended June 30, 2014 and 2013”  below.

 

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

 

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

 

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Revenue,  Order Trends, Projections and Acquisition Highlights

 

The tables below show our total revenues (in millions) for the most recent five quarters and the years ended December 31, 2013, 2012 and 2011 and the percentage change over the prior year period,  the percentage of cloud-based and on-premises orders as a percent of total orders for the most recent five quarters and the years ended December 31, 2013, 2012 and 2011 and a summary of orders received during the three and six months ended June 30, 2014 and 2013.

 

Orders

 

 

 

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Geographic Mix

 

The following table shows the percentage of orders derived from each of our geographic regions for the periods presented: 

 

 

Full Year Operating Projections

 

As our business continues to shift towards offering more cloud-based solutions, and revenues related to cloud orders are recognized over the contract period, we may report periods of operating losses. We are currently projecting a taxable net operating loss for 2014 to be between $20.0 million and $22.0 million, of which $10.8 million will be carried back to December 31, 2012 for tax purposes.  The remaining projected net operating loss carryforward is a result of compensation for tax purposes for stock option exercises. Even though cloud orders push revenue to future periods, we believe that this adds to our share of the leadership market for cloud communications services. 

 

Acquisitions

 

 

On May 14, 2014, we entered into a stock purchase agreement and acquired OrgSpan, Inc. (“OrgSpan”), a privately held provider of cloud-based enterprise social communications solutions.  As previously disclosed, Donald E. Brown, our Chairman of the Board, President and Chief Executive Officer, was a founder and majority stockholder of OrgSpan.  We purchased OrgSpan for approximately $14.1 million, which included the repayment of OrgSpan’s outstanding debt of approximately $8.0 million. OrgSpan’s outstanding debt consisted primarily of operating loans provided by Dr. Brown bearing interest at a rate of 4.25% per annum. Approximately $1.4 million in cash was paid to OrgSpan’s stockholders (other than Dr. Brown) and to holders of vested OrgSpan stock options. In exchange for his shares of OrgSpan stock, Dr. Brown has the right to receive an aggregate of 98,999 restricted shares of our common stock (the “Restricted Shares”), representing approximately $4.7 million of the purchase price, which Restricted Shares will vest and be issued by us upon the achievement of certain performance-based conditions tied to the launch and sales of our next generation cloud communication platform, which incorporates certain OrgSpan products and technology. The Restricted Shares will be unregistered. The difference between the $15.6 million purchase price previously disclosed in the Form 8-K filed on May 14, 2014 and the $14.1 million noted above is a result of the change in the value of the 98,999 Restricted Shares received by Dr. Brown. We also retained 38 OrgSpan employees as part of the transaction.

 

On April 1, 2013,  we entered into an agreement with Amtel Communications Ltd. (“Amtel”),  a New Zealand reseller, and acquired certain Interactive Intelligence related contact center assets of Amtel.   We purchased these assets for approximately $725,000,  funded with cash-on-hand and also obtained five Amtel employees as part of the transaction.

 

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Comparison of Three and Six Months Ended June 30, 2014 and 2013

 

Revenues

 

Our revenues include: (i) product revenues; (ii) recurring revenues; and (iii) services revenues. These revenues are generated by direct sales to customers and through our partner channels.

 

Product revenues include sales of on-premises software licenses and hardware. Not all software and hardware product orders are recognized as revenue when the orders are received from the customer because of product general availability, certain contractual terms or the collection history with particular customers or partners. Consequently, product revenues for any particular period not only reflect certain of the orders received in the current period but also include certain orders received but deferred in previous periods and recognized in the current period. In addition, a portion of product orders are related to support, and thus that portion is recognized over the support period as recurring revenues. 

 

Recurring revenues include renewals of the support fees from on-premises license agreements and all revenues from our cloud solutions. The support fees are recognized over the support period, generally between one and three years. Cloud-based orders are typically for periods of one to five years, with an overall average new contract term of 55 months in the three and six months ended June 30,  2014.

 

Services revenues primarily include professional and education services fees. Services revenues fluctuate based on the solution implementation requirements of our customers and partners as well as the number of attendees at our educational classes. We believe services revenues will continue to grow as product and cloud-based revenues increase, order sizes increase and as we license a greater percent of our orders directly to our customers. 

 

Revenues

 

 

Product Revenues

 

 

Product revenues decreased during both the three and six months ended June 30, 2014, primarily due to the decrease in the dollar amount of on-premises orders received related to the increasing shift of our business to the cloud.  The dollar amount of product orders received decreased 17% and 16% during the three and six months ended June 30, 2014, respectively, compared to the same periods in 2013. In addition, we deferred $4.8 million and $10.0 million of revenues from product orders that were not recognizable based on contract terms during the three and six months ended June 30, 2014, respectively, partially offset by the recognition of $3.6 million and $9.2 million of previously deferred product revenues during the same periods.

   

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Recurring Revenues

 

The breakdown of recurring revenues was as follows:

 

 

 

 

Support fees increased with the continued growth of our installed base of on-premises customers, and renewal rates were consistent between the 2014 and 2013 periods.  Cloud-based revenues increased by 77% and 80%, respectively, between the three and six month periods in 2014 and 2013, reflecting continuing robust demand for our cloud solutions.  The average monthly number of seats associated with our cloud-based orders was 31,000 and 30,000 during the three and six months ended June 30, 2014, up from 17,000 and 16,000 during the same periods in 2013. Per seat pricing was consistent for both periods.

 

Our unbilled future cloud-based revenues were $224.8 million and $136.0 million as of June 30, 2014 and 2013, respectively.  These unbilled cloud-based revenues are not included in deferred revenues on our balance sheet, but represent the remaining minimum value of non-cancellable agreements that have not been invoiced to the customer. Unbilled cloud-based revenues continue to increase as we build our cloud customer base.

 

Services Revenues

 

 

Services revenues increased primarily due to growth in the number and scope of professional service engagements, for both on-premises and cloud-based deployments.  The 3% and 9% year-over-year increases in services revenues for the three and six months ended June 30, 2014, respectively, were lower than the increases experienced in previous periods because of the shift in our business to the cloud, which usually involves deployments requiring shorter professional services engagements. As our cloud business grows, the growth rate of our services revenues may decline.

 

Costs of Revenues

 

 

Our costs of revenues include costs of:  (i) product revenues; (ii) recurring revenues; and (iii) services revenues. 

 

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

 

Costs of recurring revenues consist primarily of compensation expenses for technical support personnel as well as costs associated with deploying our cloud offerings. Some costs related to our cloud offerings, such as equipment expenses, are recognized over time, but others such as salary and travel-related expenses are recognized as incurred.  Some of these costs are fixed while others are variable based on usage and call volume. We expect operating margins for our cloud-based offerings to improve over time as this portion of our business continues to scale and as we implement planned improvements in our infrastructure.

 

Costs of services revenues consist primarily of compensation expenses for our professional services, client success and educational personnel. 

 

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Costs of Revenues

 

 

Costs of Product Revenues

 

Costs of product revenues decreased primarily due to lower product revenues and the related decrease in cost of goods sold to third parties.  Our  overall product revenues gross margin decreased primarily due to an increase in third party cost during the second quarter of 2014.  Third party cost fluctuates based on the mix of software sold. Additionally, for the six months ended June 30, 2014, our overall product revenue gross margin decreased due to a higher mix of hardware sales received during the first quarter of 2014, which contribute to lower margin than software sales and increases in third party costs in the second quarter of 2014.

 

Costs of Recurring Revenues

 

Costs of recurring revenues increased primarily due to growth in compensation expenses related to staffing increases to support our expanding customer base and the growing number of cloud-based deployments, as well as related increases in depreciation, telecommunications, data center and other related expenses as we continue to build the infrastructure to support our cloud deployments around the world. Recurring revenue gross margin decreased primarily due to the increase in cloud revenues which have a lower gross margin than support fees.

 

Costs of Services Revenues

 

Costs of services revenues increased, resulting in a decrease in service revenue gross margin, primarily due to an increase in compensation, travel, and other direct expenses resulting from an increase in staff hired to meet the demand for our professional services. We also supplemented our services staff by increasing our utilization of third parties to assist with customer implementations during the three and six months ended June 30, 2014, resulting in increased outsourced services expense compared to the same periods in 2013. 

 

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Gross margin decreased during the three and six months ended June 30, 2014 compared to the same periods in 2013 primarily due to our investment in technical staff and increased data center costs to support our expanding cloud customer base.

 

Operating Expenses

 

Our operating expenses include costs for:  (i) sales and marketing; (ii) research and development; and (iii) general and administrative operations. 

 

Sales and marketing expenses primarily include compensation, travel, and promotional costs related to our sales, marketing, client success and channel management operations for our on-premises and cloud-based deployments. We expect sales and marketing expenses to increase in future periods as we continue expanding our sales organization and increasing our marketing and other promotional efforts, which we believe is critical to our future growth as we continue to increase our market share and expand internationally.  

 

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

 

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

 

As our cloud-based orders as a percentage of total orders increase, operating expenses as a percentage of total revenues may increase because revenues for cloud-based deployments are recognized over time while most related operating expenses costs are recognized as incurred.

 

Operating Expenses

 

Sales and Marketing 

 

Sales and marketing expenses increased primarily due to increases in compensation expenses as a result of staffing increases. Additionally, we increased spending year-over-year on marketing programs, including promotional and branding initiatives.

 

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Research and Development

 

Research and development expenses increased primarily due to increased compensation and other related expenses resulting from staffing increases. Additionally, expenses related to outsourced services for localization and third party data center services as well as expenses related to recruiting increased to support staffing increases.

 

We capitalized $2.7 million and $4.5 million of development costs for internal use software for our next generation cloud communication platform in the three and six months ended June 30, 2014, respectively. We will continue to capitalize development costs related to this project and will begin amortizing such costs once the software is released for general availability, which we expect to be in the fourth quarter of 2014.  

 

General and Administrative

 

General and administrative expenses increased primarily due to an increase in compensation cost, primarily resulting from staffing increases to support our overall personnel growth, and expenses related to legal services, software, consulting, professional development and recruiting increased to support growth in our business.

 

Other Income (Expense):

 

Interest Income, net

 

Interest income, net, consists of interest earned from investments, receivables and interest-bearing cash accounts. Interest expense and fees, which were not material in either period reported, are also included. We invest in longer term investments with maturities up to three years to increase our overall yield on investments and monitor the allocation of funds in our investment accounts to maximize our return on investment within our established investment policy. We do not have investments in subprime assets.

 

Interest earned on investments increased primarily as a result of higher average cash balances invested compared to prior periods.

 

Other Income (Expense)

 

Other income (expense) primarily includes foreign currency gains and losses. These foreign currency gains and losses fluctuate based on the amount of receivables we generate in certain international currencies, the exchange gain or loss that results from foreign currency disbursements and receipts, the cash balances and exchange rates at the end of a reporting period and the effectiveness of our hedging activities.

 

 

Other expense decreased during the six months ended June 30, 2014 compared to the same period last year because  we began hedging our exposure related to certain foreign intercompany loan receivables in April 2013.

 

 

 

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Our effective tax rate for the three and six months ended June 30, 2014 was 40.5% and 41.0% respectively, without the effects of discrete tax items, compared to 61.4% and 2.4%, respectively, for the same periods in 2013.   During the six months ended June 30, 2014, the Company recorded a $150,000 credit related to a discrete item.  There was no such discrete item recorded in the three months ended June 30, 2014. The effective tax rate for the three and six months ended June 30, 2014 was 40.5% and 42.0%. If the U.S. federal research and development tax credit is extended through 2014, our annual effective tax rate is expected to be 44.6%.  This tax rate was determined by considering the annual expected federal tax rate, rates in various states and international jurisdictions in which we have operations, and certain income tax credits.  

 

We are currently projecting a taxable net operating loss for 2014 of $21.0 million of which $10.8 million will be carried back to December 31, 2012.  The remaining projected net operating loss carryforward of $10.2 million as a result of compensation for tax purposes for stock option exercises.  In accordance with FASB ASC 718, these stock option compensation deductions have not been recognized for financial reporting purposes because they have not yet reduced taxes payable.  The tax benefit of these deductions will be recorded as a credit to additional paid-in-capital if and when realized.

 

We operate foreign entities under both the cost plus and reseller models. The impact of the foreign effective income tax rates could become more material as we expand our operations in foreign countries and calculate foreign income taxes based on operating results in those countries.

 

The change in foreign tax expense for the three and six months ended June 30, 2014 was in part due to switching our Canadian subsidiary from a  cost plus model to the reseller model during the first quarter of 2014.  

 

Liquidity and Capital Resources

 

We generate cash from the collection of payments related to licensing our products as well as from selling hardware, renewals of support agreements, and the delivery of other services. We use cash primarily to pay our employees (including salaries, commissions and benefits), lease office space, pay travel expenses, pay for marketing activities, pay vendors for hardware, other services and supplies, purchase property and equipment, pay research and development costs and fund acquisitions. We continue to be debt free.

 

As our order mix continues to shift to a higher percentage of cloud-based orders as a percentage of total orders, our liquidity may decrease due to cash collection being spread over the term of the contract. Gross margins decreased during the three and six months ended June 30, 2014 compared to the same periods in 2013 as we continued to invest in infrastructure and personnel for our cloud solutions. Since we continue to invest in infrastructure for our cloud solutions ahead of orders, our margin on cloud-based orders is lower than on-premises orders, which may decrease our liquidity.  We expect our margin on cloud-based orders will increase as we continue to build a stream of recurring revenues and implement changes in our cloud infrastructure.  

 

We determine liquidity by combining cash and cash equivalents and short-term and long-term investments as shown in the table below. Based on our recent performance and current expectations, we believe that our current liquidity position, when combined with our anticipated cash flows from operations, will be sufficient to satisfy our working capital requirements and current or expected obligations associated with our operations over the next 12 months and into the foreseeable future. Our largest potential capital outlay in the future is expected to be related to acquisitions and purchases of furniture and equipment. If our liquidity is not sufficient to purchase a targeted company with our existing cash, we may need to raise additional capital, either through the capital markets or debt financings. However, there can be no assurance that we would be successful in raising additional capital on terms that are satisfactory.

 

 

 

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We believe that the funds of Interactive Intelligence Group, Inc. and its subsidiaries that are held in foreign accounts can be transferred into the U.S. with limited tax consequences. Given our strong liquidity in the U.S., however, we do not expect to repatriate earnings from our foreign subsidiaries in the foreseeable future. As of June 30, 2014, Interactive Intelligence Group, Inc. held a total of $1.0 million in its various foreign bank accounts and its foreign subsidiaries held a total of $18.3 million in their various bank accounts. The temporary difference related to unremitted earnings of our foreign affiliates as of June 30, 2014, that have not been subject to United States income taxation as dividends and are indefinitely invested outside the United States, was  $21.7 million. If we were to repatriate all of those earnings to Interactive Intelligence Group, Inc. in the form of dividends, the incremental U.S. federal income tax net of applicable foreign tax credits would be $4.6 million.

 

The following table shows the U.S dollar equivalent of our foreign account balances for the stated periods:

 

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

 

 

Cash flow from operations was  $8.9 million lower during the first six months of 2014 compared to the same period in 2013. Cash flow from operations consists of our earnings adjusted for various non-cash expenses, such as depreciation and amortization, as well as balance sheet changes. Our cash flow from operations during the first six months of 2014 was primarily affected by changes in deferred revenues,  net income,  taxes, accounts receivables and accrued liabilities.

 

Deferred revenues decreased and reduced our cash flow from operations during the first six months of 2014 compared to the same period in 2013 as a result of the recognition of previously deferred revenues during the first six months of 2014 as well as decreases in product orders during the first six months of 2014. 

 

Increases in taxes receivables decreased our cash flow from operations. We had a tax receivable balance at June 30, 2014 of $5.3 million related to an income tax benefit recognized during 2013 resulting from the changes we adopted in the second quarter of 2013 with respect to our transfer pricing methods for our foreign subsidiaries.

 

Accounts receivables  positively affected our cash flow from operations during the first six months of 2014 compared to the same period in 2013 as a result of strong collections on our outstanding accounts receivable balance, which improved our Day Sales Outstanding (“DSO”).  

 

Cash used in investing activities increased $15.7 million in the first  six months of 2014 compared to the same period in 2013, primarily due to a  $10.1 million increase in purchases of available-for-sale investments as well as increases in capitalized software costs and $9.3 million in cash used to fund the OrgSpan acquisition, partially offset by increased proceeds resulting from the sale of available-for-sale investments.  

 

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Cash provided by financing activities decreased $4.7 million in the first six months of 2014 compared to the same period in 2013, primarily due to decreases in proceeds from stock options exercised,  reduced tax benefit from stock-based payment arrangements and additional tax withholdings on RSUs.

 

Contractual Obligations

 

Contractual obligations for operating leases increased by $59.7 million as of June 30, 2014 compared to contractual obligations as of December 31, 2013, as a result of our headquarters expansion. Our world headquarters are located in three office buildings in Indianapolis, Indiana, which space was formerly leased pursuant to that certain Office Lease Agreement (the “Office Lease”), dated April 1, 2001, between us and Duke Realty Limited Partnership (formerly Duke-Weeks Realty Limited Partnership), as amended.  On May 6, 2014, we entered into a lease termination agreement with Duke Realty Limited Partnership, whereby the Office Lease (and the eight amendments thereto) was terminated.  In place of such Office Lease and amendments, on May 6, 2014, we entered into new separate lease agreements with Duke Realty Limited Partnership for each of the three office buildings, one of which expires on March 31, 2018 and two of which expire on or after June 30, 2025.

 

On May 6, 2014, we entered into an additional lease agreement with Duke Construction Limited Partnership to expand our world headquarters to include a fourth, build-to-suit office building in Indianapolis, Indiana.  The target date for completion of construction of the fourth office building is July 1, 2015 and the lease term expires 10 years after construction is completed. 

 

For an updated Contractual Obligations table as of June 30, 2014, see Note 8 – Commitments and Contingencies of Notes to Condensed Consolidated Financial Statements included in Part I, Item I of this Quarterly Report on form 10-Q.

 

 Off-Balance Sheet Arrangements

 

Except as set forth in the Contractual Obligations table disclosed in Note 8 - Commitments and Contingencies of Notes to Condensed Consolidated Financial Statements included in Part I, Item I of this Quarterly Report on form 10-Q, we have no off-balance sheet arrangements that have or are reasonably likely to have a current or future material impact on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources as of June 30, 2014. 

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

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

Critical Accounting Policies and Estimates

 

The preparation of our condensed consolidated financial statements requires us to make estimates and judgments that affect the reported amount of assets, liabilities, revenues and expenses. Actual results may differ from those estimates and judgments under different assumptions or conditions. We have discussed the critical accounting policies that we believe affect our more significant estimates and judgments used in the preparation of our consolidated financial statements in the “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies and Estimates” section of our Annual Report on Form 10-K for the year ended December 31, 2013 and in Note 2 of Notes to Consolidated Financial Statements included in our Annual Report on Form 10-K for the year ended December 31, 2013. For a further summary of certain accounting policies, see Note 2 of Notes to Condensed Consolidated Financial Statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q.

 

 

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

 

Foreign Currency Exchange Rates

 

We transact business in certain foreign currencies including the British pound, Canadian dollar, South African rand, Australian dollar, New Zealand dollar and the euro. However, as a majority of the orders we receive are denominated in United States dollars, a strengthening of the dollar could make our solutions more expensive and less competitive in foreign markets. We continue to mitigate our foreign currency risk by generally transacting business and paying salaries in the functional currency of each of the major countries in which we do business, thus creating natural hedges. Additionally, as our business matures in foreign markets, we may price our products and services in certain other local currencies. If this were to occur, foreign currency fluctuations could have a greater impact on us and may have an adverse effect on our results of operations. As of June 30, 2014, we had outstanding hedging arrangements for the euro, South African rand, Australian dollar, Canadian dollar, British Pound and New Zealand dollar.  For the three and six months ended June 30, 2014, we recorded  foreign currency losses of $190,000 and $385,000, respectively. 

 

For the three and six months ended June 30, 2014, approximately 21% and 22% of our revenues and 21% and 20% of our expenses, respectively, were denominated in a foreign currency. As of June 30, 2014 we had net monetary assets valued in foreign currencies subject to foreign currency transaction gains or losses, consisting primarily of cash and receivables, partially offset by accounts payable, with a carrying value of approximately $13.1 million. A 10% change in foreign currency exchange rates if not hedged would have changed the carrying value of these net assets by approximately $1.3 million as of June 30, 2014, with a corresponding foreign currency gain (loss) recognized in our condensed consolidated statements of operations.

 

Interest Rate Risk

 

We invest cash balances in excess of operating requirements in securities that have maturities of up to three years and are diversified among security types. The carrying value of these securities approximates market value. These securities bear interest at fixed interest rates. Based on the weighted average maturities of the investments, if market interest rates were to increase by 100 basis points from the level at June 30, 2014, the fair value of our portfolio would  decrease by approximately $439,000.

 

 

We maintain a set of disclosure controls and procedures that are designed to ensure that information required to be disclosed by us in the reports filed by us under the Exchange Act is (a) recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and (b) accumulated and communicated to our management, including our principal executive and principal financial officers, to allow timely decisions regarding required disclosures. We carried out an evaluation, under the supervision and with the participation of our management, including our President and Chief Executive Officer (principal executive officer) and our Chief Financial Officer (principal financial officer), of the effectiveness of the design and operation of our disclosure controls and procedures as of June 30, 2014, pursuant to Rule 13a-15 of the Exchange Act. Based on that evaluation, our President and Chief Executive Officer and our Chief Financial Officer concluded that our disclosure controls and procedures were effective as of June 30, 2014.  

 

There have been no changes in our internal control over financial reporting that occurred during the quarter ended June 30, 2014 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

PART II. OTHER INFORMATION

 

 

The information set forth under “Legal Proceedings” in Note 8 of Notes to Condensed Consolidated Financial Statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q is incorporated herein by reference.

 

 

In addition to the information set forth in this Quarterly Report on Form 10-Q and before deciding to invest in, or retain, shares of our common stock, you also should carefully review and consider the information contained in our other reports and periodic filings that we make with the SEC, including, without limitation, the information contained under the caption Part I, Item 1A “Risk

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Factors” in our Annual Report on Form 10-K for the year ended December 31, 2013. Those risk factors could materially affect our business, financial condition and results of operations. The risks that we describe in our public filings are not the only risks that we face. Additional risks and uncertainties not currently known to us, or that we presently deem to be immaterial, also may materially adversely affect our business, financial condition and results of operations.

 

Except as set forth below, there have been no material additions or changes from the risk factors previously disclosed in our Annual Report on Form 10-K for the year ended December 31, 2013.

 

WE HAVE EXPERIENCED OPERATING LOSSES IN RECENT PERIODS. IF WE CONTINUE TO EXPERINCE THESE LOSSES, WE MAY NOT BE ABLE TO UTILIZE NET OPERATING LOSS CARRY FORWARDS AND MAY HAVE TO RECORD A VALUATION ALLOWANCE

 

At June 30, 2014, we have recorded a net deferred tax asset of $26.0  million.  FASB ASC Topic 740, Income Taxes (“FASB ASC 740”) permits this asset to be recorded if the asset meets a more likely than not standard (i.e. more than 50 percent likely) that the asset will be realized. Realization of our net deferred tax asset depends on our ability to generate sufficient future taxable income of the appropriate character within carryforward periods of the jurisdictions in which the net operating and capital losses, tax credits and deductible temporary differences were incurred. Because the realization of the deferred tax asset relies on a projection of future income, we view this as a critical accounting estimate.

 

In making this estimate, we considered our on-going ability to generate operating income. The realization of the deferred tax asset is highly dependent on our future profitability. If we continue to experience operating losses, we may not be able to utilize the net operating loss carryforwards prior to their expiration. Cumulative losses over a recent period (generally considered to be three years) are significant negative evidence related to our ability to rely on future projections of taxable income.  We continuously evaluate our forecasts of future operating income to determine whether there will be sufficient operating income. However, there are many risk factors that could affect the attainment of our forecasted financial results, including, but not limited to, those disclosed in Item 1A, “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2013.  

 

When assessing the realization of our deferred tax assets at June 30, 2014, we considered all available evidence, including (i) the nature, frequency, and severity of current and cumulative financial reporting losses, (ii) actions completed during 2014 and expected to be completed during 2014 and 2015 that are designed to eliminate or limit a recurrence of the factors that contributed to the recent cumulative losses, giving greater weight to actions completed through June 30, 2014 and to the expectation that strategies will be executed in 2015 to mitigate losses in the future, (iii) the carryforward periods for the net operating and foreign tax credit carryforwards, (iv) the sources and timing of future taxable income, giving greater weight to discrete sources and to earlier future years in the forecast period, and (v) tax planning strategies that would be implemented, if necessary, to accelerate taxable amounts.

 

 

On May 14, 2014, we acquired all of the outstanding capital stock of OrgSpan, Inc. (“OrgSpan”) pursuant to the terms of a Stock Purchase Agreement, dated as of May 14, 2014, among the Company, Dr. Brown, Jeffrey Swartz and each of the other sellers named therein. As previously disclosed, Dr. Brown, our Chairman of the Board, President and Chief Executive Officer, was a founder and majority stockholder of OrgSpan.  Under the terms of the Stock Purchase Agreement, in consideration for all of the capital stock of OrgSpan, we paid consideration of approximately $14.1 million, which included the repayment of OrgSpan’s outstanding debt of approximately $8.0 million and approximately $1.4 million in cash paid to OrgSpan’s stockholders (other than Dr. Brown) and to holders of vested OrgSpan stock options. In exchange for his shares of OrgSpan stock, Dr. Brown has the right to receive an aggregate of 98,999 restricted shares of our common stock (the “Restricted Shares”), representing approximately $4.7 million of the purchase price, which Restricted Shares will vest and be issued by us upon the achievement of certain performance-based conditions tied to the launch and sales of our next generation multi-tenant cloud communication platform, which incorporates certain OrgSpan products and technology. The number of Restricted Shares to be received by Dr. Brown was determined on the basis of a 20-day average closing price of our common stock of $61.65. The difference between the $15.6 million purchase price disclosed in the 8-K filed on May 14, 2014 and the $14.1 million noted above is a result of the change in the common stock price of the 98,999 restricted shares received by Dr. Brown. The Restricted Shares will not be registered under the Securities Act, in reliance upon an exemption from registration provided by Section 4(a)(2) under the Securities Act.  In the Stock Purchase Agreement, Dr. Brown represented as to his status as an “accredited investor,” as such term is defined in Rule 501(a) of Regulation D under the Securities Act, and as to his intention to acquire the securities solely for his own account for investment purposes only and not with a view toward their distribution.

 

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Item 6. Exhibits

 

 

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SIGNATURE

 

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