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Executives

Donald Volk - Chief Financial Officer

Rudy Karsan - Chief Executive Officer

Troy Kanter - President and Chief Operating Officer

Analysts

Peter Goldmacher - Cowen and Company

[Yo John] - Goldman Sachs

Justin Bandy - Keybanc Capital Markets

[Greg Lippman] - Deutsche Bank

Richard Davis - Needham & Company

Rich - Jefferies & Co.

Ariel Sokol - Wedbush

Kenexa Corporation (KNXA) Q3 2008 Earnings Call November 3, 2008 5:00 PM ET

Operator

Good afternoon ladies and gentlemen and welcome to the Kenexa's Corporation Third Quarter 2008 Earnings Conference Call. At this time all participants are in listen-only mode. Following the presentation we will conduct a question-and-answer session and instructions will be given right at that time on how to queue for questions. I would like to remind everyone that this conference is being recorded. Now I'd like to turn the conference over to Don Volk, Kenexa's Chief Financial Officer. Please go ahead sir.

Donald Volk – Chief Financial Officer

Thank you, Paul. With me today is Rudy Karsan, our Chief Executive Officer, and Troy Kanter, our President and Chief Operating Officer. Today we will review Kenexa's third quarter 2008 results and provide guidance for the fourth quarter and full year 2008. Then we will open up the call for questions.

Before we begin, let me remind you that this presentation may contain forward-looking statements that are subject to risks and uncertainties associated with the Company's business. These statements may concern among other things, guidance as to future revenues and earnings, operations, transactions, prospects, intellectual property, and the development of products. Additional information that may affect the company's business and financial prospects, as well as factors that would cause Kenexa's actual performance to vary from our current expectations are available in the company's filings with the Securities and Exchange Commission.

Also, I would like to remind you that today's call may not be reproduced in any form without the expressed written consent of Kenexa. We may refer to certain non-GAAP financial measures on this call. I will discuss the reconciliation of adjusted numbers to the GAAP numbers and a reconciliation schedule showing the GAAP versus non-GAAP is currently available on our company website with the press release issued earlier today. Our website is located at www.kenexa.com. I will now turn the call over to Rudy Karsan. Rudy?

Rudy Karsan – Chief Executive Officer

Thanks Don and thanks to all of you for joining us on the call to review our third quarter results. Back in September 10 we revised our revenue and profitability outlook for the quarter and the full year 2008 based on two factors, including the macroeconomic environment and the strengthening of the US dollar which negatively impact the quarter revenue given the fact that international version has been the factors cum component of our revenue. Our results for the quarter were consistent with our revised outlook. However, the business environment deteriorated even worse than expected, its still mode in the financial market during the last few weeks of the quarter created a situation in which customers cause to value the status of the global economy and the market. While we see a segment of customers moving ahead with new deals and strategic projects, the level of scrutiny placed on any and all investments is at the highest level we have seen in all our years of being in business.

We have said in the past that we believe the talent management would pay strong head wins if you are in permanent rate to reach 5%. We have not only fastest levels, but there are no fears that the unemployment may reach the upper single digit range in the quarters ahead. Our business is clearly feeling the impact of the macroeconomic environment and the short term slowdown in the talent management business. That said, our business has a solid foundation and we remain well positioned for the long term. We have significant critical math, a global presence, strong balance sheet and a business model that enables us to generate significant profitability and cash flow. We are staying two-two commitments that we have reiterated many times mainly, that in the most difficult of time we will make the tough decision to continue delivering a soft ability and cash flow to ensure the long term health of Kenexa.

To that end we recently took action to reduce our workforce by approximately 11% to 12% in an asset to your line across structure for the lower revenue run rate we expect to see in the fourth quarter. This was a difficult decision but we are in a difficult macroeconomic environment. Importantly, these cuts will not slow our product commitments or development plan, and our service delivery and customer support effort will continue to receive the highest level of commitment and focus as this is an area that is close to our company, our culture, our values and our competitive differentiation. It is uncertain that the business environment will improve, but we are managing our business with a view that the macroeconomic environment will remain challenging throughout 2009. We will continue to monitor the health of the global economy in order to drive investment decisions across our business as well as to take appropriate action to balancing delinquent profitability and cash flow for our shareholder with ensuring that we are well positioned to drive long term growth.

If you look at the details of the business the core EPS fees is clearly holding in the best on the relative basis at the moment. More deals make through the final in this area, and our customers are continuing to renew at a high rates. We estimate that the ATS related component to our business was up on a quarter-over-quarter basis during the third quarter. It is also worth pointing now that we believe our competitive while already high is improved noticeably in this area over the course of the past several quarters. We believe the primary driver to this has been our investment in R&D in particular relative to the significant enhancement of offering clearly the best of freed offering which we believe is not clearly the best of read offering for the high end of the marketplace.

In the past we assured with you that the RPO segment of our business given the structure of engagement was most exposed to a slowdown in the global hiring and economic trends. To this point more than 25% of our RPO clients have global hiring and there is a chance that that number could climb. This obviously reduces our revenue that is tied directly to the numbers of employees we hire. To provide increase data on our RPO business revenues in 2Q were approximately 18.5 million and we currently expect to do a lot in the RPO revenue during the fourth quarter.

As we have discussed before our RPO revenue is not 100% service based it also include software and content to a degree. We expect to continue providing specific RPO revenue on a quarterly basis at least as long as the economic environment remains challenging and uncertain. The result is important to reiterate the key reason that we remain firmly committed to this business, in spite of the short term decline in revenue. First, our overall profitability is enhanced by our RPO business. Second, we provided Kenexa with domain expertise that no other talent management software company has.

Third, in many cases we are able to bundle our software and content into the overall relationship and finally this brings significant value to our customers. Kenexa appreciate that the revenue associated with this business viable than appear subscription model, however, we firmly believe that ultimate winners in the talent management phase will deliver not only software and content but there will be a requirement to have services expertise and then outsourcing offering available to our clients. As such, we will continue to invest in this business and aggressively pursue new customer relationship.

The final area of business that I would point out relates to our content and service. In this case we have seen a segment of customers delayed limitation and projects to the extent possible, on the other hand we continue to see a high level of interest in our solution and we are signing up new customers which has added those two parts by having overall number of new preferred partner customers that we added in the quarter.

Turning to some of the key metrics that we normally report, we added over 40% partner customers during the quarter, this compares to a 50 preferred partners added last quarter and to over 50 preferred partners added during the year ago period. The sequential decline affects the slowdown and decision making that I was referring to at the beginning of my remarks. It also shows that there are good numbers of deals moving forward.

On the talent acquisition side of our business we closed business with customers such as CIDC, GMac, Kohl's, autotrader.com and TransGlobal as it relates to our employee retention solution. We closed business with customer such as Health Plus Michigan, South Florida Water, and community transits. Our growing customer’s base provides Kenexa with a growing opportunity to expand our relationship overtime. Our PQ which measures average annual revenue contribution of our top 80 customers was over $1.4 million during the third quarter which is consistent with last quarters level and up 1.1 million during the year ago quarter. While we expect a flattening of this figure, during the current environment the value of Kenexa brings to customers is reflected by the fact of course PQ metric has 40% over the course of the last five years.

As Kenexa demonstrates value we see customers expanding the commitment to Kenexa as a strategic found management. When the economic environment does pay the lines and it will and improve as it will. We continue to believe that Kenexa will be a primary beneficiary. We believe that optimizing talent management purpose is a considered of top long term strategic priority for growing number of companies and while short term uncertain is created to handwritten long term demand drivers are not going to change in a time soon mainly the aging of the workforce, declining 10 year globalization, cash flow reduce and employee mobility just to name a few.

While it is clear that our general tone of the business environment, lighter customer is cautious right now. We are very bullish in Kenexa's division within the market. And on September 10th we noted that the size of our pipeline in the verbal wind selection stage was in a all time higher. This continues to be the case. We are confident that we were closing many of the deals and our growing numbers of other opportunities when the economic environment improves and companies increasingly move forward with new projects. Kenexa is highly differentiated by our business model that combined software content and services and we continue to enhance our market position.

On the product front Kenexa continues to invest in our products which is evidenced via being recognized as one of the market leaders in the area of recruitment software by the Gartner Group last quarter.

During the third quarter our SJT Solution and one of human resource executive magazine 2008 top HR products of the year. In addition we continue to expand the scope of our value preposition, mostly, recently with introduction of Kenexa learning management solution. Kenexa is the only talent management vendor that can serve as a single source of recruiting, on boarding, assessment, learning, performance management, career development, succession planning and the employee life cycle service solutions.

In summary, we believe Kenexa is well positioned to not only weather the storm that to also continue building on a strong market position as a result of our differentiated value proposition expanding sweetest solution, large global foot prints and industry leading domain expertise.

Talent managements is a good long term market and we are market leader. I will now turn it over to Don to review our third quarter results and fourth quarter outlook in more detail. Don.

Donald Volk - Chief Financial Officer

Thanks Rudy. Let me begin by reviewing our results for the third quarter starting with the P&L. Total revenue for the third quarter was $54 million, inline with our revised guidance of 54 to 56 million. Total revenue increased 15% on a year-over-year basis whether decreased 4% on a sequential basis. In the geographic perspective our revenue mix of domestic versus international revenue was consistent with the previous quarter as 74 to 76%. The sequential decline in international revenue was driven primarily by the strengthening of the US dollar.

Within total revenue subscription revenue was 43 million, representing growth of 13% on a year over year basis and a decrease of 2% sequentially. Subscription revenue was 80% of total revenue which is at the high end of our targeted mix of the high 70 to 80% range. In the spirit of providing extra data relative to our RPO business, we will further share RPO's contribution to our subscription revenue. RPO represented approximately $9 million of our subscription revenue in the third quarter. Keeping in mind that RPO engagements also include our technology solutions in many cases. We typically purchase multiyear subscriptions with an average length of approximately two years. During the third quarter, our renewal rates declined from our typical 90% plus range to the high 80% range. The decline in renewal rates was predominantly related to a renewal that is delayed for a couple months. To be clear, based on our discussions we firmly believe that this client will ultimately renew their relationship with Kenexa. The remaining $11 million of our total revenue in the third quarter came from other and professional services which increased 28% over last year, but declined 14% compared to the second quarter of 2008.

The sequential decrease in our other revenue was driven by two primary factors. First, the slowdown in consulting revenue and second the slowdown in hiring leading to reduce success fees with our RPO customers. Both of these are side effect of the more challenging economic environment.

Turning to profitability, we'll be providing non-GAAP measures for each third quarter 2008 expense category which excludes stock based compensation charges associated with the implementation of FAS-123R and the amortization of intangibles associated with previous acquisition. All comparisons will be using the non-GAAP current period results. Non-GAAP gross margin was 70% in the quarter. Consistent with the level in the second quarter and 30% in the year-ago quarter. Non-GAAP sales and marketing expense came in at $10.2 million or 19% of revenue, consistent with the level of the second quarter and up slightly from 80% in the prior quarter.

Non-GAAP R&D expense came in at $3.6 million or 7% of revenue which is consistent with our long-term target of 6 to 9% and comparable to 7% last quarter, but down from 10% in the year-ago quarter. Of note, the sequential decline in reported R&D spend was driven by the US dollar, will be exchange rate as a significant portion of R&D is executed in our low cost, offshore location. Non-GAAP G&A expenses were approximately $11.7 million or 22% of revenue which is an increase of 21% from the previous quarter and 19% in the prior year quarter. During the quarter, our G&A expense included approximately $100,000 in charges, related to our Indian office movie to Vaizag.

As previously discussed these one time leaded charges are being recognized throughout the year of 2008. We do not expect to incur these charges in 2009. Our non-GAAP income from operations was $10.3 million for the quarter. Consistent with our guidance of 10.3 to $10.6 million in representing a 19% non-GAAP operating margin. During the third quarter, our non-GAAP tax rate for reporting purposes was 22%, resulting in non-GAAP net income of 8.2 million based on 22.8 million shares outstanding, non-GAAP diluted earnings per share were $0.36 consistent with our revised guidance and an increase from $0.33 in the year ago quarter.

Turning to our results on a GAAP basis, which include $1.3 million related to the allocation of stock-based compensation and $1.5 million related to the amortization of intangibles associated with previous acquisitions, the following were expense levels determined in accordance with GAAP.

Cost of revenue 16.5 million, sales and marketing 10.3 million, R&D 3.8 million and G&A 12.7 million. For the third quarter, our GAAP income from operations was 7.5 million. Net income applicable to common shareholders was 5.4 million resulting in GAAP diluted EPS of $0.24. A reconciliation of non-GAAP to GAAP expenses and income from operations can be found in our press release and current report on Form 8-K filed with the SEC.

Kenexa had cash, cash equivalents, and short and long-term investments of 42.9 million at September 30, 2008; a decrease of 5.4 million from the end of the prior quarter. The decrease in cash was due to approximately $8 million used to pay contingent consideration associated with prior period acquisitions. During the quarter the company generated 8.7 million in positive cash from operations and used approximately 5 million associated with capital expenditures.

Accounts receivable DSOs were 65 days at the end of the quarter compared to 65 days at the end of the prior quarter and 60 days at the end of the year ago quarter. Our deferred revenue at the end of quarter was 47 million up from of 38.7 million at the end of the prior quarter and up from 35.1 million during the year.

And now I’d now like to turn to guidance for the full-year and the fourth quarter of 2008. For the fourth quarter of 2008, we expect the following: Revenue to be 45 to 47 million. We currently estimate that our fourth quarter subscription revenue will be flat to slightly down with the just reported quarter with the sequential decline being driven primarily by our other revenue. It is also worth noting that within the sequential decline approximately $3 million is due solely to adverse movement and affects based on recent exchange rates.

To put in perspective the decline in our total revenue run rate from approximately 56 million in the second quarter to 46 million at the mid point of our guidance to the fourth quarter approximately $3 million relates to the adverse impact of the strengthening US dollar on our reported revenue with approximately 6 to 7 million due to the slowdown of our RPO revenue. This also shows how the technology solutions components to our business has been relatively resilient during the economic downturn.

With the completion of our headcount reduction we currently expect to deliver 14 to 15% non-GAAP operating margin at our current targeted revenue level. This translates to non-GAAP operating income of approximately 6.3 to 7 million. Assuming the 22% tax rate for reporting purposes and 22.6 million shares outstanding, we expect our diluted non-GAAP earnings per share to be 22 to $0.25.

Our full year 2008 outlook based on our just reported third quarter results and fourth quarter guidance its total revenue of 203.6 million to 205.6 million. Non-GAAP operating income of 36.6 million to 37.3 million. Assuming the 22% tax rate for reporting purposes and 22.9 million shares outstanding, we expect our diluted non-GAAP EPS to be a $1.29 to $1.32. as a reminder our full year 2008 guidance includes the one time charge related to the opening of our new office space in India, which we have encouraged throughout the year.

Of note our fourth quarter and full year 2008 non-GAAP guidance excludes the impact of restricting charges associated with the previously mentioned headcount reduction. We currently estimate that the restructuring charge will be in the range of 2 to 2.5 million.

In summary we have taken action to put Kenexa in position to continue delivering solid profitability and cash flow during this very challenging economic time period. We will continue to manage to focus. The macro economic environment will eventually improve and we believe Kenexa will emerge with an even stronger market position.

We’d now like to turn it over to the operator to being the Q&A session. Operator?

Question-and-Answer Session

Operator

Thank you. [Operator Instructions]. And we will go first to Peter Goldmacher with Cowen and Company.

Peter Goldmacher

Hi guys. Hey Rudy, when you talk a little bit about your optimism in the business once we – hopefully the economy settles down. What sort of things are you going to be -- what sort of earnings before you start reinvesting in the business? And maybe before you answer that, if you can talk a little bit as you are going through your headcount reductions, what areas are you focusing as on? Thanks.

Rudy Karsan

If you look at the headcount reductions, our focus was primarily on G&A physicians and non-customer facing physicians. We met research and development and customer facing virtually untouched. As part of the reduction, there was non-deductive sales people also – although I’ve considered bench type sales people will also reduce. So that number now, which I think we had at some point over 130 sales with quotas were now between 100 and 110. The sign that we will see or but we will judge that we are now starting to bottom out is when our variables starts dropping. So if we fall at Stage 5, starts to reduce a new into signage while the pipeline still remains somewhat robust. In terms of development and investing in the product suite, we have continued to invest very heavily in this. If you look at between ’07 and ’08, our average spend on R&D has climbed and I expect that it may continue to climb into 2009 as well. So our commitment to innovation, our commitment to products remains unchanged.

Peter Goldmacher

Okay, great. Thank you.

Operator

Our next question will come from Sasha Jorbig with Goldman Sachs.

Unidentified Analyst

Hi. This is [Yo John] on behalf of Sasha Jorbig. Couple of questions. Could you comment on customer churn that we saw in the last quarter? And the second question is could you also comment on the pay back period in your contracts and in your contracts that you got signed in the last quarter? Thanks.

Rudy Karsan

As far as renewal rates are concerned, for the first quarter, we dropped below 90% to the high 80s. This was primarily due to a customer in Europe that delayed their renewal, which we fully expect to come on and get us back about the 90% going into the future. Sorry, I didn’t quite understand the second question.

Unidentified Analyst

The second question is the pay back period for new contracts and new contract that you have? Are the contract differing, was there any pricing pressure that you are seeing due to competition?

Don Volk

No, the terms are staying pretty much the same and we are not experiencing as much – we are not seeing pressures from competition, we are seeing more pressure (multiple speakers).

Unidentified Analyst

Okay, thank you.

Operator

Next, we will take a question from Steven Koenig with Keybanc Capital Markets.

Justin Bandy

Hi guys. This is actually Justin Bandy, I am for Steve. I wanted to ask you about the RPO business and specifically what sort of volatility do you see in your results going forward into 2009? On previous calls you have spoken about contracts that may renew. I am just wondering what we loose after end and what possible scenarios we might be see in the RPO business?

Don Volk

Well, the – there was a renewal that is schedule to take in place in the back half of the year that we talked about that renewal will not happen. There are no other renewals for 2008. For 2009 beginning in the second quarter we have five renewal strategies before. Four renewals most of the mind of back half of the year.

Justin Bandy

Okay. That’s great and then for contracts that are not being renewed that I get a sense that there maybe some quarter-to-quarter adjustments that are going on. For the RPO customers that you have, how guarantee are those cash flows, do they have the ability to strength the size of the contract?

Don Volk

The number that we gave you in the subscription number, those are the numbers that are contractually obligated for the customers, additional amounts into revenue going to other revenue from our success fees. So, it’s for success for each that are shrinking duet to the economic environment.

Justin Bandy

Okay, great. And then just as a final followup, for those success fee how much volatility could you considerably see going forward or what's the range in success fees a years in having quarter-to-quarter?

Don Volk

We have seen a steady deterioration of that number from Q4 of 2007. We don't have a sense of where the bottom might be.

Justin Bandy

Okay, thank you very much.

Operator

And we slowly move on to our next caller (Operator Instructions). And next we will hear from Tom Ernst, with Deutsche Bank.

Greg Lippman

Hi good evening. Thanks for taking my questions. This is actually (Greg Lippman) on behalf of Tom Ernst. You are talking about the macro slow down, where there specific verticals in which you saw a greater slowdown than others and which verticals do you think are more holding up better?

Don Volk

Across the board we're seeing clients take pause. Obviously there's stuff in the financial services hit harder than some of the other verticals, but we're really seeing it across most of the verticals that we serve.

Greg Lippman

Okay and then, slightly different topic, in terms of continuing to invest in your R&D, what specific areas are you targeting to broaden your portfolio?

Don Volk

We feel that we have the most complete portfolio in the marketplace now. The focus is really on, our BrassRing platform as well as the additional margins that are our platform in our 2X platform as we continue to build out more robust releases within each part of category.

Rudy Karsan

We also introduced the learning management solution in Q3. Which we're hoping to see take up in next year.

Greg Lippman

Okay. Thank you.

Operator

Our next question comes from Richard Davis, with Needham & Company.

Richard Davis

Thanks, two questions. One are you guys using another firm's learning management system or is this something new to your customer. Do I get a call and connect say, hey, look we have a got a new learning management system? Second question is, you do have, as you said, several you know, financial service customers. When these guys merge, what is the process that you guys go through? You must put like a SWAT Team over Wachovia, Merrill, whatever, and how can we make sure we're beneficial to you guys. Can you talk about strategy-wise, obviously we don't know the outcomes but help people understand how you approach that.

Don Volk

Let's answer the first question, your answer is accurate. Your answer is that accurate. We do have salespeople calling and saying this is a learning management system, you're performance management you are on this or you are on that, how would you like to try it or how would you like to install it, et cetera. That's an accurate statement. As far as the game plan on MNA activity between not much as financial company but in general what we find is our apps don't get touched for the first six to nine months upon the signing of a major acquisition. And we've got past examples of that of Wachovia taking over South Trust and World Savings Banks for Followers we didn’t see of our change initially. Now, we for example at Merrill Lynch, where BFA has taken we don’t know, the reality of the situation is there is a lot of jostling that takes place and would then be merged entity. So to a vendor you don’t fear or see much of credible value for the first three to four months following the merger. Once that shaker is completed, most organization go through a step by step best of breed and then decide on – okay, we are going to keep this app and this and that. The exception that we have seen is when companies decide to trade on their own brand names like we have seen in the retail operation or their might be certain geographical distributions. Does that answer your question?

Richard Davis

Yes, that of course. I think, I know it’s an unanswerable question, but I was just curious I thought about it. Thank you very much.

Don Volk

You are welcome.

Operator

Our next question comes from Ross Macmillan with Jefferies.

Rich

Hi guys this is Rich (Biwani) for Ross. A quick question and one is you are starting the FX impact in the quarter And two is you could talk a little bit about margins next year, given significant in margins which was in your guidance for the fourth quarter? Thanks

Rudy Karsan

I think as Don put it, given the full detail on the FX, Don given an added for color….

Don Volk

Was that the question about FX?

Rich

Yes, in third quarter.

Don Volk

Well, as you all know probably between June 30th and to the current numbers FX has dropped about 20%. There is a dollar strengthen against the yield and the panel. Now we have taken that as a consideration for our Q4 and it’s dropped about 12% just from the month of September so that – that’s how we relate that. As far as going into 2009, we haven’t given guidance to 2009 but we feel like we are managing the company for profitability and cash flow, trying not to jeopardize the customer position and service, but going into 2009 we expect to get our operating percentages up to where they have been in the past, we are slightly below that.

Rich

Okay, thanks guys.

Operator

[Operators Instruction]. Our next question comes from Ariel Sokol with Wedbush.

Ariel Sokol

Hi guys good afternoon. Certainly upon increased transparency with respect to the RPO business, just a couple of quick questions over here, just kind of thinking very high level. One, what kind of re-precautions for your business are you seeing given to acquisition of web. Do you hire any, or did you acquire any web customers or like vacations of doing so over the next several quarters?

Don Volk

See, we were able to pickup the number very talented executive sales people and we are – again it’s a very competitive marketplace specifically on that Applicant tracking product category. So there are a number of renewals that are pending, of course, we are actively pursuing.

Ariel Sokol

Great. And then next question this market is very challenging for a number of companies, many private vendors who are competing your space, what are your thoughts about acquisitions moving forward over the next year taking advantage of some of the companies that may have some trouble with financing.

Rudy Karsan

We have the opportunistic on acquisition, one of the things that we have noticed is the private valuations haven’t dropped is dramatically the public valuations. I think reiterating of whatever enterprise value of about three or four times we haven’t been able to find cumulative three to four times EBITDA to make it accretive for us, we will keep hunting, and when the mass make sense and the strategy make sense and it gives one of three things, more geography, stronger solutions or offerings I should say and more verticals we will then pull the trigger.

Ariel Sokol

Okay, the last question is if you could speak in regards to how are the other businesses doing, for example how its performing to management during given the challenging times?

Rudy Karsan

We are up quarter over quarter on that as well, like the ATS. So the software business is up. The consulting business is flat to slightly down. And the RPO business is down.

Ariel Sokol

Okay, great. Thank you very much for your time.

Operator

(Operator Instructions). We have no further questions in the queue. I would like to turn it back to Rudy Karsan for any closing comments.

Rudy Karsan

Thanks Paul. I guess in summary I would like to say that thanks for joining the call. We were like we have some competition today in this time slot and for those of you who have joined the call, we do appreciate your time. We do appreciate the continued support from the Street. And as I said in my prepared comments, the tide will turn. Look forward to talk to you a quarter from now. Good night.

Operator

Once again, that does conclude our conference call for today. We thank you for your participation. Have a great day.

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