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

Q3 2009 Earnings Call

October 27, 2009 5:00 pm ET

Executives

Mitchell K. Dauerman - Chief Financial Officer, Executive Vice President, Treasurer

Scott Scherr - Chairman of the Board, President, Chief Executive Officer

Analysts

Richard Baldry - Canaccord Adams

Ilya Grozovsky – Morgan Joseph

Richard Davis - Needham & Co.

Michael Nemeroff - Wedbush Securities

Mark Murphy - Piper Jaffray

Mark Marcon – R. W. Baird & Co., Inc.

Nathan Schneiderman – Roth Capital Partners

Franco Turrinelli – William Blair & Company, LLC

Andrew Shaw - Raymond James

Ragavan Sorasi - Doherty

Presentation

Operator

Welcome to the Ultimate Software's third quarter 2009 financial results conference call. (Operator's Instructions) Today's conference is being recorded. Your presenter 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. We will begin with comments from Mitchell Dauerman.

Mitchell E. Dauerman

Thank you, Ann. 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 it's a result of new information, future events, or otherwise. I'm going to begin by reviewing our financial results for the third quarter of 2009 and then I'll provide financial guidance. 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 included in the press release published on our website.

Turning to the quarter, total revenues were $48.2 million for the quarter compared with $43.9 million last year. Non-GAAP net income was $1.6 million or $0.06 per share compared with a net loss of $100,000 or $0.00 per share last year.

For Q3, our recurring revenues were $34.2 million compared with our guidance of $34-$35 million. Recurring revenues grew by 27.7% from the same period last year and represented 71% of total revenues. Recurring revenue costs were favorable coming in less than our expectations, resulting in a 71.3% gross margin compared with our expectations of 70%-71%.

The annualized retention rate was greater than 97% for our recurring revenue customer base. Our customers on a same-score type basis experienced a 4.1% reduction in their employment since December 2008. Our time to live periods for Core UltiPro remained in line with our expectations.

Service revenues for Q3 were $13.8 million, which was less than our expectations and was impacted by both implementation and training services. We managed to control our services cost to a large extent as they were favorable to our internal forecast.

The combination of lower service revenues and lower service cost generated a services gross margin of 18.3% which was slightly less than our expectations. With the current environment we are starting to experience some customers stalling on discretionary spending. While most customers are spending their resources on Core UltiPro and the related complimentary product and the related services, there are some customers that are pushing start dates of our complimentary products in light of their budgetary and internal resource constraints.

We've felt the impact in our services revenues both last quarter and this quarter. Also, we've begun to experience the impact in recurring revenues as well. As of now, we expect these trends to continue and we've adjusted our guidance to take them into consideration.

License revenues were $250,000 for the quarter. There were no new perpetual license sales in Q3. We expect similar license revenue results in Q4. Our total gross margin rate was better than our expectations due to a more favorable revenue mix while gross margin dollars from all revenue sources were in line with our expectations.

On the operating expense side, our total operating expenses were $24.5 million. Consistent with the pattern this year, these expenses were slightly better than our expectations due to a combination of permanent savings from lower costs such as T&E, and to a lesser extent, some timing issues which will reverse in Q4.

Operating margins were 5.6% which is better than our guidance of approximately 5%. Lower than expected overall cost including both cost of revenues and operating expenses and a favorable revenue mix towards higher margin returning revenues accounted for most of the excess operating margin.

Our non-GAAP income tax rate of the quarter was 39.3%, bringing the full year expected rate to 41.1%. Our cash income tax will remain in the low-single digits.

Turning to the balance sheet, total cash and investments in marketable securities were $30.7 million at September 30th. For the quarter we generated $5.6 million in cash from operations, we invested $1.5 million in total capital expenditures, and free cash flow was $4.2 million.

For the year to date through September cash from operations was $16.2 million and CapEx was $5.3 million. Free cash flow for the nine month period was $10.8 million or $0.42 per share. As part of our stock repurchase program, we used $7.2 million in the quarter to acquire 263,250 shares of our common stock.

Today we announced the expansion of our stock repurchase plan by 1 million shares. We have 1,203,175 shares authorized for repurchase as of today. Accounts receivable increased to $35.3 million from $32.2 million at the end of last year, DSOs were 67 days at the end of September, comparing favorably with 69 days at September 30th, 2008. Deferred revenues were $64.4 million on September 30th which was an increase of $7.5 million from September of last year.

As a reminder, deferred revenues reflect the change in contractual implementation services which tend to fluctuate from one period to the next.

Now turning to guidance, for the year 2009, we expect returning revenues to grow by about 26% over 2008, and they should represent about 68% of total revenues. We expect total revenues to grow by approximately 10%. While these revenue goals are slightly below our previous expectations, we have continued to control costs accordingly. Our operating expenses for the year will grow by approximately 10%. We remain confident about achieving operating margins for the year of between 6%-7%.

Excluding perpetual license revenues which we ceased selling during the year from both periods, our operating margins in 2009 should expand by 500-600 basis points.

For 2010, our preliminary view is for recurring revenue growth to be between 26%-29%. We expect service revenues to grow modestly and we expect license revenues relating to existing customers to be about $1 million. Total revenue should grow between 18%-20%. As we discussed in the past, we expect gross margins for recurring revenues to expand annually by about 100 basis points. Considering the current environment, we have taken a tempered view of service revenues and will manage the services business to achieve a gross margin of 15%-18%.

We expect operating expenses to grow around 13% for the year. Operating margins of 10%-12% should be produced for 2010. Again, excluding the impact of license revenues, this represents an expansion of our operating margins by 500-600 basis points and essentially 100% growth in our pretax non-GAAP operating income.

Our non-GAAP tax rate for 2010 should be approximately 40%-41% and diluted weighted average shares should be about $27 million. We expect capital expenditures to be approximately $10 million, depreciation and amortization to be approximately $12 million, and free cash flow to be in the range of pre tax non-GAAP operating income.

Turning to our upcoming conference schedule, during the next quarter on January 12th we will be at the Needham 12th Annual Growth Stock Conference in New York. If you're available to meet at that conference with us, please let us know. And now I'll turn the call over to Scott.

Scott Scherr

Thanks, Mitch. Thank you to everyone for participating in our call this evening. Our two key metrics; recurring revenues and customer retention, both remain strong in the third quarter. Recurring revenues were up 28% over those of last year's third quarter to $34.2 million and our customer retention remains consistent at more than 97%. Our total revenue for the quarter exceeded $48 million, up 10% over last year's third quarter.

I'm going to begin by giving you some color on our third quarter new customers in the enterprise channel. All of our software as a service (inaudible) sourcing customers. Carlisle Corporation, one of Wendy's leading franchises with 3,100 employees and stores in four states, signed up for recruitment, performance management, learning management, and salary planning and budgeting in addition to Core UltiPro.

Education Corporation of America with 2,500 employees owns private institutions of higher education throughout the United States. They selected on boarding, recruiting, performance management, learning management, and salary planning and budgeting, in addition to Core UltiPro.

McLaren Health Care with 12,700 employees is an integrated medical network with 150 facilities including eight hospitals and many specialized medical centers. They chose bonding, recruitment, performance management, and salary planning and budgeting.

Pacific Dental Services with 2,500 employees and 195 affiliated dental practices selected bonding, recruitment, time and attendance, performance management, and salary planning and budgeting.

RTF Furniture Corp, the Rooms to Go Company, with 5,700 employees, selected paycheck modeling and salary planning and budgeting as well as Core UltiPro.

Weezer's (ph), an employee-owned grocery store chain with 2,800 employees signed up for on bonding, recruitment, performance management, learning management, along with Core UltiPro.

And the Chicago Cubs baseball team joined Major League Baseball and the majority of Major League Baseball teams in selecting UltiPro to manage their human resources and payroll. In fact, UltiPro will be paying the World Series champions as both the New York Yankees and Philadelphia Phyllis are valued customers of ours.

In workplace we had another benchmark quarter in Q3 topping Q2 sales performance. Some of our workplace customers are Crescent Crown Distribution, a Louisiana based beverage distributor with more than 600 employees whose workplace plus recruitment, benefits enrollment, performance management, salary planning and budgeting, and time management.

Lathrop & Gage, LLP, a law firm founded in 1873 with 620 employees selected recruitments, benefits enrollment, and time management, as well as core workplace. Mainline Information Systems, an information technology with 620 employees selected recruitment’s benefits enrollment, and time management in addition to core workplace.

And Naropa University, an undergraduate and graduate school in Colorado with 575 employees chose recruitments, benefits enrolment, and time management. Protelegin (ph) a consulting and technology firm with 625 employees chose recruitment, benefits enrolment, performance management, and salary planning and budgeting, in addition to Workplace.

And T.Y. Lin International, a San Francisco based civil and structural engineering firm with 625 employees selected recruitment, benefits enrolment and salary planning and budgeting, along with core Workplace. Both our enterprise and Workplace team had a good third quarter and we are poised for a strong fourth quarter. Both are also staffed and in very good shape to achieve our 2010 goals.

To give you a sense of where our pipeline is, in Q3 we brought in the highest number of prospects looking to buy for our workplace channel ever, a 78% increase over the same metric in Q3 '08. The overall increase in total (inaudible) for both Workplace and enterprise was 56% higher than in Q3 of 2008.

Another fundamental indicator of buyer interest is our regional sales seminars. The goal of these events is 100% to attract and sell new customers and in the third quarter we had the highest number of registrants ever, nearly double those in the second quarter of this year.

Our customer relationships and references remain positive. We held our second annual users conference at the end of the quarter and quotes from our attendees clearly show their level of satisfaction. Ted Kof (ph) from Calloway Golf said "UltiPro Staff Solution is extremely flexible. I have worked with UltiPro for multiple companies and UltiPro is flexible enough to adapt to almost any business regardless of size, industry, or complexity." Burt King (ph) from Sorensen Communications, the nation's leading provider of video relay service for deaf and hard of hearing individuals says, "I really like UltiPro's global capabilities. We have over 100 offices across the United States, Canada, and Puerto Rico, and these remote employees can quickly and easily access the web portal to get the same information as the rest of the company. I can also monitor, make changes, add new employees, set rights, export and perform mass updates to an UltriPro system anywhere I have web access."

Kevin Brown from Seattle Biomedical Research Institute, a research firm for global infectious disease said "We love Ultimate's software as a service. We're very happy. It made sense for us financially because we don't have to support the servers and we have time to focus on other projects that are critical to our business." Scott Hopeful (ph) from Hunton & Williams, a law firm in major US cities with more than 100 separate practice areas — "We chose Ultimate 10 years ago because it was the best solution for our business and it still is."

Sue Wilburn from Camden Living, one of the largest reefs in the nation, "We love Ultimate. UltiPro's web HR tools have helped us become almost completely paperless, allowing us to focus on more strategic processes and reduce cost by a conservative estimate of $60,000 per year." Christopher Montana from Kinetico Water Systems, a leading manufacturer of water treatment systems with customers in about 100 countries said, "With our employees in Canada, the UK, Denmark, France, and Germany, we want to make sure managers have easy access to information so they can make better business decisions. After an extensive search, we search UltiPro for its global capabilities and because it does much more than just HR. Implementation was easy and Ultimate's customer support has been great at every level."

Danny Shield from Guan Foods (ph), the leading manufacture in food distributors said, "UltiPro Workplace is the smartest thing we have ever done at Guan Foods since I have been here. With our previous system we had errors on a weekly basis with payroll, now with UltiPro workplace we don't have those issues.

We also continue to receive accolades from the analyst community. Jim Holincheck the lead human capital management and enterprise analyst at Gartner was quoted in the July issue of Workhorse magazine, saying that Ultimate was a pioneer in making the shift (inaudible) and they really understand how that model works.

In closing we ended Q3 with 977 associates, 25% of them represent R&D, 25% represent support, and 30% represent the implementation and training teams. 80% of our headcount is dedicated to our customers. Their only goal is to make UltiPro the finest unified HR payroll and talented management solution set in the industry, and insure that we implement and train our customers well and make sure that we take care of our valued customers with the service they deserve. These three areas have always been our highest priority and they always will be.

October 1 was our 19th anniversary. In Q4 we will achieve our long-term goal of having recurring growth margins cover all of our operating expenses. We believe this is a significant financial milestone and proof positive that our business is well positioned for the future.

Thanks again for your support. It's greatly appreciated, and let's go to the Q&A.

Question-and-Answer Session

Operator

(Operator's Instructions) Your first question comes from Richard Baldry with Canaccord Adams.

Richard Baldry - Canaccord Adams

Thanks. In the past you've talked about attach rates on the various modules. I was wondering if you could update us on that either overall or maybe between enterprise and Workplace. Thanks.

Scott Scherr

I didn't say because it was consistent with what I said last quarter. I don't have the exact numbers in front of me, but like I said, I think people are going for the unified solution and we're having a high attach rate against all our products.

Richard Baldry - Canaccord Adams

And I think you also said last quarter that the (inaudible) play per month had been on the rise for Workplace. Do you think that's still consistent as a trend and where do you see that shaking out as you head into '10?

Scott Scherr

It's consistent and I think it's going to keep growing higher as we move forward.

Richard Baldry - Canaccord Adams

And I think the last one will be, last quarter you had zero turnover in the enterprise side on the sales side, I'm wondering if that's still also consistent heading into the second half, want to presume that if you made it to the second half you're probably not going anywhere with year end approaching.

Scott Scherr

I met with both sales teams on Workplace twice in the quarter and the enterprise sales team had zero turnover and we have the team in place for next year. Workplace we have the team in place for next year and we had one turn in Workplace.

Richard Baldry - Canaccord Adams

Thanks, and congrats on the quarter.

Operator

We'll go next to Ilya Grozovsky with Morgan Joseph.

Ilya Grozovsky – Morgan Joseph

Thanks. Guys, you had said that the employment reduction for your customers was 4.1%, was that year to date or was that in the quarter?

Mitchell K. Dauerman

That's for the year to date, Ilya. What we do is measure the same clients who were in our base in December and those that are in our base in September and so that's the stat we quoted, their change in their employment.

Ilya Grozovsky – Morgan Joseph

And what was the number in the quarter for change in employment?

Mitchell K. Dauerman

I think we started the quarter with 3.4, we ended at 4.1. It dipped down a little bit more in the middle of the quarter and then came back up in the last month of the quarter.

Ilya Grozovsky – Morgan Joseph

Great. And then so how should we think of the, I guess the distance, between your current recurring revenues and the floors that you've put into these contracts? How much room is there? Are you guys measuring and thinking about how much room there is to go down before customers potentially would be paying for seats that they don't actually occupy?

Scott Scherr

Well, whenever you’re doing revenue projections you're taking into account those factors as well as all of the other factors as you bring up; employment changes, growth sometimes, price increases, and so on. So it is a factor in what we look at.

Ilya Grozovsky – Morgan Joseph

Okay. So it's factored into your projections going forward that there is some more movement in these numbers?

Scott Scherr

Yes.

Ilya Grozovsky – Morgan Joseph

Okay. Great, thank you.

Operator

We'll take our next question from Richard Davis from Needham & Co.

Richard Davis - Needham & Co.

Hey, thanks. Does it make sense now or in the future to establish a tight or a tighter relationship with one or more of the live systems integrators to do some of your professional services? Or is your business just not amenable to that? I was just kind of curious if that made sense.

Scott Scherr

I think our plan is to be 5%-10% of our business is third parties as we've had relationship with a long period of time, but I would say that any more than that is not amenable to our business.

Richard Davis - Needham & Co.

Got it. And then, I mean I'm not sure what this percentage is, but I mean as a rough percentage of the kind of (inaudible) purchase, or however you want to think about it — if I’m a larger organization, larger enterprise, and I purchase, you know, more or less the full suite of your product, how much of that is going to be customized as opposed to configured? Now, obviously configured is much easier and customization is more difficult so is there customization involved and if so, is there any kind of percentage that that occurs?

Scott Scherr

It would be simply a gut — I could tell you that our customs have gone significantly down from a year ago. My gut, it might be 10%, but we looked at — from last year we looked at all the customs and a lot of things that we saw are customs that basically a lot of customers use. We've put it into the system as something that was part of the system. So our goal is to have quite frankly no customs. So we're constantly — when we see something that customers are asking for, we try and put it in the system. But my gut is that it would be less than 10%.

Richard Davis - Needham & Co.

Got it. (Inaudible) to be precise, the order of magnitude. That is very helpful, thanks a lot.

Operator

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

Michael Nemeroff - Wedbush Securities

Hey, guys. Thanks for taking my questions, just a couple. Mitch, on the services gross margin, what levels do you have to get or what revenue level do you have to get it up to for you to get that services margin below or above 20%?

Mitchell K. Dauerman

You probably have to be a bit north of 60.

Michael Nemeroff - Wedbush Securities

Okay. So and then for Scott, I know you're talking about all the attachments and all the customers that are buying multiple solutions, can you tell us if you're seeing some of the (inaudible) other HCM vendors like Success Factors or Toledo (ph) and are you competing against them and then if so, why are you winning? Any commentary around that would be great.

Scott Scherr

Yeah. I would just say that they don't show up in any of our — we track where we get our business from and who the — they say the last competitor standing is that we face and those point solutions — if we went into — some of the deals I mentioned, they didn't have recruitment. Maybe they use one of those people in recruitment, we show them what we have — they may be using one of those point solutions and they say they're happy with it so then we move in and we don't get that.

I mean, our cash rate's of performance recruitment is a little over 50% now and when we got into the additional solutions we thought that 25% would be a metric that — if we thought we can get 25% attach rates on new deals then that would be something good for us to be in so we've doubled that. They're really not our competitors, those people

Michael Nemeroff - Wedbush Securities

So what is the average number of products that each customer has currently?

Scott Scherr

Again, it would be a guess but I would say three or four.

Michael Nemeroff - Wedbush Securities

Three or four per customer?

Scott Scherr

Yes.

Michael Nemeroff - Wedbush Securities

Okay. And then just one last one, Scott, if I may — as we're in Q4, are you noticing any increased activity or any budget flush, so to speak, or extra dollars at the end of the year? Does it seem as if from your point of view that customers are willing to spend a little bit more than they have over the last couple of quarters?

Scott Scherr

It's been an exciting year for us as far as sales goes. The whole year we've seen more people at our seminars, we've seen more people at the different shows we do, and (inaudible) has been strong all year. I gave the numbers in marketing of people who were coming to our seminars and people who aren't responding to us so I don't know if it's that, but clearly our pipe is getting larger as we move forward.

Michael Nemeroff - Wedbush Securities

Okay. All right, guys, thanks very much.

Operator

We'll go next to Mark Murphy with Piper Jaffray.

Mark Murphy - Piper Jaffray

Thank you. I'm wondering how you would assess level of customer frustration out there in the ADP customer base and also in the Ceridian customer base, and also, do you see them doing anything different architecturally or do you think that they're still running into the same issues?

Scott Scherr

I tell my people all the time just keep making our products better, keep making our service better — we'll keep the culture going at Ultimate and then, you know, w take care of our own business and when we compete hopefully we get selected. But I think the people you mentioned as well as anyone else in the market, I think if customers do their due diligence then I think they’re going to find that we have the best product here is right now and we have the best service that there is right now and if they're looking for someone o partner with today it should be us and if they're looking for that person who to partner with 10 years from now, I think we're committed to making the product better and the service better and nothing else. I tell my people always take the high road so I'm taking the high road here.

Mark Murphy - Piper Jaffray

Understood. Okay, and then for Mitch, you're guiding for a recurring revenue growth of 26%-29% for 2010, and I'm wondering if you can comment on what is your sensitivity to two factors, one is the deployment time to live that you've referenced, and then secondly is unemployment. If you look at those under different scenarios, if everything goes strongly in your favor how much do you think that number changes by and vice versa for next year?

Mitchell K. Dauerman

Matck, I think the short answer is the fact that we have a range of 4% reflects kind of where we think those metric can end up from a reasonable basis and I think as your term, if everything goes right, you're up at the north end, if things don't go as well and some of the stuff you don't control, then I think you end up at the south end. We try to approach it the same way we do each year and we try to learn from what we've experienced. So we monitor time to lives, we monitor as Ilya brought up earlier, companies, their employee levels and where their contract minimums are, and we try to make an educated guess on where we think the same store type of employment can go.

So I think the end of it is we think the range is a reasonable range.

Mark Murphy - Piper Jaffray

Okay. Thank you very much, appreciates it.

Operator

We'll go next to Mark Marcon with R. W. Baird & Co., Inc...

Mark Marcon – R. W. Baird & Co., Inc.

Good afternoon. I was wondering if you could talk a little bit about the gross margin trends that you saw and the recurring revenue for this quarter and as you’re thinking about it going into Q4 and next year?

Scott Scherr

Mark, I think the last time we said that, because we had the license cost moving back into cost of recurring, that we thought gross margin for this quarter would be between 70 and 71 and we came in a little bit ahead of it.

I'd probably say we're 71 to 72 Q4ish. I think we finished the year a little bit norths of 71. And again if you look annually, that will be the line, but again we're moving the license cost down into recurring. And then I think as you go to 2010, I think that our business should support expanding the recurring revenue margins by about 100 basis point s a year.

Mark Marcon – R. W. Baird & Co., Inc.

Great. And so that would basically imply incremental margins for next year in the high 73, 74ish range?

Scott Scherr

You probably did the math. I think it might be a little higher, but whatever it gets out to, I guess probably in the 72 range.

Mark Marcon – R. W. Baird & Co., Inc.

Okay. And so it feels pretty comfortable, despite the economic environment, probably not getting too much push back with regards to pricing at this point?

Mitchell K. Dauerman

No. I mean, Scott, I haven't seen it. I think we have a fair price and good long-term customers so I haven't seen it.

Mark Marcon – R. W. Baird & Co., Inc.

Okay, great. And then can you talk a little bit about what your thoughts are with regards to your marketing expenses for the fourth quarter and going into next year?

Scott Scherr

Yeah, Mark. They're probably up a little bit and just on the direct market — and again we have a team of 15 people who are in marketing, but they’re probably up a little bit and the next year we'll spend probably — I don’t know, about 5% more for the full year.

But again, some of that gets adjusted. As we look at the year and we plan the workshops that go on during the year and the things that are bringing in leaves an opportunity.

Mark Marcon – R. W. Baird & Co., Inc.

So it sounds like we should have another year of pretty decent leverage on that line?

Mitchell K. Dauerman

Yeah, I think so. I think that’s why we said — I think when you look at the 2010 operating margin targets, they're reasonably achievable because recurring revenue continues to grow, as you point out, with the high incremental growth margins, but then on the cost side, we're targeting a 13% growth rate blended. Sales and marketing is a little bit higher. As you know, positions get amortized over the initial term of the contract with the growth in revenue we had higher commissions. We got the sales teams in place so we're not looking at incremental headcount costs. R&D we talked about — throughout this year we made significant investment in building out the product wheel in 2007, 2008, and that team is operating probably at about a 10% growth rate. And then G&A for the rest of the business so you are somewhere 10%-15%.

And I think we are very confident about managing the operating expenses as we were this year and as we are this year.

Mark Marcon – R. W. Baird & Co., Inc.

Perfect, thank you.

Operator

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

Nathan Schneiderman – Roth Capital Partners

Hi, Scott and Mitch. Thanks very much for taking my questions. I was hoping you could share with us the ending headcount for the enterprise quarter of reps and also the Workplace quarter reps?

Mitchell K. Dauerman

I think enterprise is going to be right around 31 or 32.

Nathan Schneiderman – Roth Capital Partners

Including the back to the base guys.

Mitchell K. Dauerman

Yeah. Quota carries including the back to the base is 31, and Workplace 'well end the year with 32 — quota carriers.

Nathan Schneiderman – Roth Capital Partners

Okay. And then what are your sales rep hiring plans for next year?

Scott Scherr

Enterprise remains flat and workplace 10%-15% during the year.

Nathan Schneiderman – Roth Capital Partners

Okay. Mitch, in your prepared comments you referenced a customer stall that was having an impact on recurred revenue and I was hoping you could just describe the dynamic in more detail and then what are your expectations for this behavior going forward? Do you think the pressure eases, stays the same gets worse?

Mitchell K. Dauerman

Well as we said in the prepared comments we built in what we — our expense into our guidance for next year so we think — what we know today is this is the behavior and I don't think we're expecting it to get worse and in our guidance we're not expecting it to get better.

We did see, like we said in the comments, some customers on the additional product electing to push out those start dates because of the wrong constraints, so that had a direct impact on our (inaudible) services and recurring revenues.

Operator

We'll take our next question from Franco Turrinelli with William Blair & Company, LLC.

Franco Turrinelli – William Blair & Company, LLC

Hey, Mitch and Scott. So just I'd like to show that we understand something, it's more of a general customer behavior in pushing back some of these ancillary modules, is that correct?

Scott Scherr

Yes.

Franco Turrinelli – William Blair & Company, LLC

And I'm curious as to you said their resource or constraints — is it financial resources or is it people resources, why more specifically maybe are they deferring some of this?

Mitchell K. Dauerman

Franco, I think it's coming from both sides. It's people in companies deferring budgets into next year so they take an ancillary product and they put it on hold so they don’t' incur the costs for the services right now. And then you do have companies who are resource constrained on their side so they have to be — part of our implementation process is really about both our team and our customer’s team working together so that when the customer goes live on the product, their people know how to use the system well.

Franco Turrinelli – William Blair & Company, LLC

Right. So that’s helpful. I guess part of the reason that I was curious bout that was you guys have been pretty creative about changing things of across many years to kind of respond to the relation of the marketplace. I guess I didn't know how much a company might really be saving by not implementing some of the ancillary modules. How is the implementation fee structured? Is it one fee for everything or is it really kind of module by module?

Mitchell K. Dauerman

Generally it is a time inventorial basis for all our all our estimations so it's module by module.

Franco Turrinelli – William Blair & Company, LLC

Okay. Thank you, that' very helpful, and congratulations on the expense control, really great performance.

Operator

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

Andrew Shaw - Raymond James

Hi. This is Andrew Shaw in for Terry. Just wondering one question for you, can you guys talk at all about how the mix of business looked in the quarter just in terms of replacing the service bureaus versus replacing traditional client-server technologies?

Scott Scherr

I have something that has — for the nine months — I think the third quarter was consistent, but in enterprise, 65% of our new business came from service bureaus and 35% form what I'll call other or in house. And in Workplace, almost 85% came from service bureaus and the other 15% would be other or in house, through nine months.

Andrew Shaw - Raymond James

Okay, thanks.

Operator

We'll go next to Ragavan Sorasi (ph) with Doherty.

Ragavan Sorasi - Doherty

Good afternoon, and thanks for taking my questions. I had ac couple of questions for Scott and a few more for Mitch. Scott, can you give us some sense how many customers you brought live in the third quarter?

Scott Scherr

It' about 20% more than we did last quarter.

Ragavan Sorasi - Doherty

Okay. What was the comparable number for the same quarter last year?

Scott Scherr

I don't have it in front of me.

Ragavan Sorasi - Doherty

All right. Then in terms of the 2010 plan, you gave us some color when you talked about 2009 (inaudible) how many new enterprise customers and Workplace customers do you need to add? Can you give us some color on that, what your 2010 plan calls?

Scott Scherr

It's probably somewhere — I don't know, a little north of 500 units combined.

Ragavan Sorasi - Doherty

That's the total of enterprise and workplace?

Scott Scherr

Yeah, with over 500 units combined.

Ragavan Sorasi - Doherty

Can you give (inaudible) Workplace versus enterprise? Now that we are not adding enterprise sales people, does it mean that —

Scott Scherr

I wonder — again, this is — 325ish, 125ish, obviously that can move different places but probably if you look in a perfect world we have got 125 enterprise clients, maybe 375 workplace clients. Obviously it never works out exactly like that, but that gets us there.

Ragavan Sorasi - Doherty

Right okay. So on the enterprise site, so you are not adding any head count, it is basically going to come from increased productivity and how should we think about that?

Scott Scherr

Yeah. We've said it before that they grow 5%, 10%, 15%, the growth engine is Workplace going underneath them. They grow 30%-40%, that's the plan.

Ragavan Sorasi - Doherty

Great. And a couple of questions on net, so do you reduce recurring revenue guidance slightly about a million or so as we look at the second half of the year, but they're all related to the (inaudible) and implementation related to the add on modules or are they something else?

Scott Scherr

No. For the most part that was it.

Ragavan Sorasi - Doherty

Okay. If you tried to answer the question I didn't quite get it, was the reduction in the same cells (inaudible) and do you expect that to be, for instance, low there? How should you think about that?

Scott Scherr

Rag, I think it's anybody’s guess. Just like we started this year out and we thought we'd go 4% pro rated throughout the year and it was spiked in the first quarter. We build different models which give us our range of the 26-30. If I had to guess I'm guessing 2%.

Ragavan Sorasi - Doherty

2% for the whole year?

Scott Scherr

Yes, but that's one of the models.

Ragavan Sorasi - Doherty

Wouldn't that put employment up around 12%? I mean, you said 2% for the whole year.

Scott Scherr

Just like we did this year from the beginning to the end of the year, it's one of the models that we run, yes.

Ragavan Sorasi - Doherty

Oh, I'm sorry. I want to make sure I understand this, is it 2% for the whole year?

Scott Scherr

Yes.

Ragavan Sorasi - Doherty

(Inaudible) 4% now in the third quarter is so high, so you are expecting shrinkage to bring it down next year, that's your expectation?

Mitchell K. Dauerman

Rag, when we're talking about it, it's 2% from where we expect to end at the end of the year so it's an additional 2% on top of the 4.1% we're at right now, plus whatever happens in Q4.

Ragavan Sorasi - Doherty

Oh, so you are expecting another 2% on that of that for next —

Mitchell K. Dauerman

Yes.

Ragavan Sorasi - Doherty

Okay. And then on the professional services side, it looks like we are looking at about 7% year to year increase in professional services revenues. When you look at this year, it seemed like you didn’t have that much visibility in the professional services, but also seeing some delays now. When you look at the pipeline, what do you see there (inaudible) that you're going to see a growth in professional services?

Mitchell K. Dauerman

Well, I think one, we've got the training number down here we — that was one of the big areas that revenues went down. So our expectation for next year is somewhere around the same thing, but we did sell more business in Workplace and Workplace does generate additional service revenues albeit a lower cost per employee than enterprise.

I think like I said earlier to a question when asked about the recurring revenue range, when we factor in our total revenue guides of 18-20, we're making a reasonable estimate of where we think services can go, and I think what we're trying to be very clear on is we are going to manage down to a 15%-18% gross margin. So to the extent the revenue is off a little bit, I think we feel that it's built into our guidance range which will obviously produce the operative margins by using a lower gross margin rate for services.

Ragavan Sorasi - Doherty

All right, thank you.

Operator

We'll take one more question, a follow-up from Ilya Grozovsky from Morgan Joseph.

Ilya Grozovsky – Morgan Joseph

Hi. Just two housekeeping questions; share count, you had given some guidance for the share count for next year, what was that?

Scott Scherr

About 27 million.

Ilya Grozovsky – Morgan Joseph

27 million for the year average you mean?

Scott Scherr

Yeah.

Ilya Grozovsky – Morgan Joseph

So where do you think — I mean, that's a pretty big increase from where we are now and that’s not really how you guys have done it in the past. Where that— how are you getting there?

Mitchell K. Dauerman

I'm probably being a little bit conservative in giving that out right now. Generally you have a couple hundred thousand shares a quarter and it is dependent on how many stock equivalents which are dictated by the stock price.

Ilya Grozovsky – Morgan Joseph

Okay. And then just on the margins for the services business, I'm just trying to understand how this business back in '07 was doing about 22%, we came down to 20 and a little under 19 and now we're talking about even touching somewhere between 18% and 15%. What is happening structurally in the business now? I know in the past you guys have used third parties that sort of hurt the margins, but I thought we were sort of passed that and now that the margins would actually benefit from not using third parties. What's happening there?

Scott Scherr

Oh, I think the biggest thing is the training revenues were shrinking. And just like the airplanes the last seat is 100% profit. So I think that's a big factor in it, and the second thing is you would look at your discretionary services. Again, those incremental hours are very high margin type hours so you try to adjust your labor structure can your cost structure beneath it, but for us when w look at services, what's important to us is we want our customers to have experienced consultants that are implementing them. When we look at it as a business, its a few percentage points off, but it's not the driver of our business. What is important is the customer is happy, they're trained well, they're implimented well, and that we gain new customers. Like Rag was getting at, the 500 new customers, I think that’s a result of doing that and we’re consistently said we would trade of lower service margins to help your recurring revenue business because it carries higher incremental gross margins.

Ilya Grozovsky – Morgan Joseph

Okay. That makes sense, thank you.

Operator

This does conclude the question-and-answer session today. At this time I'd like to turn the conference over to Scott Scherr for any additional or closing remarks.

Mitchell K. Dauerman

No. Thank you and thank you all for being on the call. Look forward to having a happy new year and see you all in February.

Scott Scherr

Take care, and let's go Yankees.

Operator

This does conclude today's conference. We thank you for your participation.

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Source: The Ultimate Software Group Q3 2009 Earnings Call Transcript
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