Interactive Intelligence 10-Q 2008
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
For the quarterly period ended June 30, 2008
For the transition period from ____________to____________
Commission File Number: 000-27385
INTERACTIVE INTELLIGENCE, INC.
(Exact name of registrant as specified in its charter)
Indicate by 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 R No r
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 r No R
As of July 31, 2008, there were 17,991,526 shares outstanding of the registrant’s common stock, $0.01 par value.
PART I. FINANCIAL INFORMATION
Item 1. Condensed Consolidated Financial Statements and Notes to Condensed Consolidated Financial Statements.
Condensed Consolidated Balance Sheets
As of June 30, 2008 and December 31, 2007
(In thousands, except share and per share amounts)
See Accompanying Notes to Condensed Consolidated Financial Statements
Condensed Consolidated Statements of Income (unaudited)
For the Three and Six Months Ended June 30, 2008 and 2007
(In thousands, except per share amounts)
See Accompanying Notes to Condensed Consolidated Financial Statements
Condensed Consolidated Statement of Shareholders’ Equity (unaudited)
For the Six Months Ended June 30, 2008
See Accompanying Notes to Condensed Consolidated Financial Statements
Condensed Consolidated Statements of Cash Flows (unaudited)
For the Six Months Ended June 30, 2008 and 2007
See Accompanying Notes to Condensed Consolidated Financial Statements
Notes to Condensed Consolidated Financial Statements
June 30, 2008 and 2007 (unaudited)
The accompanying unaudited condensed consolidated financial statements of Interactive Intelligence, Inc. (the “Company”) have been prepared in conformity with accounting principles generally accepted in the United States of America (“US 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 US 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) for the fair presentation of the results of the interim periods presented.
The Company’s accompanying condensed consolidated balance sheet as of December 31, 2007 has been derived from the Company’s audited consolidated financial statements at that date but does not include all of the information and notes required by US 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, 2007, included in the Company’s most recent Annual Report on Form 10-K as filed with the SEC on March 17, 2008. 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.
Reclassifications and Adjustments
During the second quarter of 2008, the Company identified an error in the classification of the unearned premium/discount between cash and cash equivalents and short-term investments. In the December 31, 2007 balance sheet, $89,000 has been reclassified from cash and cash equivalents to short-term investments. This reclassification did not have any impact on results previously reported.
Effective March 31, 2008, in order to properly classify noncurrent deferred revenues from the current portion, the Company reclassified $5.3 million of noncurrent deferred revenues to a separate line item on the accompanying condensed consolidated balance sheets. In addition, $582,000 of related prepaid commissions associated with the Company’s noncurrent deferred revenues have also been appropriately reclassified from the current portion of prepaid expenses and included in noncurrent other assets, net. This error did not have any impact on results previously reported.
During the fourth quarter of 2007, the Company identified an error that affected amounts previously reported on its Quarterly Reports on Form 10-Q for the first three 2007 quarterly periods. During the first three 2007 quarterly periods, the Company deferred maintenance and support revenues based on an assumed 18 month maintenance and support period but in certain cases, the actual support period was less than the maximum period. With respect to the three and six months ended June 30, 2007, the Company under-recognized product revenues in the amount of $155,000 and $250,000, respectively, and related commission expenses during the same periods was also under-recognized by $17,000 and $27,000, respectively. This error did not have a material impact on results previously reported.
Prior to July 1, 2007, costs related to certain commissions for the sale of services were included in cost of services. Beginning July 1, 2007, for all periods, these costs have been reclassified from cost of services to sales and marketing expenses, including $100,000 of commissions reclassified for the three months ended June 30, 2007.
The Company’s interim critical accounting policies and estimates include the recognition of income taxes using an estimated annual effective tax rate. For a complete summary of the Company’s other significant accounting policies and other critical accounting estimates, refer to Note 2 of Notes to Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2007.
During the six months ended June 30, 2008, there were no material changes to the Company’s significant accounting policies or critical accounting estimates other than the recent accounting pronouncements discussed below.
In May 2008, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 162, The Hierarchy of Generally Accepted Accounting Principles (“SFAS 162”). SFAS 162 identifies the sources of accounting principles and the framework for selecting the principles to be used in the preparation of financial statements of nongovernmental entities that are presented in conformity with US GAAP. SFAS 162 is effective sixty days following the SEC’s approval of the Public Company Accounting Oversight Board (“PCAOB”) amendments to AU Section 411, The Meaning of ‘Present Fairly in Conformity with Generally Accepted Accounting Principles’. The Company is currently evaluating the potential impact, if any, of the adoption of SFAS 162 on its consolidated financial statements.
In December 2007, the FASB issued SFAS No. 141 (revised 2007), Business Combinations (“SFAS 141R”) and SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements– an amendment to ARB No. 51 (“SFAS 160”). SFAS 141R and SFAS 160 require most identifiable assets, liabilities, noncontrolling interests, and goodwill acquired in a business combination to be recorded at “full fair value” and require noncontrolling interests (previously referred to as minority interests) to be reported as a component of equity, which changes the accounting for transactions with noncontrolling interest holders. Both SFAS 141R and SFAS 160 are effective for periods beginning on or after December 15, 2008, and earlier adoption is prohibited. SFAS 141R will be applied to business combinations occurring after the effective date. SFAS 160 will be applied prospectively to all noncontrolling interests, including any that arose before the effective date. The Company does not expect that the adoption of SFAS 141R and SFAS 160 will have a material impact on its results of operations and financial position.
In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities - Including an amendment of SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities (“SFAS 159”). SFAS 159 permits entities to choose to measure many financial assets and financial liabilities at fair value. Unrealized gains and losses on items for which the fair value option has been elected are reported in earnings. SFAS 159 became effective for the Company beginning January 1, 2008. Upon adoption of SFAS 159, there was no material impact on the Company’s condensed consolidated financial statements.
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (“SFAS 157”). SFAS 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. This Statement applies to previous accounting pronouncements that require or permit fair value measurements. Accordingly, SFAS 157 does not require any new fair value measurements. SFAS 157 became effective for the Company beginning January 1, 2008. Upon adoption of SFAS 157, there was no material impact on the Company’s condensed consolidated financial statements.
In February 2008, the FASB issued FASB Staff Position (“FSP”) No. 157-2 (“FSP 157-2”), which delays the effective date of SFAS 157 for one year for all nonfinancial assets and nonfinancial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis. The Company elected a partial deferral of SFAS 157 under the provisions of FSP 157-2 related to the measurement of fair value used when evaluating goodwill, other intangible assets and other long-lived assets for impairment. See Note 3 for further information and related disclosures regarding the Company’s fair value measurements.
SFAS 157 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. SFAS 157 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:
The Company’s assets that are measured at fair value on a recurring basis are generally 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 most money market securities and equity investments. Such instruments are generally 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 the Company’s corporate notes, commercial paper and asset-backed securities. Such instruments are generally 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 and short-term investments on its condensed consolidated balance sheet, measured at fair value on a recurring basis as of June 30, 2008 (in thousands):
Basic net income per share is calculated based on the weighted-average number of common shares outstanding in accordance with SFAS No. 128, 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. When the Company reports net income, the calculation of diluted net income per share excludes shares underlying stock options outstanding that would be anti-dilutive. Potential common shares are composed of shares of common stock issuable upon the exercise of stock options. The following table sets forth the calculation of basic and diluted net income per share (in thousands, except per share amounts):
The Company’s calculation of diluted net income per share for the three months ended June 30, 2008 and 2007 excludes stock options to purchase approximately 1.4 million and 741,000 shares of the Company’s common stock, respectively, and diluted net income per share for the six months ended June 30, 2008 and 2007, excludes stock options to purchase approximately 1.2 million and 577,000 shares of the Company’s common stock, respectively, as their effect would be antidilutive.
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 (the “2006 Plan”), stock appreciation rights, restricted stock, restricted stock units, performance shares, performance units and other stock-based awards. After adoption of the original 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. 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 Market, on the business day immediately preceding the date of grant. The number of shares available under the 2006 Plan is subject to adjustment for certain changes in the Company’s capital structure.
At the Company’s 2008 Annual Meeting of Shareholders held on May 30, 2008, the Company’s shareholders approved an amendment to the 2006 Plan. A maximum of 5,850,933 shares are available for delivery under the 2006 Plan, which consists of (i) the 2,150,000 shares, plus (ii) up to 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 Company currently issues two types of stock options: (1) non-executive employee and director grants and (2) executive officer grants. Stock options granted to non-executive employees and directors are subject only to time-based vesting. 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 vesting period.
Performance-based stock options are typically granted to executive officers during the first quarter of the year with the grants subject to cancellation if specified performance targets, as approved by the Company’s Compensation Committee, are not achieved. If the applicable performance targets have been achieved, the options will vest in four equal annual installments beginning one year after the performance-related year has ended.
The fair value of the executive officer 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. Although the valuation assumptions used for executive officer grants are similar to grants made to non-executive employee and director grants, the assumptions for executive officer grants are used to measure each vesting tranche of the awards.
For most options granted through December 31, 2004, the term of each option is ten years from the date of grant. In 2005, the Company began issuing options with a term of six years from the date of grant.
If an incentive stock option is granted to an employee who, at the time the option is granted, owns stock representing more than 10% of the voting power of all classes of stock of the Company, the exercise price of the option may not be less than 110% of the market value per share on the date the option is granted and the term of the option shall be not more than five years from the date of grant.
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 under SFAS No. 123 (revised 2004), Share-Based Payment, and the guidance of Staff Accounting Bulletin No. 107, as amended by Staff Accounting Bulletin No. 110, for the three and six months ended June 30, 2008 and 2007 (in thousands):
No customer or partner accounted for 10% or more of the Company’s accounts receivable as of June 30, 2008 or December 31, 2007. In addition, no customer or partner accounted for 10% or more of the Company’s revenues for the three and six months ended June 30, 2008 and 2007.
From time to time, the Company has received notification from competitors and other technology providers claiming that the Company’s technology infringes their proprietary rights. The Company cannot assure you 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.
In November 2002, the Company received a notification from the French government as a result of a tax audit that had been conducted encompassing the years 1998, 1999, 2000 and 2001. In December 2005, the Company received an additional notification from the French government as a result of an updated tax audit that they conducted. Both of these assessments claim various taxes are owed related to Value Added Tax (“VAT”) and corporation taxes in addition to what has previously been paid and accrued. In May 2007, the French court ruled against the Company on the first notification and declared the amounts due ($3.7 million for VAT and $371,000 for corporation taxes). Because the judgment from the French court was against Interactive Intelligence France S.A.R.L. (“SARL”), a wholly owned subsidiary of the Company, the Company does not believe that the French government can impose the liability on Interactive Intelligence, Inc. and SARL does not have any significant assets with which to pay. In addition, the Company’s tax counsel and advisors contend that the case is without merit and the Company has two more appeal routes, which could take up to ten years to resolve.
As of June 30, 2008, the assessment related to VAT was approximately $6.7 million and the assessment related to corporation taxes was approximately $807,000. As of June 30, 2008 and December 31, 2007, the Company has recorded an accrual for an amount it deems probable of payment for the corporation tax assessment. No accrual has been made by the Company with respect to the VAT assessment.
The Company has filed for VAT refunds in France of more than $600,000, which the Company has not recorded as a receivable and to which the French government has not yet responded. The Company believes that these VAT refunds could be used to offset amounts owed to the French government in connection with the assessments, if necessary. Although the Company is appealing both the VAT and corporation tax assessments, it cannot assure you that these matters will be resolved without further litigation or that it will not have to pay some or all of the assessments.
The Company has recently been in negotiations with the French Taxing Authority to settle all the claims. Currently, the Company does not believe it is necessary to make any adjustments to its financial statements based upon these discussions.
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.
The Company leases its world headquarters building under an operating lease agreement (“world headquarters lease”), which expires on March 31, 2018. The 120,000 square foot building is located in Indianapolis, Indiana. In addition, on June 19, 2007 and March 14, 2008, the Company entered into the third and fourth amendments, respectively, of its world headquarters lease under which the current leased space is to be expanded in three installments through March 2009 totaling approximately 80,000 square feet in an office building that is adjacent to the Company’s world headquarters. Rent payments for the expanded space commenced in March 2008. In consideration for entering into the amendments, the landlord paid the Company a total discretionary allowance of $478,000. The allowance, which the Company intends to use for certain costs associated with its world headquarters building and/or the additional space, as defined in the amendment, will be recognized as a reduction of rent expense over the term of the world headquarters lease.
The Company has received and may continue to receive certain payroll tax credits and real estate tax abatements that were granted to the Company based upon certain growth projections. If the Company’s actual results are less than those projections, the Company may be subject to repayment of some or all of the payroll 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.
The following table is a reconciliation of the difference between the actual provision for income taxes and the provision computed by applying the federal statutory rate, 35%, on income before income taxes (in thousands):
Upon adoption of FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes an interpretation of FASB Statement No. 109, the Company has identified an uncertain tax position related to the tax credits that the Company currently believes meets the “more likely than not” recognition threshold to be sustained upon examination. Prior to the fourth quarter of 2007, this uncertain tax position had not been recognized because the Company had a valuation allowance established. The balance of the unrecognized tax benefit was approximately $328,000 at December 31, 2007 and, if recognized, would impact the effective tax rate. As of June 30, 2008, the unrecognized tax benefit has not changed.
The Company and its subsidiaries file federal income tax returns and income tax returns in various states and foreign jurisdictions. Tax years 2004 and forward remain open for examination for federal tax purposes and tax years 2003 and forward remain open for examination for the Company’s more significant state tax jurisdictions. To the extent utilized in future years’ tax returns, net operating loss and capital loss carryforwards at December 31, 2007 will remain subject to examination until the respective tax year is closed.
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 Item 1A “Risk Factors” section of our Annual Report on Form 10-K for the fiscal year ended December 31, 2007. The following will be discussed and analyzed:
· Forward-Looking Information
· Financial Highlights
· Historical Results of Operations
· Liquidity and Capital Resources
· Critical Accounting Policies and Estimates
Certain statements in this Quarterly Report on Form 10-Q contain “forward-looking” information (as defined in the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933, as amended and Section 21E of the Securities Exchange Act of 1934, as amended) 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 their 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, rapid technological changes in the industry; our ability to maintain profitability, to manage successfully our growth and increasingly complex third party relationships, to maintain successful relationships with our current and any new partners, to maintain and improve our current products and to develop new products and to protect our proprietary rights adequately; and other factors set forth in our Securities and Exchange Commission (“SEC”) filings, including the Item 1A “Risk Factors” section of our Annual Report on Form 10-K for the fiscal year ended December 31, 2007.
Interactive Intelligence, Inc. (“Interactive Intelligence”, “we”, “us” or “our”) was formed in 1994 as an Indiana corporation and maintains its world headquarters and executive offices at 7601 Interactive Way, Indianapolis, Indiana 46278. Our telephone number is (317) 872-3000. You can find our website at http://www.inin.com. Our periodic and current reports and all amendments to those reports required to be filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 are available free of charge through our investor relations website located at http://investors.inin.com under “SEC Filings”.
We are a leading provider of software applications for contact centers and we are leveraging that leadership position to provide mission-critical Voice over Internet Protocol (“VoIP”) applications to enterprises. Our solutions are installed by customers in a wide range of industries including, but not limited to, financial institutions, higher education, healthcare, retail, technology, government, business services and increasingly for the remote and mobile workforce. We also offer a pre-integrated all-software Internet Protocol Private Branch Exchange (“IP PBX”) system, a phone and communications solution for mid- to large-sized enterprises that rely on the Microsoft Corporation (“Microsoft”) platform. We offer innovative software products and services for multi-channel contact management, business communications, messaging, and VoIP solutions supported on the Session Initiation Protocol (“SIP”) global communications standard. Many of our solutions can be deployed at the customer’s site or can be provided in a Software as a Service model.
Our application-based solutions are integrated on a platform developed to increase security, broaden integration to business systems and end-user devices, enhance mobility for today’s workforce, scale to thousands of users, and more wholly satisfy today’s diverse interaction needs in markets for:
By implementing our all-in-one solutions, businesses are able to unify multi-channel communications media, enhance workforce effectiveness and productivity, and more readily adapt to constantly-changing market and customer requirements. Moreover, organizations in every industry are able to reduce the cost and complexity of traditional “multi-point” legacy communications hardware systems that are seldom fully integrated.
For further information on our business and the products and services we offer, refer to the Item 1 “Business” section of our Annual Report on Form 10-K for the year ended December 31, 2007.
The information below shows our total revenues (in millions) for the most recent five quarters and the years ended December 31, 2007, 2006 and 2005 and the percentage change over the previous period.
We have experienced revenue growth of 4%, 1% and 0% over the most recent three quarterly periods, respectively, as illustrated in the table above. We believe that these growth rates are attributable to the general economic conditions and the fact that companies are being more cautious in making large system purchases. In the second quarter of 2008, we saw a decline in the dollar amount of orders we received from existing customers wanting new functionality or additional licenses. Although the sequential growth rates for the last three quarters are lower than historical growth rates, the volume of activity we are experiencing in the sales cycle is still high and we believe that our success rates remain consistent. We expect that as the economic conditions improve so will the dollar value of orders that we receive.
For the three months ended June 30, 2008, revenues grew 13% over the three months ended June 30, 2007 primarily due to contracts that were deferred in previous periods being recognized during the quarter, partially offset by a lower dollar amount of orders from existing customers compared to the same period in the prior year.
The dollar amount of orders we receive does not entirely determine the amount of revenues recognized because the terms in the contracts, collection history with the customer or partner and other contractual conditions can affect whether we recognize the order during the quarter or in subsequent quarters. Consequently, product revenues for any particular quarter are impacted not only by orders received in the current quarter but also by orders received in previous quarters that are being recognized in the current quarter.
During the three and six months ended June 30, 2008, services revenues increased primarily due to additional support fees and annually renewable license fees, which were recognized for our growing installed customer base, compared to the same periods in 2007. The increase in recognized support was offset in part by professional services revenues decreases for the three and six months ended June 30, 2008 compared to same periods in 2007. These professional services are not essential to the functionality of our software. Professional services revenues decreased due to a reduction in the delivery of professional services that assisted in implementation of our solutions at our customers’ locations.
Our costs of product increased due to our media servers and gateway appliances that we have developed and licensed, additional hardware delivered by us and increased royalty expenses as a result of licensing more third party software as part of the orders received.
Our costs of services and operating expenses, which include sales and marketing, research and development and general and administrative expenses, increased for the three and six months ended June 30, 2008, compared to the same periods in 2007, primarily due to a $2.4 million and $5.1 million increase, respectively, in company-wide compensation and related costs. Staffing increased 14% overall at June 30, 2008 from June 30, 2007. In addition, our general corporate allocable costs including rent, insurance and depreciation increased primarily due to additional offices we opened during the last two years. In March 2008, we expanded into one floor of a new building adjacent to our world headquarters and will be expanding into another floor during the third quarter of 2008. We also opened or expanded offices domestically and internationally.
During the three and six months ended June 30, 2008, we recorded income tax expense of $700,000 and $1.6 million, respectively, compared to $103,000 and $200,000 in the same periods during 2007. During the fourth quarter of 2007 we recorded a tax benefit of $8.1 million associated with the elimination of the valuation allowance on the deferred tax assets. Of the total income tax expense recorded, only $44,000 and $148,000 for the three and six months ended June 30, 2008, respectively, is expected to result in cash payments, and the remainder of the expense reduced recorded deferred tax assets.
Due to the growth rate in the dollar amount of orders during the last three quarters, we have reduced our spending plans for the rest of 2008 where possible. We expect to hire for certain positions but expect to maintain a relatively steady total number of staff. We do have certain facilities and related equipment and furniture commitments which will increase our expenses. As a result, we expect to recognize higher operating expenses in the third and fourth quarters of 2008 compared to the first two quarters of 2008.
Historical Results of Operations
The following table presents certain financial data, derived from our unaudited statements of income, as a percentage of total revenues for the periods indicated. The operating results for the three and six months ended June 30, 2008 and 2007 are not necessarily indicative of the results that may be expected for the full year or for any future period.
Comparison of Three and Six Months Ended June 30, 2008 and 2007
Product revenues, which include software and hardware, increased $719,000 during the three months ended June 30, 2008 compared to the same period in 2007. This increase was primarily due to contracts that were deferred in previous periods being recognized during the quarter, partially offset by a lower dollar amount of orders from existing customers compared to the same period in the prior year.
Product revenues increased $3.2 million for the six months ended June 30, 2008 compared to the same period in 2007 primarily due to an increase in the dollar amount of orders received during the six months ended June 30, 2008 compared to the same period in 2007.
Product revenues can fluctuate from quarter to quarter depending on the mix of orders between perpetual licenses and annually renewable licenses. If other revenue recognition criteria are satisfied, we recognize license revenue upfront for perpetual licenses, and we recognize revenue for annually renewable licenses ratably over the term. The impact of the mix of contracts on our product revenues occurs only in the initial year of an order; subsequent renewal fees received for the annually renewable licenses and the renewal support fees for perpetual contracts are all allocated entirely to services revenues.
Services revenues include the portion of the initial license arrangement allocated to maintenance and support revenues from annually renewable and perpetual contracts, license renewals of annually renewable contracts, and support fees for perpetual contracts, as well as professional services, educational and other miscellaneous revenues.
The increase during the three and six months ended June 30, 2008 compared to the same periods in 2007 was primarily due to our growing installed base of customers, both in number and dollar amount of licenses, and the revenue recognition of related annual license renewal fees and support fees for perpetual licenses. License renewal and support revenues increased by $2.3 million, or 24%, and $4.6 million, or 25%, during the three and six months ended June 30, 2008, respectively, compared to the same periods in 2007. As we sign contracts and install our solutions with new customers and partners, we expect that our services revenues will continue to increase as customers and partners renew licenses and pay for support on our software applications. The actual percentage fee charged for renewal of annually renewable licenses and perpetual support agreements as compared to the initial annually renewable license fee and perpetual license, respectively, is comparable on a relative percentage basis, and therefore, the mix of these types of contracts in the future is not expected to impact our future services revenues.
During the second quarter of 2008, our professional services revenues decreased $508,000, or 26%, but our educational and other services increased $891,000, or 85%. For the six months ended June 30, 2008, our professional services revenues decreased $380,000, or 10%, but education revenues and other services increased $1.1 million, or 52%. Professional services revenues fluctuate based on the amount of assistance our customers and partners need for implementation and installation. Education revenues and other services increased primarily due to more partners and customers attending our training sessions as we expanded these globally and due to an increase in hosted and managed services.
Costs of product consist of hardware costs, principally for media server and interaction gateway appliances which we have developed; servers, telephone handsets and gateways which we purchase and resell; royalties for third party software and other technologies included in our solutions; and, to a lesser extent, software packaging costs, which include product media, duplication and documentation. Costs of product can fluctuate depending on which software applications are licensed to our customers, the third party software, if any, which is licensed by the end user from us as part of our software applications and the dollar amount of orders for hardware.
Most of the increase in costs of product resulted primarily from a $457,000 increase in hardware costs from $1.8 million to $2.3 million for the three months ended June 30, 2008 and a $984,000 increase in hardware costs from $3.0 million to $4.0 million for the six months ended June 30, 2008 compared to the same periods in 2007.
Costs of services consist primarily of compensation expenses for technical support, educational and professional services personnel and other costs associated with supporting our partners and customers. These expenses increased primarily due to a $763,000 increase in compensation expense as a result of an 18% staffing increase in our services personnel for the three months ended June 30, 2008 compared to the three months ended June 30, 2007, and a $1.8 million increase as a result of an 18% staffing increase for the six months June 30, 2008 compared to the six months ended June 30, 2007. Depreciation expense increased $127,000 and $270,000 for the three and six months ended June 30, 2008, respectively, compared to the same periods in 2007. During the six months ended June 30, 2008, travel and related expenses increased $160,000 compared to the six months ended June 30, 2007, which increase was offset by a $400,000 decrease in outsourced services. The need for outsourced services decreased as we increased the number of professional services staff.
Gross profit as a percentage of total revenues decreased slightly during the three and six months ended June 30, 2008, compared to the same periods in 2007, primarily due to additional costs of product as discussed previously. The gross margin on our hardware sales is less than the gross margin on our software licenses; therefore, as we continue to sell more hardware such as media servers and interaction gateways, our total gross margin percentage may decrease compared to historical margins. Gross margins in any particular quarter are dependent upon revenues recognized versus costs of product and costs of services incurred and are expected to vary.
Sales and marketing expenses are comprised primarily of compensation expenses, travel and entertainment expenses and promotional costs related to our sales, marketing, and channel management operations. Compensation expense increased $543,000 and $1.0 million during the three and six months ended June 30, 2008, respectively, compared to the same periods in 2007, which was due in part to a 12% staffing increase in our sales and marketing personnel at June 30, 2008, compared to June 30, 2007. We increased our corporate marketing costs by $149,000 and $585,000 during the three and six months ended June 30, 2008, respectively, compared to the same periods in 2007, which included increased advertising and brand promotions, seminars, web seminars and tradeshows. Travel expenses increased during the second quarter of 2008 by $158,000 compared to the second quarter of 2007 and $181,000 for the six months ended June 30, 2008 compared to the six months ended June 30, 2007. Outsourced services, mainly related to marketing efforts, increased $243,000 during the six months ended June 30, 2008 compared to the prior period. Finally, the fees we paid to certain third parties for referring customers increased by $176,000 for the three months ended June 30, 2008 compared to the three months ended June 30, 2007 and $299,000 for the six months ended June 30, 2008 compared to the six months ended June 30, 2007. The additional increases from the prior periods were related to general corporate expense increases including rent, depreciation and corporate insurance.
Research and development expenses are comprised primarily of compensation and depreciation expenses. Research and development expenses increased during the three months ended June 30, 2008, as compared to the same period in 2007, primarily due to an increase in compensation expense of $906,000, resulting from a 26% staffing increase in our research and development personnel at June 30, 2008 compared to June 30, 2007 and increased compensation expense of $1.7 million for the six months ended June 30, 2008 compared to the six months ended June 30, 2007. Of the new hires, 18 were summer internship students. Depreciation expense increased $147,000 and $258,000 for the three and six months ended June 30, 2008, respectively, compared to the same periods in 2007. Allocated general corporate expenses such as rent, communication and office expenses also increased.
We continue to believe that investment in research and development is critical to our future growth and competitive position in the marketplace and is directly related to timely development of new and enhanced solutions that are central to our business. As a result, we expect research and development expenses will increase in future periods. In the short term, we expect research and development expenses to remain a relatively constant percentage of revenues.
General and administrative expenses are comprised of compensation expense and general corporate expenses that are not allocable to other departments including legal and other professional fees and bad debt expense. General and administrative expenses increased during the three and six months ended June 30, 2008, as compared to the same periods in 2007, primarily due to an increase in compensation expense of $280,000 and $615,000 for the three and six months ended June 30, 2008, respectively, compared to same periods in 2007. This increase was the result of a 12% staffing increase in our general and administrative personnel as of June 30, 2008 compared to June 30, 2007.
Other Income (Expense)
Interest earned on investments during the three and six months ended June 30, 2008, compared to the same periods in 2007, decreased slightly due to lower interest rates as a result of decreases in interest yields on investments. We continue to monitor the allocation of funds in which we have invested to maximize our return on investment within our established investment policy. We had short-term investments of $14.0 million as of June 30, 2008, compared to $17.0 million as of December 31, 2007. We do not have any investments in subprime assets.
Other income (expense), net includes foreign currency transaction gains and losses, as well as foreign tax withholdings. These amounts depend on the amount of revenue that is generated in certain international currencies, particularly the Euro, and the exchange gain or loss that results from foreign currency disbursements and receipts. The income for the three and six months ended June 30, 2008 consisted of $50,000 and $259,000 in gains related to foreign currency transactions, respectively, offset by $102,000 and $214,000, respectively, in foreign tax withholdings. For the three and six months ended June 30, 2007, the majority of the amounts related to foreign tax withholdings.
In the fourth quarter of 2007, we recorded an income tax benefit of $8.1 million to reduce the valuation allowance of the deferred tax assets at December 31, 2007. As a result, we began recording income tax expense in the first quarter of 2008. We incurred $700,000 and $1.6 million of income tax expense during the three and six months ended June 30, 2008, respectively; however, only $44,000 and $148,000 of the income tax expense recorded for the three and six months ended June 30, 2008, respectively, is expected to result in cash payments and the remainder was the impact of utilizing the deferred tax assets.
We had over $45.5 million of tax net operating loss carryforwards and $1.6 million in tax credit carryforwards at December 31, 2007. Included in the net operating loss carryforwards was $23.1 million of operating losses that were generated as a result of compensation for tax purposes for stock option exercises. In accordance with SFAS 123R, 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 primarily recorded as a credit to additional paid-in capital if and when realized. The effective income tax rate was 45% as of June 30, 2008. However, due to the tax net operating loss carryforwards, the tax credit carryforwards and stock option related compensation deductions, we do not expect to have a significant cash outlay to pay income taxes in 2008.
Liquidity and Capital Resources
We generate cash from the collections we receive related to licensing our contact center and IP-PBX applications and from annual license renewals, maintenance and support and other services revenues. We use cash primarily for paying our employees (including salaries, commissions and benefits), leasing office space, paying travel expenses and marketing activities, paying vendors for hardware, other services and supplies and purchasing property and equipment. We continue to be debt free.
We determine liquidity by combining cash and cash equivalents and short-term investments as shown in the table below. Based on our recent performance and current expectations, we believe that our current liquidity position, when combined with our anticipated cash flows from operations, will be sufficient to satisfy our working capital needs, capital expenditures, investment requirements, contractual obligations, commitments and other liquidity requirements associated with our operations over the next 12 months. If cash flows from operations are less than anticipated or we have additional cash needs (such as an unfavorable outcome in legal proceedings), our liquidity may not be sufficient to cover our needs. In this case, we may be forced to raise additional capital, either through the capital markets or debt financings. In doing so, we may not be able to receive favorable terms in raising this capital.
On October 31, 2007, our shelf registration statement on Form S-3, as amended, was declared effective by the SEC. This registration statement allows us to offer and sell up to 3,000,000 shares of our common stock, and allows Donald E. Brown, our Chairman of the Board, President and CEO, to sell up to 1,000,000 shares of our common stock that he owns, from time to time in one or more transactions. The offer and sale of any shares of our common stock under the shelf registration statement remains at the discretion of our Board of Directors, and there is no assurance that we would be able to complete any such offering of our common stock.
On July 28, 2008, we announced the approval of a share repurchase program by our Board of Directors. Under the share repurchase program, we may purchase our common stock for up to a maximum aggregate purchase price of $10 million from time to time over the next year. Any repurchases that we make will be made using our cash resources.
Our liquidity position at June 30, 2008 and December 31, 2007 was as follows:
The amount that we report as cash and cash equivalents or as short-term investments fluctuates depending on investing decisions in each period. Purchases of short-term investments and property and equipment are reported as a use of cash and the related receipt of proceeds upon maturity of investment is reported as a source of cash.
During the six months ended June 30, 2008 and 2007, our operating activities resulted in net cash provided of $6.8 million and $6.9 million, respectively.
Net cash used in investing activities was $1.0 million and $3.3 million during the six months ended June 30, 2008 and 2007, respectively. We purchased property and equipment with a cost of $4.0 and $2.6 million during the six months ended June 30, 2008 and 2007, respectively. During the last two years, we have opened or expanded offices domestically and internationally, including one floor of an office building next to our headquarters. As staffing increases, our property and equipment becomes obsolete and our operations continue to increase, we anticipate that our purchases of property and equipment will continue to increase in future periods.
Net cash provided by financing activities was $573,000 and $1.3 million for the six months ended June 30, 2008 and 2007, respectively. The decrease in cash provided was mainly due to lower proceeds from stock options that were exercised during the six months ended June 30, 2008 compared to the same period in 2007.
As of June 30, 2008, there have been no material changes in our contractual obligations as set forth in the Contractual Obligations table disclosed in our Annual Report on Form 10-K for the year ended December 31, 2007.
Off-Balance Sheet Arrangements
Except as set forth in the Contractual Obligations table disclosed in our Annual Report on Form 10-K for the year ended December 31, 2007, 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, 2008.
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, revenue and expenses. Actual results may differ from those estimates and judgments under different assumptions or conditions. We have discussed the critical accounting policies that we believe affect our more significant estimates and judgments used in the preparation of our consolidated financial statements in the “Management’s Discussion and Analysis of Financial Condition and Results of the Operations—Critical Accounting Policies and Estimates” section of our Annual Report on Form 10-K for the year ended December 31, 2007 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, 2007. 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 various factors, including changes in foreign currency exchange rates or weak economic conditions in certain markets. We transact business in certain foreign currencies including the British pound and the Euro. However, as a majority of the orders we receive are denominated in United States dollars, a strengthening of the dollar could make our products more expensive and less competitive in foreign markets. We have not historically used foreign currency options or forward contracts to hedge our currency exposures because of variability in the timing of cash flows associated with our larger contracts. We did not have any such hedge instruments in place at June 30, 2008. Rather, we attempt to mitigate our foreign currency risk by generally transacting business and paying salaries in the functional currency of each of the major countries in which we do business, thus creating natural hedges. Additionally, as our business matures in foreign markets, we may offer our products and services in certain other local currencies. As a result, foreign currency fluctuations would have a greater impact on our company and may have an adverse effect on our results of operations. Historically, our gains or losses on foreign currency exchange translations have been immaterial to our consolidated financial statements.
We invest cash balances in excess of operating requirements in short-term securities that generally have maturities of one year or less. The carrying value of these securities approximates market value, and there is no long-term interest rate risk associated with these investments.
We maintain a set of disclosure controls and procedures that are designed to ensure that information required to be disclosed by us in the reports filed by us under the Securities Exchange Act of 1934, as amended (the “Exchange Act”) is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. We carried out an evaluation, under the supervision and with the participation of our management, including our President and Chief Executive Officer (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, 2008 pursuant to Rule 13a-15(b) of the Exchange Act. Based on that evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures were effective.
There have been no changes in our internal control over financial reporting that occurred during the three months ended June 30, 2008 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 in Note 7 of Notes to Condensed Consolidated Financial Statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q is incorporated herein by reference.
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 Item 1A “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2007. 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. During the three months ended June 30, 2008, there were no material changes from the risk factors previously disclosed in our Annual Report on Form 10-K for the year ended December 31, 2007.
We held our Annual Meeting of Shareholders on May 30, 2008. At that meeting, our shareholders:
The final results of the votes taken at the annual meeting were as follows:
In addition, the following Directors also have terms in office that continue until the annual meeting of shareholders in the year indicated:
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.