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Executives

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

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

Analysts

Michael B. Nemeroff - Crédit Suisse AG, Research Division

Michael Huang - Needham & Company, LLC, Research Division

Laura Lederman - William Blair & Company L.L.C., Research Division

David Togut - Evercore Partners Inc., Research Division

Richard K. Baldry - Wunderlich Securities Inc., Research Division

Gregory Dunham - Goldman Sachs Group Inc., Research Division

Jeffrey L. Houston - Barrington Research Associates, Inc., Research Division

Shawn Yuan - Roth Capital Partners, LLC, Research Division

Matthew J. Coss - Piper Jaffray Companies, Research Division

Raghavan Sarathy - Dougherty & Company LLC, Research Division

Terrell Frederick Tillman - Raymond James & Associates, Inc., Research Division

Brian J. Schwartz - Oppenheimer & Co. Inc., Research Division

The Ultimate Software Group (ULTI) Q2 2012 Earnings Call July 31, 2012 5:00 PM ET

Operator

Hello, and welcome to Ultimate's Second Quarter 2012 Financial Results Conference Call. [Operator Instructions] Today's conference is being recorded. Your presenters today will be Mr. Scott Scherr, Chief Executive Officer, President and Founder of Ultimate; and Mitchell K. Dauerman, Executive Vice President and Chief Financial Officer. We will begin with comments from Mr. Dauerman.

Mitchell K. Dauerman

Okay. Thank you, Melanie. Good afternoon, everyone, and thank you for your interest in Ultimate Software. Before we begin, please be aware that we will be discussing our business outlook and we'll 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 for additional information on risk factors that could cause actual results to differ materially from our current expectations. We assume no duty or obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

I'm going to begin by reviewing our financial results for the second quarter of 2012 and then I'll provide financial guidance for the third quarter. 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. And the primary difference between GAAP and non-GAAP financial information is noncash stock-based compensation. Please refer to the reconciliation of our financial information on a GAAP basis to that on a non-GAAP basis, which is included in the press release that’s published on our website.

For the quarter, recurring revenues grew 24.3% to $64.6 million and represented 82% of total revenues. Total revenues grew by 23.3% to $79.2 million. Operating income increased by 55.4% to $10.3 million and the operating margin expanded to 13%. Net income grew to $5.9 million compared to $3.8 million last year, and the related net earnings per diluted share was $0.21 compared with $0.14 per diluted share in 2011.

Both the recurring revenue for the quarter of $64.6 million and the recurring revenue gross margin of 71.2% were slightly better than our forecast. Annualized customer retention exceeded 96% for our recurring revenue customer base. And then please remember that our recurring revenue gross margin is impacted by the investment in and the continued growth of our Tax Filing business. Speaking of the Tax Filing business, our average daily float balance for the year-to-date was $300 million, and this is compared to $180 million for the same period last year. Due to the current yield environment, the revenue impact of these funds is immaterial. Service revenue was $14 million, representing an increase of 19.1% over the same quarter last year. The services gross margin for the quarter was slightly better than we expected. Keep in mind that on a sequential quarter basis, the revenues and gross margins reflect the seasonality of W-2 revenues. The gross margin rate for total revenues was 58.5% compared to 57.9% for the same period last year. The change from 2011 was related to the growth in recurring revenues and a 40-basis point expansion in the related gross margin. Operating expenses were $36 million for the quarter and were favorable to our expectations. We do expect a significant portion of these expenses to be incurred later this year and as reflected in our full year guidance.

Operating income was $10.3 million, and our operating margin was 13% for the quarter versus $6.6 million and 10.3% for the same quarter last year. The excess margin over our guidance was due to slightly higher recurring revenues coupled with lower costs. Net income was $5.9 million or $0.21 per diluted share compared with $3.8 million and $0.14 per diluted share for the same quarter last year. Our non-GAAP income tax rate for the quarter was 42%.

Turning to the balance sheet. Total cash and investments in marketable securities were $73.1 million. On a year-to-date basis, we generated $22.7 million in cash from operations compared with $15.2 million last year. We purchased $7.4 million in capital expenditures for the first 6 months of this year compared with $7.6 million for the same period last year.

We used $4.3 million in the 6-month period to repurchase shares required to settling employees tax withholding obligations associated with the restricted stock units that vested. We have 1,058,000 shares remaining that are available for repurchase under our plan.

Accounts receivable were $53.7 million at June 30. DSOs were 62 days at the end of the second quarter compared to 66 days for the comparable period last year. Current deferred revenues were $82.7 million on June 30, compared with $73.2 million at June 30 last year. As a reminder, deferred revenues in the first half of the year reflect the seasonality in annual maintenance bills. Long-term deferred revenues were $2.1 million on June 30, compared with $4.8 million on June 30 last year, reflecting the elimination of the onetime infrastructure fee in our SaaS contracts.

Turning to guidance. We're reaffirming our full-year guidance for 2012, recurring revenues are expected to grow by approximately 25%. Total revenues are expected to grow by approximately 23%, and our operating margin is expected to be approximately 15%. For the third quarter of 2012, we expect recurring revenues to be approximately $68 million and total revenues to be approximately $84 million. We expect our operating margin to be approximately 16%. Our guidance reflects the capitalization of R&D cost relating to software projects beginning in Q3.

As we previously discussed, we are estimating capitalizing between $2 million and $2.5 million in each of Q3 and Q4. Capitalization will continue in 2013. We will give you our estimates in October when we discuss our preliminary guidance for 2013.

Turning to the upcoming conference schedule. During the next quarter, I'll be at the Oppenheimer Conference on August 14 and the Canaccord Conference on August 15, both in Boston. In addition, I'll be at the Deutsche Conference in Las Vegas on September 11 and the CL King Best Ideas Conference on September 13 in New York. If you're available at those conferences to meet, please let me know.

And now I'll turn over -- the call over to Scott.

Scott Scherr

Thank you, Mitch, and thank you everyone for participating on our call this evening. For 2012 second quarter, we continue to execute on our business plan, achieving our 3 most important goals: growth in recurring revenues, customer retention and growth in our operating margins. Our recurring revenues were up 24%, our annualized customer retention rate was greater than 96% and our operating margin was 13%. We had the best overall sales quarter in our history for value of new business. I recently attended our midyear sales meetings. Our activity levels are high, and our forecasts are strong, and we have added some great talent. We're in great shape to continue the momentum into the future.

In Enterprise, some of our new SaaS customers in the second quarter were: our third largest customer to date, a restaurant chain with more than 70,000 employees that signed up for Time Management in addition to Core UltiPro; our largest Canadian company to date, a retailer with 17,000-plus employees, that added Salary Planning and Budgeting and Position Management; a health care company with more than 9,000 employees that added Recruitment, Onboarding, Performance Management, Salary Planning and Budgeting and Succession Management; a Midwestern retailer with 7,000 employees that added Recruitment, Onboarding and Performance Management; a specialty food retailer with more than 6,000 employees that added Onboarding, Recruitment, Performance Management, Succession Management and Time Management; and a health care software company with more than 6,000 employees that added Onboarding and Salary Planning and Budgeting. Our Workplace team had the best quarter in their history. Attach rates continued to be strong. Onboarding came in at 88%, Recruitment 82%, Time Management 80% and Performance Management at 67%. Some new Workplace customers in the second quarter were: a packaging company, with approximately 1,000 employees, that selected Recruitment, Onboarding, Performance Management, Time Management, Salary Planning and Budgeting and Succession Management in addition to the core solution; a children's home, with approximately 900 employees, that selected Recruitment, Onboarding, Performance, Succession Management and Time Management; a health care technology company, with 900 employees, that added Recruitment, Onboarding, Salary Planning and Budgeting and Time Management; an industrial minerals company, with 800 employees, that added Recruitment, Onboarding, Performance Management, Time Management and Succession Management; a hospital, with 850 employees, that added Recruitment, Onboarding, Performance Management and Salary Planning and Budgeting; and a golf equipment manufacturer, with 870 employees, that added Performance Management and Time Management. Our marketing metrics confirmed that market desire for our solutions continues at a healthy pace.

This year's Q2 was 1 of the top 3 highest quarters in our history for number of prospects who reported they are looking to purchase a new solution within 12 months or less. The number looking to buy in this rapid time frame is 22% higher than in Q2 of 2011 and 10% higher than in Q1 of this year. We have the second highest quarter ever of website visits in Q2 this year, second only to our fourth -- first quarter this year when a spike in traffic was generated from our Fortune Best Companies ranking and our new brand launch. Also, in Q2 this year, the busiest time for our industry's large trade shows, we had our highest quarter ever in the history for looking to buy respondents from national shows, a 53% increase over Q2 last year.

Our Canadian success stories are helping us to extend our footprint in Canada. We are building strong relationships with our Canadian customers. And as we do through consistent performance and communication, we developed the kind of trust that makes our customers our most vocal supporters.

Concord Hospitality, a North American hotel management and development company with a portfolio that includes more than 80 hotels in Canada and the United States, has completely transformed its people-facing practices since deploying UltiPro. Debra Punke, Concord's Vice President of Human Resources, says that they have enhanced employee engagement by starting with a positive onboarding experience through UltiPro and created efficiencies with other HR processes and at the same time, have reduced labor cost for their HR staff. Concord Hospitality operates hotels and resorts under such well-known brands as Marriott, Hilton, Hyatt, Starwood and Choice Hotel. UltiPro has become Concord's single solution of record for its people, Concord's executives, HR team and managers. Executives now have immediate visibility into employee information, which is used to evaluate and improve productivity, monitor and control manpower costs and make forecast about future trends.

Columbia Forest Products, North America's largest manufacturer of hardwood, plywood and hardwood veneer, reported it has reduced hard costs by more than $100,000 annually and also reduced HR headcount while improving the effectiveness and efficiency of its HR operations and services.

According to Ben Vann, HRIS manager at Columbia, they are especially pleased with the increased control over their own data, the business intelligence analytics on workforce metrics and the improved data integrity that comes with sider general ledger integration. On a social media site, when discussing what his favorite UltiPro feature is, Vann said, "Business intelligence is the best. We have streamlined more information to more people at less cost than we ever have done before. No one is better at reporting than UltiPro."

Our Partners for Life program has continued to motivate our customers to have more of their people take advantage of our learning services. In Q2 this year, we had a 26% increase in attendees to our classes over Q2 of 2011. We know that the larger the number of people we train, the more our circle of influence grows. Class attendees appreciate the depth and completeness of UltiPro's functionality better and are more skilled in sharing our solution's benefits with interested prospects. To extend our circle of influence still further, in April, we introduced a third type of training we call flexible learning that has no class size restriction and allows us to better leverage our trainers and increase the numbers of people we train. This new program offers audiovisual courses where the trainer demos the product live online, but without the learner needing to complete hands-on activities during the instruction. Instead, later, at their convenience, they are able to practice what they have learned after the training in our 24-hour online UltiPro sandbox. There are no class size restrictions with this model. It's a no lines, no waiting experience, and large numbers of new customers' employees can become comfortable with UltiPro faster, speeding up our customers' client activation. The first classes we're offering in this model are those in highest demand. Our overview courses that introduce new uses to UltiPro's features, already we see that this training model is an effective new vehicle for increasing the numbers of people we can train rapidly.

We closed the quarter with 1,470 associates, and we are confident in our collective ability to retain our current and future goal. As we always have, we will continue to focus on enhancing our solutions to make them the best they can be for our customers and to care for our employees with a passion that is unique in our industry. We are, we believe, the leader in cloud-based people management, having the highest number of people records in the cloud, over 7 million for unified HR, payroll, talent and time management. And we have the most customers using a SaaS solution for strategic and unified human resources payroll talent and time management. We intend to respect our leadership position by continuing to listen closely to our customers and to partner with them to stay at the forefront of HCM innovation. We thank you, as well as our customers, for your continued support. We are excited about what we have achieved and where we're going in the future together.

Let's go to the Q&A.

Question-and-Answer Session

Operator

[Operator Instructions] We will go first to Michael Nemeroff with Credit Suisse.

Michael B. Nemeroff - Crédit Suisse AG, Research Division

Scott, for you. You answered partially my first question by announcing a 70,000-seat deal. I was wondering how comfortable are you with the compares that you're creating in 2012 to mitigate some of those tough compares in 2013? Are there more deals of that size in the pipeline, in that 50,000 to 100,000 range?

Scott Scherr

My gut is that we've done it now 3 years in a row, so it seems to me like it would make sense that we could do what I would consider as a large deal with somewhat over 50,000 employees, that we would do one a year at least.

Michael B. Nemeroff - Crédit Suisse AG, Research Division

Okay. And then also, you talked about your success in Canada. I was just wondering if you have any aspirations of taking the product to other geographies since you're doing particularly well here in the U.S.?

Scott Scherr

Not right now. I think our penetration rate, 10% on Enterprise in the United States, less than 2% in Workplace, fairly well less than 1% in Canada. I think we're going to focus on penetrating those markets. And on an HR and talent basis, if they're a North American company and they had global employees, that's a good fit for us as well.

Michael B. Nemeroff - Crédit Suisse AG, Research Division

Okay. And then just one for you, Mitch, I may. I know you don't update the guidance throughout the year and then you kind of keep the numbers steady as you guided for 2012, but you've beaten estimates here in Q2 pretty handily there by a couple hundred thousand on -- and especially on the margin. Is there -- assuming that the environment doesn't change, is there a potential for upside to those estimates -- as to the annual estimates that you've given for the year?

Mitchell K. Dauerman

Well, there's always potential. I mean, I think what we do know is we had some expenses that we know our timing. We expect them to be spent in the second half of the year. If they aren't, that could provide upside. We know, on recurring revenue, we’re a little bit ahead of it. Not a lot in dollars, but you get some pushes -- some pulls rather. You could have some pushes that are normal in the business and you have seasonality in the -- in workforce. And I think the other thing is, with the strength of sales growth, it may be prudent to invest some of that excess in the business.

Operator

We will go next to Michael Huang with Needham & Company.

Michael Huang - Needham & Company, LLC, Research Division

So couple of questions for you. So first of all, I believe that you mentioned that Q2 was the best quarter ever in terms of value of new bookings. I wanted to clarify, was that both in terms of volume of deals? Or is this more a function of larger deals that you're getting done?

Scott Scherr

I think it's 100% in total value of the deal. I don't know 100% if I went back in time, but it's a very good unit quarter as well. Very high. I don't know if it's #1, but I do know 100% it was the #1 sales quarter of new sales business.

Michael Huang - Needham & Company, LLC, Research Division

All right. Okay. And given the strength of attach rates, both across Workplace and Enterprise, and your continued push on market, how much bigger are kind of deals now in an annualized cost of value versus a year ago? I mean, do you have anything that kind of helps us understand kind of how much bigger these deals are?

Scott Scherr

I think it's been going on since we introduced Workplace about 5 years ago. And I think as Workplace was going higher -- at the first Workplace was 200 to 700, then we moved them from 700 to 1,000. So I think it just moved Enterprise sales up, Workplace moved up and lower market. In general, we're averaging somewhere a little under 5,000 employees per deal in Enterprise right now. And in Workplace, we're averaging a little below 500 employees per deal, which are both very good numbers for us.

Michael Huang - Needham & Company, LLC, Research Division

Okay. And then last question for you, just in terms of that megadeal with the large retailer. Who was the primary competition in this deal? And ultimately, what were the key drivers behind the win?

Scott Scherr

I believe it was service bureaus. And I think it's, like we've done on the other deals, it's one unified system and our technology, our relationship, certainly, the other ones we've had in the past, a reference of a client base and with hospitality company and we do very, very well in hospitality with a lot of great references and a lot of big numbers there. So all in all, I think it was the culture. They wanted to partner with a company like us. They have a good culture with this company. Certainly, liked the product or they wouldn’t have gone with us and they believe in our service.

Operator

We'll go next to Laura Lederman with William Blair.

Laura Lederman - William Blair & Company L.L.C., Research Division

For the large deals, 50,000 seat, even 20,000 seat, who are you seeing competitively, particularly in the quarter, so we can understand not only who you're displacing but also who you're competing with after seeing this quarter for larger deals?

Scott Scherr

I think it's mostly service bureaus who we compete against up there and typically larger deals are like -- it could be a restaurant chain with hundreds of locations. So if you took one location, it wouldn't seem like a large deal. But if you put them all together, they end up with something like a 70,000-employee deal. So I don't think there's any magic to it. It's just that some of these businesses have grown through adding restaurants or adding hospitals, which was what we did a couple of years ago. And -- I mean, mostly service bureaus.

Scott Scherr

Are you still seeing Workday only about 10% of the time than if you've seen Dayforce get with their payroll? Or have you seen them much in time and have timed them?

Scott Scherr

No. We don't sell standalone time of attendance, so we'd have to see which [indiscernible] is filled up 15% of their time. We see happy [ph] workdays in Enterprise. We don't see them as much at all in Workplace than in Enterprise. I think it's a little north of 10% we see them.

Laura Lederman - William Blair & Company L.L.C., Research Division

And final question for me and I'll pass it on. The software capitalization that's starting in the second half of the year, can you give us a sense of which features and functions -- or what that is? I mean, is that the globalization? Is that the ability to change more fields? I'm just trying to get a sense for what are kind of the features that are being capitalized.

Scott Scherr

There's so many things involved in it, Laura. As you know, there are different architectural things in it, different features and functionalities. There is certainly a lot of global in it. It's something we've been working on for a while and we're going to keep working on this. It's just the future of UltiPro.

Laura Lederman - William Blair & Company L.L.C., Research Division

And does it creates a type of change for the customers in terms of having to migrate? Or is this just another roll forward update for them?

Scott Scherr

Down the road, it will be a roll forward for the customers, just like we've always done in the 22-year history of Ultimate, as we went from DOS to client service to the Web. I mean, the customers always came along with us as we enhanced the product.

Operator

We'll move next to David Togut with Evercore Partners.

David Togut - Evercore Partners Inc., Research Division

Scott or Mitch, you referenced Ceridian 15% of the time in the quarter. Have your, I guess, win rates changed at all overall versus Ceridian or ADP, both for Workplace and Enterprise?

Scott Scherr

No. If we can run our process and go through it, we have a very good chance to get the business.

David Togut - Evercore Partners Inc., Research Division

Okay. And then ADP released Vantage HCM for general release in July. I'm wondering if your sales force has any anecdotal experience versus Vantage HCM. Any thoughts?

Scott Scherr

It’s just that [ph] we have a national midyear sales meeting and national end of year sales meeting. I was just at the midyear sales meeting and that was not brought up to me by anybody. I mean, we tend to hear a focus on UltiPro and the product and the service and trying to keep making it better and trying to get our -- keep our people and trying -- selling the business and keep the [indiscernible] happy. So like we said, our #1 competitor is ourselves.

David Togut - Evercore Partners Inc., Research Division

Got it. And then any status update on the implementation of the 2 large contracts you announced early in the year, the hospital chain and the restaurant chain?

Scott Scherr

Yes. They're running on track for, as we discussed before, at the beginning of the fourth quarter this year.

David Togut - Evercore Partners Inc., Research Division

Okay. A final question for me. Biggest drivers, Mitch, of non-GAAP operating margin expansion in the third quarter?

Mitchell K. Dauerman

In the third quarter?

David Togut - Evercore Partners Inc., Research Division

Third calendar quarter. I think you put a 16% non-GAAP operating margin.

Mitchell K. Dauerman

Yes. I think it's the combination of the growth and -- continued growth in recurring revenues, bringing along higher dollars, and then I factor in it just mathematically is the capitalization of the R&D cost.

Operator

We'll go next to Richard Baldry with Wunderlich Securities.

Richard K. Baldry - Wunderlich Securities Inc., Research Division

Again, with your sales peaking in the quarter, can you talk a little bit about any plans to alter sort of your go-to-market there or as in terms of adding headcounts or maybe moving the ceiling on the work site guys a little bit higher to push them in the larger deals and keep that productivity climbing?

Scott Scherr

Our plan as far as the sales force right now is to increase it by 20%. So when we're talking this time next year, we'll have 20% more quota carriers in the field. And we've already started that. We've got about 5% added already of that 20%, so we'll continue to do that as we move forward. As far as raising it, nothing scheduled for '13 to do that, or plan for '13.

Richard K. Baldry - Wunderlich Securities Inc., Research Division

I think you talked about the charted first time you talked about adding to the headcount in the sales in a little while. So what was the driver behind that? And do you feel that the productivity is at a level that's an important to staff? Or was it just opportunistic kind of people who runs major of seeing on certain geographies you thought were in need of kind of splitting territories?

Scott Scherr

No. I think it was just timing. I think -- I mean, Workplace is 5 years old. But to us, with Enterprise, the average tenure is over 10 years on our Enterprise sales team. So I think Workplace got to a point where we're having just more and more confidence as we move forward. At the Enterprise, we think we can grow a few more places around the country, whether we have additional opportunity in Canada that we could take more advantage of. I think the growth, when you put it down to heads, it's about 6 heads in Enterprise, it’s about 8 heads in Workplace that I think we could do over the next 12 months without upsetting anyone’s apple’s cart at Ultimate.

Operator

We'll go next to Greg Dunham with Goldman Sachs.

Gregory Dunham - Goldman Sachs Group Inc., Research Division

I actually want to shift a little bit to the kind of customer support of some of these bigger implementations. I know that the strength of '12 release has a lot more functionality for some of these larger organizations. And obviously, with the 70k deal that you signed that's going to be coming on, do you feel that you have enough capacity to support the implementations of some of these bigger customers? And should we expect some of the investments that you're making in the early part of 2013 to focus on that dynamic?

Scott Scherr

Certainly, we have the implementation power to do it. And yes, as we -- the implementation is very tight with how sales is doing. And we have a pipeline of people we can go to. Also, we have third-party implementors. We actually have a national implementation meeting going on right now. We spoke at it yesterday. We have over 300 people there, and we had some of our implementation partners who come to our meeting. So yes, I think we certainly have that and then I think it just rolls into support with one of the deals we got 2 years ago. So we have ample time to ratchet up, the support to handle that. The other one we got last year, it's actually is going live -- same thing, it's been over a year for us to ramp up support. Both organizations also have -- sometimes, the larger the deal, the easier the support because they have support structures within their organization that some of the smaller accounts don't have. We're in good shape on both those areas, implementation and support.

Gregory Dunham - Goldman Sachs Group Inc., Research Division

Yes. That makes sense. And as a follow-up, how important is the spring '12 release? I know a lot of it is for -- to handle these kind of 100,000 seats or pay customers. I mean, is that critical for you to win some of these larger accounts down the road?

Scott Scherr

No. Obviously, we won 2 of them before the spring release. I think it was just enhancements made to -- I mean, one of them was -- we're always trying to make UltiPro faster. But honestly, the larger the account, the faster you want it. So those are in there. I think on the global front, none of these really have global -- they don't have global needs. But for some of our other customers and our new prospects and customers that have global needs, it gave us a lot of ammunition on the global front. So that helped us. And every release helps us, because every release we're putting more and more functionality into the product.

Operator

We'll go next to Jeff Houston with Barrington Research.

Jeffrey L. Houston - Barrington Research Associates, Inc., Research Division

So following up on an earlier one regarding the product roadmap. I think the price per employee per month can go up to $22 if a client where to adopt all of your products. And I think your goal is to increase that to $30 or so in 3 years. What features and functionality are you developing to deliver those additional $8?

Scott Scherr

I think certainly, global and all the things around global that we have could get us half of the way there. The predictive analytics, we have upside in that as we take that deeper. And we have more functionality around that within the product. And then we have a whole product strategy team that looks at things that -- what could we have in the market that our customers want? So without giving away, like any plans for exactly what it is, we have a system in place where we're always trying to build out UltiPro and add value to our clients, which in turn adds value to us.

Jeffrey L. Houston - Barrington Research Associates, Inc., Research Division

And is the global functionality more of a talent management suite, I imagine, rather than the payroll?

Scott Scherr

Well, right. It's not payroll, it's HR and talent. We recently had one of our clients, because of the spring release, that was able to add, I believe, it almost 10,000 employees in 46 different countries and report on it because of the spring release. So that was something that allowed us to get that many more people into UltiPro from an HR standpoint and a reporting standpoint than we had the capability to do before the spring release. So I think it just makes us better, stronger, more competitive having it.

Operator

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

Shawn Yuan - Roth Capital Partners, LLC, Research Division

This is actually Shawn Yuan for Nathan. My question is a follow-up with David's question regarding those 2 large customers that we were talking about. In previous quarters, we talked about those customers to go live in Q4. And can you share with us on what month do you expect that -- those 2 customers who will go live? And can you comment on, is that ahead of your plan or behind or it is consistent with what you've seen with other integration process?

Scott Scherr

Shawn, it's scheduled for October, and it's right on track with the plan that both our team and their respective teams worked out.

Shawn Yuan - Roth Capital Partners, LLC, Research Division

Okay, great. And how much revenue are you expecting from these 2 customers in Q4?

Scott Scherr

Yes. We really haven't gone into that kind of detail, but it is baked into our recurring revenue guidance. And I think as everybody knows, we started the year with a lower growth rate on a year-over-year basis and we'll end up somewhere around 29%, 30%.

Operator

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

Matthew J. Coss - Piper Jaffray Companies, Research Division

Scott, Mitch, this is Matt Coss on for Mark Murphy. It seems like -- these really large deals, I mean, it seems like you're getting pretty good attach with some of the other products. Is that what's actually happening? Are you seeing a higher attach rate on larger deals?

Scott Scherr

No, no, no. I think it's across the board. Well, the highest attach rates we have is in Workplace, under 1,000 pays, because in general those people don't have those products. And I think above, it's a little less. It's still high for us. But no, I don't think it's that at all with it. Especially the large deals, it's not based on the attach rate. It's based on having a unified system across multiple locations throughout the country that got them excited and there's not too many people who can handle that from a payroll, HR side.

Matthew J. Coss - Piper Jaffray Companies, Research Division

Got it, okay. And then last quarter you talked about a smartphone and tablet version of your application for UltiPro. Is that still under development? And when it gets out the door, I mean, do you think it'll be a kind of a big selling point for you guys?

Scott Scherr

Matt, we demoed it now to people. I think it's in the next release that is coming out. We do some things right now with the -- on the phone. It's just taking it to another level. When we do to all now, it's just adding more and more capability for the end user to take advantage of on the tablet or the phone.

Operator

We'll go next to Raghavan Sarathy with Dougherty & Company.

Raghavan Sarathy - Dougherty & Company LLC, Research Division

The first question is on the operating margin guidance. So Mitch, you are guiding for 300 basis point sequential increase in operating margin this year. It seems like very similar to last year. But if I look at the recurring revenue growth, you're expecting $3.5 million increase this year compared to $2.5 million. You're also going to capitalize $2.5 million in R&D expenses. So I'm wondering where the expenses -- where you're going to invest -- where the expenses are going to step up?

Mitchell K. Dauerman

Okay. I'm sorry, you're asking where are the expenses going to step up?

Raghavan Sarathy - Dougherty & Company LLC, Research Division

Yes. So if you look at the guidance, the recurring revenue guidance this year sequentially is going to be up $3.5 million. This was $2.5 million last year. And you're also going to capitalize $2.5 million of R&D expenses this year as compared to last year. Yes, you're looking at only 300 basis point margin expansion from second quarter to third quarter, which just -- which appears to be similar to last year. Now it seems like you're expecting a similar seasonality in margin expansion from second quarter to third quarter while you are going to capitalize some expenses albeit a step up in recurring revenue.

Mitchell K. Dauerman

I'm not sure if I'm answering your question, but if you -- the operating expenses, excluding the cap software, are probably flat with Q2 just like they were a year ago. So you're getting a little step-up there, but you also have higher recurring revenue and you have a higher gross margin on recurring revenue as well. So that's contributing to the expansion of the operating margin.

Raghavan Sarathy - Dougherty & Company LLC, Research Division

Right. Actually, what I'm asking is why is the margin not expanding more than 300 bps on second quarter or third quarter when you seem to have some favorable situation with R&D and recurring revenue.

Mitchell K. Dauerman

There's nothing there that's unusual that stands out in our model. Services will probably be comparable margins to this quarter. Recurring revenue is probably just slightly up in the third quarter. Recurring revenue expense -- recurring revenue as a percentage of total is probably about the same as last year. You do have -- if you remember, you have some cost that we expected to spend in the first half of the year that we didn't. So the operating margin actually has been higher than expected for that reason in the first half of the year. And right now, we expect to see those expenses in the second half. So that may be the reason why it appears that it's not expanding as much relative to last year when those expenses were incurred in the first half.

Raghavan Sarathy - Dougherty & Company LLC, Research Division

Okay. And can you -- it looks like the recurring revenue exceeded your expectation. Can you talk about what led to the performance?

Mitchell K. Dauerman

Well, as I said in the call, it's slight. We're not talking about a lot of money. It's something that has to do with that whole you pull some deals a little bit forward like we did in the first quarter. You balance it with change in seasonality of employment or growth of employees. But in the scheme of things, relative to the total recurring revenue, it's not a lot of money.

Raghavan Sarathy - Dougherty & Company LLC, Research Division

Final question. The 70,000 employee that Scott talked about, when do you expect that customer to go live?

Scott Scherr

Q4 next year.

Operator

And we'll go next to Terry Tillman with Raymond James.

Terrell Frederick Tillman - Raymond James & Associates, Inc., Research Division

Mitch, the first question, you just kind of touched on it in terms of some of the delta in your recurring revenue could come from employment levels. Anything at all you can share year-to-date you've seen in employment levels within your install base and any cost into the back half of the year in terms of the assumptions you're making there or are any change in assumptions.

Mitchell K. Dauerman

Well, we've been modestly up. We used to give a same-store employment number. We don't give the exact number but it's modestly up, and we're expecting modestly up again as we go into the end of the year. So we'll see.

Terrell Frederick Tillman - Raymond James & Associates, Inc., Research Division

Okay. And I guess the other question and I'm done is, in Canada, could you remind us again in terms of the tam there [ph] , whether it's units or dollar value, and then where you are in terms of sales coverage or sales resources you have dedicated to that market at this point?

Mitchell K. Dauerman

For the product sales and the opportunity in Canada, it's the same as we had in the U.S. in terms of products we can sell. The territory is, we said before, is probably about a 10% type territory relative to...

Scott Scherr

Yes. We're bringing in -- so far, the first half of this year, they accounted for about 5% of our new sales in Canada and looking to -- I have one super guy up there right now who's doing all this by himself. There's a lot of people around him helping him. But as far as quota carriers, it's one. So we think there's huge opportunity up there as we go forward, that we can get to 10% to 15% of our total sales moving forward. But we've been trying to do it the right way. Get the base in, get them referenceable and move forward from there. But right now, 5% of our total sales is coming from there and I think the opportunity, when we get to 2014 to '15, is 10% to 15% of the sales we do in the United States.

Operator

And we will take one more question from Brian Schwartz with Oppenheimer.

Brian J. Schwartz - Oppenheimer & Co. Inc., Research Division

Few questions here, starting off with Mitch. I just wanted to ask you about -- you're talking about the capitalized software, I guess giving us a little more detail into the future of UltiPro. With all of the development that's still ahead of you on the roadmap, is it likely to expect that you'll be capitalizing R&D expenses throughout 2013?

Mitchell K. Dauerman

Yes. I think we will be for 2013 and we'll give you specific guidance on where estimates are when we do the Q3 call, where we typically give 2013 preliminary guidance.

Brian J. Schwartz - Oppenheimer & Co. Inc., Research Division

Okay, that's helpful. And then one more for you and then one for Scott. This is a kind of follow-up on an earlier question, first question really from Michael here at the start, but looking at the guidance that you've given up here for the year and I think even talked about it at the Q4 recurring revenue growth rate. It's likely to fall on the very high 20s, maybe even appears 30%, which would be the highest quarterly growth rate in more than 2 years and that's certainly fantastic. Just wondering if, looking at your pipeline, you'll go live with some of these larger deals, is it possible to weigh the odds that, that quarter might possibly be the peak recurring revenue growth rate quarter for you? Or on a quarterly basis next year, do you think the odds are likely that you might even be able to grow the recurring piece even faster than what we might see in Q4 this year?

Mitchell K. Dauerman

I think Q4 is a function of having 2 large deals that happen to go live in the same quarter. My gut is it’s probably a peak. Unless you have an unusual situation where you had large deals going live, again, it's not a typical quarter to go live in the fourth quarter. But again, I think the way we look at things and I expect that this is probably what we'll say at the end of Q3, we expect to grow recurring revenues by approximately 25% over the course of the year. It's driven by the deals we have in backlog. We have a very high degree of visibility into 2013, but the timing in the quarters kind of will depend on those deals.

Brian J. Schwartz - Oppenheimer & Co. Inc., Research Division

That's certainly very helpful especially for next year. Last question I have for Scott, it's really philosophical for you, Scott, or maybe really how you're thinking about the future product rollout here for UltiPro. You got a good tie-in really into the financial transaction, certainly on the payroll side of what you do for all your customers and certainly had a tremendous amount of success here expanding into -- deeper into talent management over the years. My question is, as we look out 3 to 5 years in the future, are the odds more likely for you to continue going deeper into talent management? Or is there any consideration to potentially move into the financials aspect to support your mid-market customers, whether that's budgeting or forecasting or maybe anything accounting related? That's all I had.

Scott Scherr

Yes. The odds would be much greater that we're just going to keep going deeper and deeper in the HR payroll and talent and anything around that. So that's our goal now. Our penetration rates are so low in the United States and certainly in Canada. So I think we have a lot of room to grow and I think the shorter we make the product in those areas, the stronger we'll be as a company. So that's the goal right now so the odds would be in that favor.

Operator

That will conclude today's question-and-answer session. At this time, I will turn the conference over to Scott Scherr for any additional or closing remarks.

Scott Scherr

Okay. Just thanks, everyone. I appreciate your support. I'll speak to you next quarter. Goodnight.

Operator

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

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