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INTERACTIVE INTELLIGENCE GROUP, INC. - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations.
[November 07, 2014]

INTERACTIVE INTELLIGENCE GROUP, INC. - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations.


(Edgar Glimpses Via Acquire Media NewsEdge) The following Management's Discussion and Analysis of Financial Condition and Results of Operations is intended to provide our investors with an understanding of our past performance, our financial condition and our prospects and should be read in conjunction with other sections of this Quarterly Report on Form 10-Q.



Investors should carefully review the information contained in this report under Part II, Item 1A "Risk Factors" and in the Part I, Item 1A "Risk Factors" section of our Annual Report on Form 10-K for the fiscal year ended December 31, 2013. The following will be discussed and analyzed: · Forward-Looking Information · Overview · Revenue, Order Trends, Projections and Acquisition Highlights · Comparison of Three and Nine Months Ended September 30, 2014 and 2013 · Liquidity and Capital Resources · Critical Accounting Policies and Estimates Forward-Looking Information Certain statements in this Quarterly Report on Form 10-Q contain "forward-looking" information (as defined in the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933, as amended (the "Securities Act") and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act")) that involves risks and uncertainties which may cause actual results to differ materially from those predicted in the forward-looking statements. Forward-looking statements can often be identified by the use of such verbs as "expects," "anticipates," "believes," "intend," "plan," "may," "should," "will," "would," "will be," "will continue," "will likely result," or similar verbs or conjugations of such verbs. If any of our assumptions on which the statements are based prove incorrect or should unanticipated circumstances arise, our actual results could materially differ from those anticipated by such forward-looking statements. The differences could be caused by a number of factors or combination of factors, including, but not limited to, worldwide economic conditions and their impact on customer purchasing decisions; rapid technological changes and competitive pressures in the industry; our ability to maintain profitability; to manage successfully our growth; to manage successfully our increasingly complex third-party relationships resulting from the software and hardware components being licensed or sold with our solutions; to maintain successful relationships with certain suppliers which may be impacted by the competition in the technology industry; to maintain successful relationships with our current and any new partners; to maintain and improve our current products; to develop new products; to protect our proprietary rights and sensitive customer information adequately; to successfully integrate acquired businesses and to improve our brand and name recognition, as well as other factors set forth in our Securities and Exchange Commission ("SEC") filings.

Overview We are a global provider of software and services designed to improve the customer experience. Our primary offering is a suite of applications that provides customers with a multichannel communications platform that is deployed on-premises or through the cloud. We are a recognized leader in the worldwide contact center market. Our software applications provide a range of pre-integrated inbound and outbound communications functionality and this same platform provides solutions for unified communications and business process automation. Our solutions are broadly applicable, and are used by businesses and organizations in various industries, particularly teleservices, insurance, banking, accounts receivable management, utilities, healthcare, retail, technology, government and business services. We continue to invest in our next generation cloud communication platform, Interactive Intelligence PureCloud, which includes various services which will address unified communications and contact center markets and has functionality such as Director and Content Management that can be used by our current premises-based and cloud-based customers.


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

Our management monitors certain key measures to assess our financial results. In particular, we track trends in on-premises and cloud-based orders and contracted professional services from quarter to quarter and in comparison to the prior year actual results and current year projected amounts. We also review leading market indicators to identify trends in economic conditions. In addition to orders and revenues, management reviews costs of revenue, operating expenses and staffing levels to ensure we are managing new 18 --------------------------------------------------------------------------------expenditures and controlling costs. For additional discussions regarding trends, see "Revenue, Order Trends, Projections and Acquisition Highlights" and "Comparison of Three and Nine Months Ended September 30, 2014 and 2013" below.

Our management also monitors diluted earnings per share ("EPS"), a key measure of performance also used by analysts and investors, based on accounting principles generally accepted in the United States of America ("GAAP"). In addition to measures based on GAAP, our management monitors non-GAAP operating income and margin, non-GAAP net income and non-GAAP EPS to analyze our business.

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

Reconciliations of these non-GAAP measures to the most directly comparable GAAP measures are included below (in thousands, except per share amounts): Three Months Ended Nine Months Ended September 30, September 30, 2014 2013 2014 2013 Net income (loss), as reported $ (2,143) $ 1,627 $ (11,504) $ 5,985 Purchase accounting adjustments: Increase to revenues 4 44 14 192 Reduction of operating expenses: Customer relationships 427 419 1,285 1,260 Acquired technology 177 49 363 147 Non-compete agreements 45 45 135 135 Acquisition costs 10 7 610 48 Total 663 564 2,407 1,782 Non-cash stock-based compensation expense: Costs of recurring revenues 385 213 1,059 588 Costs of services revenues 117 69 338 185 Sales and marketing 1,248 821 3,381 2,446 Research and development 741 689 3,047 1,998 General and administrative 851 629 2,453 1,739 Total 3,342 2,421 10,278 6,956 Non-GAAP income tax expense adjustment 1,606 (471) 5,016 (3,623) Non-GAAP net income (loss) $ 256 $ 4,141 $ (3,835) $ 11,100 Operating income (loss), as reported $ (3,464) $ 3,675 $ (19,789) $ 7,939 Purchase accounting adjustments 663 564 2,407 1,782 Non-cash stock-based compensation expense 3,342 2,421 10,278 6,956 Non-GAAP operating income (loss) $ 541 $ 6,660 $ (7,104) $ 16,677 Diluted EPS, as reported $ (0.10) $ 0.08 $ (0.55) $ 0.29 Purchase accounting adjustments 0.03 0.03 0.12 0.08 Non-cash stock-based compensation expense 0.16 0.11 0.49 0.33 Non-GAAP income tax expense adjustment (0.08) (0.02) (0.24) (0.17) Non-GAAP diluted EPS $ 0.01 $ 0.20 $ (0.18) $ 0.53 19 -------------------------------------------------------------------------------- Revenue, Order Trends, Projections and Acquisition Highlights The tables below show our total revenues (in millions) for the most recent five quarters and the years ended December 31, 2013, 2012 and 2011 and the percentage change over the prior year period, year-over-year order growth and the percentage of cloud-based and on-premises orders as a percent of total orders for the most recent five quarters and the years ended December 31, 2013, 2012 and 2011 and a summary of orders received during the three and nine months ended September 30, 2014 and 2013.

Period Revenues Year-over-Year Growth % Three Months Ended: September 30, 2014 $ 89.5 15 % June 30, 2014 79.8 5 March 31, 2014 79.4 8 December 31, 2013 90.8 29 September 30, 2013 78.0 32 Year Ended December 31: 2013 $ 318.2 34 % 2012 237.4 13 2011 209.5 26 Orders Period Year-over-Year Growth % Orders as a % of Total Orders Three Months Ended: Cloud-based On-premises Cloud-based On-premises September 30, 2014 104 % (9) % 68 % 32 % June 30, 2014 (50) (1) (17) 52 48 March 31, 2014 165 (14) 59 41 December 31, 2013 1 (26) 47 53 September 30, 2013 75 29 48 52 Year Ended December 31: 2013 87 (1) 50 50 2012 121 25 35 65 2011 187 11 23 77 Three Months Ended September 30, Nine Months Ended September 30, 2014 2013 2014 2013 Change in dollar amount from prior year period: Total orders 46 % 47 % 6 % (2) 67 % On-premise orders (9) % 29 % (14) % 17 % Cloud-based orders 104 % 75 % 24 % (2) 175 % Cloud-based orders as a % of total orders 68 % 48 % 61 % 52 % Orders from new customers as a % of total orders 68 % 53 % 53 % 40 % Direct orders as a % of total orders 71 % 65 % 65 % 69 % Number of new on-premises customers 43 40 124 168 Number of new cloud-based customers 28 27 71 62 Total orders greater than $250,000 56 47 129 129 ______ (1) Includes the largest contract in our history which was signed in the second quarter of 2013. Excluding this order, our year-over-year cloud-based order growth would have been 69% for the three months ended June 30, 2014. (2) Includes the largest contract in our history which was signed in the second quarter of 2013. Excluding this order, our total and cloud-based order growth would have been 34% and 102%, respectively, for the nine months ended September 30, 2014.

20 -------------------------------------------------------------------------------- Geographic Mix The following table shows the percentage of orders derived from each of our geographic regions for the periods presented: Three Months Ended September 30, Nine Months Ended September 30, 2014 2013 2014 2013 Americas 84 % 78 % 78 % 81 % Europe, Middle East, and Africa 9 15 15 12 Asia-Pacific 7 7 7 7 Full Year Operating Projections As our business continues to shift towards the licensing of cloud-based solutions, and revenues related to these licenses are recognized over the contract period, we have reported and may continue to report periods of operating losses. We are currently projecting a taxable net operating loss for 2014 of between $20.0 million and $22.0 million, of which $10.8 million will be carried back to December 31, 2012 for tax purposes. The remaining projected net operating loss carryforward is a result of compensation for tax purposes for stock option exercises.

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

On April 1, 2013, we entered into an agreement with Amtel Communications Ltd.

("Amtel"), a New Zealand reseller, and acquired certain Interactive Intelligence related contact center assets of Amtel. We purchased these assets for approximately $725,000, funded with cash-on-hand and also obtained five Amtel employees as part of the transaction.

21 --------------------------------------------------------------------------------Comparison of Three and Nine Months Ended September 30, 2014 and 2013 Revenues Our revenues include: (i) product revenues; (ii) recurring revenues; and (iii) services revenues. These revenues are generated by direct sales to customers and through our partner channels.

Product revenues include sales of on-premises software licenses and hardware.

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

Recurring revenues include renewals of the support fees from on-premises license agreements and all revenues from our cloud solutions. The support fees are recognized over the support period, generally between one and three years.

Cloud-based orders are typically for periods of one to five years. The cumulative weighted average term of our cloud customer contracts was 56 months as of September 30, 2014. The weighted average term of new cloud customer contracts entered during the quarter ended September 30, 2014 was 59 months.

Services revenues primarily include professional and education services fees.

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

Revenues Percent of Total Revenues Three Months Ended Three Months Ended September 30, September 30, Increase 2014 vs.

2014 2013 2014 2013 2013 ($ in thousands) (%) (%) (%) Product $ 27,764 $ 26,913 31.0 34.5 3 Recurring 48,095 37,537 53.8 48.1 28 Services 13,603 13,519 15.2 17.3 1 Total revenues $ 89,462 $ 77,969 15 Percent of Total Revenues Nine Months Ended Nine Months Ended Increase / September 30, September 30, (Decrease) 2014 vs.

2014 2013 2014 2013 2013 ($ in thousands) (%) (%) (%) Product $ 72,158 $ 82,813 29.0 36.4 (13) Recurring 136,121 106,470 54.7 46.8 28 Services 40,461 38,166 16.3 16.8 6 Total revenues $ 248,740 $ 227,449 9 Product Revenues Product revenues increased during the three months ended September 30, 2014, primarily due to the recognition of $6.3 million of previously deferred on-premises orders, which included approximately $1.5 million related to a large customer order received in 2012, partially offset by a 9% decrease in on-premises orders received compared to the same quarter last year. Additionally, we deferred $4.7 million of on-premises orders received during the three months ended September 30, 2014 that were not recognizable based on their contract terms. During the three months ended September 30, 2013, we recognized $7.0 million of previously deferred on-premises orders, and deferred $5.5 million of on-premises orders received during the quarter.

Product revenues decreased during the nine months ended September 30, 2014 primarily due to the 14% decrease in the dollar amount of on-premises orders received related to the increasing shift of our business to the cloud.

In addition, we deferred $14.7 22 -------------------------------------------------------------------------------- million of on-premises orders received during the nine months ended September 30, 2014 that were not recognizable based on contract terms, offset by the recognition of $15.5 million of previously deferred on-premises orders. During the nine months ended September 30, 2013, we recognized $16.6 million of previously deferred on-premises orders and deferred $15.9 million of on-premises orders received during the period.

Recurring Revenues The breakdown of recurring revenues was as follows: Three Months Ended September 30, Nine Months Ended September 30, 2014 2013 2014 2013 ($ in thousands) ($ in thousands) Support fees $ 33,429 $ 28,918 $ 94,517 $ 82,891 Cloud-based 14,666 8,619 41,604 23,579 Total $ 48,095 $ 37,537 $ 136,121 $ 106,470 Support fees increased with the continued growth of our installed base of on-premises customers, and renewal rates were consistent between the 2014 and 2013 periods.

The most significant driver of cloud-based revenues is the number of licensed users. Cloud-based revenues increased by 70% and 76%, respectively, between the three and nine month periods in 2014 and 2013 primarily due to volume-driven increases from new customers as well as upgrades and additional subscriptions from existing customers. The net price per user per month for our primary offerings varies from period to period, but has remained within a consistent range during the 2014 and 2013 periods. The net price per user per month was not a significant driver of revenue growth for the periods presented.

Our unbilled future cloud-based user revenues were $265.9 million and $153.0 million as of September 30, 2014 and 2013, respectively. These unbilled cloud-based revenues are not included in deferred revenues on our balance sheet, but represent the remaining minimum value of non-cancellable agreements that have not been invoiced to the customer. Unbilled cloud-based revenues continue to increase as we build our cloud customer base.

Services Revenues Services revenues increased primarily due to increases in the number and scope of professional service engagements for both on-premises and cloud-based deployments. The 1% and 6% year-over-year increases in services revenues for the three and nine months ended September 30, 2014, respectively, were lower than the increases experienced in previous periods because of the shift in our business to the cloud, which usually involves deployments requiring shorter professional services engagements. As our cloud business grows, we may experience slower growth rates for services revenues.

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

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

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

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

23 -------------------------------------------------------------------------------- Costs of Revenues Percent of Total Revenues Three Months Ended Three Months Ended September 30, September 30, Increase 2014 vs.

2014 2013 2014 2013 2013 ($ in thousands) (%) (%) (%) Product $ 6,932 $ 6,599 7.7 8.5 5 Recurring 16,816 11,466 18.8 14.7 47 Services 11,550 9,609 12.9 12.3 20 Total cost of revenues $ 35,298 $ 27,674 28 Product revenue gross margin 75.0 % 75.5 % Recurring revenue gross margin 65.0 % 69.5 % Services revenue gross margin 15.1 % 28.9 % Percent of Total Revenues Nine Months Ended Nine Months Ended Increase / September 30, September 30, (Decrease) 2014 vs.

2014 2013 2014 2013 2013 ($ in thousands) (%) (%) (%) Product $ 20,269 $ 21,691 8.1 9.5 (7) Recurring 46,196 31,423 18.6 13.8 47 Services 33,365 27,316 13.4 12.0 22 Total cost of revenues $ 99,830 $ 80,430 24 Product revenue gross margin 71.9 % 73.8 % Recurring revenue gross margin 66.1 % 70.5 % Services revenue gross margin 17.5 % 28.4 % Costs of Product Revenues Costs of product revenues increased during the three months ended September 30, 2014 primarily due to higher product revenues and the related increase in costs of third party goods sold and direct operating expenses. Our product revenue gross margin remained consistent year-over-year.

Cost of product revenues decreased during the nine months ended September 30, 2014 primarily due to lower product revenues and the related decreases in costs of third party goods sold and direct operating expenses. Our overall product revenue gross margin decreased due to a higher mix of hardware sales received during the period, which have a lower margin than software sales, and increases in third party costs. Third party costs fluctuate based on the mix of software sold.

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

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

24 -------------------------------------------------------------------------------- Gross Profit Three Months Ended September 30, Nine Months Ended September 30, 2014 2013 2014 2013 ($ in thousands) ($ in thousands) Gross Profit $ 53,987 $ 50,246 $ 148,547 $ 146,872 Change from prior period 7 % 27 % 1 % 32 % Percentage of total revenues 60.3 % 64.4 % 59.7 % 64.6 % Gross margin decreased during the three and nine months ended September 30, 2014 compared to the same periods in 2013 primarily due to our investment in technical staff and increased data center costs to support our expanding cloud customer base.

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

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

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

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

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

Operating Expenses Percent of Total Revenues Three Months Ended Three Months Ended September 30, September 30, Increase 2014 2013 2014 2013 2014 vs. 2013 ($ in thousands) (%) (%) (%) Sales and marketing $ 30,651 $ 24,765 34.3 31.8 24 Research and development 15,528 12,348 17.4 15.8 26 General and administrative 10,800 8,994 12.1 11.5 20 Total operating expenses $ 56,979 $ 46,107 24 Percent of Total Revenues Nine Months Ended Nine Months Ended September 30, September 30, Increase 2014 2013 2014 2013 2014 vs. 2013 ($ in thousands) (%) (%) (%) Sales and marketing $ 89,559 $ 74,306 36.0 32.7 21 Research and development 45,233 38,040 18.2 16.7 19 General and administrative 32,124 25,192 12.9 11.1 28 Total operating expenses $ 166,916 $ 137,538 21 25 -------------------------------------------------------------------------------- Sales and Marketing Sales and marketing expenses increased primarily due to increases in compensation expenses and other related expenses resulting from staffing increases. Additionally, we increased spending year-over-year on marketing programs, including promotional and branding initiatives.

Research and Development Research and development expenses increased primarily due to increased compensation and other related expenses resulting from staff hired and staff acquired as a part of the OrgSpan acquisition. Additionally, expenses related to outsourced services for localization and third party data center services as well as expenses related to recruiting increased to support staffing increases.

We capitalized $5.1 million and $9.6 million of development costs for internal use software for our next generation cloud communication platform in the three and nine months ended September 30, 2014, respectively, compared to the capitalization of $1.7 million during the same periods in 2013. We will continue to capitalize development costs related to this project and will begin amortizing such costs once the software is released for general availability, which we expect to be in the fourth quarter of 2014.

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

Other Income (Expense): Interest Income, net Interest income, net, consists of interest earned from investments, receivables and interest-bearing cash accounts. Interest expense and fees, which were not material in either period reported, are also included.

Interest income, net breakdown Three Months Ended September 30, Nine Months Ended September 30, 2014 2013 2014 2013 ($ in thousands) ($ in thousands) Interest income on investments $ 128 $ 142 $ 492 $ 459 Interest income on receivables 93 34 323 144 Other interest (expense) 53 (7) 16 16 Total interest income, net $ 274 $ 169 $ 831 $ 619 We invest in longer term investments with maturities up to three years to increase our overall yield on investments and monitor the allocation of funds in our investment accounts to maximize our return on investment within our established investment policy. We do not have investments in subprime assets.

Three Months Ended September 30, Nine Months Ended September 30, Return on investments 2014 2013 2014 2013 ($ in thousands) ($ in thousands) Cash, cash equivalents, and investments (average) $ 77,766 $ 88,639 $ 88,690 $ 88,016 Interest income on investments 128 142 492 459 Return on investments (annualized) 0.66 % 0.64 % 1.11 % 1.04 % The yield on investments has been relatively constant and the change in interest income, net during the three and nine months ended September 30, 2014 compared to the same periods in 2013 was due to the change in invested balances.

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

Three Months Ended September 30, Nine Months Ended September 30, 2014 2013 2014 2013 ($ in thousands) ($ in thousands)Other expense $ (279) $ (476) $ (665) $ (1,851) Other expense decreased during the three and nine months ended September 30, 2014 compared to the same period last year because we began hedging our exposure related to certain foreign intercompany loan receivables in the second quarter of 2013.

Income Tax Benefit (Expense) Three Months Ended September 30, Nine Months Ended September 30, 2014 2013 2014 2013 ($ in thousands) ($ in thousands) Income tax benefit (expense) 1,326 (1,741) $ 8,119 $ (721) The Company's effective tax rate for the three and nine months ended September 30, 2014 was 38.2% and 40.6%, without the effects of discrete tax items, compared to 36.2% and 19.5%, respectively, for the same periods in 2013. During the nine months ended September 30, 2014, the Company recorded a $150,000 credit related to a discrete item. There was no such discrete item recorded in the three months ended September 30, 2014. With the effects of the discrete tax item, the Company's effective tax rate for the nine months ended September 30, 2014 was 41.4%. If the U.S. federal research and development tax credit is extended through 2014, our annual effective tax benefit rate is expected to be 46.0%. This tax rate was determined by considering the annual expected federal tax rate, rates in various states and international jurisdictions in which we have operations, and certain income tax credits.

We are currently projecting a taxable net operating loss for 2014 of between $20.0 million and $22.0 million, of which $10.8 million will be carried back to December 31, 2012. The remaining projected net operating loss carryforward is a result of compensation for tax purposes for stock option exercises. In accordance with FASB ASC 718, these stock option compensation deductions have not been recognized for financial reporting purposes because they have not yet reduced taxes payable. The tax benefit of these deductions will be recorded as a credit to additional paid-in-capital if and when realized.

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

Three Months Ended September 30, Nine Months Ended September 30, Foreign Subsidiaries 2014 2013 2014 2013 ($ in thousands) ($ in thousands) Foreign Subsidiary Income Before Taxes $ 1,072 $ 451 $ 2,700 $ 1,800 Foreign Tax Expense 242 107 590 517 The change in foreign tax expense for the three and nine months ended September 30, 2014 was primarily due to switching our Canadian subsidiary from a cost plus model to the reseller model during the first quarter of 2014.

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

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

We determine liquidity by combining cash and cash equivalents and short-term and long-term investments as shown in the following table. Based on our recent performance and current expectations, we believe that our current liquidity position, when combined with our anticipated cash flows from operations and borrowing capacity, will be sufficient to satisfy our working capital requirements and current or expected obligations associated with our operations over the next 12 months. Our largest potential capital outlay in the future is expected to be related to acquisitions and purchases of furniture and equipment.

If our liquidity is not sufficient to purchase a targeted company with our existing cash, we may need to raise additional capital, either through the capital markets or debt financings. However, there can be no assurance that we would be successful in raising additional capital on terms that are satisfactory.

September 30, 2014 December 31, 2013 ($ in thousands) Cash and cash equivalents $ 30,263 $ 65,881 Short-term investments 29,608 32,162 Long-term investments 9,679 9,787 Total liquidity $ 69,550 $ 107,830 We believe that the funds of Interactive Intelligence Group, Inc. and its subsidiaries that are held in foreign accounts can be transferred into the U.S.

with limited tax consequences. Given our liquidity in the U.S., however, we do not have plans to repatriate earnings from our foreign subsidiaries. As of September 30, 2014, Interactive Intelligence Group, Inc. held a total of $579,000 in its various foreign bank accounts and its foreign subsidiaries held a total of $15.9 million in their various bank accounts. The temporary difference related to unremitted earnings of our foreign affiliates as of September 30, 2014, that have not been subject to United States income taxation as dividends and are indefinitely invested outside the United States, was $21.7 million. If we were to repatriate all of those earnings to Interactive Intelligence Group, Inc. in the form of dividends, the incremental U.S. federal income tax net of applicable foreign tax credits would be $4.5 million.

The following table shows the U.S dollar equivalent of our foreign account balances for the stated periods: September 30, 2014 December 31, 2013 ($ in thousands) Euro $ 6,630 $ 9,561 New Zealand dollar 2,130 1,699 Canadian dollar 1,924 1,581 Australian dollar 1,848 5,886 South African rand 1,532 4,108 British pound 1,068 1,401 Other foreign currencies 1,332 1,391 Total $ 16,464 $ 25,627 28 --------------------------------------------------------------------------------The following table shows cash flows from operating activities, investing activities and financing activities for the stated periods: Nine Months Ended September 30, 2014 2013 ($ in thousands) Beginning cash and cash equivalents $ 65,881 $ 45,057 Cash provided by (used in) operating activities (3,065) 23,544 Cash used in investing activities (37,217) (31,980) Cash provided by financing activities 4,664 13,464 Ending cash and cash equivalents $ 30,263 $ 50,085 Days sales outstanding (DSO) 71 74 Cash flow from operations was $26.6 million lower during the first the nine months of 2014 compared to the same period in 2013. Cash flow from operations consists of our earnings adjusted for various non-cash expenses, such as depreciation and amortization, as well as balance sheet changes. Our cash flow from operations during the first nine months of 2014 was primarily affected by lower net income, deferred taxes and changes in deferred revenues.

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

Increases in taxes receivables decreased our cash flow from operations. We had a tax receivable balance at September 30, 2014 of $6.5 million related to an income tax benefit recognized during 2013.

Cash used in investing activities increased $6.2 million in the first nine months of 2014 compared to the same period in 2013, primarily due to a $11.4 million increase in capitalized software cost as well as an $8.4 million increase in cash used for the purchase of OrgSpan, partially offset by increased proceeds resulting from the sale of available-for-sale investments.

Cash provided by financing activities decreased $7.9 million in the first nine months of 2014 compared to the same period in 2013, primarily due to decreases in proceeds from stock options exercised, reduced tax benefit from stock-based payment arrangements and additional tax withholdings on RSUs.

Contractual Obligations Contractual obligations for operating leases increased by $56.5 million as of September 30, 2014 compared to contractual obligations as of December 31, 2013, as a result of our headquarters expansion. Our world headquarters are located in three office buildings in Indianapolis, Indiana, which space was formerly leased pursuant to an Office Lease Agreement (the "Office Lease"), dated April 1, 2001, between us and Duke Realty Limited Partnership (formerly Duke-Weeks Realty Limited Partnership), as amended. On May 6, 2014, we entered into a lease termination agreement with Duke Realty Limited Partnership, whereby the Office Lease (and the eight amendments thereto) was terminated. In place of such Office Lease and amendments, on May 6, 2014, we entered into new separate lease agreements with Duke Realty Limited Partnership for each of the three office buildings, one of which expires on March 31, 2018 and two of which expire on or after June 30, 2025.

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

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

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

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

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

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

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