The Ultimate Software Group, Inc. Q3 2008 Earnings Call Transcript

The Ultimate Software Group, Inc. (ULTI)

Q3 2008 Earnings Call Transcript

October 28, 2008, 5:00 pm ET

Executives

Mitchell K. Dauerman – CFO, EVP and Treasurer

Scott Scherr – Chairman, President, and CEO

Analysts

Richard Baldry – Canaccord Adams

David Cohen – JP Morgan

Michael Nemeroff – Wedbush

Richard Davis – Needham & Company

Nathan Schneiderman – Roth Capital Partners

Steve Koenig – KeyBanc Capital Markets

Mark Marcon – Robert W. Baird

Brad Reback – Oppenheimer

Terry Tillman – Raymond James

Franco Turrinelli – William Blair & Co.

Tom Ernst – Deutsche Bank

Brad Whitt – American Technology Research

Dan Cummins – Lime Rock Research

Presentation

Operator

Good day, everyone, and welcome to Ultimate Software's third quarter 2008 financial results conference call. Today's call is being recorded.

Your presenters today will be Mr. Scott Scherr, chief executive officer, president, and founder of Ultimate Software, and Mitchell K. Dauerman, executive vice president, and chief financial officer.

At this time, all lines are in a listen-only mode. After today's Presentation, there will be a question-and-answer session, and now at this time, I would like to turn the conference over to Mr. Mitchell K. Dauerman. Please go ahead, sir.

Mitchell K. Dauerman

Thank you, Dustin. Good afternoon and thank you for your interest in Ultimate Software. Before we begin, please be aware that we will be discussing our business outlook and will be making other forward-looking statements regarding our current expectations of future events and the future financial performance of the Company.

These forward-looking statements are based upon information available to us as of today's date, and are subject to risks and uncertainties. We encourage you to review our filings with the SEC at www.sec.gov for additional information on risk factors that could cause actual results to differ materially from our current expectations. We assume no duty or obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

I'm going to discuss the financial results for our third quarter of 2008. Unless otherwise noted, our discussion will be on a non-GAAP basis for all costs, gross margins, net income, and EPS, when comparing to the same period in the prior year. The primary difference between GAAP and non-GAAP financial information is non-cash stock-based compensation.

Please refer to the reconciliation of the financial information on a GAAP basis to that on a non-GAAP basis attached to the press release published on our website.

Based upon our revised guidance from last quarter, I'm going to focus my comments on our third quarter performance relative to our revised forecast, our fourth quarter guidance, and our look for 2009.

New ARR for the third quarter was $10.8 million, a 51% increase over the same quarter last year, and a 46% year-to-date growth for the comparable 9 month periods. Workplace sales contributed 19% of the new ARR for the quarter.

For Q3, our recurring revenues were $26.7 million, coming in slightly above our expectation. The new time to live period for our intersourcing sales discussed last quarter remained in line with our expectations. The attrition rate for our intersourcing customers stayed consistent with Q2 at a 3% annualized rate.

Service revenues for Q3 were in line with our revised expectations; however, the composition within service revenues was different than we anticipated. Our implantation revenues were higher than expected, because we made a decision to bring in third party implementation partners to help clear the backlog, which we discussed last quarter. This third party program will continue into Q4.

We also began to experience pressure on our standard time and material hourly billing rate as compared to our expectations. Partially offsetting this increase in implementation revenues were training revenues and forms revenues which were lower than expected. On the training revenue side, we experienced some class cancellations due to the hurricanes that hit the country during this quarter.

We noticed clients deciding to send fewer participants to class, as well as fewer clients requesting onsite training. On the forms side, we've always been advocates for going paperless, and it appears that clients began going green more so in Q3 than in the past, saving them time and money associated with printing and distributing checks. License revenues came in $2 million less than our expectation.

From a business perspective, the shift of these sales into inter-sourcing will produce a much higher financial return over time. It appears that the uncertainty of the economy is impacting a customer's likelihood of purchasing licensed software when they experience higher up-front costs when compared to subscription-based offerings.

We experienced this change back in 2000. We did not have a defense then to solve the financial problem, but now we do – intersourcing.

Turning to the cost of revenue and gross margin side of our Q3 results, recurring revenue costs were approximately $300,000 over our expectations. These were mostly attributable to higher data center costs.

Last quarter, we successfully moved our Atlanta-based data center, and this quarter we successfully moved our Miami-based data center. The moves were substantial and were necessary to handle the growth in our intersourcing business. We found opportunities during the moves to provide higher levels of service to our customers and after both moves were completed, the result was higher data center costs than we had expected.

Service costs in Q3 were impacted by the additional third party implementation partners used, and, to a lesser extent, bringing on additional billable consultants to handle the higher than expected sales production.

Turning to the operating expense side, research and development expenses were $300,000 above our expectations, mainly because we ended up capitalizing less development costs than we had originally expected.

Sales and marketing expenses exceeded our previous expectation, as we incurred higher advertising and marketing expenses, as well as certain higher labor costs relating to an investment in a new strategic customer relationship program geared towards our growing larger customer base, which Scott will discuss further.

Finally, G&A costs were higher than we expected for Q3, because we increased our allowance for doubtful accounts as a cautionary measure tied to the current uncertain economic environment. As usual, we will continue to monitor our reserve needs for accounts receivable as we go forward.

Okay, next I'd like to discuss our guidance for Q4. The continued success in selling new business gives us confidence in achieving or exceeding our 2008 guidance of 30% growth in ARR for the year.

We expect our recurring revenues to be between $28 million and $29 million, taking into account reduced annual maintenance revenues as they relate to lower license sales, as well as adjusting our employee growth and attrition assumptions for our recurring revenue customers.

Our service revenues are expected to be between $18 million and $19 million after taking into account a $5 lower than expected rate per hour, the continued use of implementation partners, and lower expectations for both training and forms revenues.

We are forecasting license revenues of $2 million for Q4, which are down from our prior estimate of $4.3 million. Gross margins for recurring revenues should be approximately 72%, and service margins should be 20%.

Research and development expenses for Q4 should be around $8.4 million. The reduction from Q3 is due to the fact that the third party contract labor used in Q3 met their deliverables in Q3, and therefore, is not expected to return in Q4. This accounts for about a $500,000 decrease in Q4.

Second, the typical reduction in compensation expense for unused vacation time that cannot be carried forward to the next year and is therefore written off at year-end, accounts for about $200,000 of the expected decrease and, the planned reduction in internal training from Q3 to Q4 primarily represents the balance of the decrease.

All in all, our total R&D expenses for Q3 and Q4 combined should be just slightly above our expectations set in July. For the fourth quarter, sales and marketing costs are expected to be $9.6 million. The reduction from Q3 is mostly due to the fact that we incurred costs for the national sales meeting and midyear club expenses in Q3 which do not recur in Q4, as well as lower commission expense tied to the lower than expected licenses forecasted for Q4.

Our combined Q3 and Q4 sales and marketing expenses should be just slightly above our previous expectation. For the fourth quarter, we expect G&A costs to be around $3.3 million. We should produce operating margins of 9% to 10% in Q4, and I'd note the reduction in the – in our estimated license sales accounts for about a 3% reduction in the overall operating margin for the fourth quarter.

We expect capital expenditures to be around $3 million, and diluted weighted average share count to be 26.5 million shares. Before turning to 2009 guidance, I'd like to compare in a summary way our expectations for the second half of 2008 to the prior guidance we provided in July.

In our model, the total operating income changes by $6.5 million. Of this, $4 million is attributable to lower license revenues, which are offset by higher ARR from intersourcing that we see as a positive for our business going forward. Approximately $1.5 million is due to several things connected with services.

First, there's an increase in the use of implementation partners. Second was the $5 lower than expected services rate per hour, and third were lower training revenues. The remainder is due to higher than expected hosting costs in connection with the two data centers, and other operating costs associated with higher than expected sales growth.

For 2009, our preliminary view for new ARR growth stays at 30%, as we continue to build out our Workplace sales team during the next year. License revenues are estimated at $2 million per quarter, or $8 million for the year, versus $15 million previously expected.

Recurring revenue growth is 30% to 31%, after taking into consideration both the lower maintenance revenues as a result of lower license sales, and adjustments to customers, employment growth, attrition and price increases in our financial model in response to recent economic times.

Total revenues should grow between 22% and 23%. We expect our operating expense growth rate to be between 11% and 12%, as we expect to leverage the R&D investment we made in 2008 during 2009. Recall, we incurred significant third party costs for R&D during 2008 which are not planned to repeat in 2009.

Operating margins of 10% to 12% should be produced for 2009. Consistent with the fourth quarter, the reduction in our license revenues expectations resulted in a 3% reduction in the overall margin. We expect the capital expenditures will be about $13 million, and diluted weighted average shares should be approximately 26.5 million shares.

Turning to our upcoming conference schedule, during the next quarter on December 4th, we will be at the JP Morgan 10th Annual SMid Conference, and on January 6th, we will be at the Needham 11th Annual Growth Stock Conference. Both conferences are held in New York. If you're available at those conferences to meet, please let us know, and now I'd like to turn the call over to Scott.

Scott Scherr

Thanks, Mitch, and thank you to everyone participating in our call this evening. I'd like to start out by talking about sales. We had a great third quarter. New ARR, annual recurring revenues, are the best indicator of our sales performance, and they were $10.8 million, representing a 51% growth over last year's third quarter ARR. That makes our year-to-date growth in new ARR 46%.

Another metric that reflects our continuing success is the increase in our number of new units. Unit growth for the quarter was up 48% over those in 2007's Q3. Year-to-date unit growth is up 38% as of September 30th.

Our Enterprise team finished Q3 at 103% of planned and they are now 106% of planned year-to-date. They continue to deliver a task rate in line with previous quarters, and 70% of the team are at or above quota as of third quarter close.

An important point about the new business they brought in is that 50% of the new ARR in the third quarter was attributable to companies with more than 3,000 employees. This is consistent with the 49% in new ARR we saw in the second quarter this year from the large-sized Enterprise companies.

Our Workplace team finished the quarter strong as well at 112% of planned. Year-to-date, that makes them 124% of planned. 70% of the Workplace salespeople are above quota, and they contributed 19% of the new ARR for the third quarter this year.

To give you a little more color on their new business, the average size of the new Workplace customer for Q3 was 350 employees and the attach rates were very high. The attach rate for tax filing was 100%. For performance management, it was 86%. For recruitment, 60%, and for time management, 37%, and this was the first full quarter that we offered time management to the market.

These attach rates pushed the average per-employee per-month rate for the new Workplace customer to $14.50. Our plan for expanding market penetration through UltiPro Workplace is obviously working.

We are giving smaller businesses access to an integrated complete talent management suite beyond core HR and payroll, and they clearly see the value. For the first time, they are getting the same kind of advantages that larger companies have for managing their people effectively and efficiently.

To sum up where we are with sales, we are well-positioned for a strong close to 2008. Both teams continue to have very healthy pipelines, and many deals are already in the contract process. We are aware of the current economic environment, and our teams are working harder than ever to prove our value proposition.

We had our all-team meetings earlier this month, and both teams are exceptionally confident and enthusiastic. I want to point out that both our Enterprise and Workplace teams are currently staffed to a level very capable of growing new ARR in 2009 by more than 30%. Now, I'm going to turn to our customer support area and our client base. We maintained our industry-leading 97% customer retention rate in the third quarter. We also analyzed our customers' employee growth and attrition numbers looking at our existing customer base, starting in January of 2008, and tracking them through the end of September 2008.

We found that the average employee count of the consolidated group grew by 1%. In the same analysis, we also found that 53% of our client companies grew in employee size for the first 9 months of 2008. The bottom line is that we now have more than 900,000 employees live in our intersourcing environment.

We achieved our goal of 99.9% uptime in the third quarter, and we maintained our 97% customer retention rate as I mentioned earlier. At the same time, in response to our continued success in selling companies with larger employee populations, we have created and staffed a new strategic client relationship management program for our larger customers that complement our standard client relationship service set.

Our goal, as always, is to strive beyond our best to define a new and better model for excellence in order to set the bar still higher for customer value and satisfaction. In closing, I want to talk about growth and head count.

As of September 30th, we had 908 associates. We had 63 new hires in Q3. 51 of those 63 were directly related to higher sales numbers. Our original 2008 plan was to grow new ARR by 25%. Year-to-date, we have achieved 46%. With that better-than-projected-performance has become a requirement for more infrastructures.

It is clearly a high priority to get all the new Enterprise and Workplace customers live on core HR and payroll, as well as all the additional products they have bought, and to recognize that revenue as soon as possible. To do that, we had to hire more people. We are not investing ahead of sales; we are investing because of sales.

Our business is stronger than it has ever been before, and I want to share some details on why I know this. First, last month I went to our fourth Thought Leadership workshop. It was in Washington, D.C., and we had a record turnout of more than 300 companies.

In a couple of weeks, I'll be attending our fifth Thought Leadership event, and already we have more than 300 registered there as well. The HR market is responding to us, and we are working closely with them to produce solutions that best address their day-to-day administrative and strategic needs. Demand for what we have to offer has very plainly not slowed down. In fact, the momentum has increased.

Second, the results of the Forrester Wave Human Resource Management Systems for 2008 were just published. Forrester Research is an independent technology and market research firm that provides the international business community with advice about technology, and they described Ultimate Software's product as the best of the HR Management Systems for the United States midmarket, and called Ultimate "the only leader in that space".

Ultimate Software received the highest overall score among all vendors evaluated, and specifically, the highest score in product strategy and vision, cost and value in overall current offering. Forrester also named Ultimate Software a leader and the top-score vendor for strategy in the multinational enterprise wave for HR systems.

Here's a quote from the Forrester analyst Paul Hammerman, the lead author of the report. "Ultimate Software leads the pack. Ultimate Software's well-rounded HRMS solution has strong core transactional capabilities, including payroll, as well as good flexibility and usability. The product is sold mostly via the SaaS model and good cost and time-to-value factors, making it appealing to midsize US companies as well as enterprises."

Last, I want to share some detail from our first annual user conference last week in Atlanta, where we hosted 700 of our client associates. It is so clear to me that the road to greatness is about having the best products and services.

The positive feedback and raves that we hear from our customers tell us that we are on the right path. Some of the quotes from people who were there may give you an idea of the value our customers are receiving from our products, and their level of satisfaction. From Excella Health, an organization with 4,900 employees, three hospitals and 10 component companies, "We can now unify our distributed workforce with self-service and our employees love it".

From Christiana Care Health Systems, "Ultimate is our people system and it is the center of all processes and systems that touch both employees and non-employees. At night, UltiPro feeds dozens of applications and departments in our 11,000 employee and 7,000 non-employee companies. We are so pleased that UltiPro has helped us move to a paperless HR environment so quickly."

From International Dairy Queen, "We love Ultimate. The culture radiates, and compared to the service bureau we used before, processing our payroll has been like day and night."

From Trader Joe's, the gourmet grocery store chain with more than 20,000 employees and 300 stores, "UltiPro's reports have been the number one lifesaver for us. We used to have to go to IT for every report, and wait. With UltiPro, we are managing compliance more effectively and staying on top of changing workforce trends. By empowering our managers with UltiPro's manager self-service, we have moved entry to the people closest to the transaction, reducing data entry for HR, and improving accuracy."

From Washington Trust Bank, "Your support is phenomenal." From Sony BMG Entertainment, "Now that we are live on UltiPro, I can easily net out the benefits compared to the highly-rated Enterprise system we used previously. UltiPro is better, cheaper, and faster." One person even told us that he went to work for a company just because they used UltiPro, and he loves working with UltiPro better than any other system he has ever used

In tough times like these, it is so refreshing to hear our customers tell us how much our solutions help them. Quality products matter to business, quality services matters, and strong relationships make an impact. Our customers told us in large numbers that they want to be references for us.

Ultimate Software is in a very good position to continue executing in the toughest of times, and we intend to continue our growth in the fourth quarter of this year and in 2009.

Let's go to the Q&A, Dustin.

Question-and-Answer Session

Operator

(Operator instructions) We'll go first to Richard Baldry with Canaccord Adams.

Richard Baldry – Canaccord Adams

Thanks. It looks like if you look through the Q4 guidance and you took the 10% op margin on a $50 million top line, you've reversed pretty sharply, sequentially on the earnings side. You've actually come in higher than you did in the first quarter.

So, given the demand you're seeing in the environment and the bookings that you've had, well, some reasons that you might not see op-ex get sort of, ahead of your expectations again as we've seen sort of in the last two quarters?

It doesn't look like demand's falling down, so it seems like that's going to be probably your toughest execution in the quarter. Thanks.

Scott Scherr

Rich, I think on the op-ex side, if I heard your question correctly, the variables probably come in sales and marketing in terms of commission expenses related to the sales, and how they flow in. In terms of R&D, we know the head count. We know what their plans are there. So I think in that area, I think we have a pretty good handle on the op-ex in Q4.

Richard Baldry – Canaccord Adams

And, then, just on the balance sheet so we can start to figure out going forward, I'm curious that the funds held for clients is basically flat and slightly non-sequential as you're adding customers onto the tax platform. So, how do we think about that on a go-forward –?

Scott Scherr

Again, remember that the amount of taxes we hold depends on when the taxes have to be turned over to the authorities. Let me look up something, the day before, so it's going to vary on a daily basis. The day before was $3.5 million. So it's really a function of when the taxes get remitted to the authorities, but the average daily balance went up and the next question is it's not so much where we ended a quarter, but it's what happens to the average daily balance, and by the end of the third quarter, that was up to about $1.4 million compared to, I think it was $600,000 at the end of Q2.

Richard Baldry – Canaccord Adams

And, then, with it looks like your Performa profitability again will step up in the fourth quarter, so do you expect to get back to more of an aggressive buyback plan? It sort of looks very strong in the second quarter, a little more moderate in the third quarter. I'm just curious what your thoughts there with your stock trading where it is? Thanks a lot.

Scott Scherr

Yes, Rich, we're going to continue our buyback program. We're going to monitor the cash on the balance sheet like we always have, and we'll execute accordingly.

Richard Baldry – Canaccord Adams

Thanks.

Operator

We'll go next to David Cohen with JP Morgan.

David Cohen – JP Morgan

Hi, guys. Thanks for taking my questions. I think if I understood you right, you said that you were seeing license deals sort of switch to become recurring deals. Can you talk a little bit more about sort of the visibility you have, what you're hearing from customers on that?

Scott Scherr

I think our objective, our comp plan everything is based on trying to get people to intersourcing.

David Cohen – JP Morgan

Sure.

Scott Scherr

I just think we've been through this before and we see what Q3 came in at. I can look in the forecast at Q4 and see the companies that were saying they were going to go licensed, and now changing to intersourcing. I think it's a normal progression that we welcome.

David Cohen – JP Morgan

Sure. For the third quarter how many units had you expected to be licensed at the end the intersourcing deal or percentage?

Scott Scherr

The difference could be two deals. I could do that, but, again, I think that our Enterprise salespeople are always trying to get the clients to go intersourcing. We believe that's a better solution for the client, as well as for us. I just think that economic environment makes it easier to make that pitch.

David Cohen – JP Morgan

Right, you talked about some pricing pressure on the services part of the business. What have the pricing conversations been like for intersourcing?

Scott Scherr

I think as I said on the PEPM, we've been strong. I mentioned the Workplace number and I mentioned that Enterprise stayed pretty much the same as previous quarters. The pressure comes on the implementation side a little.

David Cohen – JP Morgan

Thanks for talking about the client employment levels that was helpful. In terms of business closures, any change in the third quarter relative to the first half of the year, any expectations on the potential impact of either business closures or if unemployment levels rise materially from current levels?

Scott Scherr

I think as we've said, we maintained our 97% retention rate in the quarter. I think on the whole client base, unfortunately we had four companies that closed down. Typically they're smaller companies. But we took all that into account when we modeled Q4, and we took all that into account when we modeled 2009 and then that's why we wanted to get exactly where we were January through September so that everyone is seeing exactly, those are our facts as of now for nine months. We do have minimums in our contract which everybody knows.

David Cohen – JP Morgan

That's great. Thanks very much, guys.

Operator

We'll take our next question from Michael Nemeroff of Wedbush.

Michael Nemeroff – Wedbush

Hi. Thanks for taking my questions, a couple of questions here. Mitch, that $2 million license per quarter that you threw out there, is that sort of the worst-case scenario going forward into 2009, do you think?

Mitchell K. Dauerman

I think it's a reasonable scenario, given where we are, given the economy and given the push to intersourcing.

Scott Scherr

Mike, I think two things to happen, one, the economy pushes people there, and I just think that over 900,000 employees now in intersourcing, SaaS is becoming more recognized, and we're always pushing intersourcing.

I think it was inevitable that that number would go down somewhat. I think the current economy just leads us to believe, and we think that that's a number we should put out there, $2 million a quarter going forward.

Michael Nemeroff – Wedbush

Scott, can you tell us what size the largest customer was that went live this quarter, and, then, on the flip side of that, can you tell us how large the largest customer was that asked for relief on their minimums?

Scott Scherr

Do you know the largest request for relief?

Mitchell K. Dauerman

I think that there was really no activity in the ask-for-relief, it was small.

Michael Nemeroff – Wedbush

I'm sorry, Mitch. What was that?

Mitchell K. Dauerman

I don't think there were many – I don't have the exact data, and on the ones who went live, I don't – do you have those?

Scott Scherr

Might be here.

Michael Nemeroff – Wedbush

Well, what was the largest customer that went – what was the size of the largest customer that went live in the quarter?

Scott Scherr

Let me get the information. It will take me one second to get you that information.

Michael Nemeroff – Wedbush

Okay. So while you're checking on that, Mitch, could you just tell us specifically about a couple of the cost items, specifically the data center, you said that this was the second data center that you moved? What was different about the second time that you didn't see the costs in the first time around? And, also, if you could tell us specifically what the third party R&D was related to?

Mitchell K. Dauerman

Well, to answer the second one first, related to certain functionality for version 10 that we thought – the development team thought it was best to outsource to a third party instead of hiring heads, because they would not need that on an ongoing basis, so there was a time period they wanted to get it done with.

And, then, in the hosting environment, Miami being the larger environment, there was some – as they were going through the move, there were some opportunities with this new center to provide certain things, enhance levels of service, enhance levels of security, in that they made a decision to go forward with it, and I think when we shook out all the costs and looked at where this can go, we got a better handle on it this time.

Scott Scherr

Yes, we took a little over 40 – well, on the Enterprise, a little over 40 accounts live. I just have the names. I don't know the exact counts. I mean, some of them are names that I know are big, but I think if I gave you the count it may not be accurate.

Michael Nemeroff – Wedbush

That's okay. We can take that offline. Thanks for answering my questions.

Scott Scherr

Okay. You're welcome. Thank you.

Operator

We'll go next to Richard Davis, Needham and Company.

Richard Davis – Needham & Company

Hey, thanks. You've been doing a good job kind of moving up to larger deals. When you talk about your thoughts about '09, have your forecasts incorporated an assumption of any kind of extension or slowdown – further slowdown in the pace of deployment for these larger deals, because sometime you see with larger deals and other industries we've seen in the past, and more recently I suppose, that they will sometimes elongate their deployment cycles, which, I guess would free up your services guys, but I was just kind of – how you triangulated on that with regard to your thoughts of your outlook for '09.

Scott Scherr

Sure. Absolutely we took that into effect. That's what took our time to live from six months to eight months. This quarter, 50% of Enterprise ARR was from accounts over 3,000. Q2 was 49%. Q1 was 43% and Q4 was 47%. So I think we saw the trend. If we go back to Q1 2007, it was 21%.

Mitchell K. Dauerman

But in terms of going forward Rich, when a customer's made the decision to go forward with us, they're not looking to extend a deployment, so it's really about us with them getting the deployment done as fast as possible, and right now, our model is based on maintaining that time to live.

Scott Scherr

I think we addressed what you've said. What we did last quarter by taking the time to live from 6 months to 8 months.

Operator

We'll go next to Nathan Schneiderman with Roth Capital Partners.

Nathan Schneiderman – Roth Capital Partners

I was just curious on the operating margin guidance. I understood the 10% to 12% would have been more like 12% to 15% if the perpetual had stayed along plan, but last quarter you gave guidance for 15% to 18%, so I'm just curious if we do come more of an apples to apples and ignore the license difference, why do you experience that 300 basis points hit in areas outside of the perpetual license?

Scott Scherr

We're being conservative.

Mitchell K. Dauerman

Nate, I'd also add that if you look at the recurring revenue guidance, that's come down a little bit, so that's going to go pretty much right to the bottom line, and in the service margins we're expecting them to be a little bit lower, as Scott said, we're being conservative and we're thinking the $5 below our expectation probably holds, and we're thinking that training revenue doesn't grow the way we originally thought it would, which is good, because it makes the upfront costs to a customer lower.

They can get trained faster, and the other point about going paperless, going green. If we can lower forms costs and forms revenues, because the customer doesn't use checks. That's good for them, but those things would impact the margins.

Nathan Schneiderman – Roth Capital Partners

So, the combination of slightly lower recurring revenue and slightly lower services margin drives a 300 basis point hit to operating margin?

Mitchell K. Dauerman

And I probably would add is if you look at the hosting costs being a little bit higher than we expected.

Nathan Schneiderman – Roth Capital Partners

Okay and then in your earlier comments, you made reference to changes to assumptions on your in customer headcount and attrition rates, etc., that maybe I missed it. What were those changes to your assumptions there about what your in customers would do as far as their own employees and attrition?

Scott Scherr

Well, Nate, we looked at all the factors that obviously go into trying to forecast recurring revenue, which include the time to live we talked about, where we think the time to live stays relatively the same.

You know, in the past we had some net employment growth, because our clients do grow. We do get paid one-time fees. In the past, we took that down. The attrition rate we modestly increased a little bit and, then, we have estimates of price increases which are tied to when customers go live, or when their contracts renew, so we took all those factors into account trying to come up with what we thought was a reasonable estimate.

Nathan Schneiderman – Roth Capital Partners

So, to be clear, you took down your expectation for employee head count growth. You took up your attrition assumption and you took down your assumption for price increases?

Mitchell K. Dauerman

No. I said we analyzed the price increases. Our employees, we took down a little bit, and the attrition was modest change, based on the fact that we're seeing the attrition rate hold pretty constant right now.

Nathan Schneiderman – Roth Capital Partners

And you're not making changes in your pricing assumption?

Mitchell K. Dauerman

When I say the price increase, it would be a calculation. I don't recall offhand what it was. We go through a fairly extensive process of looking at the clients and when they renew and what the expected price increases are going to be.

Nathan Schneiderman – Roth Capital Partners

I heard you address the issue of macro specifically as it related to the preference for intersourcing over perpetual license, but when you think about what happened during the second half of September and October with the disruption in the macro environment, can you just speak to the dynamics? You were saying they're in general, in what various ways is it affecting your business other than that perpetual license issue, and the pressure on services pricing? Thank you very much.

Scott Scherr

Our ARR group by 51%, way ahead of our expectations, we replaced $2 million of license revenue with 16% of ARR. Over the growth if you went to year-over-year. So, we went through this in 2000, and like Mitch said, we didn't have intersourcing at the time.

Our license revenue went down by 50%, so, again, I think it's in our best interest to guide to $2 million a quarter, and the other thing I think is more people are getting comfortable with SaaS. It was inevitable that license was going to come down and intersourcing was going to go up. We always guided to basically what went on in previous quarters of the prior year, and now we think it's prudent just to guide to $2 million a quarter, but the fact is, sales were great in the quarter, as by our ARR and by the units that we sold in the quarter.

Operator

We'll take our next question from Steve Koenig with KeyBanc Capital Markets.

Steve Koenig – KeyBanc Capital Markets

Hi. Thanks for taking my question. One question on revenue and then maybe one additional question if I may, on the revenue side, it looks like your guidance implies that ARR in Q4 would be relatively flat year-over-year, but then next year the following year guidance would be 30% plus. What accounts for the difference between the Q4 implied guidance and the acceleration in '09?

Scott Scherr

Nothing. We used greater than 30%. I think we felt like we’ll go through the number that's on quota. I would think we would do greater than 30%.

Steve Koenig – KeyBanc Capital Markets

In '09?

Scott Scherr

In Q4 '08. I do not believe we're going to be flat.

Steve Koenig – KeyBanc Capital Markets

Okay and then on the follow-up question would be on the cash flow side. Wondering how we should think about any change in the relationship between your cash flow and your pro forma earnings going forward. Did I hear you make reference to the idea that the one-time upfront fee would be smaller than it historically has, or are there other things that would potentially change the relationship between cash flow and earnings?

Mitchell K. Dauerman

No, Steve, our comment about the upfront was talking about the rate per hour on implantation, but I think as estimate, you could take our pro forma earnings as being close – before tax as being close to what pre cash flow per share is going to be for '09 probably real close. In '08, it's probably a little bit under because we did have capital expenditures feeding our depreciation and amortization, and, again, you may remember we bought source code this year that we're not planning on next year.

Operator

We'll go next to Mark Marcon with Robert W. Baird.

Mark Marcon – Robert W. Baird

Good afternoon. I was wondering, can you talk just a little bit more about the dynamics impacting the service revenue, and specifically just the implementations, like why specifically would the rate per hour come down, or why a client would ask for some more outside contracted help?

Scott Scherr

I think it's basically competitive. Quite frankly, our competition, they can use misinformation against us, or price. Those are the two things they use against us, and I think sometimes, we get into deals, and like Mitch said, it's $5 on average that is given up there. We try not to go to recurring revenue. That's our most important asset. Really that's what it is.

Mark Marcon – Robert W. Baird

But have the pricing negotiations become more difficult just because of the macro environment, or are the competitors getting more aggressive? I'm just trying to understand the underlying dynamic and –

Scott Scherr

Well, I think our competitors have always been aggressive from the day I opened the doors at Ultimate Software. I think it's that, and I'm sure the economy doesn't help when it comes to those things. But, again, $5 reduction in the implementation rate to create recurring revenue in the future is something.

Mark Marcon – Robert W. Baird

Yes. It's certainly a no-brainer. It doesn't seem like it would be that big of a difference in terms of the total cost, and so I'm having a hard time imagining a client would switch for just that reason, or make a decision. It seems like your service offering is materially different than somebody else's and –

Scott Scherr

I think it is, but when you're talking $5, our published book rate is $190. Then you have your actual rates. You're talking $5 from some number off our actual rate. So it's not a lot off the rate. It's not like we're charging $10 and we're giving up $5. The book rate is $190.

Mark Marcon – Robert W. Baird

Okay and can you talk a little bit about why you would use outside people for the implementations as well?

Mitchell K. Dauerman

Well, I think as we talked about last quarter, we had a buildup in – the interfaces –

Scott Scherr

Integration.

Mitchell K. Dauerman

Integrations and stuff, and we thought it was a better decision to try to clear as many of those out as we could, so the decision was made. We created a war room; we brought in a bunch of implementation partners to help clear us through that backlog so we could get back to regular state of business.

Scott Scherr

Also just in our normal operating, we've always had implementation partners for the overflow. So we always keep a certain amount of implementation partners busy. Normally, I think John Howard is in charge, made the decision which I agree with. Like Mitch said, create a war room and get through some of these interfaces integration that a lot was due to the selling larger accounts. Just be done with it.

Mark Marcon – Robert W. Baird

Do you feel like you've gotten caught up from that perspective?

Scott Scherr

I think by the end of this quarter we'll be caught up.

Mark Marcon – Robert W. Baird

Okay. Thank you.

Scott Scherr

Thank you.

Operator

We'll go next to Brad Reback with Oppenheimer.

Brad Reback – Oppenheimer

Hi guys, how are you?

Scott Scherr

Good, thanks.

Brad Reback – Oppenheimer

Could you remind us as we look at going forward, what percent of ARR do you think Workplace will represent?

Scott Scherr

Workplace, 30% our plan was for it to represent 30% next year. Our plan this year was to represent around 15%. I'm not sure what it is year-to-date but it was 19% in the quarter, but 30% next year.

Brad Reback – Oppenheimer

Got it and I think you had said earlier that your time to live was within expectations during the quarter? So, building on some of these questions around third party implementation, or using third party, it seems like at some point during the quarter you decided to accelerate that usage. If you had not done that, would you still have been able to keep on that same time to live timeframe, shall we call it?

Scott Scherr

Yes.

Mitchell K. Dauerman

I think the answer is yes, and I think our goal is to decrease it.

Brad Reback – Oppenheimer

Okay, great. Thanks a lot, guys.

Scott Scherr

Thank you.

Operator

Our next question comes from Terry Tillman with Raymond James.

Terry Tillman – Raymond James

Yes, thanks for taking my questions. First question just relates in terms of the licensing business. Have you guys taken away all incentives so a sales rep – it actually makes no sense to even try to push for that deal in terms of their own economics, or are there still some incentives in place?

Mitchell K. Dauerman

We haven't changed a comp plan at all. The salesperson was always intended to sell intersourcing over license, and we've always said that someone goes licensed because their – its part of their covenants and nothing breaches their firewalls, or you just get some companies where the CIO just feels like everything should be in-house.

I think with SaaS growing and growing, that covenant of not breaching the firewalls is becoming less and less, and then I think with the current economic environment, I think intersourcing's a better choice either way, but I think with the current economic environment, either two things, one, some of it – we can switch someone to intersourcing, or that license customer who might have gone with us is just not going to go with us right now because they're not going to pay the upfront economic fees in this environment.

Terry Tillman – Raymond James

Okay and then, Scott, in terms of the mix of business – I know in the past you all had it like a pie chart that shows the mix of business, one replacing service bureaus home-grown solutions. I'm curious, are you still seeing the same type of mix of business come in, or are you seeing any up-tick in order replacement of like PeopleSoft, kind of like Version 8, earlier version-type stuff, or is that actually minimal?

Scott Scherr

So through 9/30 in the Enterprise, 65% of our business came from service bureaus year-to-date, and 35% should be Enterprise or in-house, and in Workplace, really almost 80% of Workplace comes from service bureaus.

Terry Tillman – Raymond James

Okay and then, Mitch, in terms of the assumption around the employment growth, I mean, can you help us at all in terms of historically, I mean, was it just worth a couple of points of growth, and now the headwind, I mean, anything to let us understand how helpful this was in the past, to growth?

Mitchell K. Dauerman

I think as Scott said before, if you took what we saw from January to September of this year, we had a net 1% growth. Last year was 1.8% in that same time period. So we're looking – I look at the trends, the amount of employee reduction in the quarter was relatively small. But, again, we have the clients who are growing, that are adding customers as well, so I think in our estimates, Yes , we've tried to be cautious and take that into account.

Scott Scherr

I would also say we're very horizontal as we're throughout the whole country, a large percentage of our business does not come from any part of the country, and we have minimums.

Terry Tillman – Raymond James

Okay and just, Mitch, in terms of CapEx for '09, I apologized if I missed it, any guidance on '09 CapEx?

Mitchell K. Dauerman

Yes , right now I would say $13 million.

Terry Tillman – Raymond James

Okay, thank you.

Mitchell K. Dauerman

Okay.

Scott Scherr

Thank you.

Operator

We'll go next to Franco Turrinelli with William Blair & Company.

Franco Turrinelli – William Blair & Co.

Yes, hi guys. How are you this afternoon?

Scott Scherr

Franco?

Franco Turrinelli – William Blair & Co.

Mitch and Scott, the third quarter I think in the past we sort of understood it to be a little bit unusual because of the – now kind of summer season not much gets decided, which makes it maybe a little bit more backend loaded than usual.

I'm thinking that maybe things started really to get weird towards the end of the quarter from a macro point of view. Do you think that we may have seen a little bit more than a normal impact, kind of because of that in this quarter?

Scott Scherr

Obviously our sales numbers were tremendous.

Franco Turrinelli – William Blair & Co.

Yes, I'm wondering particularly maybe on the license fee, I mean, maybe here's a different way of asking it.

Do you think there was just some deferrals rather than some switching, or was this really just this $2 million is kind of a run rate for the fourth quarter and beyond?

Mitchell K. Dauerman

I think with what I know and what we know, that's a right run rate and I think, obviously, which we've always said, if we can replace that with intersourcing dollars, that's good for us.

Franco Turrinelli – William Blair & Co.

So of the fees – the license fees that didn't take place in the quarter, I think, Mitch, you yourself said that they ended up being below your expectations. Could you give us kind of a sense of whether those missed license fee sales did, in fact, turn into intersourcing sales, or did they just kind of go away relative to your expectations?

Scott Scherr

I think that would be very hard to do, Franco.

Mitchell K. Dauerman

But then I think, Franco, with looking at the ARR being above what the expectations were, some of it had to translate into that, and some, as Scott said before, may have gone a little bit on the sidelines.

Franco Turrinelli – William Blair & Co.

Sure.

Mitchell K. Dauerman

It's not that granular.

Franco Turrinelli – William Blair & Co.

Okay. Hey, Mitch, I apologize if I missed and I sort of think I can back into it. Thanks to the all disclosure that you've given us on the operating expenses, but can you help us walk through, or can you walk us through a little bit more the gross margin forts for the fourth quarter and maybe to the extent that you're willing to do so for 2009?

Mitchell K. Dauerman

Sure. We think the gross margin in hosted and recurring is going to be 72%, services are going to be 20%, you end up getting to a blend, somewhere around 53%, total and then for next year, we see the recurring revenue, coming in pretty close to the same for the full year.

And service margins will probably come up a little bit for the full year it's probably about 22%, 23%, and the overall margin for the year, again, because license is going to decrease, probably stays flat.

Franco Turrinelli – William Blair & Co.

Thank you. That's very helpful.

Mitchell K. Dauerman

Sure. Thanks, Franco.

Operator

We'll go next to Tom Ernst with Deutsche Bank.

Tom Ernst – Deutsche Bank

Hey, guys. Any thoughts about changing the tactics, either pricing or perhaps compensation quotas to either emphasize or deemphasize the license revenue next year?

Scott Scherr

I mean, I think we've only deemphasized license, we're having more conversation on license on this call maybe than ever before. We've always deemphasized it and whenever even in previous quarters of previous years, when we got more ARR and less license, we always viewed that as a positive and, like I said, I would never do anything to increase license sales, so –

Tom Ernst – Deutsche Bank

I guess what I'm asking is, given that it's fallen below 5% of revenue, and you're giving us guidance for it to stay at this low level, are you perhaps decreasing the compensation to further deemphasize it to cause it to fall away, or is the basic pricing and compensation the same as last – as this year?

Scott Scherr

Exactly the same, did not do anything with compensation at all, it was the same.

Tom Ernst – Deutsche Bank

How about pricing?

Scott Scherr

The Enterprise sales team sells license, the Workplace sales team is 100% intersourcing.

Tom Ernst – Deutsche Bank

Right. Did you change the pricing at all in your assumption for next year?

Scott Scherr

No.

Tom Ernst – Deutsche Bank

Okay and then, just a quick clarification, I'm guessing you just misspoke on the call.

The press release said you're guiding for 10% to 12% operating margin in Q4, and I think you said, if I didn't mishear, 9% to 10% in the script.

Scott Scherr

I'm sorry. We said 9% to 10% for Q4 of this year, and 10% to 12% for next year for the full year.

Tom Ernst – Deutsche Bank

Oh, you know what? I just wrote it down wrong. You're right. Okay, thanks again.

Scott Scherr

Okay. Thank you.

Operator

We'll go next to Brad Whitt with American Technology Research.

Brad Whitt – American Technology Research

Hey, guys. Thanks for taking my questions. Most of them have been answered, but I guess in follow-up on some of the other questions. If we were to just assume, for example, that $2 million worth of license revenue convert – actually became recurring revenue this quarter, how would that impact ARR?

So, what would normally be $2 million in license revenue, what would that be in ARR – approximately?

Scott Scherr

I'll give you that one now.

Mitchell K. Dauerman

Probably, $0.5 million.

Brad Whitt – American Technology Research

Okay. That's helpful. Thanks. Mitch, I apologize if you answered these too, but do you have a tax rate assumption for Q4? Should we stick with 39, or –?

Mitchell K. Dauerman

Yes, 32.

Brad Whitt – American Technology Research

Okay, great and, then, depreciation amortization for '09 –?

Mitchell K. Dauerman

I think it's going to be 13, the amortization and CapEx for '09 are going to be the same.

Brad Whitt – American Technology Research

About the same, okay very good. That's all I have. Thanks for taking my questions.

Mitchell K. Dauerman

Okay, Brad.

Scott Scherr

Thank you.

Operator

We'll go next to Dan Cummins, with Lime Rock Research.

Dan Cummins – Lime Rock Research

Just two quick questions, Mitch, have you seen anything in October, thus far that leads you to believe you'll have to put more in the reserve in the fourth quarter, or do you think you've been sufficiently conservative with what you've done, and I had a question on services margin.

Mitchell K. Dauerman

No, we've seen nothing that would say that reserve would change, that it would go up.

Dan Cummins – Lime Rock Research

Okay. The incremental gross margin year-over-year, is down to zero. I think it's normally like 20% to 25%. I thought you said it was both a billable rate for the implementation consultants as well as the missing maintenance, because of the lower license, is that correct?

Mitchell K. Dauerman

I'm sorry, in terms of '09 over '08?

Dan Cummins – Lime Rock Research

Well, I was just looking at '08 over '07, just looking at the incremental gross margin on services. Because the $5, as Scott was saying, on a base of $190, that wouldn't explain all of it, so it sounds like there was also that missing maintenance component.

Mitchell K. Dauerman

Maintenance wouldn't go into services.

Dan Cummins – Lime Rock Research

Okay. Sorry, where do you book your maintenance revenue?

Mitchell K. Dauerman

Maintenance goes into recurring.

Dan Cummins – Lime Rock Research

So I'm just having trouble understanding why your incremental gross margin on services would roll all the way back to 0 this quarter, and where do you get the confidence to put it all the way back to 20% to 25% next quarter?

Mitchell K. Dauerman

Dan, do me a favor. Answer the question again, because I'm not tracking with what you're asking me to compare. I'm happy to do it, but –

Dan Cummins – Lime Rock Research

Okay, sorry. I'm looking at the incremental gross margin on services. It was 0, year-over-year on your GAAP numbers. I recognize it's probably better to do it on a cash numbers basis.

Mitchell K. Dauerman

Yes, that's why I'm having trouble. You're saying the incremental on year-over-year for just Q3?

Dan Cummins – Lime Rock Research

Yes, Services.

Mitchell K. Dauerman

I had it going up a little bit.

Dan Cummins – Lime Rock Research

Okay. I've gotten around 0, it was tracking year-to-date at around 20%. We can do this offline.

Mitchell K. Dauerman

Can we do this offline? Unless somebody else has an interest, because I'm just having trouble tracking what you're asking me to compare. I'm happy to do it, and anyone else who has the question can call me later and ask as well.

Dan Cummins – Lime Rock Research

Okay. Alright, thank you.

Mitchell K. Dauerman

Thank you.

Operator

And that does conclude the question-and-answer session. At this time, I'd like to turn things back over to Mr. Scherr, for any additional or closing comments.

Scott Scherr

Okay. I think before I close I wrote down a few points quite frankly about the year and what's been going on, but I think the fact is we're growing new sales faster than expected.

In Enterprise sales, we're selling more larger deals than we expected. That 50% of our ARR is over 3,000 employees. Quite frankly, Workplace is killing it, above any expectations we had, and then, finally licensed software sales are going down and they're being replaced by intersourcing, which is a better long-term result for us.

So I appreciate all the questions and everyone being on the call, and obviously, if you need to speak to Mitch or myself, we're both here. Thanks for your time. Goodnight.

Operator

Once again, that does conclude today's conference call. We again thank you for your participation and you may disconnect at this time.

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