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The Ultimate Software Group, Inc. (NASDAQ:ULTI)

Q2 2009 Earnings Call Transcript

July 28, 2009 5:00 pm ET

Executives

Mitchell Dauerman – CFO, EVP and Treasurer

Scott Scherr – Chairman, President and CEO

Analysts

Richard Baldry – Canaccord Adams

Michael Nemeroff – Wedbush Morgan Securities

Nathan Schneiderman – Roth Capital Partners

Richard Davis, Jr. – Needham & Company, Inc.Franco Turrinelli – William Blair & Company

Ilya Grozovsky – Morgan Joseph

Terry Tillman – Raymond James

Brad Mook – MKM Partners

Mark Marcon – Robert W. Baird

Brad Whitt – Broadpoint AmTech

David Cohen – JP Morgan

Zubin [ph] – Deutsche Bank

Brian Schwartz – Piper Jaffray & Co.

Raghavan Sarathy [ph] – Sidoti & Company

Brad Reback – Oppenheimer

Operator

Welcome to Ultimate Software’s second quarter 2009 financial results conference call. Your presenters today will be Mr. Scott Scherr, Chairman, President, and Chief Executive Officer; and Mitchell K. Dauerman, Executive Vice President, Chief Financial Officer, & Treasurer.

At this time all participants are in a listen-only mode. Today’s conference is being recorded. We will begin with comments from Mitchell Dauerman.

Mitchell Dauerman

Okay thank Jay. Good afternoon and thank you for your interest in Ultimate Software. Before we begin, please be aware we will be discussing our business outlook and we 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 risk 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 it is a result of new information, future events or otherwise.

I'm going to begin by reviewing our financial results for the second quarter and then I will provide financial guidance for the third quarter and the balance of the year. Unless otherwise noted, our discussion will be on a non-GAAP basis for all costs, gross margins, operating, and net income, as well as 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 our financial information on a GAAP basis to that on a non-GAAP basis, attached to the press release published on our Web site.

Total revenues were $47.3 million for the quarter to $41.5 million last year. Non-GAAP net income was $1.7 million or $0.07 per share, compared to $1.3 million or $0.05 per share last year. For Q2, our recurring revenues were $32.6 million, compared with our guidance of $32 million to $33 million.

Recurring revenues grew by 28.6% for the same period from the same period last year and represents 69% of total revenues. Recurring revenue costs were better than our expectations, resulting in a 71% gross margin, compared to our expectation of 69% to 70%. Our time to live periods for our core Intersourcing product remained inline with our expectations.

The annualized retention rate was more than 97% for our recurring revenue customer base, and our customers experienced a 3.4% reduction in employment since December 2008, and this was based upon measuring the changes in employment of our clients that we laid on our core Intersourcing product both in June and in December of 2008.

Service revenues for Q2 were $13.4 million, less than our expectations as they continue to reflect the impact of the economy on discretionary implementation and training services. Service costs were inline with our forecast, resulting in a lower related gross margin.

License revenues were $1.3 million for the quarter. They were no new perpetual license sales in Q2 as we no longer intend to sell new onsite perpetual licenses. However, we did have three carry over contingent license sales that occurred in Q1, which we were unable to convert to subscription type on premise sales.

In addition, we have some additional license revenues generated from existing license customers, which primarily resulted from growth provisions in their existing agreements with us. We expect the impact of these types of license revenues to be minimal for the rest of the year.

Total gross margins from all revenue sources both in dollars and as a percentage of revenues were better than our expectation, as a result of a more favorable revenue mix. On the operating expense side, our total operating expenses were $24 million. Sales of marketing, R&D, and G&A were favorable to our expectations.

Due to a combination of permanent savings from lower cost such as T&E and to a lesser extent, some temporary savings, which were due to the timing of some operational expenses that did not occur this quarter as planned, but are affected to be encouraged before year-end and have been factored into our guidance, which we will discuss later.

Operating margins were 6.1% compared with our guidance of 3%. Lower-than-expected overall cost, including both cost of revenues and operating expenses and additional license revenues contributed to most of the excess operating margins. On non-GAAP income tax rate for the quarter was 40.8%, bringing the full-year expected rate to 41.9%. Our cash income tax rate will remain in the low single digits.

Now, turning to the balance sheet, total cash and investments in marketable securities were $31.3 million at June 30. For the quarter, we generated $7.1 million in cash from operations. We invested $1.4 million in total capital expenditures and free cash flow was $5.8 million. We did not purchase any of our company’s stock during this quarter.

Accounts receivable increased to $33.8 million from $32.1 million at the end of June last year. DSOs were 65 at the end of June compared to 70% at June 30 of last year. Deferred revenues were at $62.5 million as of June 30. This was an increase of $9.3 million from June of last year. As a reminder deferred revenue in the first half of the year reflects seasonality in annual maintenance billings.

It is typical in the first of the year that maintenance revenues recognized in the income statement will exceed the annual maintenance billings recorded as deferred revenue on the balance sheet. In addition, deferred revenues also reflect a change in contractual implementation services, which tend to fluctuate from one period to the next.

Now turning to our expectations for Q3, we expect recurring revenues to be between $34 million and $35 million. Total revenues should be between $49 million and $50 million. Operating margins should be approximately 5%. Stock-based comp and amortization of intangibles should be about $3.5, and deluded weighted average share count should be about 26.3 million shares.

For the full-year, we expect our total revenues to grow approximately 12%. This reflects a revised estimate that service revenues will likely stay under pressure and will be flat with last year. After taking into account the front loaded and higher than expected same-store employment reductions of our existing clients, we are now expecting that recurring revenues growth will be approximately 27%.

We expect license revenues to be approximately $3.6 million for the year. We have successfully managed our total expenses so far this year, and service revenues had not grown as expected. We will continue to monitor and control our cost for the balance of the year. Accordingly, we feel confident that we'll be able to achieve operating margins for the year of between 6% and 7%.

Turning to our upcoming conference schedule, I will be at the Oppenheimer annual communications technology and Internet conference on August 11 and at the Canaccord Adams 29th annual Global Growth conference on August 12. Both are in Boston and if you're available to meet, please let me know. And now I will turn the call over to Scott.

Scott Scherr

Thanks, Mitch. Thank you everyone for participating in our call this evening. As Mitch said, our second-quarter 2009 recurring revenues were $32.6 million up 29% over those in the second quarter of last year and our total revenues were more than $47 million, up 14% over last year's second quarter.

I just returned from our mid-year sales meeting for both enterprise and workplace. In enterprise, we had zero turnover in our sales force in the first half of this year. We added another salesperson in Canada that brings the team to 26 with five additional client-based players. The team is positioned for a strong second half and it’s staff to attain our 2010 goal.

Some of our new enterprise customers in the second quarter were PPG Companies, a health care service conglomerate with more than 6,500 employees that had signed up for on boarding in addition to Core UltiPro, unit trend, one of Americas leading financial services providers with 3,000 employees has selected Core UltiPro, as well as recruitment time and attendance and performance management.

The David Joseph Company, a world leader in scrap processing and trading with 2,100 employees has signed up for Core UltiPro recruitment and on boarding. Daymon Worldwide Inc., the world's leading private brand broker with 1,500 employees had selected recruitment on boarding performance management and time and attendance.

Nueterra Holdings, a diversified healthcare real estate and capital management services company with 2,000 employees had signed on for recruitment on boarding performance management and time and attendance, and SNC-Lavalin ProFac, a diversified facilities management company with 3,300 employees in Canada.

A tax rate of our complementary products continue to reflect the markets appetite for integrated payroll, human resources, and talent management solution. For new enterprise customers the tax rates for recruitment were 65%, onboarding 62%, performance management 57%, and time and attendance 35%.

In workplace, we added our fourth and final division as planned. We have officially completed our mission to become a nationwide player in the 200 to 700 market. We hired four new a players in the quarter, bringing our total to 34. We will higher three more January 1 and will stay at that level through 2010.

Q2 was the best quarter in the workplace’s history, record units and dollars. Our tax rates were very strong again showing market desire for unified products. For workplace, the attach rate for tax filing was 100%, for time and attendance 77%, performance management 58%, and recruitment 54%.

Some of the new workplace customers are CFG Health Systems, a New Jersey-based health care provider with 700 employees, added recruitment and time management. Lawry's Restaurants Inc., a restaurant chain with 660 employees added recruitment performance management and time management.

Presbyterian Homes of Georgia, a healthcare facility with 650 employees also added recruitment, performance management, and time management. An RTI Biologics Inc., the leading provider of several biological implants for surgeries around the world with 630 employees added the same three complementary products, recruitment, performance management, and time management.

Our sales teams are excited about their success and the road ahead. They see how market demand for our products continues to grow and they are confident of achieving our 2009 and 2010 annual goals. We are pleased to have a pipeline that continues to expand. In this year's second quarter, we had a 34% increase in total responses to a marketing campaign's over those in Q2 ’08.

And we had three other record indicators for market interest in Q2 ‘09. We have the highest number ever of leads looking to buy within the next 24 months that came in proactively through our website. We have the highest number ever of looking, registering [ph] at our regional sales seminars, and we have the largest number of attendees ever to our in directed workshop on strategic AR for a single quarter.

Our customers have continued to support us at our strategic workshops across the country. In Boston, for example some of the customers who spoke for us were Perry Sholes, Vice President of Talent Management for Thomas & King, a restaurant chain with more than 7,500 employees that owns and operates 90 Applebee's restaurant and seven Carino’s restaurant.

Heidi Shepherd, a partner at Goodwin Procter, one of the nation's leading law firm that has 900 attorneys. Martha Higgins, Executive Vice President and Director of Human Capital Resources of Boston Private Holdings, a NASDAQ firm that owns financial services firms across the United States. Scotty Gerard [ph] Vice President of Human Resources (inaudible), a privately held software company with more than 20 global offices.

And William Cox Vice President of Human Resources Ahlstrom Corporation, a global leader in the development and manufacture of fiber faced materials.

In closing, we received two major recognition awards in the second quarter that speak volumes about who we are. The first, was UltiPro being named Number 1 in the People's choice competition sponsored by American Business Awards for the favorite new Software-as-a-Service solution in America.

In a vote open to the public, more than 100,000 votes were cast. Some of the companies competing in the favorite SaaS solution category with Ultimate were Salesforce.com, Cisco

WebEx, Citrix Online, NetSuite, and Peopleclick. We are honored to be chosen by the people as the most popular among such excellent solutions.

The second recognition we received, was Ultimate’s ranking as the Number 1 best medium-size company to work for in America by the Great Place to Work Institute, for the second consecutive year. No other company has ever been named Number 1 twice in the 250 to 1000 employee rankings.

I had the honor of accepting the award before an audience of more than 10,000 at the Society for Human Resource Management’s 61st Annual Conference in New Orleans. From the beginning when there were four of us, we believed that if we took care of our people, they will take care of our customers.

Today with 947 of us, we believe the same thing. Together, we have built a culture of trust. A culture along with our passion and a strong sense of ownership has been a huge differentiator for us. It is what drives our results. We will continue to talk the talk and walk the walk. It is the only path me know. Thank you for all your support, greatly appreciate it. Let’s move to the Q&A.

Question-and-Answer-Session

Operator

(Operator instructions) And we will go first to Richard Baldry with Canaccord Adams.

Richard Baldry – Canaccord Adams

Thanks. As a strong cash generating quarter and we saw the buyback was ultimately touched, could you talk a little bit about your thoughts on that side of the table, and then maybe qualitatively talk about where you feel your team is in sales in relation to the quarters at this point in the year? Thanks.

Mitchell Dauerman

Rich I mean cash flow, we had stronger and been better than expected earnings for the quarter. On second, we had better cash projections, good quality AR that is remaining, and the third is on the capital expenditure side, we then were been able to manage to keep our customers happy to do the right things and we have spent less in CapEx.

Scott Scherr

Both teams are doing well and they expect we are going to achieve our goals this year and as I mentioned in my prepared remarks, we there position for 2010.

Richard Baldry – Canaccord Adams

On the cash flow side, could you talk about that in relation to the possibility of going back into an active buyback mode? Thanks.

Mitchell Dauerman

Yes, we had an active buy back program. We intend to be active by this company.

Richard Baldry – Canaccord Adams

Thanks.

Operator

And we will go next to Michael Nemeroff with Wedbush.

Michael Nemeroff – Wedbush Morgan Securities

Hi guess thanks for taking my questions. Just on the services revenue, obvious it was under pressure this quarter, how much of the services revenue are discretionary as you mentioned and how much of it is necessary for implementations. I guess what I'm trying to get at is, should we see the slowdown in services revenue as an issue with the slowdown in ARR or bookings because mu understanding is all the services revenue is implementation related? And then I have a follow-up.

Mitchell Dauerman

Yes Mike. I don't have the exact percentages, but services revenues consist of implementation, which are both to new customers, which we mentioned before. You know our customers share how much of the implementation. They are going to do we are going to do, so there is a little bit of discretionary there as to how much they want to contribute to the process and stay on track. There is also training, services and then there is a back to the implementation, there are additional services that our customers buy. You know to write more reports to do more inter-phases to do other things.

So, I think you will have the feeling we are seeing the bottom of that, we have better visibility into where we end up for the year and that's why I think we came out now and said, you know we now think it is going to be flat for the year, as opposed you may remember in the beginning of the year, we thought we would be acquired to 8% uptick.

Michael Nemeroff – Wedbush Morgan Securities

And then just as a follow-up, for Scott, I know you are not giving that aero metric anymore, but could you qualitatively comment on how do you felt the quarter went in terms of new bookings?

Scott Scherr

Yes I thought it went great.

Michael Nemeroff – Wedbush Morgan Securities

And then just one last one, any changes to be expected, I think you talked about in the past and improvement in the margin for 2010 of 500 to 600 BPs, is that anything that – this quarter shaken that in any way.

Scott Scherr

We haven't seen anything that would change that Mike. We will go through, will give our preliminary guidance for 2010 after next quarters fall, but everything just seems to be in line.

Michael Nemeroff – Wedbush Morgan Securities

Thanks very much guys. Thanks for taking my questions.

Operator

And we will go will go to Nathan Schneiderman with Roth Capital Partners.

Nathan Schneiderman – Roth Capital Partners

Hi thanks very much for taking my question. I was curious Scott and Mitch given the upside in operating margin this quarter never enjoying a favorable mix shift, why wouldn’t you expect to see operating margin progress upwards versus that 6% to 7% level that you talked about last quarter and if you are actually spending more to offset that, where a spending more?

Mitchell Dauerman

Well I think it was a combination. One is, don't forget license is going to go away, you know in the third quarter. So, if you're looking at this quarter's operating margin is going to drop back down. And then, typically in the second half of the year, you know we are making our investments that set up the following years. So, I think it is too soon to say whether – let me say the other way, I think we are comfortable by getting to 6% to 7% operating margins compared to where we were in the past year is a good plan to have and it sets us up as Mike asked the question, you know where we are going next year. And I think if we can continue on that which is our goal, you know we get to, you know in our next championship is $200 million and another 25% operating margins, 400 million and 25% operating margins in 2012.

Nathan Schneiderman – Roth Capital Partners

Scott, a couple of questions for you. One, if you think about the selling environment and sales cycles do you feel like the Q2 environment versus Q1 was stable getting better or getting worse? And then I thought you referenced 2009 and 2010 goals, could you articulate what those where? Thanks very much.

Scott Scherr

We had a good Q1, we had a good Q2. Like I mentioned workplace saw the most unit and the most dollars ever in Q2. We have a quarter plan that generates our business plan this year for 2009. I know we have one for 2010, my point in saying that was that we are staffed now really with all the new people who came on during the year that achieved not only what we intend to achieve in 2009, but we are positioned for 2010, and in hiring, we are going to get highest three workplace sales people in January and then we will be it. What our plan is what are plan has been to achieve 2010. So, I am confident in the second half of the year and I am confident right now in 2010.

Operator

And our next question will come from Richard Davis with Needham & Company, Inc. Mr. Davis your line is open.

Richard Davis, Jr. – Needham & Company, Inc.

I am sorry, I had it on mute. So, with regard to services Mitch, should we notionally kind of think next year, because I don't think that your services business would grow roughly in line with your recurring revenues, especially as you move up market and when you know some nice larger accounts, or is it that you are pushing those out to kind of partner so that we should not expect that to grow with the same pace as your recurring revenues just kind of directionally for next year?

Mitchell Dauerman

Rich I think there hasn’t been a connection between return in revenue growth and services for a while. Couple of things, one is kind of the growth in return revenue is coming from workplace, which has a much lower service to employee or service to return revenue dollar ratios and that is the first point and in terms of our enterprise clients, you know one thing is we are always trying to find ways to make the implementations more efficient and push those productivity savings to our customers. You know off a lot of these have always been, if we can lower the cost for services, you know we will have the opportunity to sell more customers and bring on more recurring revenue. So, I think it is a little early to kind of guess where it is going to go next year. I think that – keep in mind our focus is growing new sales customer retention and growing recurring revenues. That is our focus. So, services we kind of look at if you will secondarily.

Richard Davis, Jr. – Needham & Company, Inc.

Got it. And then we are hearing from some FAS companies and I was curious if you could comment on it, if you have seen it that some of them has had to kind of – when a contract which comes up for renewals since they had lost feet or something like that they would something have to either discount additional modules or even throw in free modules that keep the subscription at the same price. If I was getting a $100 a year, my seek panel went down 10%, that asset growing as a company in (inaudible) 10% to keep that $100 per year revenues stream. Have you seen that happen to you guys or is that been something that people back for, but you have said no?

Scott Scherr

We haven't seen that.

Richard Davis, Jr. – Needham & Company, Inc.

Got it. Okay, well those are my questions. Thanks a lot.

Operator

And we will go next to Franco Turrinelli with William Blair & Company.

Franco Turrinelli – William Blair & Company

Hi Mitch, hi Scott.

Scott Scherr

Hello Franco

Mitchell Dauerman

Hi Franco.

Franco Turrinelli – William Blair & Company

Mitch, could you kind of go back to your comments on the operating expense from – and candidly we’d had much higher operating expenses, particularly on the sales and marketing from Scott told us, but we've had a bang out quarter for sales, so it doesn't look like it was lower commission, so I just was trying to understand a little bit better on some of those savings, but you alluded to on the operating expense front.

Mitchell Dauerman

Franco, when you think about commissions just keep in mind that on returning revenue the commissions get amortized over the initial contract periods. So it's a function of when those clients come online and then you'll see the rationing up there. But we saw, you know T&E lower across the board. Sort of little bit less in some of our internal trading costs, but those are probably most of them.

Franco Turrinelli – William Blair & Company

Okay. So, that was very helpful thank you. Because obviously you know the superficial, you know kind of media concern was that below our sales and marketing expense reflected lower commissions, but were in turn the result of lower sales and Scott has clearly said that's not the case, so that's what I just want to make sure I understood.

Mitchell Dauerman

Yes, just to be clear commissions on license sales expense right away. So, now that license sales are nominal and will be virtually nothing, you won't have that immediate effect in sales and marketing.

Franco Turrinelli – William Blair & Company

Okay great thank you that is very helpful.

Operator

And we will go next to Ilya Grozovsky with Morgan Joseph.

Ilya Grozovsky – Morgan Joseph

Thanks guys. I just wanted to get a clarification, you said I think in the prepared remarks that your customer base saw a 3%, did I get that right, reduction in headcount?

Mitchell Dauerman

3.4 million.

Ilya Grozovsky – Morgan Joseph

3.4. And so looking back at the end of the first quarter in your comments, you had said that for 2008 your customer base despite the economic situation saw 1% increase in headcount, net effect. So can you sort of just recap the last, I guess two quarters, what was the first quarter like in terms of that number and what was the second quarter like and sort of how do you reconcile, you know last year obviously unemployment was up a lot and continue to move up in sort of – what changes are you seeing that it is now beginning to effect your headcount, your customers headcount?

Mitchell Dauerman

IIya, I don't know that I could explain in all the specific customers why they change and why last year was up one percentage as you said, but this year it was down 2.7% at the end of the first quarter and it was down 3.4% cumulatively through the end of second quarter.

So, it is more that we had originally expected and it is more front loaded in the year than we originally expected. So, when we take a look at our models and we try to, I think like everyone else does, try to read the (inaudible) as to where we think it is going to go. You know one thing to keep in mind, we have a number of seasonal type customers, a number of retail customers, so – you know one of the things it is tough to do, is you have to look at the fourth-quarter and ordinarily we pick up a decent amount of revenue in the fourth quarter.

So, you know now you have to wonder what's going to happen this year. You know again I think I have told you and a number of people, you know that is a piece of the puzzle, but it is not as important as the fact that we retained 97% of our customers. You know those companies that may shrink a little are going to come back at some point and create some wind in our sale. So, like I said, we are just trying to give our best estimates based on what we have seen so far.

Ilya Grozovsky – Morgan Joseph

Okay. And then, just as a follow-up to that, so that’s happening at your customers, but if we calculate, if we add in your new customers, so that can you give a general sense of what the overall number of users, the growth in the overall numbers of users of your software from let’s say the end of – over the past–

Scott Scherr

I don’t – I don’t have those numbers.

Mitchell Dauerman

I think we have said that our goal this year was an enterprise of 100 units and workplaces have 300 units. So still 400 units this year and we are on track to accomplish that.

Ilya Grozovsky – Morgan Joseph

Okay. Great. Thank you.

Operator

We'll go next to Terry Tillman with Raymond James.

Terry Tillman – Raymond James

Yes. Good afternoon, guys. In terms of, if I look at the new recurring revenue growth at 27%, so its down from 27%, 29%, that looks like 3 million or 4 million are of the recurring revenue mix, that’s a lot. Is that all just employee attrition or is there anything related to assumptions in the back half around time delays or just may be softer bookings in the first half?

Mitchell Dauerman

I think if you go from the midpoint of our original guidance to the 27%, you are probably looking in the area of $1.5 million, maybe $2 million and basically the way I am looking at is about 2% higher shrinkage than I would have forecasted at the beginning of the year. And I am hesitating because it is combination of that same store type approach plus a kind of revisiting the seasonality number.

Terry Tillman – Raymond James

Okay. And in terms of the license business, I mean I am trying to get a simple apples-to-apples because I wasn’t assuming any meaningful license and I could take our license in the cost of licensees I enough. I am sharp enough to be able to get that done. But on sales and marketing, what would I take out of the commissions to kind of look at on apples-to-apples just pure recurring revenue business during 2Q to get an earnings number that’s more apples-to-apples what we were looking for? Is it a meaningful amount or was it actually a small little piece in sales and marketing?

Mitchell Dauerman

I would say, it’s a 100,000 or less.

Terry Tillman – Raymond James

Okay. So small, okay.

Mitchell Dauerman

And there was just, you know Terry, there is also a small piece that sits in cost of revenue, that’s incremental as a result of license sales.

Terry Tillman – Raymond James

Okay.

Mitchell Dauerman

Again all of those items are probably around 200,000 or so.

Terry Tillman – Raymond James

Okay. And then just lastly, Mitch, if you could give us an update on, I think in the past you have talked about may be a relationship with free cash flow and maybe non-GAAP operating income, I am just trying to get a sense on what’s kind of a full year logical view on free cash flow? Thanks.

Mitchell Dauerman

Terry, I think for now I want to stick with what we have said. It’s going to be approximately equal to non-GAAP pretax income. Obviously, the opportunity is there to be better but I think right now that’s our expectations around that number and if we do better, we do better and we will judge from there.

Terry Tillman – Raymond James

Thank you.

Operator

Our next question comes from Brad Mook with MKM Partners.

Brad Mook – MKM Partners

Hi, guys. Mitch, I want to revisit the install base quickly I don’t want to be the dead horse, but the one question I have, how much wiggle room have you left yourselves if the base – if the unemployment continues to pick up and are we going to be looking at potentially another revision or two in the third and fourth quarters?

Mitchell Dauerman

Well, the fourth quarter will be exact. It’s a hard answer to – hard question to answer, Brad, because when you are doing – I think what sometimes is hard to understand is when you are building a recurring revenue, it's not as simple as just adding a new customer when they come on board and you have a number of other factors. They go in to both changes in employment, seasonality, pricing, you know we have run offs at one time fees, you have all of those things that go into it. We have run our models, we have run different scenarios, we felt that by saying approximately 27% was, we were basically sharing with you the way we are seeing it. I would know how to answer your question about how much wiggle room or if you are saying did we put free cushion in for that? No, we don’t approach it that way.

Brad Mook – MKM Partners

Okay. So let me approach it differently. The 3.4% number, where do you expect that to be in two quarters?

Mitchell Dauerman

I can’t give you an exact number, but I can tell you that if I did it on a full year average basis, it’s probably 2% higher than what we originally estimated.

Brad Mook – MKM Partners

Which was?

Mitchell Dauerman

Well, if you remember, we had originally estimated we would have a 4% pro rata reduction from the beginning of the year which would give you roughly a 2% weighted average. So now I am saying that 2% goes up to 4%, but I am being very cautious to point out that, that doesn’t necessarily mean the base at the end of the year is 6% or 7% lower, it depends on the monthly weighting and that’s what we saw continuing to happen here from the first quarter, it was down but if it continued to drop in the second so that frontloading effect will have an impact on the recurring revenues for the balance of the year, if it stay at that level or they decline a little bit.

Brad Mook – MKM Partners

Okay. Yes, that kind of helped. I appreciate that. And just to make sure that I am clear, Scott, you are saying you don’t need to hire any enterprise sales people at the beginning of next year?

Scott Scherr

Yes, we are set right now.

Brad Mook – MKM Partners

Okay. And then finally, this improvement in the pipeline seems pretty exciting and seems accumulation of lot of efforts through the years, but is there anything in particular that’s driving any kind of inflection or change there?

Mitchell Dauerman

My belief as you go, you brand more, you see more people and also think that people out there now are, they are looking for an integrated HR product. So I just know the results are good for us and more people are in our pipeline than ever, and we have a sales team that’s very tenured that can close, we have over 90% close rate when we can get in and run our process. I don’t see why that would change. We said the whole ride that the more people get in the pipe, the more business will sell and I think that’s what happening.

Brad Mook – MKM Partners

Got it. So what you are doing is working, so you will do more of the same.

Mitchell Dauerman

I think we have been doing it for 19 years by the way. It keeps; I don’t know when the tipping point is for certain things. I wouldn’t say we are near at tipping point yet but certainly more people know about us. I was at the Sherm show accepting that award and our booth was five, six the whole time at Sherm and I think it’s just, if you build a good brand and a good franchise, and more people might look at you and I think fairly they are looking at us, more people are looking at us. The more clients you have, the more people they know in the business so they might refer us. I mean if everything that happens when a business grows, I think it’s successful at a good product and the support.

Brad Mook – MKM Partners

Great. Fair enough. Thank you.

Mitchell Dauerman

Okay.

Operator

And our next question comes from Mark Marcon with R. W. Baird.

Mark Marcon – Robert W. Baird

Just wondering if we could talk a little bit about the margin expectations as we look out at Q3 and Q4, can you talk a little bit about how you would expect the recurring revenue margins to unfold? It looks like we are hitting some stability and in fact may be the incremental gross margin actually kicked up a little bit here in Q2.

Mitchell Dauerman

Mark, I think the answer is we will stick with our kind of 69%, 70% and 71% target range and depending on where expenses come in, we could do a little bit better or we could be on lower end. And I think that’s what how we have been managing throughout the whole year is expecting that and as you know, we have done a little bit better in the first two quarters.

Mark Marcon – Robert W. Baird

Yes, I was just wondering if you were expecting it to continue to be a little bit better or particularly as revenue ramps up a little bit?

Mitchell Dauerman

During this year, my expectations still stay in that 70% to 71%.

Mark Marcon – Robert W. Baird

Okay. And how are you thinking about the services revenue?

Mitchell Dauerman

Services revenue or–

Mark Marcon – Robert W. Baird

Or gross margin. I am sorry.

Mitchell Dauerman

Yes, 20%. It’s become the really difficult area to gauge and to repeat what I said earlier, it's not the prime focal point for us. So we know that the team that’s out there is doing absolutely the best they can to run a good business, but I think the reality is its probably in the 20%, may be its 21%, but I think as long as our customers are happy, as long as they were being installed maybe we get some return to the training revenue which you know is all 100% margin on that extra sheet. May be it picks up a little, but I think as far as setting our kind of expectations, we have had, if you will, lowered them to flat revenue and 20%ish service revenue with knowing that there could be some upside.

Mark Marcon – Robert W. Baird

Great. And can you talk a little bit about the operating expenses? It sounds like sales and marketing probably doesn’t change that much. You are adding three more workplace people, R&D, G&A, how should we think about this sequential progression there?

Mitchell Dauerman

Well, you got to remember some of the patterns that go on. With sales and marketing, commission expense, we will go up as more customers come on board. And in Q3, we will have – we had our national meeting and club, so that will increase a little bit, of course a little bit of increase.

When you go into Q4, sales and marketing will probably drop, let’s say flat, but because you don’t have that meeting in the cost there and you also have this item that hits all the areas across which is vacation pay. We build up, we approve vacation pay throughout the year, at the end of the year there is an adjustment based on our plan and typically it creates a reduction in compensation expense. So you could say sales and marketing probably goes up a little bit, may be stays at that level for Q4 probably a fair thing to think.

On R&D, we do expect to see R&D go up and that’s because some of the planned training expenses were planned for the second half of the year. And so I think that will pull up a little bit and R&D often shares the most benefit of this vacation pay adjustment, so they will come back down in Q4. And G&A, it probably stays around the same maybe goes up a little bit.

Mark Marcon – Robert W. Baird

Great. That was very helpful. Thank you.

Mitchell Dauerman

Okay.

Operator

We will go next Brad Whitt with Broadpoint AmTech.

Brad Whitt – Broadpoint AmTech

Hi, guys. Thanks for taking my questions here. I was wondering Mitch, if you could go back to the license revenue this year and explain that a little more detail. I didn’t quite understand that because I thought it's got to zero license revenue this quarter.

Mitchell Dauerman

Well, yes, I did a great. What happened was, at the end of the first quarter, there were three contracts that were signed but they had contingency provisions in that meaning that the customer if they chose not to go forward could walk away from them. From an accounting perspective, we were not allowed to recognize that as license revenue until that contingency lapsed because we didn’t intend to sell anymore license. What we had done was, we thought that we could go back to those customers and convert them to our subscription based on premise sale. We feel we could do that, so we have really didn’t expect much in the way of license revenue coming in, but if it turned out, we were not able to convert those. We honored the agreements and the result was the license revenue. We did not sell any new perpetual license, there are no new contacts that have contingencies either. Did that help?

Brad Whitt – Broadpoint AmTech

Yes. I wasn’t that familiar of contingency orders in software anymore those kind of things. Anyway, can you also give us some update on your CapEx guidance for the year? I think it was 12 million?

Mitchell Dauerman

Yes, it’s probably looking more like 9 million to 10 million.

Brad Whitt – Broadpoint AmTech

Okay. And then also it seem like you confirm the 12% to 13% operating margin target for ’10, are you also still comfortable with the 250 million in revenue in ’10?

Mitchell Dauerman

Let me, you used the word confirmed, what we said was because we talk generally about 2010 and where we are going; and we said, you know, around 500 to 600 basis points of expansions were taking and when we get the guidance here after Q3, I think that we are comfortable with the total revenues, the 250 was probably based on when we had service revenues a little bit higher, we will have to look at that. So but again, I think right now we are comfortable that the model is working that the operating margins can expand at the level they are. It will tighten up our expectations on revenues when we get to at the end of next quarter.

Brad Whitt – Broadpoint AmTech

Okay. Thanks. And this is the final question on the services revenue, it looks like based on your guidance that implies a pretty good up tick this quarter maybe somewhere in the 15 million range from the 13.4 you had in Q2, what do you see in there that gives you confidence in that? And what kind of visibility do you have on that number?

Mitchell Dauerman

Yes. One of the things that happens is, we do our national user group meeting here in Q3 this year so that and we run that as a potentially a breakeven operation. So that will contribute a decent amount of service revenues.

Brad Whitt – Broadpoint AmTech

Okay. Thanks, Mitch. Thanks for taking my questions.

Mitchell Dauerman

Okay.

Operator

Over next to Brad Cohen with JP Morgan.

David Cohen – JP Morgan

Hi, this is David Cohen from JP Morgan. Just a couple of questions, Mitch, I think you said that the slightly lower recurring revenue guidance relates to the checks per client. Is that that’s all what’s going on?

Mitchell Dauerman

Well, as I said, it’s a combination of being that trend, being a bit more unfavorable in the beginning of the year. So you have frontloading and it’s caused us to take a look at some of the seasonality patterns that may happen in the fourth quarter. So I think its more combination of those two items.

David Cohen – JP Morgan

Okay. It seems like may be it’s a fairly large impact given sort of the contract minimum, so I just want to make sure I understand–

Mitchell Dauerman

Again, if you put it in perspective, we are going from, if you go down to the 27% growth from 28.5, you are talking about a $1.5 million which does relate to about another 2% or so of reduction.

David Cohen – JP Morgan

Okay.

Mitchell Dauerman

And again, we thought because we didn’t know any different, we thought that we would have a 4% reduction pro rata throughout the year and we are at 3.4% right now. And even when you take into as you point out a good point, the minimums, it's still running higher than our forecast.

David Cohen – JP Morgan

Okay. And then, it sounds like workplace was very strong, I know you are not disclosing the ARR, but was enterprise – how does enterprise compare relative to plan for the quarter?

Scott Scherr

They were strong. Enterprise is strong for the quarter.

David Cohen – JP Morgan

Okay.

Scott Scherr

It was record units and record dollars.

David Cohen – JP Morgan

Enterprise as well?

Scott Scherr

No. But I think when you look at workplace, when you have all these new people coming on, contributing like they do, it’s something we expected and they have delivered. An enterprise, it’s based with the same headcount over time with a few ads and either the 26 we have 22 veterans and four what we call, well three sophomores and one freshman, so they are doing a good job, they are doing what was expected. For them to have a record quarters, not the same as workplace, workplace is a growth engine, enterprise is the foundation. They are both doing their job.

David Cohen – JP Morgan

Okay. And then last question, in the competitive environment and pricing, any change from the first quarter to the second quarter?

Mitchell Dauerman

To tell you the truth, our PEPM in workplace ended up going up because clients are taking more products. So we had positive PEPM average in workplace and enterprise the average was same as it's been for the last two or three quarters.

David Cohen – JP Morgan

Okay. And then any change in the relative aggressiveness of your competitors?

Mitchell Dauerman

No, not really. Same old, same old.

David Cohen – JP Morgan

Okay. Thanks, guys.

Operator

Over next to Thomas Ernst with Deutsche Bank. Mr. Ernst?

Zubin – Deutsche Bank

Hi, this is Zubin [ph] on behalf of Tom. I think most of the questions have been answered. Thanks.

Operator

We will go next to Mark Murphy with Piper Jaffray.

Brian Schwartz – Piper Jaffray & Co.

Hello. Hi, this is Brian Schwartz for Mark Murphy. Most of my questions have been answered too. If I could just ask one, Scott, it’s possibly to comment just on the business trends or the linearity across the quarter and may be what you are seeing so far here through July. Thanks.

Scott Scherr

Brian, we typically don’t go into that kind of detail. In a typical quarter, you are going to get about 25% in the first, 25% in the second and 50% in the third maybe a little more. So I would say that was pretty representative this year and we don’t expect to see really any change with that now so –

Operator

We will go next to Raghavan Sarathy [ph] with Sidoti & Company.

Raghavan Sarathy – Sidoti & Company

Good afternoon and thanks for taking my question. If I can go back to the enterprise side of the business if I can get a better understanding of that side of the business, Scott, you talked about in the last call, the business plan calls for 100 million to place customers, can you give us some color on how that side of the business is doing related to those expectations?

Scott Scherr

Rag, I didn’t understand that.

Raghavan Sarathy – Sidoti & Company

I think in the last call you said, you are expecting to add 100 semi enterprise customers and that was the business when 2009 calls for 100 new enterprise customers.

Scott Scherr

Yes.

Raghavan Sarathy – Sidoti & Company

And can you give us some color on how enterprise side of the business is doing related to those expectations?

Scott Scherr

We are ahead of that target. If I take the first half annualize it, we will be 10% or 15% above that number.

Raghavan Sarathy – Sidoti & Company

Okay, thanks and then one for Mitch. Mitch, you are looking for 20% services margin. I presume that’s for the full year.

Mitchell Dauerman

Yes.

Raghavan Sarathy – Sidoti & Company

Can you give us some sense for the progression for the next couple of quarters, seems like there have to be material pickup in the fourth quarter.

Mitchell Dauerman

I didn’t think so, Rag. I think if you have 24.8% in Q1 and 19.5% in Q2, you probably need to be 20% and a little bit above 20%, or 20% to finish the year.

Raghavan Sarathy – Sidoti & Company

Okay. Thanks.

Mitchell Dauerman

Okay.

Operator

And we have time for one more question. That question will come from Brad Reback with Oppenheimer.

Brad Reback – Oppenheimer

Good morning, guys. How are you?

Scott Scherr

Hello, Brad.

Brad Reback – Oppenheimer

Just a quick question, Mitch, as we look forward to 2010 on the P&L, are there any meaningful expenses that get layered back in like 401(k) matches that you may not have done this year, anything along those lines that we should be thinking about?

Mitchell Dauerman

No, I don’t know why you picked. We match 30% of our 401(k), we have always done that and we did this year, and we repaid 100% of our benefits for employees and we have continued to do that. We did – there is nothing dramatic and up tick generally speaking of expenses, Scott mentioned the headcount in workplace, so that’s really going to cover most of your sales and marketing, probably in the R&D area, its going to be relatively flat like it was this year and G&A will go with the growth in the business which should be modest and your services, it will just adjust along with what we anticipate for revenue. And then hosting, you have to add – if you have to add service, you had to add equipment, you have to do that, but again we think that growth consistent with the business there is no step function coming into place.

Brad Reback – Oppenheimer

Great. Thanks a lot.

Scott Scherr

Thank you.

Operator

And that’s all the time that we have for questions. And I would like to turn the call back over to Mr. Scott Scherr for any additional or closing remarks.

Scott Scherr

Yes, thanks. Do want to make one comment that, when I accepted the award at Sherm for the best company that workforce second year in a row, lot of the people over the year, when we won it last year, they would call me my head of HR and they would say that their senior management didn’t believe that it can make a difference if you have a good culture if you compare to people.

At that meeting, in front of those people I took out a memo, I got from one of our people and said that, how appreciative they were about how Ultimate is treating everybody in these times. Although in the past, when we went through and I would consider tough times maybe, we never changed how we acted. We always did the right thing all the time, but he also mentioned that he is personally kind of saved expenses from the bottom. So that person makes it all the people aware of them and try to save expenses. And I think that is reverberating through the company, not for Mitch, but I think everybody in this environment is thinking how lucky they are to work in Ultimate and may be the dinner they go to, maybe their car they rent, maybe when they travel somewhere, its like everybody is trying to save money and I can assure you its some ground which is exactly what I said at interim to everybody if they want to go backup to their senior management phase. Why it is productive, why it is good business to take care of the employees obviously seems like a ridiculous thing have to say. So I think when we look at this thing, our whole base of employees just looking at things differently and including myself just trying to save a little more money here and there. And I think the cumulative effect creates whatever the number is. So thank you all for being on the call. I guess I look forward to another good quarter in Q3. Take care, bye now.

Operator

This concludes today's conference call. We thank you for your participation.

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Source: The Ultimate Software Group, Inc. Q2 2009 Earnings Call Transcript
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