JDA Software Group Management Discusses Q2 2012 Results - Earnings Call Transcript

| About: JDA Software (JDAS)

JDA Software Group (NASDAQ:JDAS)

Q2 2012 Earnings Call

August 06, 2012 5:00 pm ET


Mike Burnett - Group Vice President of Treasury & Investor Relations

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

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


Richard T. Williams - Cross Research LLC

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

Brian Murphy - Sidoti & Company, LLC

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


Ladies and gentlemen, thank you for standing by, and welcome to the JDA Software Group, Inc. Second Quarter 2012 Earnings Conference Call. [Operator Instructions] This conference is being recorded today, Monday, August 6, 2012. And I would now like to turn the conference over to Mike Burnett, Group Vice President, Investor Relations. Please go ahead.

Mike Burnett

All right. Thank you, Michaela. Good afternoon, and welcome to the JDA Software's Second Quarter 2012 Earnings Call. We will be covering a number of different areas today, including the review of the impact of the financial restatement on our previously reported results, as well as the year-to-date results for 2012 and a discussion of our outlook for the remainder of the year.

Before we begin discussing these 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 facts 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, 2011. The 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 website to accompany the review of our results.

You saw earlier today, we filed our 2011 Form 10-K containing restated selected financial data for 2007 and 2008, restated full financial statements for 2009 and 2010 and full financial statements for 2011, reflecting the impact of the restatement adjustments. In addition, we filed our Forms 10-Q for both the first and second fiscal quarters in 2012. With these actions we are again compliant with our filings, which should satisfy the rules of the Securities and Exchange Commission, as well as the listing requirements of NASDAQ. We've also fulfilled over covenant requirements under our credit facility and our senior notes indenture, and we'll cease paying the additional 50 basis points on the notes that we incurred beginning June 1 of this year.

Also, I'd like to point out that we will be holding our 2012 Investor and Analyst Meeting in New York on Tuesday, September 18. During that morning, Hamish and Pete, along with members of our executive leadership team covering global sales, global services, retail and manufacturing license sales and cloud services, will be discussing JDA's strategy and views on each of these areas of our business. We hope to see many of you there in September.

We'll begin the call today with a discussion of the financial restatement by Pete Hathaway, our Chief Financial Officer. JDA President and CEO, Hamish Brewer, will join Pete for a discussion of the business and operating results for the first half 2012, as well as our outlook for the remainder of 2012 before we open the call to questions.

Because of the amount of content and the quantitative nature of much of what we will be discussing, we have included additional slides related to the restatement in the supplemental slide deck to assist the overall communications, which can be found on our website.

With that, I will now turn the call over to Pete Hathaway.

Peter S. Hathaway

Thanks, Mike. First, I will discuss the significant elements of the investigation undertaken over the past 8 months. Second, I will describe the findings from that process and how the restatement has been reflected in JDA's financial statements. Lastly, I will describe the corrections we have made to our internal control environment.

As we have reported 8 months ago, we received a comment letter from the Division of Corporation Finance of the U.S. Securities and Exchange Commission, as well as a subpoena requesting documentation about our revenue recognition, policies and practices from the SEC's Division of Enforcement. Since that time, we have worked diligently to investigate and resolve any issues related to this matter.

The Audit Committee of the Board of Directors immediately began an investigation of the company's revenue recognition accounting policies and practices for the years 2008, 2009 and 2010 corresponding to the years referenced in the subpoena. We expanded the review to include the years 2006, 2007 and 2011. The Audit Committee engaged independent legal counsel, who in turn engaged independent accountants to investigate with the committee and to report their findings back to Deloitte, our auditors.

Over the past several months, we provided the SEC with the documents requested in the subpoena, and we responded to all comments and questions communicated to us by the Division of Corporation Finance. In all, there were nearly 3.7 million documents collected, nearly 100,000 documents reviewed and over 11,000 documents delivered to the SEC.

In addition, independent counsel conducted 42 interview sessions with current and former employees, supported by the full cooperation of management. We believe that the third-party legal and accounting cost of this effort will approximate $17 million for 2012, of which we incurred $11 million through June 30.

The financial statements are back on file, but the investigation of the Division of Enforcement has yet to be concluded. We do not know when the investigation will conclude.

The results of these undertaking are as follows: First and importantly, the investigation did not uncover any fraud or intentional wrongdoing. In addition, it did not identify any revenue recorded in the past that was false or fictitious. As we have stated throughout this process, the impact of the restatement affects the timing of the revenue recorded and not the existence of the revenue and thus, it does not affect cash.

In terms of the quantification of the impact of the restatement, we prepared a schedule that is included in the second quarter slide presentation, which you can find on our Investor Relations webpage, to highlight the adjustments associated with each of the items causing the restatement for each of the impacted years.

To summarize, revenue for 2007 and 2008 on a combined basis was reduced by $11 million. Revenue in 2009 was increased by $5 million. Revenue in 2010 was decreased by $23 million. Dollar revenue in 2011 was increased by $19 million. If you sum the net impact for all years affected, you will see that about $10 million of revenue is deferred and not yet recognized at the end of 2011. We expect about $6 million of that to be recognized in 2012 and the remainder to be recognized over 2013 through 2015.

The investigation identified 3 areas of revenue recognition accounting that were determined to be improperly handled and required adjustments to our financial statements for the years 2007 through 2011. I will give a brief description of each of these areas and then provide an overview of the financial impact.

As you're probably aware, Software revenue recognition requires the application of complicated accounting rules and interpretations to situation-specific details of individual transactions. My intention today is to address the restated areas at a high-level rather walk through the areas in granular detail. That detail is available in the restatement included in the Form 10-K we filed today. I encourage you to read the disclosure and, of course, we will be happy to answer any questions you might have.

The first area of restatement, we previously disclosed in our press release issued April 10, 2012. We refer to this area as linkage. We sell our software under an ILF, or initial license fee model, as provided by the accounting literature and Accounting Standards Codification section 985-605. Under this policy, we record the revenue associated with a software license sale in the period the license is signed. In circumstances where we also enter into a services agreement that, under the accounting interpretations, is considered to be negotiated, along with the site software license. The 2 transactions are deemed to be linked. Sometimes the linked services arrangement is signed contemporaneously with a license agreement in which case, the license revenue is recorded right away.

Sometimes, the link services arrangement is signed after the license agreement is signed. If this occurs generally up to 90 days after the license is signed, then the license revenue may not be permitted to be recognized and might be deferred until the services statement of work is signed. After reviewing license transactions and services or statements of work over the period 2007 through 2011, we concluded we had 31 out of about 1,200 license transactions during this 5-year period that needed to be adjusted.

The accounting remediation for this matter requires that we remove the impacted license revenue from the quarter in which it was initially recorded and move it into the next sequential quarter. Consequently, there is no net impact to revenue over the aggregate time frame. At the beginning of this year, we changed our internal operating controls to ensure that when we have linked arrangements, they are recorded in the proper period. These new controls have not significantly impacted our license sales for this year.

The second area impacting the restatement relates to vendor-specific objective evidence, or what we call VSOE for Managed Services, which we later renamed cloud services. This is a complicated area, so bear with me. The accounting rules and interpretations around VSOE are designed to ensure that an appropriate value is assigned to all elements in a transaction that might include a license, a maintenance agreement and a services agreement. This is considered a multielement arrangement. In order for a license sale to be reported upon signing, a VSOE value must be established.

If the VSOE value is not established, the license revenue must be deferred and recognized over the longest term and the multielement arrangement. In our case, this is usually the 3-year term of the maintenance agreement. Incidentally, if the multielement arrangement includes services in addition to element-lacking VSOE, the revenue for all elements must be deferred as well. The rules for establishing VSOE are complex, and the application of the rules can involve -- evolve over time as the nature of the business changes.

Over this period for JDA, the cloud services business was evolving and was not ready for market until late 2009. During the start-up process, there were only a limited number of transactions that qualified under the rules to allow for the establishment of VSOE. At the time, we recorded the license sale associated with a cloud services arrangement upfront since we believe we had a sufficient population of transactions to support the establishment of VSOE. After we completed the evaluation of linkage during the investigation, as I just described above, some of the transactions that were included in our cloud VSOE population had to be removed, leaving us with an sufficient population to establish cloud VSOE.

As such, until late 2011, we were unable to use upfront revenue recognition for any license sale in a multielement arrangement, including cloud services. In the meantime, the license revenue is deferred. This heavily impacted 2010 because during this period, we sold 8 significant license deals with cloud services. In late 2011, we established VSOE for most of the cloud services businesses and then, according to the accounting rules, we were required to record all previously deferred and unrecorded revenue for those license transactions. This is why in the restatement you see a large amount of license revenue flowing out of 2010 and into 2011.

There remains a residual amount of deferred revenue that will be recognized through 2015 due to a long-term contract that was impacted. As this implies, we spent 2011 establishing a stronger basis for cloud VSOE. And by the fourth quarter, we had a substantive population. Our processes for VSOE had been revised to consider these changes in the cloud business. Our operating procedures have also been modified to ensure that we sign a sufficiently large population of cloud services transactions to maintain cloud VSOE. Our internal controls have been updated to consider these changes, including appropriate testing.

The third area impacting the restatement relates to VSOE for our consulting services business. Similar to cloud VSOE, if in a multielement arrangement we are an able to establish a VSOE value for the consulting services, then we would need to defer the upfront recognition of revenue over the term of the longest element in the multielement arrangement. Again, this is usually the 3-year maintenance contract. For the consulting business, we established billing rates by job position and by geographic area designated by currencies.

In our case, we did not have a sufficiently large population of transactions for VSOE value when certain foreign currencies and fixed-bid contracts were involved. The investigation revealed that we did not adequately establish VSOE in 4 currencies and thus, we are required to defer the associated license revenue and services revenue of the impacted transactions.

As with the cloud business, by late 2011 we had established VSOE in each of the 4 currencies. Similarly, for some fixed-bid contracts the VSOE value was not adequately supported, resulting in the deferral of license revenue and ratable recognition until the completion of the fixed-bid consulting arrangements.

We expect the amounts related to the fixed bid contract deferral to be caught up and recognized by the end of 2012. As with the cloud business, the operating procedures and internal controls had been updated to ensure the maintenance of VSOE values for the consulting business. Also, as a result of opening the books to restate the financial statements for revenue accounting, it is also customary to record immaterial, unrecorded adjustments from prior periods. Therefore, you will see various small amounts impacting each of the restated financial statements.

And one final item I will point out is that we settled the previously disclosed patent infringement matter against the company for $4 million in the first quarter of 2012. However, because we did not file the 2011 10-K on time, the accounting rules required this to be recorded in 2011. As such, you will see this expense hitting Q4 of 2011 and the payment in the second quarter of this year.

Management and the Board of Directors have been and are committed to ensure that our accounting is handled properly, professionally and responsibly. As a part of the investigation and restatement, we have also evaluated the internal controls and processes to identify any deficiencies or weaknesses.

In general, the investigation identified a revenue recognition accounting and control environment that did not keep pace with the industry accounting and control practices during a period of significant change at the company. Revenue recognition practices did not adequately scale for our organizational structure, content-specific competencies and qualifications, general and specific internal controls and systems and processes.

Specifically, we identified 2 areas that were deemed to be material weaknesses in our processes. The material weaknesses relate to both the insufficient design and the ineffective operation of certain internal controls over the identification of license agreements linked to consulting arrangements, as well as testing and documentation of VSOE for cloud and consulting services.

We have discussed the material weaknesses with our Audit Committee and our auditors, and have implemented, are implementing or we plan to implement the measures to remediate these situations. These measures are described in detail in our Form 10-K and include personnel additions and changes, finance transaction review processes, expanded policies and procedures around revenue recognition and increased training content and frequency in the revenue recognition area.

Again, I know this has been a detailed discussion about technical accounting matters. I wanted to lay out the results in a manner that hopefully is understandable and in a way to give you visibility to the financial impact, both historically and going forward.

I will now turn the call over to Hamish for a discussion on the first half 2012 business results and conditions.

Hamish N. J. Brewer

Thanks, Pete. My goal in this call today is to provide you with an update of the company's performance during the first half of 2012, discuss the changing market environment, provide you with an update on our strategic initiatives and finally, to review our full year guidance for 2012.

With respect to the restatement, as you will have seen, the primary impact on 2012 will be to add about $3.4 million of license revenues deferred from prior years. In addition, the restatement added about $15 million of license revenues in 2011 which, of course, is going to make our year-over-year comparisons appear rather challenging.

In my discussion of license revenues today, I will try and help you see the effects of the deferred revenues, as well as to gain a clearer perspective regarding new business signed in 2012, hence the pre-restatement revenues better reflects when and how we stowed licenses.

First of all, let me address the dynamics of our software sales performance in the first half, which is a picture of contrasts. Some aspects of our license sales business are doing well, and some are facing headwinds due substantially, I believe, to macroeconomic conditions.

Starting with retail in North America, as you may remember, we hit a sudden and unexpected decline in license sales in North America in the retail market in the fourth quarter of 2011. This is a major market for JDA and consequently, this slowdown led us to reassess our prospects for 2012. Looking back at the first 2 quarters of 2012, we saw some improvement in the first quarter in U.S. retail. I am pleased to be able to report to you that we were able to substantially build on that recovery in the second quarter. This is significant for us, and it appears that our license sales to U.S. retail have recovered and are now performing at a level that is historically strong.

Looking out to the balance of the year for retail in North America, although the third quarter will be seasonally down quarter-over-quarter, the pipeline for the fourth quarter appears quite robust at this stage. Less positively, license sales to manufacturing in the U.S. slowed somewhat in the first half of 2012. The recent industry indicators show that manufacturing generally may be in for a tough year.

EMEA has been somewhat the inverse of U.S. retail, with strong sales in the second half of 2011 and into the first quarter of 2012, then slowing in the second quarter. We expect those slow sales to continue in Q3 but interestingly, we see a sizable pipeline of business building in the fourth quarter.

Latin America had an excellent first half of 2012 with a traditionally weak first quarter due to annual holidays followed by an outstanding performance in the second quarter. Results we are seeing in this part of the world are at record levels. We expect Latin America to continue to perform well throughout the rest of 2012.

Finally, in Asia-Pacific, I also have good news to report. In the second quarter, our license sales performance was the best that we've seen in a couple of years. Although I expect some ongoing variability in license sales result in Asia, I'm encouraged by these latest positive results.

When you combine all of these trends, the net result was that software and subscription revenues in the first half of 2012 were down about $3 million compared to 2011, if you remove the impact of the deferred revenue associated with the restatement. Sequentially we saw a trend which showed significant improvement from the first quarter to the second quarter and a solid pipeline of deals as we enter the second half of the year.

Competitively, we continue to perform well and our win rates remain high. Though I do not believe that these results reflect a structural weakness specific to JDA, as I mentioned earlier, I believe that most of the headwinds faced by our sales organization today stem from macroeconomic issues, creating commercial uncertainty for our customers.

Consulting services performed well in the first half considering the decision by one of our major customers to cancel a significant program as a result of a major cost-cutting exercise. This cancellation had more than a $20 million negative impact to consulting revenues on a year-over-year basis. As you can imagine, this is a tough blow. However, I'm pleased to be able to report that we have managed to offset this loss with growth in other areas in our consulting business, principally in the U.S. And as a consequence, we expect full year revenues in this business to come in only slightly below the 2011 revenue performance.

In 2011, our cloud services revenues for the full year were about $38 million. I will address our corporate initiative around cloud offering in more detail later in the call. But focusing solely on results, this business is really starting to build momentum with more long-term customer commitments. And we expect revenues in 2012 to grow by more than 20% over 2011. Our maintenance retention remains strong at around 96%, and we expect 2012 to be another good year in this revenue line, delivering strong margins and cash flow to the company.

Growth on a year-over-year basis will be about 2% due to the size of our maintenance revenue stream relative to softer new license performance, particularly in the fourth quarter of last year and the first quarter of 2012, which have the most impact on 2012 maintenance revenues. Additionally, the year-over-year comparison is adversely affected by the strong benefits we saw from exchange rates last year, which have not recurred in 2012.

Our R&D investment in 2012 will be about flat with 2011 from a headcount perspective, which means that costs will increase in line with salary and benefit increases. The biggest cost increase that we're going to experience in 2012 will be in our G&A lines. This, of course, is due to the expense we're incurring in response to the revenue recognition investigation restatement.

As we mentioned before, we expect this cost to amount to around $17 million for the full year 2012. In addition, along with the leadership changes I highlighted in the business update call in April, we're moving forward with investments in systems and organizational changes to strengthen our back-office operations in this area to ensure that we have robust capability to handle our current workload, and we're well prepared for future growth.

To conclude this part of my discussion, we expect our business in 2012 to deliver revenues that are approximately flat with 2011 and earnings to be down a bit, primarily as a result of the additional G&A expense that I just referred to. While the new license sales outlook for 2012 will be moderate, I would like to highlight that the downturn in new licenses that we saw in the fourth quarter of 2011 and which continued through the first quarter of this year was followed by the second quarter, which delivered 15% year-over-year growth, not considering the impact of the deferred revenues from the restatement.

Of course, the second quarter is just one data point. But based on our pipeline, we believe that license revenues will increase sequentially from the first half to the second half. When making this prediction, I'm acutely aware of the mess [ph] we experienced in the fourth quarter of last year, so we've decided to take a fairly conservative view of our prospects in the second half when putting our full year guidance together.

So overall, 2012 is shaping up to be a stable year with steadily improving results within the year. With this in mind, while we've been very busy completing the revenue recognition investigation, our operations teams have been working diligently, establishing a range of strategic initiatives which we believe can start to generate pipeline that can support license growth in 2013 which, of course, would then drive services, cloud and maintenance growth.

I'd like to walk you through these initiatives and growth drivers, because I believe that we have some significant opportunities in front of us. First of all, the largest and most important initiative for JDA in 2012 is our strategic decision to transform our business over time to a cloud-based business. We believe that this transformation will improve our competitiveness, strongly differentiate us from the -- strongly differentiate us as the first broad suite planning and optimization solution provider to make this transition, deliver substantial benefits to our customers and ultimately, establish a large recurring, accretive revenue stream for the company.

Let me start with the rationale for this transition. In 2009, we started to build the capability to deliver our solutions as a services with our managed services offering. Over the past 3 years, we've steadily built up our capabilities, developed our value proposition, improved our competitive performance and established a sizable profitable revenue stream.

The most important benefit for you to consider here is that our customers, who have used this service, have experienced better performance from their JDA solutions, better results, lower cost of ownership, increased agility and higher satisfaction. In fact, although we are rapidly approaching our 100th customer in this area, so far we've had only one meaningful cancellation. What this tells me is that our cloud offering can really add value to our customers. And as a result, we can build a very strong recurring revenue stream on the back of this business plan.

To give you a sense of the opportunity ahead, we currently have around 3,000 maintenance-paying customers and just under 100 of them are using our cloud services today. This part of our business should deliver about $45 million of revenue this year at an EBIT margin that's accretive to the company. When you consider the scope of this opportunity and the extremely high satisfaction and retention rates we've seen in this business, it's clear that JDA could build a very sizable new growth platform for the company that would significantly increase the recurring revenue mix in our total revenues.

At the start of 2012, we took the decision that it was time to really start to drive the growth of our cloud business. We believe that our cloud services platform is ready to scale, and we believe we have built a world-class operation, a perspective that will be independently supported in the next 6 to 9 months when we hope to achieve ISO 20000 and 27001 certification, effectively the gold standard for these types of operations.

Consequently, we now have a major cross-functional corporate project underway, which is going to reengineer how we sell our solutions, how we implement them, how we operate them for our customers, we upgrade them, we support them and finally, how we help our customers maximize their financial benefits from our solutions.

We believe this strategic initiative is going to substantially improve our competitiveness and drive significant organic growth. In the past 3 years, selling our cloud service has been an optional add-on, and our core license sales team was not focused on this part of our business, with all cloud sales being delivered by dedicated cloud sales team.

Starting in July this year, we've restructured our compensation plans and we are reengineering just about every aspect of our go-to-market approach so that selling JDA solutions on the cloud becomes our default approach. All of our global sales organization is now targeted and compensated to make this happen and we're doing everything we can to convince our customers of the sizable benefits they can enjoy by taking advantage of the JDA cloud platform.

Already, we can see a sizable pipeline of cloud deals growing in the second half of 2012, and we expect these deals to drive revenue growth next year. As you can see, we believe this initiative is going to significantly reshape our business, increase our recurring revenue stream, accelerate our organic growth rate and increase our profitability.

Our second source of growth, an area of focus for the company in the second half of 2012 and going into 2013, will be innovation-driven. First of all, as you may remember, this year we will launch our new Customer Engagement cloud solution. This groundbreaking product offers retailers and manufacturers the opportunity to engage directly with consumers, providing a seamless omni channel sales and service capability that crosses traditional brick-and-mortar stores, web platforms and, of course, the now ubiquitous mobile and smartphone platforms.

As I've discussed before, we believe that the world of retailing is undergoing a transformation which matches any in its history as the role of the store is changed forever. You only have to think about your own shopping habits and ask, how many retailers can truly deliver a seamless cross channel experience. Can you put products into your cart online and pick up at store? Does the in-store associate have visibility to your online purchases? Did the in-store associate intelligently respond to price comparisons across channels? The answer in most cases today is no. The JDA Customer Engagement cloud solution not only solves all of these fundamental challenges, but it does so in a way that uniquely optimizes profit margins, utilizing our patented, profitable promising capabilities.

This solution is only available on our cloud platform, and it becomes available in the fourth quarter of 2012. While I don't expect to see revenue growth in 2012 from this solution, we believe that it can become a meaningful growth driver over the next 2 to 3 years as the entire retail industry starts to rewire itself to support the new paradigm which, I think you'll agree, is here to stay.

In addition to Customer Engagement cloud, we also plan to start shipping solutions on our brand-new JDA platform in the second half of 2012 and the first quarter of 2013. This solution platform allows us to seamlessly integrate products from across our suite. So for example, we are now proposing solutions to customers that incorporate demand planning from our Manugistics acquisition, along with supply chain planning engine from the i2 acquisition. This capability to sell and deliver broad combinations of JDA products operating on one integrated technical architecture will be new. Up until now, our sales teams have basically been selling the same products that we acquired from i2 in 2010.

In the next 9 months, 46 JDA products will be available on the new JDA platform, and this integrated suite will provide our sales team with a far more comprehensive and compelling product offering which we believe has the potential to drive organic license growth in 2013.

Another growth driver that I'd like to highlight is our expansion into Russia. JDA has been delivering solutions into the Russian market for a few years now, but we have not had a local presence. And we believe that the Russian retailing and manufacturing market is now ready for significant growth in the solution areas that we offer.

In the first quarter of this year, we launched our new operation in Russia and we've already sold 7 solutions into that market. In the second half of 2012, we'll be ramping that business up and we expect it to provide a solid growth platform for our EMEA business in 2013.

Our next initiative, which begins this quarter, is our program designed to significantly accelerate the adoption of our supply chain solutions in the world's top 250 retailers. Very few resellers today operate a true supply chain planning solution which provides them with the ability to perform long-range multi-echelon supply chain planning from the shelf all the way back to the manufacturing plant and every level in between.

The reason for this is that historically, the supply chain solutions that have been developed to deliver this kind of capabilities simply could not scale to handle the huge volumes of the retail business model, except in the smallest and simplest retail businesses. Over the past 3 years, JDA has been delivering these advanced capabilities to the world's largest retailers for the first time. And we believe we are the only solution provider that can successfully do this. Having sold more than a dozen of these supply chain solutions to retailers in the past few years, we now have a sizable reference base and we can readily demonstrate the very sizable financial benefit that our advanced solution can deliver compared with the more traditional replenishment solutions typically in use in retail today.

These deals are very often among our $1 million-plus license transactions and as such, we now believe that we could drive substantial license growth if we aggressively market this innovative industry capability to the world's top 250 retailers.

Starting in the second half of this year, we plan to launch a multi-year marketing program that we believe will support this goal. Finally, in 2012, we’ve have reorganized our services business, integrating our go-to-market approach across all lines of service. Along with this reorganization, we've been building of global strategic account program which we believe will better enable our services business to sell and deliver large transformational services engagements to the world's largest manufacturing and retail companies.

In the past, JDA operated with a similar services model for all customers, focused primarily on installing and configuring our software. Today, we increasingly see demand from our customers, expecting JDA to provide a more holistic approach to the large transformational projects that are increasingly dominant in our business.

We believe that we've not capitalized on these opportunities in the past because our services sales process have not developed historically the way that large systems integrators have done, and we have not seamlessly integrated our service offerings to provide a more comprehensive and compelling offering. We believe that the changes we're making this year will enable us to compete more effectively for these large transformational projects, which individually often result in $20 million to $50 million of services to over a 2- to 5-year time frame.

In 2012, we're establishing the sales team, the organizational readiness and preparing our collateral and sales tools that will enable us to compete effectively in this large project market globally. Once again, I don't anticipate much additional revenue from these transformational programs in 2012, but I expect this initiative to start to deliver results in 2013. Clearly, if we're able to sell an additional 2 or 3 programs of this magnitude in 2013, it would have a material impact on our services revenue, particularly if those projects are delivered on our cloud platform.

Hopefully, these introductions into some of the activities that we have underway would have given you some insight into the proactive and aggressive approach that we are taking to drive organic growth at JDA.

To provide you with further details on these programs along with the general company update, as Mike mentioned earlier, we intend to hold an event for our shareholders and analysts in New York on the 18th of September. At this event, senior JDA executives who are responsible for these programs will present them in more detail and answer your questions.

Finally, before I pass the call back to Pete, I'd like to present our guidance for 2012. As a reminder, the adjusted EBITDA, EPS and cash flow numbers are all adjusted to exclude the costs associated with the revenue recognition investigation and restatement.

We expect to be able to generate between $675 million and $690 million of total revenue, with $140 million to $150 million coming from software sales, approximately $270 million in maintenance revenues and $265 million to $270 million in consulting revenue. We expect to generate between $175 million and $185 million of adjusted EBITDA in 2012, and to produce adjusted EPS of $2.05 to $2.20 per share.

Turning to cash flow for 2012, we expect to generate between $130 million and $140 million of adjusted cash flow from operations. From that, we expect to spend approximately $20 million on cash -- capital expenditures, resulting in $110 million to $120 million of adjusted free cash flow. If you take the midpoint of $115 million of free cash flow, we would be generating about $2.67 of adjusted free cash flow per share in 2012.

Today, I believe that JDA is at an inflection point. We successfully acquired the world's leading solutions in the general domain of supply chain and merchandising. We've invested in the integration of these products into a suite built on our new JDA platform. We now have also built a world-class cloud deployment and solutions optimization capability, which is proven and ready to scale.

When you combine these strategic decisions, you can see that we've created a unique opportunity for JDA to aggressively seize market share in the very fragmented SDM and merchandising markets. Now is the time for us to begin that process, and you are going to see a far more aggressive approach in marketing and growth from our company over the course of the next few years.

I believe that our potential for growth in the next couple of years is significantly greater than our 2012 projection would imply and I believe that our company is ready to take the next step in our evolution as The Supply Chain Company.

And with that, I will hand the call back over to Pete to provide an in-depth review of the financial results.

Peter S. Hathaway

Thank you, Hamish. As I wrap up the final segment of our prepared remarks today, I want to start with a footnote. In my commentary, I will make reference to the restated numbers unless otherwise indicated.

The results for the first half of 2012 reflect a notable sequential improvement, signaling the prospect of increasing revenue growth. And in comparison to last year, our results reflect the stability in our business that we have grown to expect in a difficult economic environment.

In comparison to last year, first half software revenue was down $9 million, and $6 million was due to the deferred revenue coming into 2011 associated with the impact of the restatement. Maintenance revenue increased about 2% year-to-date over the prior-year period. Services revenue were up almost 4% despite the reduction in revenue from the large customer that Hamish referenced. As a result, total revenue for the first half 2012 was $331 million, which is comparable to the $333 million in the first half of 2011. Importantly, software maintenances and services revenue each increased in Q2 from the first quarter of 2012. Adjusted EBITDA for the first half 2012 was $83 million compared to $84 million in 2011, and adjusted EBITDA margin for both years was 25%.

Cash flow was outstanding in the first half as we generated $78 million of cash flow from operations, a 34% increase over the first half of last year, adjusting out of last year the $35 million of cash received from a successful patent litigation settlement. Adjusted EPS was $0.98 in the first half of 2012 compared to $1.02 in 2011, while GAAP earnings per share in the first half 2012, which includes $10.7 million of investigation and restatement costs, was $0.36 versus $1.43 in 2011.

The 2011 EPS figure also reflects $37.5 million benefit from the successful patent litigation settlement. Adjusted amounts for the current year exclude the costs associated with the revenue recognition investigation and restatement, and a complete reconciliation of GAAP to non-GAAP measures is included with the tear sheet attached to our press release.

Focusing on the current period, total revenues in the second quarter 2012 increased 2% to $168.8 million. This compares to total revenues of $165.5 million for the second quarter of 2011. Q2 revenues increased 4% sequentially from $162.2 million in Q1 2012. Software and subscription revenue in the second quarter increased 5% year-over-year to $35.8 million from $34.1 million last year and increased 22% sequentially from $29.4 million in Q1.

We closed 57 new software deals in the quarter compared to 68 in the second quarter of 2011 and 58 in the first quarter 2012. This includes 11 large transactions of $1 million or more in Q2 2012 compared to 10 in Q2 of last year and 7 in the first quarter of this year. Our average selling price for the trailing 12 months ended June 30, 2012 continued to increase to $775,000 from $691,000 in Q2 of 2011 and from $741,000 in Q1 of 2012.

Maintenance revenue presented another consistent quarter, increasing 1% to $66.8 million in Q2 of 2012 compared to $66.1 million in the second quarter of 2011. Maintenance gross margin improved to 78.4% from 77.7% in Q2 of the prior year. Our customer retention rate on expiring maintenance contracts continues to track in line with our expectations. We ended the quarter with a year-to-date retention rate of 95.9% compared to the strong Q2 last year of 96.7%. This recurring high-margin revenue and cash flow stream represents 40% of our revenue in the quarter.

Services revenue increased 1% year-over-year to $66.1 million from $65.3 million in Q2 2011. Sequentially, services revenue increased slightly from $66 million in Q1. Taking into consideration the impact of consulting revenue lost from a major customer, our core consulting business grew over 10%, more than offsetting this loss. Services gross margin in the second quarter increased substantially to 21.6% from 17.8% in Q2 of 2011. This current quarter margin improvement is due to a year-over-year increase in average billing rates and a decrease in unbilled hours. Sequentially, gross margin declined 50 basis points from 22.1% in Q1, along with a slight decline in utilization.

Moving on to operating costs. As a percentage of revenue, total operating expense, excluding amortization expense, was 40% in the quarter compared to 37% in Q2 2011. The increase was driven by an increase in G&A expenses, much of which was due to the revenue recognition investigation and restatement cost of $5.2 million in Q1 and $5.5 million in Q2.

Also, there is another variance in G&A and operating expenses that I should highlight that is due to our equity-based compensation plan. The approval of the grant for the 2012 plan was delayed into the filing of our 10-K, and therefore the 2012 expense was also delayed. As a result, only $4.6 million of the projected $16 million of stock-based compensation expense for 2012 was recorded in the first half of the year. Last year, $10.1 million of the total $13 million was recorded in the first half of 2011. This will cause distorted comparisons for this year and next until we get back on a normal year-over-year comparison cycle. For the remainder of this year, we would expect to record approximately $5 million of stock-based compensation in the third quarter and approximately $6.5 million in the fourth quarter.

Product development expenses decreased as a percentage of revenue to 11.1% in the current quarter from 11.9% in Q2 of 2011, and decreased sequentially from 11.8% in Q1. On an absolute dollar basis, product development expenses decreased to $18.7 million in the current quarter from $19.8 million in Q2 2011 and $19.1 million in Q1 of 2012. We continue to prioritize the investment in R&D and product development that will enable us to maintain and expand our market-leading product and service offerings. We expect to maintain this level of investment at about 11.5% of revenue.

Sales and marketing expenses decreased this quarter to $24.5 million or 14.5% of revenue from $25.4 million or 15.3% of revenue in Q2 2011. Sequentially, sales and marketing expenses also decreased slightly from $24.9 million. The year-over-year decrease is due to a slight decrease in compensation, including the decrease in stock-based compensation that I mentioned. General and administrative expenses increased $8.2 million to $24.5 million from $16.3 million in Q2 2011. $5.5 million of the increase is due to the costs associated with the revenue recognition investigation and restatement, as well as a year-over-year increase in salaries and compensation associated with building out the back office functions, including the accounting and revenue areas I mentioned earlier.

Adjusted EBITDA for the second quarter 2012 increased 4% to $44.2 million from $42.3 million in Q2 of 2011, and increased 14% sequentially from the $38.9 million in Q1 of this year. Adjusted earnings per share increased 6% to $0.54 from $0.51 in Q2 of last year, and increased 23% sequentially from the $0.44 in Q1 of 2012. The effective tax rate on GAAP earnings was 37.3% for the quarter. This is consistent with expected blended effective tax rate for the federal and state taxes.

Turning now to cash flow, we are extremely pleased with the strong first half performance where we generated $78 million in operating cash flow compared to $58 million in the first half of last year, after adjusting out the $35 million of cash received from the patent -- favorable patent litigation settlement.

Disciplined working capital management drove the favorable results in the first half as we focused on improving our receivables and payables management. We collected over $12 million more of our receivables in the first quarter of this year versus Q1 of last year. DSO in the second quarter increased -- excuse me, decreased to 67 days from 73 days in Q2 of 2011. Additionally, in the first quarter of 2011, we had about $10 million more in payments compared to Q1 of 2012 due to the timing of payables.

Our cash position at June 30 increased to $366 million, an increase of $71 million from December 31, 2011. This leaves us in a net cash position, as our cash now exceeds our debt, of $93 million. We had $4 million of restricted cash at quarter end. In addition to the overall guidance that we provided earlier today that Hamish discussed, I'd like to add a couple of housekeeping items. For our second half license revenue, we expect Q3 to be similar to Q2 of this year, and the typical seasonal strengthening to occur in Q4.

Cash interest for the year is expected to be consistent with 2011 at about $25 million, and cash taxes are expected to be approximately $10 million. Fully diluted weighted average shares are expected to be about 43 million for the year.

In conclusion, many of JDA's core attributes are clearly on display in our first half 2012 results. JDA is one of the largest, best-of-breed software suite providers as a result of our disciplined acquisition strategy executed over the past decade. We have assembled the most comprehensive end-to-end product offering in the supply chain sector, along with the industry-leading technology, JDA is also firmly established as the industry thought leader and service provider.

Based on this leadership position, our company is positioned to not only grow in a stronger macroeconomic environment but to also withstand the negative impact of slower growth in recessionary environments. The breadth of our software product offering allows us to capitalize on growth in one sector while another may be slowing. The diversity of our global footprint allows us to take advantage of growing markets such as Russia and Latin America or through the recovery in Japan, while growth is slowing elsewhere like certain regions in Europe. This portfolio effect is evident in our software revenue results for the first half.

Additionally, with more than $0.25 million of maintenance revenue generating almost, say 80% gross margins, our business has a significant foundation of annuity-like revenue and cash flow to create stability in the face of both macroeconomic changes, as well as short-term fluctuations. JDA continues to be one of the most profitable mid-sized software companies with adjusted EBITDA margins in the mid to upper 20% range, and is generating more than $125 million of adjusted cash flow from operations and $2.67 of adjusted free cash flow per share.

Over the past year, we have faced challenges. Our position as the supply chain leader has remained strong, and we are well positioned to execute.

With that, I would now like to open the call up for questions.

Question-and-Answer Session


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

Richard T. Williams - Cross Research LLC

Just in a nutshell, can you sum up for us the impact from an investor's perspective of the whole process?

Peter S. Hathaway

Well, yes. I mean, I'll do my best. There's -- yes, I think at the end of the day, what we saw was there wasn't any impact or evidence of intentional wrongdoing or any fraud. There was a shifting of revenue from period to period. At the end of the day, it really had very little impact on -- in fact, no impact on total revenues, although there will be some that remain at the end of 2011 that continue to be recognized ratably over the next few years. In substance, all the transactions that we entered into were valid, legitimate transactions. We provided services to our customers. We delivered license. We agreed, they paid, and we ended up with the cash. So there was really no impact to cash either. So we have some internal control issues we have to work through. We've made a lot of changes to -- already to people and processes and our internal controls. We'll continue to do that. The Audit Committee is very focused on this, as is Hamish and I and the rest of the accounting and finance team, as well as the broader organization. So we think it's behind us. The internal investigation is complete. The Audit Committee has finished their investigation. The SEC is not completed, and as you know, we have a hard time estimating when that'll be over with. So we'll continue to work through that but for the lion's share of the work and then the distraction at the company, we believe that's now behind us.

Hamish N. J. Brewer

Yes, and if I could just add that to that, Rich. I think obviously, you can imagine we've been engaged in a pretty extensive internal review here, which is consuming a lot of time and energy, particularly from our back-office, if you like. But at the same time, what I wanted to convey to you was that we've also been working pretty diligently on trying to put together what I think is an expensive list of growth opportunities and strategic initiatives that we think we can execute in the next coming months and quarters. And so I wanted to give you a picture that we haven't -- we've also been thinking about how we can start to drive growth forward in the business as well when we come out of this thing.


And our next question comes from the line of Jeff Van Rhee with Craig-Hallum.

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

First, just want to follow up on the structural changes to the sales force and the way you're going to sell the product. It sounds like very significant changes in the go-to-market. At the same time, you're going to try to push on the cloud front. So just 2 questions. One, can you give us sort of an apples-to-apples of how a product sale would have been recognized and then how you perceive or how you expect it to be recognized under the new cloud methodology? Obviously with the concern that you see significant deferrals there, we've seen a lot of those transition to be messy. So I just want to be very clear about that. And then also, you touched on the sales force and the structure incentivization, et cetera. And it sounded like a lot of moving parts there. So in terms of understanding the pipe, handicapping it and giving projections, walk me through how you handled that as well?

Hamish N. J. Brewer

Yes, well, let me deal with the deferred revenue issue first. Jeff, right now we don't anticipate significant impact on revenue recognition compared to our historical model from license Sales. And the reason for that is that having just been through all of the processes that we've been through and established all the controls that we have, we now have a pretty solid basis for establishing VSOE across the board in cloud sales. So the only thing that would drive out license revenue now would be if we were to see a significant shift away from upfront initial license fees towards subscription-based licensing. And so far, we have not seen any evidence in the marketplace that our customers want us to go in that direction. So while I would say we are willing to enter into subscription contracts if we feel that it's necessary to be competitive and to win a deal, that's not been the case so far in almost signing 100 customers on our cloud offering. Most of them want to buy traditional capital licenses and frankly, we're happy to sell them to them. So I do not anticipate, given the fact that we've got solid revenue recognition around our cloud deals now, we've got -- and our customers seem to continue to want to buy initial license fees from us, I do not anticipate deferrals of license revenues as a consequence of the changes I'm talking about. The realignment of the sales organization has really been around the fact that, as I mentioned, in the past, our sales organization was pretty much solely focused on signing up a license contract. And they didn't really consider it part of -- it wasn't really part of their compensation plan, a significant part of their compensation plan, to try and sell a cloud deal along with that new license. Now what we're trying to do is we're trying to make sure that our sales team acts as really the tip of the spear out there in the marketplace driving not only new license deals, but driving new license deals on the JDA cloud platform. So we're putting a lot of compensation measures in place to encourage them to do that. We've -- we mentioned -- we described that to the sales force at the beginning of this year. We've now got all of those changes in place. We've used the last 6 months to really plan that out and implement those changes. And the consequence of that is already, we're seeing a pretty sizable increase in cloud attached to license transactions so that on average, when one of our license guys sells a new license, the rate at which there's a cloud transaction going along with that is -- has already started to increase. And based on the pipeline, we see that continuing. So that's really the change that we've made. And I don't really, at this stage, anticipate any significant revenue deferrals.

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

Okay. Then you had also suggested, obviously with all these moving parts, had taken on new level of conservatism as it relates to the guidance. I think you of touched on it or alluded to it as well on a few other spots in the script. Could you just touch on that to give us a sense of the magnitude in terms of how you approach the guidance and the relative conservatism?

Hamish N. J. Brewer

Well, that's not really related to the transition to cloud at all. What I was really referring to there, Jeff, was, you may remember, in the fourth quarter of last year, we got negatively surprised on license sales in the U.S. in the retail industry. And obviously, what our projections shows this year is continued strengthening in the second half. And I was just -- obviously, we're thinking back a year ago and saying, "Well, you know, we saw the same thing in the pipeline." And we got surprised. So I guess, we were just a little bit gun shy or maybe wanted to be a little bit cautious in terms of setting our license expectations for the full year. And I just wanted to tell you that we've thought about that when we were thinking about putting our license guidance together.


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

Brian Murphy - Sidoti & Company, LLC

Hamish, just a follow-up on the Managed Services. You mentioned you have 100 customers on the cloud services right now. What percentage of those customers were sort of new sales to new customers?

Hamish N. J. Brewer

I don't know that number off the top of my head on how many of them went with new licenses versus back-selling into the existing base. But what I can say is that we had -- all we had working on this in the past was pretty much a dedicated sales team inside of our cloud operations, which was a pretty small sales team relative to the size of our global sales force. So our goal is to substantially increase that attach rate with new license transactions over the next 2 or 3 years. We've got some internal measures that we’ve been tracking. And I think that just the fact of having our global sales force, our main sales force focused on it, well, it looks like it's already having an effect. So I don't know the exact specifics from the past. We could probably try and follow up with you on that one.

Brian Murphy - Sidoti & Company, LLC

Got it. But it sounds like you're already seeing the change in the pipeline?

Hamish N. J. Brewer

Yes, we are already seeing it.

Brian Murphy - Sidoti & Company, LLC

Okay. Could you give us -- what was the core to bearing headcount at the end of the June quarter?

Hamish N. J. Brewer

I think it was just under 100.

Brian Murphy - Sidoti & Company, LLC

Okay. And what's the thinking for where you want to end up 2012?

Hamish N. J. Brewer

I don't think it's very different. We don't have substantial sales headcount growth plans for 2012. There's a little bit I think we've got planned in the fourth quarter, but not a great deal.

Brian Murphy - Sidoti & Company, LLC

Got it. And the launch of the large service contract, will that have much of an impact on the service gross margin? How do we think about the service gross margins in the back half of the year? Are they sort of similar to what came in, in the first half or lower?

Hamish N. J. Brewer

I mean, it was painful because not only was that a large contract, but also it was quite a profitable contract for us.

Peter S. Hathaway

One thing I'll mention is, my guesstimate at this point is that margins throughout the rest of the year will be more reflective of some blend of the first half. Remember, last year Q4 we had probably the high -- well, certainly, the highest utilization I have seen in my 3 years here. So it was a very high-margin quarter in our consulting business. And we actually had too much utilization to be honest with you. So I think we won't see that again this year.


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

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

Pete, just a couple of questions. Could you just provide us sort of a little bit of an overview of the steps that are left with respect to wrapping this entire process up with the SEC?

Peter S. Hathaway

Sure. We have had -- well first of all, we presented the 11,000 documents that I mentioned in response to the subpoena. Our independent council has been in contact with them on and off. They're obviously aware of the restatement, and we just filed our financials and they had a chance to preview those. Next steps, effectively, would be for a team of folks from JDA, including our investigation team, to go meet with the Division of Enforcement. And that hasn't occurred yet, which is normal. We need to get everything done and concluded before we have that meeting. And then it's pretty much up to them. We'll have presented everything that we can, and we'll obviously be more than happy to respond. They'll probably want to talk to some people here, and we'll go back and forth over some period of time. But there's not a definitive or definite time line that we can count on at this point.

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

And then, finally, Hamish, based on your guidance, just it appears that you expect a pretty big jump in your consulting services revenue in the back half of the year, and a little bit surprising based on license revenue over the last couple of quarters. Could you just talk a little bit about what's driving that big jump?

Hamish N. J. Brewer

Well, I think that actually overall, just looking at the numbers here, from first half to second half, we're not looking at a particularly large jump in consulting revenues. The -- which numbers you are looking at, but if I look at our first half, it was about $132 million and our second half is about $137 million, something like that.


[Operator Instructions] And at this time, I am showing no further questions in the queue. So ladies and gentlemen, this does conclude our conference for today. We thank you, all, for your participation. And at this time, you may now disconnect.

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