JDA Software Group's CEO Discusses Q3 2011 Results - Earnings Call Transcript

Oct.27.11 | About: JDA Software (JDAS)

JDA Software Group (NASDAQ:JDAS)

Q3 2011 Earnings Call

October 27, 2011 4:45 pm ET

Executives

Mike Burnett - Group Vice President of Treasury & Investor Relations

Hamish N. J. Brewer - Chief Executive Officer, President and Director

Peter S. Hathaway - Chief Financial Officer, Principal Accounting Officer and Executive Vice President

Analysts

Alan Weinfeld - Henley &

Mark W. Schappel - The Benchmark Company, LLC, Research Division

Greg McDowell - JMP Securities LLC, Research Division

Richard T. Williams - Cross Research LLC

Jeffrey Van Rhee - Craig-Hallum Capital Group LLC, Research Division

Brian Murphy - Sidoti & Company, LLC

Operator

Ladies and gentlemen, thank you for standing by, and welcome to the JDA Software Group Third Quarter 2011 Earnings Conference Call. [Operator Instructions] This conference is being recorded today, October 27, 2011. And I would now like to turn the conference over to Mike Burnett, Group's Vice President of Investor Relations. Please go ahead.

Mike Burnett

Great. Thank you, Mikaela. Good afternoon, and welcome to the JDA Software earnings call for the third quarter ending September 30, 2011. On our call today, we will discuss the operational and financial results for the third quarter. With me on the call is Hamish Brewer, Chief Executive Officer of JDA; and Pete Hathaway, our Chief Financial Officer.

Before we begin discussing our results, let me remind you that our comments today will contain certain forward-looking statements that often involve risks, uncertainties and assumptions. All statements, other than statements of historical fact, are statements that could be deemed to be forward-looking. These risks are described from time to time in our SEC reports including, but not limited to, our annual report on Form 10-K for the year ended December 31, 2010.

Our presentation also includes certain non-GAAP measures, which JDA uses internally in budgeting and performance monitoring activities to gauge our business performance. We believe these measures provide useful information to our investors in evaluating JDA's ongoing business results. We prepared a reconciliation of each of these measures to the most directly comparable GAAP measure in our press release, which is posted on our website at jda.com. Additionally, we have posted a supplemental presentation slide deck on our Investor Relations to accompany the review of our results.

With that, I will now turn the call over to Hamish Brewer for a discussion of the operating results and business trends.

Hamish N. J. Brewer

Thank you, Mike. The third quarter of 2011 was one of the stronger quarters in the history of the company. We've bring mouthful revenue record in what was a lackluster quarter and convert that revenue into a very satisfying 30% adjusted EBITDA margin. At the start of this year, we said that we plan to drive expansion in organic revenue growth through primarily by organic license revenue growth, and I think this quarter puts us firmly on track to achieve this objective.

And to jump straight to the conclusion, the third quarter was a record quarter for the company in many ways and reiterate once -- we reiterate once again that we expect to hit our annual guidance delivering substantial organic revenue and earnings growth. On this call today, I'll provide you with some further color around the ongoing operations, and also discuss the state of the market as we see them.

Starting with license revenue. As you know, in 2011, we decided to increase investment in sales and marketing to support our objective of $145 million to $160 million of software and subscription revenue, which at the midpoint implies a healthy 17% year-over-year growth rate.

The third quarter was about flat year-over-year, so we know we had to have further growth in the second half. With an impressive 67% year-over-year organic license growth rate, we believe that the third quarter 2011, combined with a strong license pipeline that we see in the fourth quarter, positions us very well to achieve our annual software and subscription objective, and we reiterate that guidance today. This excellent result was driven by strong sales in both the Americas and in Europe. In the Americas, we grew by an impressive 65%, and in Europe, we more than doubled our license revenue. Of course, in our business, success of this nature cannot be achieved if North America does not perform well. So it was very satisfying to see the strong license performance in this critical region.

What we're particularly pleased this year, however, is license sales growth in Europe. Last year, license sales in Europe were distinctly underperforming. And as I've said before, I believe that it was significantly attributable to operational issues within the company. It seems we're in a solid part to addressing those issues as the year-to-date license sales in Europe are up 106%, largely a substantial turnaround by the new management team that we put in place there. We are being impacted by the economy, and we've seen a number of sales transactions aborted or significantly downsized at the 11th hour. We saw all this kinds of phenomenon last quarter, and we've experienced the same again this quarter. So my working assumption is that this will continue into the foreseeable future.

However, the fact is that these headwinds are being more than offset by strong license growth across the board. In 2009, we suggest -- suggested that our offerings was potentially more resilient to economic downturns from, say, traditional ERP because our solutions increased operating efficiency and used in a relatively short timeframe, months rather than years. It appears once again that this theory is holding true. And in particular, it appears that this time, the larger companies we have completed the ERP deployment over the past decade are now very focused on driving operating excellence to preserve margins in a tough economy, and we are very well placed to meet that demand.

There's no doubt that our customers are under pressure today. But for those companies whose financial health allows them to make investments to improve their operating performance, I believe that this pressure may well translate into a demand driver for JDA. In these times, our customers need fast results, and we've established a very clear and distinct value proposition that positions us very well against traditional ERP vendors in the mission-critical areas of supply chain merchandising and pricing.

One specific and very real data point -- very real fine data point to support this position is that just yesterday, we held our Annual European User Conference called FocusConnect. And despite the considerable economic issues facing that market right now, we were able to attract record attendance.

Looking forward to the fourth quarter. We're facing a strong pipeline of new business opportunities. So even if we estimate the impact of continued deal of uncertainty as previously mentioned, we believe we have enough deal coverage in our pipeline to deliver a strong quarter, which we think should enable us to hit the midpoint of our software subscription guidance range, which would imply that very healthy 17% annual growth rate.

Moving on to our services business unit. Consulting revenues for the third quarter was down year-over-year. But I should remind you that we had an extraordinary onetime bump in revenue amounting to about $7.6 million during the third quarter last year related to work performed in previous quarters where the revenue could not be recognized until that quarter.

Looking through this onetime issue, overall, I would say that the backlog for consulting work is strong in North America, it's strengthening in Europe as a result of the recent succession of quarters of solid license performance. By contrast, our consulting business in Asia-Pacific does not have such a strong outlook, and we've been unable to achieve significant license growth in these markets recently, particularly in Japan and the strong backlog that we had starting off in 2011 is now being eroded. When we blend all of this together, I believe that our consulting business will make slight progress of this year in margins as we had hoped.

Next, our maintenance and support services had yet another strong quarter. With revenues up 6% reported by both strong retention rates, which on a year-to-date basis we're sitting at 95.7% and we have exchange rate benefits from a number of our non-U.S. dollar denominated contract.

Finally, moving on to cash flow from operations. As you can see from the results, we had a very strong quarter in cash flow terms, driving $38.5 million cash flow from operations which means that on a year-to-date basis, we generated $97.6 million cash flow, excluding the $35 million favorable settlement with Oracle in the first quarter.

Another way to look at this, once again excluding the $35 million settlement with Oracle in the quarter is that we've generated about $123.8 million of cash flow from operations in the past 12 months. This performance clearly shows that the operating model we established with the acquisition of i2 is working out well. And as a result, the company is financially secured today.

With that, I'll hand over to Pete to provide an in-depth review of the financial results. Pete?

Peter S. Hathaway

Thank you, Hamish. The third quarter 2011 results validated our expectations for strong year-over-year sales growth, operating margin expansion and strong sustainable free cash flow generation. We noted in our conference call after Q2 that we expect the Q3 license sales to be stronger than last year's and stronger than Q2 this year. We met that expectation, which was an important contributor to our Q3 earnings.

In addition, we saw good performance in the consulting business with substantial improvement in margins, and as usual, the support business was solid. Lastly, Q3 free cash flow was up 69% year-over-year, once again demonstrating the resiliency of our business in turbulent economic times.

In the third quarter 2011, adjusted EBITDA increased to $51.1 million, the highest quarterly adjusted EBITDA ever produced by the company, compared to $39.7 million in Q3 2010. Additionally, the adjusted EBITDA margin improved year-over-year by 500 basis points to 30% from 25% in Q3 of 2010, showing the potential of our business. The substantial margin improvement was driven by the year-over-year change in revenue mix with nearly 20% of the revenue coming from higher margin, software sales versus only 10% in the prior year. Adjusted earnings per share climbed 36% to $0.64 compared to $0.47 in the third quarter of 2010. Similarly, GAAP earnings per share increased to $0.39 from $0.20 per share in Q3 of the prior year. A reconciliation of GAAP to non-GAAP measures is included with the tearsheet attached to our press release.

Total revenues increased 8% to $171.6 million for the quarter as compared to total revenues of $158.4 million for the third quarter 2010, and software and subscription revenue increase 67% to $36.9 million from $22 million last year. We closed 49 new software deals in the quarter compared to 40 in the third quarter of 2010. This includes 9 large transactions of $1 million or more in Q3 2011 compared to one in Q3 of last year. Our average selling price for the trailing 12 months ended September 30, 2011, increased to $786,000 from $573,000 in Q3 of 2010.

Maintenance revenue presented another solid quarter, increasing 6% to $68.3 million and Q3 2011 compared to $64.2 million in the third quarter of 2010. Maintenance gross margin remain strong at just under 80%, consistent with Q3 of the prior year. Our customer retention rate on expiring maintenance contracts continues to track in line with our expectation. We ended the quarter with a year-to-date retention rate of 95.7%, similar to the strong Q3 last year at 95.9%. This recurring high-margin revenue and cash flow stream represented 40% of our revenue in the quarter. FX changes year-over-year added about $2 million to maintenance revenue for the quarter.

Services revenue decreased 8% to $66.4 million from $72.2 million in Q3 2010. As we disclosed last year and discussed again last quarter, the Q3 2010 consulting revenue included about $7.6 million of revenue that was earned earlier in 2010 but was not able to be recognized until Q3. Excluding this amount from Q3 2010, we would've shown an approximate 3% year-over-year increase in services revenue.

Growth margin on the services revenue was consistent with the prior period at 23.4% on an as reported basis. Adjusting for the Q3 2010 period for the margin impact of the $7.6 million I just mentioned, the Q3 2010 consulting gross margin would've been 20%. Thus, the pro forma year-over-year margin change is an increase of nearly 400 basis points. This current quarter margin improvement is also reflected in the sequential increase of 600 basis points from the Q2 2011 rate of 17.5%. These increases in margin are primarily due to the increase in utilization rate to 58% for Q3 2011 from 55% in Q3 2010 and 56% in Q2 2011.

Moving on to operating costs as a percentage of revenue. Total operating expense was 35% in the quarter comparable to Q3 2010. Product development expense at this quarter remained consistent at 11% of revenue, while the absolute dollar values increased to $18.9 million from $17.4 million in Q3 2010. We continue to prioritize the reinvestment in R&D and product development that will enable us to maintain and expand our market-leading product and offer -- services offering.

Sales and marketing expenses increased this quarter to $26.1 million or 15% of revenue from $20.3 million or 13% of revenue in Q3 2010. This year-over-year increase is due to a higher commissions earned in the quarter as software sales excluding subscription sales increased 104% over Q3 2010. Additionally, we have continued to make investments in the sales force and in our sales and marketing infrastructure. As a reminder, in Q4, we usually see seasonal increases in sales and marketing expenses due to the sales commission accelerators. This year will be no different, especially if we conclude the year at the strong level of scales that we are anticipating.

General and administrative expenses decreased $1.5 million to $16 million from $17.5 million in Q3 2010. As a percentage of total revenue, these costs decreased to 9% from 11% in Q3 2010. Legal cost continue to be down year-over-year due to the successful conclusion in Q1 2011 of the patent infringement case against Oracle, and the continuing cost associated with the appeal of the Dillard's litigation are not substantial. Additionally, I would like to point out that we had been very diligent and successful in credit and collection this year resulting in a benefit to G&A expense.

On a year-to-date basis, we have recovered approximately $2 million in previously written off receivables, and our aging has improved such that we have not had to increase our existing allowance for doubtful accounts during 2011. The effective tax rate on GAAP earnings was 37.6% for the quarter. This is consistent with expected blended effective tax rate for federal and state taxes.

Turning now to cash flow. We had another strong quarter, generating $38.5 million of operating cash flow compared to $29.4 million in the third quarter of last year. The improved earnings were the primary driver of the increase. DSO in the third quarter increased to -- basically decreased to 62 days from 71 days in the second quarter of 2011, an increase from 56 days in Q3 2010. This latter change is primarily from the year-over-year increase in accounts receivable at the end of this quarter largely due to the increase in software sales.

Free cash flow in the third quarter increased 70% to $35.7 million from $21 million in the third quarter 2010. Capital expenditures were $2.8 million this quarter, compared to $8.4 million in the third quarter of last year.

For the full year 2011, we now expect to spend approximately $20 million on capital items versus our original estimate of between $25 million and $30 million. This is primarily due to lower-than-expected capital expenditures for managed services. Our cash position at quarter end increased to $326.8 million, an increase of $149 million from September 30, 2010. This is attributable to the generation of $114 million in free cash flow during the last 12 months and the receipt of $35 million from Oracle for the favorable resolution of the patent infringement litigation. This leaves us in a net cash position as our cash now exceeds our debt by $54 million. We had $37.1 million restricted cash at quarter end.

Looking at the results for the 9 months of this year. Total revenue of $497.6 million is up 11%, consisting of a strong 17% increase in software, license and subscription revenue, a 10% increase in maintenance revenue and a 9% increase in services revenue. After adjusting for the i2 revenue for the month of January 2010 that is not included in our reported numbers, year-over-year software revenue growth is 14%, maintenance revenue is up 6% and services revenues is up 5%, reflecting total revenue growth of 7%.

Adjusted EBITDA for the 9-month period increased 14% to $128 million, and the EBITDA margin expanded to 26%. Similarly, adjusted EPS increased 15% to $1.54. Cash flow from operations for the first 9 months was $132.6 million, compared to $39 million in the 9 months in 2010 while free cash flow increased to $125 million from $24 million in the same period in 2010.

Given our progress for the year, we continue to support the midpoints of our guidance ranges for the total revenue, software revenue, adjusted EBITDA and adjusted EPS. Further, the expected reduction in our annual CapEx will probably place us at or above the high end of the free cash flow guidance without considering the benefit of the $35 million litigation settlement.

In conclusion, despite this year's backdrop of macro level economic uncertainty, some of which is affecting our customers' purchasing decisions, we are executing on our business plan. This quarter and also for the year, we have the evidence to support our regional strong organic growth target and our pipeline for the near-term remains robust.

Maintenance revenues and margins are tremendously healthy, and cash flows predictably strong. Our services business has continued to improve both billings and margin. With this, we are confident in our ability to achieve our goals for 2011. I would now like to open the call up for questions.

Question-and-Answer Session

Operator

[Operator Instructions] And our first question comes from the line of Richard Williams from Cross Research.

Richard T. Williams - Cross Research LLC

Part of the quarter, I'm assuming, was benefit from deals that slipped out of 2Q. Could you give us some color on that, and also on what happened in the managed services where the CapEx was lower than anticipated?

Hamish N. J. Brewer

Yes, I'd give you some elements in deals that could drive us in the second quarter. But I think that would've been enough to make up for the kind of quarter that we were able to post. I think overall, the trend is that as we said I think at the end of the second quarter, there's a strong pipeline in the third quarter. We anticipated that the third quarter is going to be stronger, and now it came significantly stronger. And as we're sitting here today, it's pretty much the same picture in the fourth quarter. So I think overall, the bigger driving force was really just the overall state of the pipeline quarter-on-quarter for the third quarter. And then with regard to CapEx from the managed services side. Nothing much has really changed from what we described at the end of the second quarter, which is to say that we are running a little bit behind our plan. We're not -- so we're not spending capital. We're not generating the revenue growth that we're hoping to, but we do feel like we're making progress with this business. The sales process is I think an area that we've been focused on primarily into the course of the last few months, and seems like we're making headway there building a stronger pipeline of new business opportunities, haven't yet translated into real revenue drivers for the revenues are yet. But we're pretty optimistic that the managed services businesses is going to set itself up for a nice run rate next year, but it's still not material given the size of our number. So I think nothing much really changed there from last quarter. It will be a little bit behind plan, but we're working on it, and I feel comfortably that we're making progress.

Richard T. Williams - Cross Research LLC

Okay. Last question, what happened in Asia, specifically Japan with the softer numbers there?

Hamish N. J. Brewer

Well, we basically have not really sold anything since the tsunami. We pretty much deemed our business growing to a halt in Japan, which for us is quite painful because Asia was -- Japan was the largest part of our business in Asia. So clearly, that's had a pretty big impact overall on our license sales performance in particular in Asia-Pacific. But we're hopeful that we're going to start to see the movement and then put it sometime in the course of the next couple of quarters. But so far, nothing much doing.

Operator

And our next question comes from the line of Patrick Walravens from JMP Securities.

Greg McDowell - JMP Securities LLC, Research Division

This is actually Greg McDowell on for Pat. My first question, the 9 deals over $1 million, I would love to hear little bit about the linearity of those deals in the quarter and whether those were mostly deals with the installed base or new logo wins, and just maybe how many of the deals were led by the JDA solutions set versus the IT solutions set, or was it a combination of the 2? That's my first question.

Hamish N. J. Brewer

I think the pitfall of the large deals for us in general, I think, was it's usually typically related towards existing customers. We're at a point now where I think in the retail market, 76 of the world's top 100 retailers are existing customers, and 83 of the top deals between customers and companies in the world are JDA customers. So new logos at the high-end where the last deals are likely to happen are relatively, and I think there were some $1 million plus deals on new logos, but the majority is always coming in from existing customers. And they're really, it's been a ongoing theme for us for a while here while selling larger footprint and solutions to big companies who are really looking to put in an integrated end-to-end planning and optimization platform and JDA is, again I'll say this, the leading player in that space.

Greg McDowell - JMP Securities LLC, Research Division

Great. And my second question reiterating your guidance for the full year, you made comment like deal uncertainty. And I was wondering, are you assuming a sort of standard Q4 close rate or have you -- how much have you handicapped your assumptions because of what is going on with the economy?

Hamish N. J. Brewer

Well, the situation -- I would describe the situation as it hasn't been terrible. It's not like we've been losing quarter of the deals and we expect to close or something like that, but it is kind of unpredictable. And so it's hard to know exactly how much to handicap it, but we have taken obviously a more cautious view of the pipeline. And still, even looking at it cautiously, we feel that we've got enough cover there to bring in the quarter that we need to hit the midpoint on the software number for the full year. So it's never the exact spend, but we feel like the pipeline that's out for the fourth quarter is very robust. And even if we get the price, the products where we have a number of clients, we should hope they'd still be in good shape.

Operator

And our next question comes from the line of Alan Weinfeld from David Securities.

Alan Weinfeld - Henley &

I was just curious, I had a conversation back in January about the most important goals for the year for JDA, and one of them was the total integration of i2. And I know you just put out a new transportation product. But I was just curious, besides the management people that have come in, who do you see as the major competitors of i2 and how are you going to market against them? And what do you think were your successes in the quarter?

Hamish N. J. Brewer

Okay. Well, first of all, I'll just talk about the integration. The product integration obviously is a multiyear thing. We put out like a 3-year and 4-year product roadmap when we acquired i2. And the first point I'd like to make is that, that roadmap is pretty much on track. I feel very good about the progress that we've already made and it looks like we're going to start, really in 2012, we're going to start to see a nice flow of integrated solutions coming out of the marketplace. They combine the strength of the traditional i2 platform, if you like, and the traditional logistics platform and also bring together a sort of a more traditional JDA pieces there as well. So I feel good about the products integration. In some of the go-to market where we compete with, it's still primarily the big ERP players, they definitely are our chief competitors. And when we're competing against them within the sort of plastic i2 markets, which will be the discrete manufacturing high-tech semiconductor, industrial kind of market. Really, where coming at it from is that you should think of your ERP as your transactional platform and JDA as your planning and optimization platform, which I think is pretty much a market positioning that we've now established successfully in the retail market. I think we've established it in the consumer product manufacturing market, and I think we're getting there with some of those traditional i2 markets. And in particular, in the i2 market where the manufacturers are actually building consumer products that actually channel through retail channels. I think we've made a lot of headway there because we've been to connect the strength that we have in retail with those consumer electronic manufacturers, where we can say here we have the programs that will enable you to channel your products more efficiently to the shelf globally through your retail sales channels. And we've proven that already with a number of customers. So that's how we compete. I've said this that primarily against the big ERP vendors, and I feel very good about state of the integration.

Alan Weinfeld - Henley &

Okay. And I'm sure you know in January, we're coming up to 101st Annual National Retail Federation Conference and you know we're going to see probably a ton of private companies. Again probably ones that can't survive those 3 to 5 years, and I know that you guys love to consolidate this industry. But I believe your balance sheet may not be ready at this time. What are your feelings about that now that you're pretty much anniversary-ed all the cost savings that you probably have from the acquisitions you've made. And I guess, all private companies thinking of doing something on the marginalization side?

Hamish N. J. Brewer

Yes. I feel pretty good actually about the state of the balance sheet. I mean, we've got -- we're doing our mix at $100 million of free cash flow into the business on an annualized basis. And so I think we're in a pretty good position to be able to make the strategic choices that we want to in the marketplace. And as you say, we're not shy of going into acquisitions. We like building this company through acquisitions and combining that with organic growth. And that's really the thing that we feel very good about today is that, we feel that we can make the acquisitions work and now we're actually starting to really drive a meaningful organic growth on top of that as a result of those acquisitions. So I don't feel overly concerned about our ability to execute on opportunities as they arise.

Operator

[Operator Instructions] Our next question comes from the line of Mark Schappel from Benchmark Company.

Mark W. Schappel - The Benchmark Company, LLC, Research Division

Hamish, starting with you. Do you get a sense that some customers are actually forcing out their year-end budgets a little bit earlier this year, because they may fear that they may see them cut off late this year or early next year if the economy still looks bad?

Hamish N. J. Brewer

I wouldn't be surprised if we do see a little bit of that. Obviously, through a lot of the year, companies have felt that things were stabilizing again, and businesses are doing well. I mean, the earnings results as seen posted across the board here are pretty strong in corporate America. And I'm sure there is going to be a little bit of uncertainty about next year. So I wouldn't be surprised if we do see a little bit of budget flush, but I haven't seen any evidence of it yet.

Mark W. Schappel - The Benchmark Company, LLC, Research Division

Okay. And do you believe that you have enough capacity in your sales force going into next year, or do you still believe that you're going to ramp your sales force throughout the early part of next year?

Hamish N. J. Brewer

Well, we set a pretty aggressive growth plan. I think we planned for the start of the year to add about 25 carrying headcount from memory. And we did a lot of that in the first half. We're certainly running a little bit behind time at the moment in terms of headcount. So we probably will still be recruiting into the first half of next year, but I would anticipate that we'd be on the start of the year adding another 25, if that's your question. But I think we'll be just gradually stepping it up. I mean we want to make sure obviously that we've got enough sales bandwidth to support the pipeline that we've got in front of us. And thankfully, our pipeline seems to continue to grow from strength to strength. And while that's the case, I want to make sure that we've got the people there to close the deal.

Mark W. Schappel - The Benchmark Company, LLC, Research Division

Okay, good. And then finally, I wonder if you could just give us an update in your perspective of the Software-as-a-Service supply chain market. I believe in the past, you thought that there wasn't much enthusiasm for SaaS-delivering models in the supply chain. I was wondering if you've had a change in about that or...

Hamish N. J. Brewer

Well, what I said in the past is a couple of things. If you ask me, do I think that one day eventually that supply chain is going to be largely delivered as a service, then the answer to that question is yes. It's not that I don't believe it's a concept, the question is the timing. Still today, the majority of the supply chain implementations we do traditional behind the firewall. It's not because we are pushing it that way. Quite frankly, we have our managed services platform, which we've actually rebranded as JDA cloud services now. We have the platform, and we have the capability. We actually prefer to sell these solutions on our cloud-based platform because we've discovered that customers go large because they get better quality results, they get better return on investment, and they're generally more satisfied. So we actually prefer to sell it on a service basis, if you like. But still today, there are a lot of companies who feel that the supply chain platform is a mission-critical piece that they just want to keep very close to their chest. So I don't know when the attitude changes, but obviously when it does, we're ready for it.

Operator

And our next question comes from the line of Brian Murphy from Sidoti & Company.

Brian Murphy - Sidoti & Company, LLC

Hamish, I just want to follow up on the questions about the sales force. It looks like the quarter-bearing headcount was down sequentially. And I'm just hoping you could help us understand what's going on there, is that forced attrition?

Hamish N. J. Brewer

Let me say, to be completely clear. It's not because we've been laying off salesman. That's absolutely not the case. In sales force as we always get a certain amount of natural rotation, performance management and stuff like that. We have been a bit loaded intentionally, frankly. We were obviously, we've got some uncertainty at the end of the second quarter on some of the deal transactions, and we wanted to build carefully going into the third quarter. And we've been holding back, but we feel like the sales force we've got we've got more than enough bandwidth to deliver the numbers that we want to deliver this year. And we would anticipate that we'll continue to going into 2012.

Brian Murphy - Sidoti & Company, LLC

And year-to-date, are your sales and marketing expenses coming in much below where you planned?

Hamish N. J. Brewer

Well, it's a little bit lower than we planned at the outset. We'll probably close of that gap somewhat in the fourth quarter. We've got a lot of salesman hitting the escalators now going into the fourth quarter. I have pretty much already got a record number of people in our sales force, ready to go to our annual president's club. So I imagine we will get back on track with spending money on salespeople.

Brian Murphy - Sidoti & Company, LLC

Okay. And I just wanted to ask about the service gross margins and the kind of steep sequential year-over-year decline in the cost of service there. Maybe could you -- where does the headcount stand in the service organization?

Hamish N. J. Brewer

The year-over-year decline is really attributable to that point that I made earlier that there was a $7.6 million that's sort of catching up on revenue recognition that happened in the third quarter of last year. Largely, work that was not performed the third quarter but is essentially revenue without cost. And that's really spiked the margins in the third quarter last year. If it makes a very unfavorable comparing year-over-year. Sequentially, I'm not saying that we are up, that margins went up from the second quarter to the third quarter. It's just that is a tough comparison to the third quarter last year because like I said, we have a big bunch of revenue that came in with no cost. So I think that margins, we said at the beginning of the year that margins in implementation services are going to gradually improve through the year. But not a runaway train but it's going to steadily improve and I feel that way. Fourth quarter is always tough. Obviously, you know that we've got -- we lose a lot of billable hours with holiday times, so I think margins will probably decline a little bit in the fourth quarter. That's normal, that's just a seasonal effect. So overall, I think we will make some slight progress on a year-over-year basis.

Brian Murphy - Sidoti & Company, LLC

Okay. So that's sort of where I was getting at is that, have we stepped up to a level here that's sustainable in terms of service gross margins and sort of the low to mid-20s going forward?

Hamish N. J. Brewer

Yes, I believe this business is sustainable. And in fact, we would hope that as I said at the start of this year, actions were sort of put in place gradually over time. And over the course of the next couple of years, we could continue to see that increase. That's not going to jump up by huge percentage points, honestly, but I think a steady slow improvement is something we could look forward to again in 2012.

Brian Murphy - Sidoti & Company, LLC

Okay. And I think I missed the litigation expense for the quarter, did you mention that?

Peter S. Hathaway

No. I just indicated that it was a partial reason for the decline from 2010 to 2011 in G&A expenses.

Brian Murphy - Sidoti & Company, LLC

Okay. And I think at the beginning of the year, you were sort of orienting investors around about an $8 million litigation expense for the year, is that still a good number?

Peter S. Hathaway

Yes. It's come down since then because we -- that $8 million contemplated that we sort of at the Oracle battle for a good part of the year, and we resolved that in Q1 so the legal expenses have come down. Q2 and Q3 in comparison to last year's Q2 and Q3, quite a bit.

Brian Murphy - Sidoti & Company, LLC

Okay, great. And if I could just ask one more about the pipeline for Q4. I mean it sounds like Asia continues to be weak. And you have a very tough comp in Europe in the fourth quarter. And just given what's going on over there, where -- are you seeing the pipeline in Europe or is this mostly just going to be a North American phenomenon?

Hamish N. J. Brewer

No. Looking the pipeline today, certainly North America's going to feature heavily on our performance in the fourth quarter. Europe, we have some opportunities, and it should be a reasonable quarter for us. It's not -- we haven't seen that sort of massive slow down or anything like that. In fact as I said yesterday, we had our European User Conference, we got record attendance. And so we're feeling reasonably good about Europe. And certainly on the year-to-date basis, sales in Europe are up over 100%. So right now, I feel like we're in pretty good shape at it and the fourth quarter is going to be canvas this quarter for Europe, but it should be a respectable result.

Operator

[Operator Instructions] The next question comes from the line of Jeffrey Rhee from Craig-Hallum.

Jeffrey Van Rhee - Craig-Hallum Capital Group LLC, Research Division

Hamish, first off, maybe just back to the acquisition question. Can you just give a little more color on thoughts there around timing, prices you're seeing out in the market, whether bolt-on technologies, vertical, new markets, geographic or otherwise are sort of in the crosshairs. Maybe just give us a little more color on what you're thinking there.

Hamish N. J. Brewer

Well, I wouldn't say we've got anything in particular in the crosshairs. Obviously, I was really just responding to our ability to act in the case that we saw an opportunity. But I mean, the fact is we stated in the acquired i2 that we wanted to be acquisition-ready within 18 months. And that time's up, and I think we're in -- the company is in good shape. We'll be on the lookout over the course of the next year or so and we will, I guess, we'll see what opportunities come up in the marketplace. And if something looks good to us, then I think we've got a balance sheet where we can capture that.

Jeffrey Van Rhee - Craig-Hallum Capital Group LLC, Research Division

Okay. And so I guess just secondly on the license front. I guess if I look at on an organic basis, year-over-year, the midpoint of the guide is 13% for this year. Assuming that's the number, just out -- give me a sense. Do you feel that any of that is catch-up from pushed-out deals in difficult environment last year whereby then maybe next year would be slower growth? Do you feel like just the overall health of the market is improving whereby next year, you might actually be able to accelerate from those levels? I realize you don't have a crystal ball on next year, but any color there would be helpful.

Hamish N. J. Brewer

Yes. You're right. I mean I don't have a crystal ball for next year. And to be honest with you, given the uncertainty that's in the market, I'm pretty much going to hold off trying to speculate on what's going to happen next year until we sort of get there, because it's -- I think it's going to be tough to call to be frank with you, Jeff. As we know, there's a lot of sort of macroeconomic issues going on and maybe, they're going to be okay. We're seeing -- on the one hand, we're seeing indications that the economy in U.S. is growing better than it was last quarter. And at the same time, we've these sort of issues potentially with the financial market, particularly in Europe. So at this point, it's very hard to say what we're going to be facing when we get to January of the 2012. If you were to ask me if things stayed exactly as they are now, should we go next year? Then my answer would be yes, but I don't know if they will.

Jeffrey Van Rhee - Craig-Hallum Capital Group LLC, Research Division

I'm not sure I understood that. Could we grow and even on absolute terms, will grow faster?

Hamish N. J. Brewer

Well, I don't know if we could grow faster, I'm just saying we could grow.

Jeffrey Van Rhee - Craig-Hallum Capital Group LLC, Research Division

Okay. And then I guess last one for me. You commented on Q4 pipeline being more than adequate, but that you've taken maybe a bit more cautious standpoint in terms of the coverage necessary to hit numbers just given macro, et cetera. How do you typically look at a -- I mean, when you're looking at a quarter like that, I don't know, did you have a rule of thumb? You're sort of looking at 3 or 4x coverage and maybe now you're requiring 5x coverage, or anything that can give us a sense of how much more conservatism you've built into that Q4 outlook?

Hamish N. J. Brewer

Yes, I mean we look at it a bunch of different ways. We look at it in terms of coverage, we also look at it in terms of maturity of the deals that we've got, how far along are they, and how committed the prospective customers seem to do a transaction. And we look at it bottom's up, we look at one deal at a time. And then we look at it top down, we look at the ratios and all that kind of stuff. I mean, we're looking at every which way we possibly could I think. And at the end of the day, we try to make a sort of judgment call as to what you think may happen, particularly as I say with regard to uncertainty in the marketplace. Because we have seen, as I said, a few transactions which is both at the 11th hour. And when they finally went through the capital board for approval, they were like no, we're not going to spend the money now. So it's hard to know exactly how much to factor into that. But yes, we've been a little bit more conservative than usual and we've certainly qualified and scrubbed up our pipeline a bit more aggressively probably than we would normally. And yes, we still come out with a good result so that's why we feel reasonably comfortable with the position that we've taken.

Operator

And we have a follow-up question from the line of Patrick Walravens from JMP Securities.

Greg McDowell - JMP Securities LLC, Research Division

It's Greg again. May be just one for you, Pete. So the midpoint of your full year non-GAAP EPS guidance is $2.10 and you've already done $1.54 in the first 9 months of the year, which at the midpoint would imply $0.56 in Q4. And that would be a sequential decline from Q3, which somewhat goes against historical patterns of Q4 EPS being above Q3 EPS. So I just want to ask you, Pete, is that just conservatism on your part or are your sales and marketing going to go up by that much because of all this quarter club number?

Peter S. Hathaway

It's a good question. I mean what we said sort of generically is, we feel like the midpoint of the range is likely to be where we end up. I think the idea of having a sequential decline in EPS is not real likely if we're able to hit the midpoint of the range for the software license. So no, I don't think sales and marketing is going up that much. So I think the bias is sort of the upper half of the range for EPS.

Operator

And at this time, I'm showing no further questions in the queue. I'd like to return the conference back over to Hamish Brewer for closing comments.

Hamish N. J. Brewer

Thank you. I'd like to thank you once again for joining us today. We're obviously very pleased with the strong results from the third quarter. We're excited about the future prospects of the company. We know we'll face economic headwinds and customer uncertainty that will make the next few quarters challenging. But we feel confident that we're going to be able to continue to execute on our strategic business plan and continue to create value for the shareholders, frontliners and collective stakeholders. The company is generating solid organic sales growth at attractive margins and producing meaningful consistent cash flow that's reflected in our capital structure. We continue to build on the multiyear track record for expecting aggressive but achievable goals, and performing in accordance with our plan. We got a great leadership team in place and a team of 3,000-plus associates across the globe that are the best in the business. We'll be working hard to close out a successful 2011 over the next 2 months, and we look forward to another great year in 2012. Have a good evening.

Operator

Ladies and gentlemen, this does conclude our conference for today. We thank you for your participation, and you may now disconnect.

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