SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

 

 

Form 10-K

 

 

Commission file number 0-27975

 

 

 

 

eLoyalty Corporation

(Exact Name of Registrant as Specified in Its Charter)

 

 

150 Field Drive, Suite 250

Lake Forest, Illinois 60045

(Address of Registrant’s Principal Executive Offices) (Zip Code)

 

Registrant’s telephone number, including area code: (847) 582-7000

Securities registered pursuant to Section 12(b) of the Act:

Common Stock, par value $0.01 per share

Preferred Stock Purchase Rights

Securities registered pursuant to Section 12(g) of the Act: None

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes  o      No  þ

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes  o      No  þ

 

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

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  Yes  þ      No  o

 

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

Large accelerated filer  o      Accelerated filer þ      Non-accelerated filer  o

 

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

 

The aggregate market value of Common Stock held by non-affiliates of the registrant, based upon the closing price per share of registrant’s Common Stock on July 1, 2006, as reported by The NASDAQ Stock Market LLC, is approximately $107,312,558.

 

The number of shares of the registrant’s Common Stock, $0.01 par value per share, outstanding as of March 8, 2007 was 9,334,249.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of eLoyalty’s Proxy Statement for its 2007 Annual Meeting of Stockholders, to be filed within 120 days after the end of eLoyalty’s fiscal year, are incorporated herein by reference into Part III where indicated.

 

 

TABLE OF CONTENTS

 

PART I

 

 

This Annual Report on Form 10-K (this “Form 10-K”) contains forward-looking statements that are based on current management expectations, forecasts and assumptions. These include, without limitation, statements containing the words “believes”, “anticipates”, “estimates”, “expects”, “plans”, “intends”, “projects”, “future”, “should”, “could”, “seeks”, “target”, “may”, “will continue to”, “predicts”, “forecasts”, “potential”, “guidance”, “outlook” and similar expressions, references to plans, strategies, objectives and anticipated future performance and other statements that are not strictly historical in nature. These forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those expressed or implied by the forward-looking statements. Such risks, uncertainties and other factors that might cause such a difference include, without limitation, those noted under “Risk Factors” included in Item 1A, Part I of this Form 10-K, as well as the following:

 

 

 

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

 

Our executive office is located at 150 Field Drive, Suite 250, Lake Forest, Illinois 60045 (telephone number 847-582-7000).

 

Overview

 

eLoyalty is a leading management consulting, systems integration, and managed services company focused on optimizing customer interactions. With professionals throughout North America and an additional presence in Europe, eLoyalty offers a broad range of enterprise CRM services and solutions that include: creating customer strategies; defining technical architectures; improving sales, service and marketing processes; and selecting, implementing, integrating, supporting and hosting best-of-breed CRM and analytics software applications.

 

eLoyalty is focused on growing and developing its business through two primary Service Lines: Behavioral Analytics ^tm and Converged Internet Protocol Contact Center (“CIPCC”) Solutions. Through these Service Lines and through our traditional CRM business, the Company generates three types of revenue: Consulting services revenue is generally project-based and sold on a time and materials or fixed-fee basis. Managed services revenue is recurring, annuity revenue that is secured through long-term (generally one to five year) contracts. Product revenue is generated through the resale of third-party software and hardware. The chart below shows the relationship between these Service Lines and the types of revenue generated from each.

 

 

In recent years, eLoyalty has invested heavily to develop the following differentiated capabilities in our primary Service Lines:

 

Behavioral Analytics ^tm

 

eLoyalty pioneered this solution, which applies human behavioral modeling to analyze and improve customer interactions. Using its Behavioral Analytics ^tm solution, eLoyalty can help clients:

 

 

 

eLoyalty has designed a scalable application platform to enable the Company to rapidly implement Behavioral Analytics ^tm solutions for its clients. The Behavioral Analytics ^tm solution is delivered as a subscription service, primarily in a remote-hosted model.

 

Converged Internet Protocol Contact Center Solutions

 

eLoyalty’s CIPCC Service Line focuses on helping clients realize the benefits of transitioning their contact centers to a single network infrastructure from the traditional two-network (voice network and separate data network) model. These benefits include cost savings, remote agent flexibility and application enhancements. eLoyalty has developed a set of tools and methodologies to help clients financially model, plan migration paths, and configure, integrate and support Converged Internet Protocol (“IP”) network solutions within their contact center environments.

 

The following table and the sections below further describe the various types of revenue we drive from the services we provide to our clients for each of the last three fiscal years:

 

 

Consulting services, Managed services and the resale of Product are frequently sold and delivered together. It is not uncommon for a Consulting services engagement surrounding the design and implementation of customer service or marketing solutions to lead to the sale of both Product and Managed services, including a long-term maintenance and support or hosting relationship. These services and products are packaged and marketed through a common business development team. Our Consulting services and Managed services delivery teams often work together and leverage common tools and methodologies to deliver this spectrum of solutions to our clients.

 

Consulting Services

 

In addition to the Consulting services revenue generated by our Behavioral Analytics ^tm and CIPCC engagements, we derive a substantial portion of our revenue from a broad range of CRM consulting work with long-standing accounts, as well as newer accounts more recently obtained through our Behavioral Analytics ^tm and CIPCC Service Lines. Our Consulting services are billed on a time and materials basis or on a fixed-fee basis and generally include a combination of the following:

 

 

 

Managed Services

 

Growth in Managed services revenue is primarily driven by Behavioral Analytics ^tm and CIPCC engagements. These Managed services consist of the following:

 

 

In addition, we also generate Managed services revenue from two other sources. Marketing Managed Services revenue is generated from the accounts we obtained through the acquisition of the assets of Interelate, Inc. in 2004. The services provided to these accounts include hosted customer and campaign data management and mass email fulfillment. We also continue to provide remote call center application support and maintenance services to a small number of long-term clients. These two sources of Managed services revenue are likely to diminish over time as we focus on growth through the Behavioral Analytics ^tm and CIPCC Service Lines.

 

Product

 

We also generate revenue from the resale of Product, which consists of software and hardware primarily sold through our CIPCC Service Line. The vast majority of this revenue relates to reselling products from Cisco Systems, Inc.

 

Business Segments

 

We operate in two reportable geographic business segments — North America (consisting of the U.S. and Canada) and International. In 2001, we globalized and centralized our delivery, business development and infrastructure organizations and processes. Accordingly, there are no material distinctions between the character and nature of the two segments, other than financial results as discussed herein.

 

Our international operations create special risks, including those relating to the economic conditions in each country, potential currency exchange and credit volatility, restrictions on the movement of cash and certain technologies across national borders, tax issues resulting from multiple tax laws, compliance with a variety of other foreign national and local laws and regulations, political instability and management of a geographically dispersed

organization. If not adequately addressed, these risks may adversely affect our business. See “Risk Factors” included in Item 1A, Part I of this Form 10-K.

 

For information regarding our segment reporting, including domestic and foreign revenue, operating income and total assets, see Note Fifteen “Segment Information” of the “Notes to Consolidated Financial Statements”, appearing under Item 8, Part II of this Form 10-K.

 

Methods of Distribution

 

A substantial majority of our Consulting services, Managed services and Product are provided to our clients through direct contractual relationships. A portion of our revenue, approximately 9% in 2006, is generated from ongoing relationships with other companies, through which we make our services and third party products available to the clients of such companies.

 

Intellectual Property Rights

 

We view as proprietary the intellectual property that underlies our work product resulting from our services for clients, including the intellectual property rights to any custom software developed in the course of an engagement. We protect our intellectual property rights with patents, copyrights, and trademarks, applicable trade secret laws and contractual restrictions on disclosure, licensing and transferring title. In addition, we rely upon a combination of trade secret and common law, employee nondisclosure policies and third-party confidentiality agreements.

 

A majority of our clients require that we grant to them some or all proprietary and intellectual property rights with respect to the original work product resulting from our services, including the intellectual property rights to any custom software developed for them. Absent agreement to the contrary, each grant of proprietary and intellectual property rights limits our ability to reuse work product components with other clients. As a result, it is our practice to retain the rights in the underlying core intellectual property on which it is based, including methodologies, workplans and software. Further, it is our policy to obtain from our clients a license to permit us to market custom software and other original materials to other clients. These arrangements may be nonexclusive or exclusive, and licensors to us may retain the right to sell products and services that compete with those of eLoyalty.

 

Seasonality

 

We typically experience declines in seasonal revenue and earnings globally in the fourth quarter, as the total number of effective billing days on Consulting services engagements are reduced due to holidays and vacations. Additionally, our European operations historically have experienced decreased revenue and earnings in the third quarter because of extended summer vacation periods.

 

Clients

 

During fiscal year 2006, our 5 and 20 largest clients accounted for 42% and 79%, respectively, of our total revenue. One client, United HealthCare Services, Inc., accounted for 20% of our 2006 total revenue. For fiscal year 2006, 18 clients each accounted for over $1 million of total revenue. While our focus, consistent with the nature of our Managed services offering, is on developing long-term relationships with our clients, the nature of our business is such that our activities with specific clients will fluctuate periodically as individual Consulting services projects are initiated and progress through their lifecycle. As a result, the percentage of total revenue contributed by any particular client can be expected to vary, perhaps significantly, among periods. See Note Two “Summary of Significant Accounting Policies” of the “Notes to Consolidated Financial Statements” included in Item 8, Part II of this Form 10-K.

 

Competition

 

We operate in a highly competitive and rapidly changing market and compete with a variety of organizations that offer services similar to ours. The market includes a variety of participants that compete with us at various levels of our business, including strategic consulting firms, systems integrators, web-consulting firms, software vendors, online agencies and firms that provide both consulting and systems integration services, including certain of our

vendors. In our opinion, few competitors offer the full range and depth of CRM services that we can provide. We believe that our principal competitors are the “Big 5” consultancies: Accenture, Cap Gemini, Deloitte Consulting, Bearing Point Consulting and IBM IGS.

 

Many of our competitors have longer operating histories, more clients, longer relationships with their clients, greater brand or name recognition and significantly greater financial, technical, marketing and public relations resources than we do. As a result, our competitors may be in a better position to respond quickly to new or emerging technologies and changes in client requirements. They may also develop and promote their products and services more effectively than we do. New market entrants also pose a threat to our business. Existing or future competitors may develop or offer solutions that are comparable or superior to ours at a lower price.

 

Employees

 

As of December 30, 2006, we employed 406 people. None of our employees are represented by a union.

 

Available Information and Other

 

Our principal internet address is www.eloyalty.com. Our Annual, Quarterly and Current Reports on Forms 10-K, 10-Q and 8-K, and any amendments thereto, as well as the Forms 3, 4 and 5 beneficial ownership reports filed with respect to our stock, are made available free of charge on our website as soon as reasonably practicable after such material is filed with, or furnished to, the SEC. However, the information found on our website is not part of this or any other report filed by us with the SEC.

 

There is a range of risks and uncertainties that could adversely affect our business and our overall financial performance. In addition to the matters discussed elsewhere in this Form 10-K, we believe the more significant of such risks and uncertainties include the following:

 

We depend on a limited number of clients for a significant portion of our revenue, and the loss of a significant customer or a substantial decline in the number or scope of projects we do for a significant customer would have a material adverse effect on our business.

 

We derive and expect to continue to derive for the foreseeable future a significant portion of our total revenue from a limited number of clients. See “Business” and “Clients” in Item 1, Part I and “Year Ended December 30, 2006 Compared with the Year Ended December 31, 2005” included in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 7, Part II of this Form 10-K. With the exception of our Behavioral Analytics ^tm subscription clients, the volume of services that we provide for a specific client is likely to vary from year to year, and a major client in one year might not use our services in a subsequent year. To the extent that any significant client uses less of our services or terminates its relationship with us, as may occur as clients respond to conditions affecting their own business, our total revenue could decline substantially, which could seriously harm our business.

 

We depend on good relations with our major clients, and any harm to these good relations may materially and adversely harm our business or our ability to compete effectively.

 

To attract and retain clients, we depend to a large extent on our relationships with our customers and our reputation for high quality Consulting services and Managed services. We design, create, implement, host, maintain and support applications and solutions that are often critical to our clients’ businesses. We believe that we generally enjoy good relations with our clients. If a client is not satisfied with our services, products or solutions, including those of subcontractors we employ, it may be damaging to our reputation and business. Any defects or errors in our services or solutions or failure to meet our clients’ expectations could result in:

 

 

 

If we fail to meet our contractual obligations with our clients, we could be subject to legal liabilities or loss of clients. Although our contracts typically include provisions to limit our exposure to legal claims for the services and solutions we provide and the applications and systems we develop or integrate, these provisions may not protect us in all cases.

 

We have not realized a profit in seven years and there is no guarantee that we will realize a profit in the foreseeable future.

 

As of December 30, 2006, we had an accumulated deficit of $139.8 million. We incurred net losses of $12.6 million in 2006 and $9.1 million in 2005, and may continue to incur net losses in the future.

 

If we do not effectively manage the risks associated with increasingly complex client projects and new service offerings, our profit margins and our financial results may suffer.

 

We may fail to accurately estimate the time and resources necessary for the performance of our services. It can be difficult to judge the time and resources necessary to complete Consulting services projects, to deploy, support and operate hosted solutions, or to support and maintain complex contact center architectures. A number of different risks must be accounted for, including, without limitation, the variability and predictability of the number, size, scope, cost, and duration of and revenue from client engagements, unanticipated cancellations or deferrals of client contracts or follow-on phases of engagements in process, collection of revenue, variable employee utilization rates, project personnel costs and engagement requirements. Accurate estimates as to the costs and timing of completion of engagements is particularly important for the limited number that are performed on a fixed-price or not-to-exceed basis. Our failure to accurately estimate these risks could reduce the profitability of, or result in a loss on, our engagements and could damage our client relationships and our reputation.

 

Our ability to recruit talented professionals and retain our existing professionals, are critical to the success of our business.

 

We believe that our success will depend substantially on our ability to attract, train, motivate and retain highly skilled management, strategic, technical, product development and other key professional employees. The information technology services industry continues to be people-intensive and faces a shortage of qualified personnel, especially those with specialized skills or experience. We compete with other companies to recruit and hire from this limited pool. If we cannot hire and retain qualified personnel, or if a significant number of our current employees leave, we may be unable to complete or retain existing engagements or bid for new engagements of similar scope and revenue.

 

If one or more of our key personnel were unable or unwilling to continue in their present positions, they could be difficult to replace and our business could be seriously harmed. This would result not only in the loss of key employees, but also potentially in the loss of client relationships or new business opportunities. In addition, there is no guarantee that the employee and customer non-solicitation and non-competition agreements we have entered into with our senior professionals would deter them from departing us for our competitors or that such agreements would be upheld and enforced by a court or other arbiter across all jurisdictions where we engage in business.

 

We rely heavily on our senior management team for the success of our business.

 

Given the highly specialized nature of our services, senior management must have a thorough understanding of our service offerings as well as the skills and experience necessary to manage the organization. If one or more members of our senior management team leaves and we cannot replace them with a suitable candidate quickly, we could experience difficulty in managing our business properly, and this could harm our business prospects, client relationships, employee morale and results of operations.

 

Our industry is very competitive and, if we fail to compete successfully, our market share and business will be adversely affected.

 

We operate in a highly competitive and rapidly changing market and compete with a variety of organizations that offer services similar to those we offer. The market includes a variety of participants that compete with us at various levels of our business, including strategic consulting firms, systems integrators, general information technology services providers, web consulting firms, application service providers, and other firms that provide both consulting and systems integration services and solutions. New market entrants also pose a threat to our business.

 

Many of our competitors have longer operating histories, more clients, and longer relationships with their clients, greater brand or name recognition and significantly greater financial, technical, marketing and public relations resources than we do. As a result, our competitors may have enhanced abilities to compete for specific clients and market share generally, including through substantial economic incentives to clients to secure contracts. Existing or future competitors may develop or offer solutions that are comparable or superior to ours at a lower price. In addition, our competitors may be in a better position to respond quickly to new or emerging technologies and changes in client requirements or expectations. They may also develop and promote their products and services more effectively than we do and be better able to compete for skilled professionals by offering substantial compensation incentives.

 

We must keep pace with the rapid rate of technological innovation and change, as well as evolving industry standards, in order to build our business.

 

Our industry is characterized by rapid and continually changing technologies, the introduction of many new products and services and evolving industry standards and client preferences. Our solutions must meet the requirements of and achieve significant acceptance among our current and prospective clients within this environment. Our future business will depend on our continuing ability to adapt to and incorporate changing technologies and emerging industry standards and to remain knowledgeable with respect to emerging CRM technology, customer loyalty research and applied CRM solutions.

 

In addition, our future business depends upon continued growth in the acceptance and use of CRM methodologies and technologies by our current and prospective clients and their customers and suppliers. Their acceptance and usage in turn may depend upon factors such as: the actual or perceived benefits of adoption and implementation of CRM methodologies and technologies, including the predictability of a meaningful return on investment, cost efficiencies or other measurable economic benefits; their actual or perceived ease of use and access to such new technologies and methodologies; and their willingness to adopt new business methods incorporating a customer-centric approach.

 

We cannot assure that we will be successful in anticipating or responding to these developments and challenges on a timely or competitive basis or at all, or that our ideas and solutions will be successful in the marketplace. In addition, new or disruptive technologies and methodologies by our competitors may make our service or solution offerings uncompetitive. Any of these circumstances could adversely affect our ability to obtain and successfully complete substantial new client engagements that are important to maintain and grow our business. The recent growth of and intensifying competition within the CRM market may increase these challenges.

 

We depend on our ability to rapidly learn, use and integrate software and other technology developed by third parties to successfully compete in the CRM market, and our ability to maintain and grow our business may be affected by our ability to maintain strong relationships with CRM software providers and other alliance partners.

 

To provide certain of our solutions and services, we rely on third party software, telephony and other infrastructure and related services. If we are unable to integrate these components in a fully functional manner, we may experience difficulties that could delay or prevent the successful development, introduction or marketing of new solutions. We could also incur substantial costs if we need to modify our services or infrastructure to adapt to changes in these third party products and services.

 

We have invested time and resources in seeking to maintain strong relationships with applicable software and technology providers and we plan to make additional investments in the future. The benefits we anticipate from these relationships play an important role in our future growth strategies. We rely on these relationships with third party vendors and alliance partners to allow us to rapidly learn about their existing and next generation technologies, to develop appropriate methods to integrate their products and services into our solutions and to obtain joint sponsorship of solution offerings. If we are unable to initiate and successfully maintain these relationships, we may fail to obtain the future benefits we hope to derive from them and significantly reduce our ability to successfully create and deploy new solution offerings incorporating their technologies. In addition, we may be adversely affected by the failure of one or more of our vendors or alliance partners, which could lead to reduced marketing exposure, fewer sales leads or joint marketing opportunities and a diminished ability to gain access to or develop leading-edge solutions. As our most important alliance relationships are non-exclusive, our alliance partners are also free to establish similar or preferred relationships with our competitors. These circumstances could adversely impact the success of our growth strategies that, in turn, could adversely affect our results of operations.

 

If growth in the use of CRM technologies declines, demand for our services may decrease.

 

CRM application and infrastructure technologies are central to many of our solutions. Our business depends upon continued growth in the use of these technologies by our clients, prospective clients and their customers and suppliers. If the number of users of this technology does not increase and commerce using this technology does not become more accepted and widespread, demand for our services may decrease. Factors that may affect the usage of this technology include:

 

 

It may be difficult for us to access debt or equity markets to meet our financial needs.

 

We may need to raise additional funds in the future, through public or private debt or equity financings, which may not be available on terms favorable to us or at all. While we believe that existing cash resources will be sufficient to satisfy our operating cash needs for the next 12 months, any substantial decline in our revenue would likely cause us to use cash more rapidly than anticipated. Future decreases in our operating results, cash flow or stockholders’ equity may impair our future ability to raise these funds as and when needed. As a result, we may not be able to maintain adequate liquidity to support our operations, take advantage of new service or solution offerings or business expansion opportunities or respond to competitive pressures.

 

We have a limited ability to protect our intellectual property rights, which are important to our success and competitive position.

 

Our ability to protect our software, methodologies and other intellectual property is important to our success and our competitive position. We regard our intellectual property rights as proprietary and attempt to protect them with patents, copyrights, trademarks, trade secret laws, confidentiality agreements and other methods. Despite our efforts to protect our intellectual property rights from unauthorized use or disclosure, parties may attempt to disclose, obtain or use our rights. The steps we take may not be adequate to prevent or deter infringement or other misappropriation of our intellectual property rights. In addition, we may not detect unauthorized use of, or take timely and effective actions to enforce and protect, our intellectual property rights. Existing laws of some countries in which we provide services or solutions afford more limited protection of intellectual property rights than laws in the United States.

 

We may be required to obtain licenses from others to refine, develop, market and deliver current and new services and solutions. There can be no assurance that we will be able to obtain any of these licenses on commercially reasonable terms or at all, or that rights granted by these licenses ultimately will be valid and enforceable.

 

Others could claim that our services, software or solutions infringe upon their intellectual property rights or violate contractual protections.

 

We believe that our services, software and solutions do not infringe upon the intellectual property rights of others. However, we or our clients may be subject to claims that our services, products or solutions, or the products of others that we offer to our clients, infringe upon the intellectual property rights of others. Any infringement claims may result in substantial costs, divert management attention and other resources, harm our reputation and prevent us from offering some services, software or solutions. A successful infringement claim against us could materially and adversely affect our business.

 

In our contracts, we generally agree to indemnify our clients for expenses and liabilities resulting from claimed infringement by our services, software or solutions, excluding third party components, of the intellectual property rights of others. In some instances, the amount of these indemnities may be greater than the revenue we receive from the client. In addition, our business includes the development of customized software modules in connection with specific client engagements, particularly in our systems integration business. We often assign to clients the copyright and, at times, other intellectual property rights in and to some aspects of the software and documentation developed for these clients in these engagements. Although our contracts with our clients generally provide that we also retain rights to our intellectual property, it is possible that clients may assert rights to, and seek to limit our ability to resell or reuse, this intellectual property.

 

Increasing government regulation could cause us to lose clients or impair our business.

 

We are subject not only to regulations applicable to businesses generally, but we and the solutions we offer to our clients also may be subject to United States and foreign laws and regulations directly applicable to electronic commerce, the Internet and data privacy. Laws and regulations in the United States, as well as legislative initiatives that may be considered in the future, may increase regulation of the Internet and impose additional restrictions relating to the privacy of personal data. We may be affected indirectly by any such legislation to the extent that it decreases acceptance or growth of the Internet or otherwise impacts our existing and prospective clients. Any such laws and regulations therefore could affect our existing business relationships or prevent us from getting new clients.

 

Our financial results are subject to significant fluctuations because of many factors, any of which could adversely affect our stock price.

 

It is possible that in some future periods our operating results may be below the expectations of public market analysts and investors. In this event, the price of our common stock may fall. Our revenue and operating results may vary significantly due to a number of factors, many of which are not in our control. These factors include:

 

 

 

We must maintain our reputation and expand our name recognition to remain competitive.

 

We believe that establishing and maintaining a good reputation and brand name is critical for attracting and expanding our targeted client base. If our reputation is damaged or if potential clients do not know what solutions we provide, we may become less competitive or lose our market share. Promotion and enhancement of our name will depend largely on our success in providing high quality services, software and solutions, which cannot be assured. If clients do not perceive our solutions to be effective or of higher quality, our brand name and reputation could be materially and adversely affected.

 

Our clients use our solutions for critical applications. Any errors, defects or other performance problems, including those in our proprietary software or products supplied by third party vendors, could result in financial or other damages. In addition to any liability we might have, performance problems could also adversely affect our brand name and reputation.

 

As of December 30, 2006, we have no unresolved comments from the SEC.

 

Our principal physical properties employed in our business consist of our leased office facilities in Lake Forest, Illinois; Eden Prairie, Minnesota; and Austin, Texas. Our total employable leased square footage is approximately 48,000. This excludes properties where we remain as the lessee but where the property has been closed as part of cost-reduction efforts and the anticipated costs therefore have been reserved for as part of severance and related costs. See Note Four “Severance and Related Costs” of the “Notes to Consolidated Financial Statements” included in Item 8, Part II of this Form 10-K. We do not own any real estate. We believe that our leased facilities are appropriate for our current and anticipated business requirements.

 

eLoyalty, from time to time, has been subject to legal claims arising in connection with its business. While the results of these claims cannot be predicted with certainty, there are no asserted claims against eLoyalty that, in the opinion of management, if adversely decided, would have a material effect on eLoyalty’s financial position, results of operations or cash flows.

 

No matters were submitted to a vote of security holders, through the solicitation of proxies or otherwise, during the fourth quarter of our fiscal year 2006.

 

The following table includes the name, age (as of March 13, 2007), current position and term of office of each of our executive officers.

 

 

Except as required by individual employment agreements between executive officers and the Company, there exists no arrangement or understanding between any executive officer and any other person pursuant to which such executive officer was elected. Each executive officer serves until his or her successor is elected and qualified or until his or her earlier removal or resignation.

 

The principal business experience of the executive officers for at least the last five years is as follows:

 

Kelly D. Conway has been the President and Chief Executive Officer and a Director of eLoyalty since its incorporation in May 1999. Mr. Conway joined Technology Solutions Company (“TSC”) in November 1993 as Senior Vice President, assumed the position of Executive Vice President in July 1995 and became Group President in October 1998. Prior to joining TSC, Mr. Conway served as a Partner in the management consulting firm of Spencer, Shenk and Capers and held various positions, including President and Chief Executive Officer with Telcom Technologies, a manufacturer of automatic call distribution equipment.

 

Karen Bolton has been Vice President, Client Services of eLoyalty since December 2004. Ms. Bolton joined TSC in 1998 as a Vice President of its Australian subsidiary, which became a subsidiary of eLoyalty prior to its spin off from TSC. She relocated to the United States in 2002, becoming a Vice President of eLoyalty, and was appointed Vice President, Global Accounts in 2003.

 

Christopher J. Danson has been Vice President, Delivery of eLoyalty since December 2004. From February 1993 until joining eLoyalty as Senior Vice President, Research & Development in February 2000, Mr. Danson held various positions with TSC in its ECM/Call Center practice, including Senior Vice President from September 1998 until February 2000, Vice President from June 1996 until September 1998 and Senior Principal for TSC Europe from June 1995 until June 1996. From 2002 until 2004, Mr. Danson served as a Vice President and Delivery Team Leader for eLoyalty’s Technology Delivery Team.

 

Steven C. Pollema has been Vice President, Operations and Chief Financial Officer of eLoyalty since December 2004. Prior to that Mr. Pollema served as Vice President, Delivery and Operations of eLoyalty since August 2001, after joining eLoyalty in June 2001 as Senior Vice President, Operations. Prior to joining eLoyalty, Mr. Pollema had been with MarchFirst, Inc. and its predecessor, Whittman-Hart, Inc., since June 1997, most recently as its President from March 2001 to May 2001. Prior to assuming the office of President, Mr. Pollema was Executive Vice President-Global Operations of MarchFirst from October 2000 through March 2001 and Managing Executive — Chicago Office/Region from October 1998 to October 2000. Prior to July 1997, Mr. Pollema was with Andersen Consulting, LLC, most recently as an Associate Partner.

 

Steven H. Shapiro has been Vice President, General Counsel and Corporate Secretary of eLoyalty since April 2006. Prior to joining eLoyalty, Mr. Shapiro served as Executive Vice President and Corporate Secretary of First Midwest Bancorp, Inc. from January 2003 until April 2006. Prior to January 2003, Mr. Shapiro was Deputy General Counsel and Assistant Secretary of FMC Technologies, Inc.

 

Please note that, in February 2002, we ceased using the title Senior Vice President for any of our officers. All persons previously holding that title currently hold the title of Vice President. For simplicity, the current office of each of the executive officers, other than Mr. Conway, is characterized as that of Vice President with respect to his or her current role in the organization. Certain of the executive officers were Senior Vice Presidents at the time they assumed those roles.

 

Our common stock, par value $0.01 per share, is traded on the NASDAQ Global Market under the symbol ELOY. The following table sets forth, for the periods indicated, the quarterly high and low sales prices of the common stock on the NASDAQ Global Market.

 

 

There were approximately 300 owners of record of our common stock as of March 5, 2007.

 

Stock Performance Graph

 

The following graph compares the cumulative total stockholder return on eLoyalty Common Stock with the cumulative total return of (i) the NASDAQ Global Market Index, and (ii) a peer group of other publicly traded information technology consulting companies selected by the Company (the “Peer Group Index”). Cumulative total stockholder return is based on the period from December 28, 2001 through eLoyalty’s fiscal year end on Saturday, December 30, 2006. The comparison assumes that $100 was invested on December 28, 2001 in each of eLoyalty Common Stock, the NASDAQ Global Market Index and the Peer Group Index, and that any and all dividends were reinvested.

 

Comparative Cumulative Total Return
For eLoyalty Corporation,
NASDAQ Global Market Index and Peer Group Index

 

 

 

 

See “Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters” included in Item 12, Part III of this Form 10-K for more information about securities authorized for issuance under our various compensation plans.

 

Dividends

 

Historically, we have not paid cash dividends on our common stock, and do not expect to do so in the future. However, cash dividends of approximately $1.5 million, in the aggregate, were paid in January and July of 2006 on the Company’s Series B convertible preferred stock (the “Series B stock”), which accrues dividends at the rate of 7% per year, payable semi-annually. A dividend payment of approximately $0.7 million was paid in January 2007 on the Series B stock. In addition, a semi-annual dividend payment of approximately $0.7 million is expected to be paid in future periods on the Series B stock. The amount of each such dividend would decrease by any conversions of the Series B stock into common stock, although such conversions would require us to pay accrued but unpaid dividends at time of conversion. Conversions of Series B stock became permissible at the option of the holder after June 19, 2002.

 

The following tables summarize our selected financial data. This information should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations, and the Consolidated Financial Statements of eLoyalty and notes thereto, which are included elsewhere in this Form 10-K. The statements of operations data for the fiscal years ended 2006, 2005, 2004, 2003 and 2002 and the balance sheet data as of December 30, 2006, December 31, 2005, January 1, 2005, December 27, 2003 and December 28, 2002, below, are derived from our audited financial statements. Fiscal year 2004 consisted of fifty-three weeks instead of fifty-two weeks, which did not have a material impact on our financial position or results of operations.

 

 

 

 

 

 

 

 

Critical Accounting Policies and Estimates

 

Our management’s discussion and analysis of financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates, including those related to the costs and timing of completion of client projects, our ability to collect accounts receivable, the timing and amounts of expected payments associated with cost reduction activities, the ability to realize our net deferred tax assets, contingencies and litigation. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions.

 

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

 

Revenue Recognition

 

eLoyalty derives a majority of its revenue from professional services. Almost half of this revenue is from Consulting services that involve operational consulting and integrating or building of a system for clients. eLoyalty

provides Consulting services on a time and materials basis or on a fixed-fee basis. For the integration or the building of a system and the performance of a Behavioral Analytics ^tm Assessment, eLoyalty recognizes revenue based on services performed with performance generally assessed on the ratio of actual hours incurred to date compared to the total estimated hours over the entire contract. For all other Consulting services, we recognize revenue as the service is performed for the client.

 

Revenue from fixed price Managed services contracts is recognized ratably over the contract period. As an example, many of our CCMS support and maintenance agreements are priced at a fixed amount for a specific period. For all other Managed services, we recognize revenue and bill customers as the work is performed for the client as the amount billed is based upon the customer usage each month. For example, revenue related to Behavioral Analytics ^tm subscriptions would be recognized as the service is provided to the client, based on the number of customer service representatives and/or hours of calls analyzed.

 

Revenue associated with the installation or set-up of long-term Managed services contracts is deferred until the installation is complete and is then recognized over the estimated life of the related Managed services engagement. Engagements related to our Behavioral Analytics ^tm offering typically require this accounting treatment as installation activities are performed prior to the commencement of the subscription services. As of December 30, 2006 and December 31, 2005, we had deferred revenue totaling $5.5 million and $1.2 million, respectively, related to Behavioral Analytics ^tm engagements. This deferred revenue is recognized over the term of the applicable subscription contract. The terms of these subscription contracts generally range from three to five years. Installation costs incurred are deferred up to an amount not to exceed the amount of deferred installation revenue and additional amounts that are recoverable based on the contractual arrangement. Such costs are amortized over the term of the subscription contract. Costs in excess of the foregoing revenue amounts are expensed in the period incurred. The deferred costs included in our consolidated balance sheet totaled $3.7 million at December 30, 2006 compared to $1.2 million at December 31, 2005.

 

For fixed price Managed service contracts where we provide support for third-party software and hardware, revenue is recorded at the gross amount of the sale because the contracts satisfy the requirements of Emerging Issues Task Force (“EITF”) 99-19 “Reporting Revenue Gross as a Principal versus Net as an Agent”. If the contract does not meet the requirements of EITF 99-19, Managed services revenue is recorded at the net amount of the sale. Historically, very few transactions did not satisfy the requirements of EITF 99-19. However in 2006, the Company signed a new reseller agreement with its largest vendor that may increase the number of transactions that require the revenue to be recognized for the net amount of the sale.

 

Revenue from the sale of Product, which consists primarily of third-party software and hardware resold by eLoyalty, is recorded at the gross amount of the sale because the contracts satisfy the requirements of EITF 99-19.

 

Software revenue is recognized in accordance with Statement of Position 97-2 “Software Revenue Recognition”. If sufficient vendor-specific objective evidence (“VSOE”) does not exist for the allocation of revenue to the various elements of the arrangement, all revenue from the arrangement is deferred until all elements of the arrangement have been delivered, unless the undelivered elements are post contract support (“PCS”) or other deliverables with similar attribution periods. Contract revenue is then recognized ratably over the remaining PCS period. As of December 30, 2006, $2.1 million of revenue has been deferred due to the lack of VSOE for PCS within these arrangements. This revenue is being recognized ratably over the remaining term of the PCS period.

 

In accordance with EITF 00-21, “Revenue Arrangements with Multiple Elements”, arrangements containing multiple services are segmented into separate elements when the services represent separate earning processes. Revenue related to contracts with multiple elements is allocated based on the fair value of the elements and is recognized in accordance with our accounting policies for each element, as described above. If fair value for each element cannot be established, revenue is deferred until all elements, other than PCS activities, have been delivered to the client. Contract revenue is then recognized ratably over the service period.

 

Reimbursed expenses revenue includes billable costs related to travel and other out-of-pocket expenses incurred while performing services for our clients. The cost of third-party product and support may be included within this category if the transaction does not satisfy the requirements of EITF 99-19 and the net revenue is

recognized as Product or Managed services revenue. An equivalent amount of reimbursable expenses are included in Cost of revenue.

 

Payments received for Managed services contracts in excess of the amount of revenue recognized for these contracts are recorded as Unearned revenue until revenue recognition criteria are met.

 

Our Consulting services and Managed services contracts may contain early termination provisions. In both cases, any amounts payable upon termination of such contracts are recognized when the recognition is probable and estimable.

 

Losses on engagements, if any, are recognized when they are probable and estimable.

 

We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments and customers indicating their intention to dispute their obligation to pay for contractual services provided by us. If the financial condition of our customers was to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.

 

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

 

We recorded accruals for severance and related costs associated with our cost reduction efforts undertaken during fiscal years 2001 through 2006. A substantial portion of the accruals relate to office space reductions, office closures and associated contractual lease obligations that are based in part on assumptions and estimates of the timing and amount of sublease rentals that are affected by overall economic and local market conditions. That portion of the accruals relating to employee severance represents contractual severance for identified employees and generally is not subject to a significant revision. To the extent estimates of the success of our sublease efforts change in the future, adjustments increasing or decreasing the related accruals will be recognized.

 

Stock-Based Compensation

 

We adopted the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123R, “Share-Based Payment”, beginning January 1, 2006, using the modified prospective method. The adoption of SFAS No. 123R did not have a material impact on our financial position or results of operations. SFAS No. 123R requires entities to recognize compensation expense from all share-based payment transactions in the financial statements after the adoption date. SFAS No. 123R establishes fair value as the measurement objective in accounting for share-based payment arrangements and requires all companies to apply a fair-value-based measurement method in accounting for all share-based payment transactions with employees. Historical Company information is the primary basis for the selection of expected life, expected volatility, expected dividend yield assumptions and anticipated forfeiture rates. The risk-free interest rate is selected based on the yields from U.S. Treasury Strips with a remaining term equal to the expected term of the options being valued. Under the modified prospective method, financial statements for periods prior to the date of adoption are not adjusted for the change in accounting.

 

Prior to January 1, 2006, we used the intrinsic value method to account for stock-based employee compensation under Accounting Principles Board Opinion (“APB”) No. 25, “Accounting for Stock Issued to Employees,” and therefore we did not recognize compensation expense in association with options granted at or above the market price of our common stock at the date of grant (see Note Thirteen “Stock-Based Compensation”).

 

Other Significant Accounting Policies

 

For a description of the Company’s other significant accounting policies, see Note Two “Summary of Significant Accounting Policies” of the “Notes to Consolidated Financial Statements” included in Item 8, Part II of this Form 10-K.

 

Forward-Looking Statements

 

For information about forward-looking statement, see discussion under “Business” included in Item 1, Part I of this Form 10-K.

 

Background

 

For background information, see discussion under “Overview” included in Item 1, Part I of this Form 10-K.

 

Business Outlook

 

In fiscal year 2007, we anticipate solid growth in Services revenue as a result of moderate improvement expected in Consulting services revenue and strong growth in our Managed services revenue. This anticipated growth is due to our continued focus on our primary Service Lines, CIPCC and Behavioral Analytics ^tm , and the shifting of selling and delivery resources toward those areas. We expect growth in Managed services revenue as a result of higher CIPCC support and maintenance revenue and substantially higher Behavioral Analytics ^tm deployment and subscription revenue. The increase in Consulting services revenue should result from strong growth in Consulting revenue from our CIPCC and Behavioral Analytics ^tm Service Lines partially offset by a slight decline in revenue from traditional CRM consulting services. Other sources of Managed services revenue, such as remote application maintenance and support and Marketing Managed services, are likely to experience a decline in 2007. We expect to significantly increase our Managed services backlog in 2007 as a result of this growth in these Service Lines. See “Managed Services Backlog” below.

 

Product revenue is likely to increase moderately in 2007 as it is driven by the growth within our CIPCC Service Line. However, there are significant variances in size among the individual engagements within this Service Line and eLoyalty is not always selected as the product supplier for the engagement. As a result, Product revenue levels may fluctuate significantly in each fiscal quarter.

 

We continue to be encouraged by the significant growth of our Managed services backlog described below, the strength of our new business pipeline, and the improvement in our revenue mix that are being driven by our Behavioral Analytics ^tm and CIPCC Service Lines. Gross margins should improve in fiscal year 2007 as we begin to recognize the subscription and deferred deployment revenue associated with an increasing number of Behavioral Analytics ^tm clients. We will continue to invest in the personnel required to sell and manage complex, long-term relationships and in the resources required to develop, deliver and support our innovative Behavioral Analytics ^tm solution. These investments should continue to put pressure on our profitability and cash resources in 2007, but we feel they are required to continue to build a significant Managed services backlog and to build and maintain a competitive advantage.

 

Near-Term Liquidity

 

Our near-term capital resources consist of our current cash balances together with anticipated future cash flows. Our balance of cash and cash equivalents was $31.6 million and $17.9 million as of December 30, 2006 and December 31, 2005, respectively. The Company has financing in place with LaSalle Bank National Association (the “Bank”). The maximum principal amount of the secured line of credit under the agreement remained at $2.0 million through fiscal year 2006 (the “Facility”). In addition, our restricted cash of $0.3 million at December 30, 2006 is available to support letters of credit issued under the Facility for operational commitments, and to accommodate a Bank credit requirement associated with the purchase and transfer of foreign currencies and credit card payments. We anticipate that our current unrestricted cash resources, together with other expected internally generated funds, should be sufficient to satisfy our working capital and capital expenditure needs for the next twelve months.

 

Managed Services Backlog

 

As a result of the strategic and long-term nature of Managed services revenue, we believe it is appropriate to monitor the level of backlog associated with these agreements. The Managed services backlog was $60.7 million and $26.7 million as of December 30, 2006 and December 31, 2005, respectively. Of the December 30, 2006 backlog, approximately 63% is related to our Behavioral Analytics ^tm offering, 26% is related to our CIPCC

offerings and the remaining balance is from other Managed services. eLoyalty uses the term backlog with respect to its Managed services engagements to refer to the expected revenue to be received under the applicable contract, based on its currently contracted terms and, when applicable, currently anticipated levels of usage and performance. Actual usage and performance might be greater or less than anticipated. In general, eLoyalty’s Managed services contracts may be terminated by the customer without cause, but early termination by a customer usually requires a substantial early termination payment. Managed services contracts range from one to five years in duration.

 

 

Net revenue is total revenue excluding reimbursable expenses that are billed to our clients. Our net revenue increased 14% to $85.6 million in fiscal year 2006, up $10.3 million from $75.3 million in fiscal year 2005.

 

Revenue from Consulting services decreased 4% to $44.3 million in fiscal year 2006, down from $46.0 million in fiscal year 2005. Consulting services revenue represented 49% and 58% of total revenue for fiscal years 2006 and 2005, respectively. The decrease in Consulting services revenue is primarily due to decreased demand for our traditional CRM Consulting services, partially offset by the 37% growth of our CIPCC Service Line. Spending by our Consulting services clients fluctuates between periods primarily due to the short-term nature of these agreements, which may result in gaps in client spending due to timing differences between the completion of existing projects and the start of new projects.

 

Revenue from Managed services increased to $27.6 million in fiscal year 2006 from $19.5 million in fiscal year 2005. Managed services revenue represented 31% and 25% of total revenue for fiscal years 2006 and 2005, respectively. The increase in Managed services revenue resulted from the continued growth in our CIPCC Service Line and the transition of several Behavioral Analytics ^tm projects to the subscription phase of their respective arrangements.

 

Revenue from the sale of Product increased $3.9 million, or 40%, to $13.6 million in fiscal year 2006 from $9.7 million in fiscal year 2005. Revenue from the sale of Product represented 15% and 12% of total revenue for fiscal years 2006 and 2005, respectively. This increase is primarily driven by the growth in our CIPCC Service Line. There are significant variances in size among individual engagements within this Service Line and eLoyalty is not always selected as the Product supplier for the engagement. As a result, annual and quarterly Product revenue may fluctuate significantly.

 

Net revenue from North American operations increased 16% to $81.5 million in fiscal year 2006, up $11.5 million from $70.0 million in fiscal year 2005. International operations net revenue (which primarily represents net revenue from Europe and Australia) decreased $1.2 million, or 23%, to $4.1 million in fiscal year 2006 from $5.3 million in fiscal year 2005. As a percentage of consolidated net revenue, net revenue from International operations represented 5% and 7% of net revenue for fiscal years 2006 and 2005, respectively.

 

Utilization of billable consulting personnel was 73% for fiscal year 2006, compared to 72% for fiscal year 2005. Utilization is defined as billed time as a percentage of total available time. We continue to experience pricing pressures that resulted in an average hourly billing rate of $151 for fiscal year 2006 and $154 for fiscal year 2005.

 

Our revenue concentration has increased as our top 5 customers accounted for 42% and 37% of total revenue in fiscal years 2006 and 2005, respectively. The top 10 customers accounted for 62% and 56% of total revenue for fiscal years 2006 and 2005, respectively. In addition, the top 20 customers accounted for 79% of total revenue for fiscal year 2006 and 72% of total revenue for fiscal year 2005. One customer accounted for 10% or more of total revenue in fiscal year 2006. United HealthCare Services, Inc. accounted for 20% of total revenue for fiscal year 2006 and 13% of total revenue for fiscal year 2005, respectively. Higher concentration of revenue with a single customer or a limited group of customers can result in increased revenue risk should one of these clients significantly reduce its demand for our services.

 

Cost of Revenue Before Reimbursed Expenses, Exclusive of Depreciation and Amortization

 

Our most significant operating cost is the cost of revenue before reimbursed expenses, which is primarily comprised of labor costs including salaries, fringe benefits, and incentive compensation of our delivery personnel, third-party pass through costs related to our Managed services and the cost of third-party product. Cost of revenue before reimbursed expenses also includes employee costs for travel expenses, training, laptop computer leases and other expenses of a non-billable nature. Cost of revenue before reimbursed expenses excludes depreciation and amortization.

 

Cost of revenue before reimbursed expenses as a percentage of net revenue is driven primarily by the prices we obtain for our solutions and services, the billable utilization of our Consulting services delivery personnel and the relative mix of business between Consulting services, Managed services and Product. The cost of Product is impacted by our ability to qualify for rebates from our largest Product vendor. The amount of the rebates will vary with the size of our Product revenue, as the rebates are calculated as a percentage of the specific Product cost. Eligibility for these rebates is determined by our ability to meet vendor-established performance criteria, some of which are outside our control. Prior to the third quarter of 2006, we recognized these rebates in our financial statements in the period when any contingency associated with the contractual payment was resolved. In the third quarter of 2006, we began to recognize the value of these rebates in the period we purchase the product because of our historical performance of meeting all required criteria and our ability to reasonably estimate the value of these rebates. The impact of this change resulted in a $0.5 million reduction of Product cost in 2006.

 

Cost of revenue before reimbursed expenses increased $12.0 million, or 21%, to $68.8 million in fiscal year 2006 from $56.8 million in fiscal year 2005. The increase is primarily due to our investment in personnel to develop and support our Behavioral Analytics ^tm and CIPCC solutions, higher third-party support costs driven by growth in our CIPCC related Managed services revenue and increased Product costs, net of rebates, due to higher Product revenue. Product rebates recognized in fiscal year 2006 totaled $2.6 million compared to $1.2 million in fiscal year 2005. Cost of revenue before reimbursed expenses as a percentage of net revenue increased to 80% in fiscal year 2006 compared to 75% in fiscal year 2005. The increase in the percentage in fiscal year 2006 is primarily due to our investment in personnel to develop and support our Behavioral Analytics ^tm and CIPCC solutions and higher third-party support costs driven by growth in our CIPCC related Managed services revenue.

 

Selling, General and Administrative

 

Selling, general and administrative expenses consist primarily of salaries, incentive compensation and employee benefits for business development, marketing, administrative personnel, facilities cost, a provision for uncollectible amounts and costs for our technology infrastructure and applications.

 

Selling, general and administrative expenses increased $4.9 million, or 24%, to $25.3 million in fiscal year 2006 from $20.4 million in fiscal year 2005. This increase was primarily the result of increased personnel costs required to support our Behavioral Analytics ^tm and CIPCC Service Lines.

 

Severance and Related Costs

 

In fiscal years 2006 and 2005, in response to the current business environment and shifting skill and geographic requirements, a number of cost reduction activities were undertaken, principally consisting of personnel reductions. Annual savings related to the cost reduction actions in fiscal year 2006 were $2.4 million and will be realized in fiscal year 2007. Annual savings related to the cost reduction actions in fiscal year 2005 were $1.6 million and were realized in fiscal year 2006. Facility costs related to office space reductions and office closures in fiscal years 2002 and 2001 should be paid pursuant to contractual lease terms through fiscal year 2007. We expect substantially all severance and related costs associated with cost reduction activities to be paid out by the end of the first quarter of 2007, pursuant to agreements entered into with affected employees.

 

Severance and related costs increased $0.3 million, to $0.7 million in fiscal year 2006 compared to $0.4 million in fiscal year 2005. The $0.7 million of expense recorded in fiscal year 2006 is primarily related to employee severance and related costs for the elimination of twelve positions in both our North American and International segments. In fiscal year 2005, severance and related costs of $0.4 million reflects $0.6 million of employee severance and related costs for the elimination of nine positions in both our North American and International segments, offset by favorable adjustments of $0.2 million primarily related to previously estimated facility and severance cost accruals.

 

Depreciation

 

Depreciation expense decreased by $3.1 million, or 60%, to $2.1 million in fiscal year 2006 compared to $5.2 million in fiscal year 2005. The decrease in depreciation is primarily related to assets from our information technology infrastructure and our Marketing Managed services becoming fully depreciated.

 

Amortization of Intangibles

 

Amortization of intangibles decreased $0.1 million, or 20%, to $0.4 million in fiscal year 2006 compared to $0.5 million in fiscal year 2005. The decrease is primarily due to intangible assets related to the Interelate Acquisition being fully amortized.

 

Operating Loss

 

Primarily as a result of the previously-described business conditions, we experienced an operating loss of approximately $11.8 million for fiscal year 2006, compared to an operating loss of approximately $8.0 million for fiscal year 2005.

 

Interest and Other Income (Expense), net

 

Non-operating interest and other income (expense) increased $0.3 million, or 75%, to $0.7 million in fiscal year 2006 compared to $0.4 million in fiscal year 2005. The $0.3 million increase was primarily related to higher yields on our investments.

 

Income Tax (Provision) Benefit

 

Income tax provision was $0.1 million in fiscal year 2006 compared to almost $0 in fiscal year 2005. As of December 30, 2006, total deferred tax assets of $56.6 million are fully offset by a valuation allowance. The level of uncertainty in predicting when we will return to acceptable levels of profitability, sufficient to utilize our net U.S. and non-U.S. operating losses and realize our deferred tax assets requires that a full income tax valuation allowance be recognized in the financial statements.

 

Net Loss Available to Common Stockholders

 

We reported a net loss available to common stockholders of $12.6 million in fiscal year 2006 as compared with a net loss available to common stockholders of $9.1 million in fiscal year 2005. We reported a net loss of $1.86 per share on a basic and diluted basis in fiscal year 2006 compared to a net loss of $1.43 per share on a basic and diluted basis in fiscal year 2005.

 

 

Net revenue is total revenue excluding reimbursable expenses that are billed to our clients. Our net revenue increased 10% to $75.3 million in fiscal year 2005, up $7.1 million from $68.2 million in fiscal year 2004.

 

Revenue from Consulting services decreased $4.2 million, or 8%, to $46.0 million in fiscal year 2005 from $50.2 million in fiscal year 2004. Consulting services revenue represented 58% and 69% of total revenue for fiscal years 2005 and 2004, respectively. The decrease in Consulting services revenue was primarily due to lower spending by our top five clients, partially offset by increased spending at various new and existing clients. Spending by our Consulting services clients fluctuated between periods primarily due to the short-term nature of these agreements, which may have resulted in gaps in client spending due to timing differences between the completion of existing projects and the start of new projects.

 

Revenue from Managed services increased $4.6 million, or 31%, to $19.5 million in fiscal year 2005 from $14.9 million in fiscal year 2004. Managed services revenue represented 25% and 21% of total revenue for fiscal years 2005 and 2004, respectively. Of the increased Managed services revenue from 2004 to 2005, $3.2 million reflected the full year impact of the Interelate Acquisition; $1.5 million was driven by growth in Contact Center Managed services through our CIPCC Service Line; and $0.6 million was from growth in Behavioral Analytics ^tm Managed services. The growth in these areas was partially offset by a $0.7 million decrease in revenue from legacy remote application maintenance and support Managed services.

 

Revenue from the sale of Product increased $6.5 million, to $9.7 million in fiscal year 2005 from $3.2 million in fiscal year 2004. Revenue from the sale of Product represented 12% and 4% of total revenue for fiscal years 2005 and 2004, respectively. While this revenue was primarily driven by the growth in our CIPCC Service Line, there were significant variances in size among individual engagements within this Service Line and eLoyalty was not always selected as the Product supplier for the engagement. As a result, annual and quarterly Product revenue may have fluctuated significantly.

 

Net revenue from North American operations increased $8.3 million, or 13%, to $70.0 million in fiscal year 2005 from $61.7 million in fiscal year 2004. International operations revenue (which primarily represented revenue from Europe and Australia) decreased $1.2 million, or 18%, to $5.3 million in fiscal year 2005 from $6.5 million in fiscal year 2004. As a percentage of consolidated net revenue, net revenue from International operations represented 7% and 10% of net revenue for fiscal years 2005 and 2004, respectively. The decrease in International operations revenue was driven by reduced demand for our services at our largest international client.

 

Utilization of billable consulting personnel was 72% and 74% for fiscal years 2005 and 2004, respectively. Utilization is defined as billed time as a percentage of total available time. We continue to experience pricing pressures that resulted in an average hourly billing rate of $154 and $161 for fiscal years 2005 and 2004, respectively.

 

Our revenue concentration has decreased as our top 5 customers accounted for 37% and 52% of total revenue in fiscal years 2005 and 2004, respectively. The top 10 customers accounted for 56% and 66% of total revenue in fiscal years 2005 and 2004, respectively. In addition, the top 20 customers accounted for 72% of total revenue in fiscal year 2005 and 80% of total revenue in fiscal year 2004. One customer accounted for 10% or more of total revenue in fiscal year 2005. United HealthCare Services, Inc. accounted for 13% of total revenue in fiscal years 2005 and 2004, respectively. Higher concentration of revenue with a single customer or a limited group of customers can result in increased revenue risk should one of these clients significantly reduce its demand for our services.

 

Cost of Revenue Before Reimbursed Expenses, Exclusive of Depreciation and Amortization

 

Our most significant operating cost is the cost of revenue before reimbursed expenses, which is primarily comprised of labor costs including salaries, fringe benefits, and incentive compensation of our delivery personnel, third-party pass through costs related to our Managed services and the cost of third-party product. Cost of revenue before reimbursed expenses also includes employee costs for travel expenses, training, laptop computer leases and other expenses of a non-billable nature. Cost of revenue before reimbursed expenses excludes depreciation and amortization.

 

Cost of revenue before reimbursed expenses as a percentage of net revenue is driven primarily by the prices we obtain for our solutions and services, the billable utilization of our Consulting services delivery personnel and the relative mix of business between Consulting services, Managed services and Product.

 

Cost of revenue before reimbursed expenses increased $7.9 million, or 16%, to $56.8 million in fiscal year 2005 from $48.9 million in fiscal year 2004. The increase was primarily due to additional product costs, net of vendor rebates, of $4.9 million, and increased personnel costs primarily associated with our investment in the Behavioral Analytics ^tm offering and the full year impact of the Interelate Acquisition, of $2.5 million. Cost of revenue before reimbursed expenses as a percentage of net revenue increased to 75% in fiscal year 2005 compared to 72% in fiscal year 2004. This percentage increase was primarily due to the impact of lower billing rates and lower billable utilization in fiscal year 2005 when compared to fiscal year 2004 experience.

 

Selling, General and Administrative

 

Selling, general and administrative expenses consist primarily of salaries, incentive compensation and employee benefits for business development, marketing, administrative personnel, facilities cost, a provision for uncollectible amounts and costs for our technology infrastructure and applications.

 

Selling, general and administrative expenses increased $0.9 million, or 5%, to $20.4 million in fiscal year 2005 from $19.5 million in fiscal year 2004. This increase was primarily the result of increased personnel costs associated with supporting our Service Line offering. In addition, fiscal year 2004 included the impact of a $0.5 million favorable adjustment resulting from the final determination of a previous estimate related to the collection of a receivable.

 

Severance and Related Costs

 

In fiscal years 2005 and 2004, in response to the current business environment and shifting skill and geographic requirements, a number of cost reduction activities were undertaken, principally consisting of personnel reductions. These actions were designed to shape the workforce to meet eLoyalty’s expected business requirements. Severance and related costs associated with cost reduction activities in fiscal year 2005 were paid out by the end of the first quarter of 2006, pursuant to agreements entered into with affected employees. Facility costs related to office space reductions and office closures in fiscal years 2002 and 2001 will be paid pursuant to contractual lease terms through fiscal year 2007.

 

Severance and related costs decreased $0.5 million, or 56%, to $0.4 million in fiscal year 2005 compared to $0.9 million in fiscal year 2004. In fiscal year 2005, severance and related costs of $0.4 million reflected $0.6 million of employee severance and related costs for the elimination of nine positions in both our North American and International segments, offset by favorable adjustments of $0.2 million primarily related to previously estimated

facility and severance cost accruals. In fiscal year 2004, severance and related costs of $0.9 million included $1.3 million of severance and related costs associated with the elimination of fourteen positions in both our North American and International segments, offset by a favorable adjustment of $0.4 million primarily related to a favorable settlement of employment litigation in the International segment. Annual savings related to the cost reduction actions in fiscal year 2005 were $1.6 million and were realized in fiscal year 2006. Annual savings related to the cost reduction actions in fiscal year 2004 were $2.4 million and were realized in fiscal year 2005.

 

Depreciation

 

Depreciation expense remained constant at $5.2 million in fiscal years 2005 and 2004, respectively, as the incremental depreciation associated with the assets from the Interelate Acquisition were offset by reduced depreciation from assets that became fully depreciated in fiscal years 2005 and 2004.

 

Amortization of Intangibles

 

Amortization of intangibles increased $0.1 million, or 25%, to $0.5 million in fiscal year 2005 compared to $0.4 million in fiscal year 2004. This increase was primarily due to the amortization of the intangibles related to the Interelate Acquisition.

 

Operating Loss

 

Primarily as a result of the previously-described business conditions, we experienced an operating loss of approximately $8.0 million for the fiscal year 2005, compared to an operating loss of approximately $6.7 million for the fiscal year 2004.

 

Interest and Other Income (Expense), net

 

Non-operating interest and other income (expense) increased $0.2 million, or 100%, to $0.4 million in fiscal year 2005 compared to $0.2 million in fiscal year 2004. The $0.2 million increase was primarily related to higher yields on our investments.

 

Income Tax (Provision) Benefit

 

Income taxes were almost $0 in fiscal year 2005 compared to a benefit of $0.6 million in fiscal year 2004. The $0.6 million benefit in fiscal year 2004 related to a favorable adjustment to a previous estimate of a foreign income tax liability. As of December 31, 2005, total deferred tax assets of $54.7 million were fully offset by a valuation allowance. The level of uncertainty in predicting when we will return to acceptable levels of profitability, sufficient to utilize our net U.S. and non-U.S. operating losses and realize our deferred tax assets required that a full income tax valuation allowance be recognized in the financial statements.

 

Net Loss Available to Common Stockholders

 

We reported a net loss available to common stockholders of $9.1 million in fiscal year 2005 as compared with a net loss available to common stockholders of $7.4 million in fiscal year 2004. We reported a net loss of $1.43 per share on a basic and diluted basis in fiscal year 2005 compared to a net loss of $1.22 per share on a basic and diluted basis in fiscal year 2004.

 

$17.8 million, partially offset by capital expenditures, dividend payments and working capital requirements. Restricted cash decreased $0.2 million, to $0.3 million as of December 30, 2006 compared to $0.5 million as of December 31, 2005. The $0.2 million decrease in restricted cash was primarily due to reducing the amount of outstanding letters of credit offset by an additional reserve to accommodate a Bank credit requirement associated with accepting credit card payments. As of December 30, 2006, we liquidated all of our short-term investments compared to $4.0 million as of December 31, 2005. See Note Two “Summary of Significant Accounting Policies” of the “Notes to Consolidated Financial Statements” included in Item 8, Part II of this Form 10-K.

 

Cash Flows from Operating Activities

 

The Company used approximately $3.0 million and $2.0 million of cash during fiscal years 2006 and 2005, respectively, for operating activities. Net cash outflows of $3.0 million in fiscal year 2006 arose primarily from operating losses, payment of deferred Managed services costs (including Behavioral Analytics ^tm deployment costs and third-party maintenance contracts), and an increase in accounts receivable, annual corporate insurance payments and incentive compensation largely offset by prepayments by our clients related to our Managed services contracts. Net cash outflows of $2.0 million in fiscal year 2005 arose primarily from operating losses, payment of accrued 2004 non-VP bonuses, annual corporate insurance payments, prepaid third-party maintenance contracts and payments with respect to severance and related costs. DSO of 49 days at December 30, 2006 represented a decrease of 3 days compared to 52 days at December 31, 2005. We do not expect any significant collection issues with our clients. At December 30, 2006, there remained $0.3 million of unpaid severance and related costs. See Note Four “Severance and Related Costs” of the “Notes to Consolidated Financial Statements” included in Item 8, Part II of this Form 10-K.

 

Cash Flows from Investing Activities

 

Cash flows from investing activities decreased $1.5 million, and was a nominal source of cash during fiscal year 2006 from $1.5 million during fiscal year 2005. During fiscal year 2006, the sale of short-term investments provided $4.0 million, which was offset by capital expenditures and other of $4.0 million. During fiscal year 2005, the net sale of short-term investments provided $3.0 million, which was offset by $1.5 million of capital expenditures and other. The level of capital expenditures for fiscal year 2007 is highly dependent upon the number of new hosted Behavioral Analytics ^tm contracts we enter. We currently expect our capital expenditures to be less than $15.0 million for fiscal year 2007.

 

Cash Flows from Financing Activities

 

Cash flows from financing activities increased by $17.9 million, to a source of cash of $16.6 million during fiscal year 2006 from a use of cash of $1.3 million during fiscal year 2005. Net cash flows of $16.6 million during fiscal year 2006 are primarily attributable to $17.8 million of net proceeds from the issuance of 1,001,342 shares in connection with the Rights Offering, $0.2 million decrease in the required deposit of cash security for the Facility, $0.1 million of cash from option exercises offset by cash dividend payments of approximately $1.5 million, paid in January and July on the Series B stock.

 

Net cash outflows of $1.3 million during fiscal year 2005 were attributable to cash dividends of $1.5 million, paid in January and July on the Series B stock, offset by a $0.2 million decrease in the required deposit of cash security for the Facility.

 

In addition, a semi-annual dividend payment of approximately $0.7 million is expected to be paid in future periods on the Series B stock. The amount of each such dividend would decrease by any conversions of the Series B stock into common stock, although any such conversions would require that we pay accrued but unpaid dividends at time of conversion.

 

Near-Term Liquidity

 

Our near-term capital resources consist of our current cash balances together with anticipated future cash flows. Our balance of cash and cash equivalents was $31.6 million and $17.9 million as of December 30, 2006 and December 31, 2005, respectively. In addition, our restricted cash of $0.3 million at December 30, 2006 is available

to support letters of credit issued under our LaSalle credit facility (as described below) for operational commitments, and to accommodate a LaSalle Bank credit requirement associated with the purchase and transfer of foreign currencies and credit card payments. As of December 30, 2006, we no longer held short-term investments compared to $4.0 million held at December 31, 2005, respectively.

 

Bank Facility

 

The Company maintains the Facility with the Bank. The maximum principal amount of the secured line of credit under the agreement remained at $2.0 million through fiscal year 2006. The Facility requires eLoyalty to maintain a minimum cash and cash equivalent balance within a secured bank account at the Bank. The balance in the secured account cannot be less than the outstanding balance drawn on the line of credit, and letter of credit obligations under the Facility, plus a de minimis reserve to accommodate a Bank credit requirement associated with the purchase and transfer of foreign currencies and credit card payments. Available credit under the Facility has been reduced by approximately $0.3 million related to letters of credit issued under the Facility for operational commitments and a Bank credit requirement associated with the purchase and transfer of foreign currencies and credit card payments. As a result, approximately $1.7 million remains available under the Facility at December 30, 2006. Loans under the Facility bear interest at the Bank’s prime rate or, at eLoyalty’s election, an alternate rate of LIBOR (London InterBank Offering Rate) plus 0.75%. We did not have any borrowings or interest expense under the Facility in fiscal years 2006 and 2005, respectively.

 

Accounts Receivable Customer Concentration

 

At December 30, 2006, we had one customer, United HealthCare Services, Inc., that accounted for 31% of total net accounts receivable. Of this amount, we have collected 99% from United HealthCare Services, Inc. through March 7, 2007. Of the total December 30, 2006 gross accounts receivable, we have collected approximately 79% as of March 7, 2007. Because we have a high percentage of our revenue dependent on a relatively small number of customers, delayed payments by a few of our larger clients could result in a reduction of our available cash.

 

Summary

 

We anticipate that our current unrestricted cash resources, together with other expected internally generated funds, should be sufficient to satisfy our working capital and capital expenditure needs for the next twelve months. If, however, our operating activities or net cash needs for the next twelve months were to differ materially from current expectations due to uncertainties surrounding the current capital market, credit and general economic conditions, competition, potential for suspension or cancellation of a large project, there is no assurance that we would have access to additional external capital resources on acceptable terms.

 

 

Letters of Credit

 

Letters of credit reflect standby letters of credit issued as collateral for operational leases.

 

Operating Leases

 

Operating leases reflect leases entered into by the Company for technology and office equipment as well as office space.

 

Severance and Related Costs

 

Severance and related costs reflect payments the Company intends to make in future periods for severance and other related costs due to cost reduction activities in fiscal year 2006 and prior years. The amounts listed have not been reduced by minimum sublease rentals of $0.1 million due in fiscal year 2007, under non-cancelable subleases.

 

Purchase Obligations

 

Purchase obligations reflect the costs of goods or services eLoyalty had procured prior to December 30, 2006, but for which eLoyalty had not tendered payment. Purchase orders for third-party support costs associated with Managed services support agreements are also included.

 

Recent Accounting Pronouncements

 

In September 2006, the Securities and Exchange Commission issued Staff Accounting Bulletin (“SAB”) No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Current Year Misstatements . ” SAB No. 108 requires analysis of misstatements using both an income statement approach and a balance sheet approach in assessing materiality and provides for a one-time cumulative effect transition adjustment. SAB No. 108 is effective for fiscal years ending after November 15, 2006 and was adopted by the Company on December 30, 2006. The adoption of SAB No. 108 had no effect on the Company’s financial statements.

 

In September 2006, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 157, “Fair Value Measurements”, which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. SFAS No. 157 does not require any new fair value measurements, but provides guidance on how to measure fair value by providing a fair value hierarchy used to classify the source of the information. This statement is effective for fiscal years beginning after November 15, 2007. We are currently evaluating the impact that SFAS No. 157 may have on our financial position or results of operations.

 

In July 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (FIN 48). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in financial statements in accordance with SFAS No. 109, “Accounting for Income Taxes.” This interpretation prescribes the recognition threshold and measurement attribute of tax positions taken or expected to be taken on a tax return. This Interpretation is effective for fiscal years beginning after December 15, 2006. eLoyalty has reviewed FIN 48 and believes the impact of adoption of FIN 48 will be immaterial to the financial statements.

 

We provide solutions to clients in a number of countries including the United States, Australia, Canada, Germany, Ireland and the United Kingdom. For the fiscal years ended December 30, 2006 and December 31, 2005, 11% and 14%, respectively, of our net revenue was denominated in foreign currencies. Historically, we have not experienced material fluctuations in our results of operations due to foreign currency exchange rate changes. As a result of our exposure to foreign currencies, future financial results could be affected by factors such as changes in foreign currency exchange rates or weak economic conditions in those foreign markets. We do not currently engage, nor is there any plan to engage, in hedging foreign currency risk.

 

We also have interest rate risk with respect to changes in variable rate interest on our revolving line of credit, as well as interest rate risk related to our cash and cash equivalents and restricted cash. Interest on the line of credit is currently based on either the bank’s prime rate, or LIBOR, which varies in accordance with prevailing market conditions. A change in interest rate impacts the interest expense on the line of credit and cash flows, but does not impact the fair value of the debt. This interest rate risk will not have a material impact on our financial position or results of operations.

 

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS OF eLOYALTY CORPORATION

 

 

Board of Directors and eLoyalty Corporation

 

We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting , that eLoyalty Corporation (the “Company”) maintained effective internal control over financial reporting as of December 30, 2006, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audit.

 

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.

 

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

In our opinion, management’s assessment that eLoyalty Corporation maintained effective internal control over financial reporting as of December 30, 2006, is fairly stated, in all material respects, based on Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 30, 2006, based on Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

 

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the balance sheet of the Company as of December 30, 2006 and the related statements of operations, stockholders’ equity and comprehensive loss, and cash flows for the year ended December 30, 2006 and our report dated February 22, 2007 expressed an unqualified opinion on those financial statements.

 

 

Chicago, Illinois

March 9, 2007

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

Board of Directors and Stockholders

eLoyalty Corporation

 

We have audited the accompanying consolidated balance sheet of eLoyalty Corporation and subsidiaries as of December 30, 2006, and the related consolidated statements of operations, stockholders’ equity and comprehensive loss and cash flows for the year then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit.

 

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

 

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of eLoyalty Corporation and subsidiaries as of December 30, 2006, and the results of their operations and their cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America.

 

As discussed in Note thirteen to the financial statements, the Company has adopted Financial Accounting Standards Board Statement No. 123(R), Share-Based Payments (SFAS 123R) in 2006.

 

Our audit was conducted for the purpose of forming an opinion on the basic financial statements taken as a whole. The Schedule II is presented for purposes of additional analysis and is not a required part of the basic financial statements. This schedule has been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, is fairly stated in all material respects in relation to the basic financial statements taken as a whole.

 

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of eLoyalty Corporation’s internal control over financial reporting as of December 30, 2006, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated February 22, 2007 expressed an unqualified opinion on management’s assessment and the effectiveness of the company’s control over financial reporting.

 

 

Chicago, Illinois

March 9, 2007

 

To the Board of Directors and Stockholders of eLoyalty Corporation:

 

In our opinion, the consolidated balance sheet as of December 31, 2005 and the related consolidated statements of operations, changes in stockholders’ equity and comprehensive loss and cash flows, present fairly, in all material respects, the financial position of eLoyalty Corporation and its subsidiaries (the “Company”) at December 31, 2005, and the results of their operations and their cash flows for each of the two years in the period ended December 31, 2005, in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule for each of the two years in the period ended December 31, 2005 presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

 

Chicago, Illinois

March 13, 2006, except for the 2005 and 2004 stock based compensation

disclosures in Note Thirteen to the consolidated financial statements, as to

which the date is March 9, 2007

CONSOLIDATED BALANCE SHEETS

(In thousands, except share and per share data)

 

 

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

CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

 

 

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

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)