TMCNet:  ULTIMATE SOFTWARE GROUP INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

[November 09, 2012]

ULTIMATE SOFTWARE GROUP INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion of the financial condition and results of operations of The Ultimate Software Group, Inc. and subsidiaries ("Ultimate," "we," "us," or "our") should be read in conjunction with the unaudited condensed consolidated financial statements and notes thereto included elsewhere in this Quarterly Report on Form 10-Q (this "Form 10-Q") and in Ultimate's Annual Report on Form 10-K for the fiscal year ended December 31, 2011, filed with the Securities and Exchange Commission (the "SEC") on February 29, 2012 (the "Form 10-K").


Overview Ultimate is a leading cloud provider of people management solutions.

Ultimate's UltiPro software ("UltiPro") is a comprehensive software as a service ("SaaS")- or cloud-based solution delivered primarily to organizations based in the United States and Canada and designed to deliver the functionality businesses need to manage the complete employment life cycle from recruitment to retirement. UltiPro includes feature sets for talent acquisition and onboarding, human resources ("HR") management and compliance, benefits management and online enrollment, payroll, performance management, salary planning and budgeting for compensation management, succession management, reporting and analytical decision-making tools, and time and attendance. UltiPro has role-based self-service capabilities for executives, managers, administrators, and employees whether they are in or out of the office, including an UltiPro application for use on mobile devices such as the iPhone and iPad.

Our SaaS offering of UltiPro (the "SaaS Offering") provides Web-based access to comprehensive human capital management ("HCM") functionality for organizations that want to simplify delivery and support of their business applications.

12-------------------------------------------------------------------------------- Table of Contents We have found that our SaaS Offering is attractive to companies that want to focus on their core competencies to increase sales and profits. Through the SaaS Offering, we supply and manage the hardware, infrastructure, ongoing maintenance and backup services for our customers. Customer systems are currently managed at three data centers-one located in the Miami, Florida area, one in the Atlanta, Georgia area, and another one in Toronto, Canada. All data centers are owned and operated by independent third parties. We recently signed an agreement for a new data center located in Phoenix, Arizona, which we expect will replace the Miami, Florida data center in the first half of 2013.

UltiPro is marketed as two solution suites, based on company size. UltiPro Enterprise ("Enterprise") is designed to address the needs of companies with 1,000 or more employees. UltiPro Workplace ("Workplace") is designed for companies with fewer than 1,000 employees. Both solution suites are delivered exclusively through SaaS. UltiPro Workplace provides medium-sized and smaller companies with nearly all the features that larger Enterprise companies have with UltiPro, plus a bundled services package. Since many companies in this market do not have information technology staff on their premises to help with system issues, UltiPro Workplace is designed to give these customers a high degree of convenience by handling system setup, business rules, and other situations for customers "behind the scenes." UltiPro is marketed primarily through our Enterprise and Workplace direct sales teams.

In addition to UltiPro's core HCM functionality, our customers have the option to purchase a number of additional features on a per-employee-per-month ("PEPM") basis, which are available to enhance the functionality of UltiPro's core features and which are based on the particular business needs of the customers. These optional UltiPro features currently include (i) the talent management suite of products (recruitment, onboarding, performance management, salary planning and budgeting for compensation management, and employee relations tools for managing disciplinary actions, grievances, and succession management); (ii) benefits enrollment; (iii) time, attendance and scheduling; (iv) time management; (v) payment services (formerly referred to as "tax filing"); (vi) wage attachments; and (vii) other optional features (collectively, "Optional Features"). All Optional Features are priced solely on a subscription basis. Some of the Optional Features are available to both Enterprise and Workplace customers while others are available exclusively to either Enterprise or Workplace customers, and availability is based on the needs of the respective customers, the number of their employees and the complexity of their HCM environment.

Our Partners for Life program, introduced in the second half of 2010, is designed to make it easier for customers to leverage the full scope of UltiPro's features and reach more users in our customers' organizations. As part of the Partners for Life program, we changed the pricing method for our services from a time and materials offering to a fixed fee offering, with the expected objective of lowering the total cost of services charged to each customer. The incremental benefit for the Partners for Life program is that we enhance the quality of our customer relationships and encourage increased customer loyalty, as well as an enhanced readiness for the customer to be a reference for us.

The key drivers of our business are (i) growth in recurring revenues; (ii) operating income, excluding primarily non-cash stock-based compensation ("Non-GAAP Operating Income"); and (iii) retention of our customers once our solutions are sold ("Customer Retention"). For the three months ended September 30, 2012, our (i) recurring revenues grew by 23%, compared with the same period in 2011 and (ii) Non-GAAP Operating Income was $14.2 million, or 17.2% of total revenues, as compared with $8.6 million, or 12.7% of total revenues, for the same period last year. For the nine months ended September 30, 2012, our (i) recurring revenues grew by 23%, compared with the same period in 2011, and (ii) Non-GAAP Operating Income was $30.9 million, or 12.9% of total revenues, as compared with $20.1 million, or 10.2% of total revenues, for the same period last year. As of September 30, 2012, our Customer Retention exceeded 96%, on a trailing twelve-month basis. See "Non-GAAP Financial Measures" below.

Our ability to achieve significant revenue growth in the future will depend upon the success of our direct sales force and our ability to adapt our sales efforts to address the evolving markets for our products and services. We provide our sales personnel with comprehensive and continuing training with respect to technology and market place developments. Aside from sales commissions, we also provide various incentives to encourage our sales representatives, including stock-based compensation awards based upon performance.

The HCM market is intensely competitive. We address competitive pressures through improvements and enhancements to our products and services, the development of additional features of UltiPro and a comprehensive marketing team and process that distinguishes Ultimate and its products from the competition. Our focus on customer service, which enables us to maintain a high Customer Retention rate, also helps us address competitive pressures.

As our business has grown, we have become increasingly subject to the risks arising from adverse changes in domestic and global economic conditions. If general economic conditions were to deteriorate further, we may experience delays in our sales cycles, increased pressure from prospective customers to offer discounts and increased pressure from existing customers 13-------------------------------------------------------------------------------- Table of Contents to renew expiring recurring revenue agreements for lower amounts. We address continuing economic pressures by, among other things, efforts to control growth of our operating expenses through the monitoring of controllable costs and vendor negotiations.

Ultimate has two primary revenue sources: recurring revenues and services revenues. Subscription revenues from our SaaS Offering and customer support and maintenance revenues are the primary components of recurring revenues. The majority of services revenues are derived from implementation services.

Subsequent to the discontinuation of selling perpetual licenses of UltiPro to new customers, which occurred in 2009, we sell licenses to existing license customers but only in relation to the customer's employee growth or for Optional Features if the customer already has a perpetual license for the on-site UltiPro solutions. As perpetual license agreements were sold in the past, annual maintenance contracts (priced as a percentage of the related license fee) accompanied those agreements. Maintenance contracts typically have a one-year term with annual renewal periods thereafter.

As SaaS units are sold, the recurring revenue backlog associated with the SaaS Offering grows, enhancing the predictability of future revenue streams. SaaS revenues include ongoing monthly subscription fees, priced on a PEPM basis. Revenue recognition for the SaaS Offering is triggered when the customer processes its first payroll using UltiPro (or goes "Live").

Critical Accounting Estimates The preparation of financial statements in conformity with U.S. generally accepted accounting principles ("GAAP") requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Ultimate's critical accounting estimates, as discussed in "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations," included in the Form 10-K, have not significantly changed, except as disclosed below: Computer Software Development Costs Certain computer software development costs are capitalized in the accompanying unaudited consolidated balance sheets. We follow different accounting guidance rules for software capitalization purposes, depending on whether the underlying software is for external use or internal use.

Computer software development costs related to software developed for external use falls under the accounting guidance of Accounting Standards Codification ("ASC") Topic 985-20, Costs of Software to Be Sold, Leased, or Marketed, in which capitalization begins upon the establishment of technological feasibility.

For software costs that are capitalized in accordance with ASC Topic 985-20, technological feasibility is typically established upon completion of a working model. Capitalization ends and amortization begins when the related developed software is ready for general release to our customers. Amortization periods for software capitalized under this subtopic are generally five years. We have begun amortization for all capitalized software that falls under this guidance.

Capitalized software falling under ASC Topic 985-20 is related to our former licensed products, which is presented in the unaudited consolidated balance sheets as capitalized software. There were no research and development expenses capitalized under ASC Topic 985-20 during the three and nine months ended September 30, 2012 and September 30, 2011. Annual amortization is based on the greater of the amount computed using (a) the ratio that current gross revenues for the related product bears to the total of current and anticipated future gross revenues for that product or (b) the straight-line method over the remaining estimated economic life of the product including the period being reported on. Capitalized software is amortized using the straight-line method over the estimated useful lives of the assets, which is typically five years.

Ultimate evaluates the recoverability of capitalized software based on estimated future gross revenues reduced by the estimated costs of completing the products and of performing maintenance and customer support. If Ultimate's gross revenues were to be significantly less than its estimates, the net realizable value of Ultimate's capitalized software would be impaired, which could result in the write-off of all or a portion of the unamortized balance of such capitalized software.

Computer software development costs related to software developed for internal use falls under the accounting guidance of ASC Topic 350-40, Intangibles Goodwill and Other-Internal Use Software, in which computer software costs are expensed as incurred during the preliminary project stage and capitalization begins in the application development stage once the capitalization criteria are met. Costs associated with post implementation activities are expensed as incurred. Costs capitalized during the application development stage include external direct costs of materials and services consumed in developing or obtaining internal-use software and payroll and payroll-related costs for employees who are directly associated with and who devote time to the internal-use computer software. In addition to capitalizing costs for software (which are used by Ultimate in its general operations, for internal purposes) , we also capitalize costs under ASC Topic 350-40 for certain 14-------------------------------------------------------------------------------- Table of Contents software development projects related to our suite of products sold to our customers exclusively on a subscription basis under our SaaS Offering of UltiPro (the "SaaS Offering"). During the three and nine months ended September 30, 2012, we capitalized $2.6 million of computer software development costs related to a development project to be sold in the future as a SaaS product only. There were no such costs capitalized in the three and nine months ended September 30, 2011. These capitalized costs are included with property and equipment in the unaudited consolidated balance sheet. Internal-use software is amortized on a straight-line basis over its estimated useful life, generally three to five years, commencing after the software development is substantially complete and the software is ready for its intended use. At each balance sheet date, we evaluate the useful lives of these assets and test for impairment whenever events or changes in circumstances occur that could impact the recoverability of these assets.

Fair Value of Financial Instruments Ultimate's consolidated financial instruments, consisting of cash and cash equivalents, investments in marketable securities, funds held for customers and the related obligations, accounts receivable, accounts payable, capital lease obligations and other borrowings, approximated fair value as of September 30, 2012 and December 31, 2011.

Results of Operations The following table sets forth the unaudited condensed consolidated statements of income data of Ultimate, as a percentage of total revenues, for the periods indicated: For the Three Months For the Nine Months Ended September 30, Ended September 30, 2012 2011 2012 2011 Revenues: Recurring 81.7 % 80.7 % 80.4 % 79.7 % Services 18.3 18.9 19.2 19.5 License - 0.4 0.4 0.8 Total revenues 100.0 100.0 100.0 100.0 Cost of revenues: Recurring 23.5 24.4 24.0 23.8 Services 19.9 19.3 19.9 19.9 License - 0.1 0.1 0.2 Total cost of revenues 43.4 43.8 44.0 43.9 Gross Profit 56.6 56.2 56.0 56.1 Operating expenses: Sales and marketing 20.9 22.1 22.2 24.3 Research and development 17.0 19.6 19.1 19.1 General and administrative 7.5 7.4 7.7 8.3 Total operating expenses 45.4 49.1 49.0 51.7 Operating income 11.2 7.1 7.0 4.4 Other (expense) income: Interest expense and other (0.2 ) (0.1 ) (0.1 ) (0.2 ) Other income, net 0.1 - - - Total other expense, net (0.1 ) (0.1 ) (0.1 ) (0.2 ) Income before income taxes 11.1 7.0 6.9 4.2 Provision for income taxes (5.4 ) (5.4 ) (3.4 ) (3.0 ) Net income 5.7 % 1.6 % 3.5 % 1.2 % 15-------------------------------------------------------------------------------- Table of Contents The following table sets forth the non-cash stock-based compensation expense resulting from the stock-based arrangements (excluding the income tax effect) and the amortization of acquired intangibles that are recorded in our unaudited condensed consolidated statements of income for the periods indicated (in thousands): For the Three Months For the Nine Months Ended September 30, Ended September 30, 2012 2011 2012 2011 Non-cash stock-based compensation expense: Cost of recurring revenues $ 658 $ 341 $ 1,809 $ 1,020 Cost of services revenues 688 360 1,854 1,107 Sales and marketing 1,886 1,734 5,332 5,244 Research and development 532 403 1,848 1,197 General and administrative 1,136 902 3,274 2,791Total non-cash stock-based compensation expense $ 4,900 $ 3,740 $ 14,117 $ 11,359 Amortization of acquired intangibles: General and administrative $ - $ 27 $ - $ 83 Revenues Our revenues are primarily derived from recurring revenues and services revenues.

Total revenues increased 22.0% to $82.6 million for the three months ended September 30, 2012 from $67.8 million for the three months ended September 30, 2011, and 22.2% to $240.1 million for the nine months ended September 30, 2012 from $196.5 million for the nine months ended September 30, 2011.

Recurring revenues, consisting of subscription revenues from our SaaS Offering and customer support and maintenance revenues, increased 23.4% to $67.5 million for the three months ended September 30, 2012 from $54.7 million for the three months ended September 30, 2011 and 23.2% to $193.0 million for the nine months ended September 30, 2012 from $156.6 million for the nine months ended September 30, 2011. The increase for the three and nine months ended September 30, 2012 was primarily due to increased subscription revenues from our SaaS Offering, partially offset by a decrease in our customer support and maintenance revenues.

a) Subscription revenues from our SaaS Offering increased 27.3% for the three months ended September 30, 2012 and 28.0% for the nine months ended September 30, 2012, both in comparison to the same periods in 2011. This increase was based on the revenue impact of incremental units sold that have gone Live since September 30, 2011, including the UltiPro core product and, to a lesser extent, Optional Features of UltiPro. Recognition of recurring subscription revenues from our SaaS Offering begins when the related customer goes Live.

b) Maintenance revenues decreased 3.1% for the three months ended September 30, 2012, and by 4.7% for the nine months ended September 30, 2012, both in comparison to the same periods in 2011. The decreases resulted from the transition of certain customers who were formerly using UltiPro in connection with the prior purchase of a perpetual license to using UltiPro under our SaaS Offering, combined with the impact of attrition in the ordinary course of business, partially offset by price increases. Maintenance revenues are recognized on a monthly recurring basis as the maintenance contracts renew annually.

Services revenues increased 18.2% to $15.1 million for the three months ended September 30, 2012 from $12.8 million for the three months ended September 30, 2011, and 20.6% to $46.2 million for the nine months ended September 30, 2012 from $38.3 million for the nine months ended September 30, 2011. The increases in services revenues for the three- and nine-month periods were primarily due to additional implementation consulting revenues which were attributable to a combination of more billable consultants and the increased utilization of seasoned consultants. In addition, there was a continued shift toward more implementation consulting revenues from fixed fee arrangements and less implementation consulting revenues from time and materials arrangements, principally as a result of the Partners for Life program. The Partners for Life program changed the method by which we charge customers for our services that are delivered primarily over the period leading up to the point the customer goes Live (the "Time to Live Period"). As new sales are generated, we now charge a fixed fee for services based on the number of the customer's employees, as compared to our former billing method for new sales, which included charging customers on a time and materials basis as these services were provided. The Partners for 16-------------------------------------------------------------------------------- Table of Contents Life program was designed to lower the total cost of services charged to each customer primarily over the Time to Live Period for UltiPro and/or Optional Features. Recognition of implementation consulting revenues related to fixed fee arrangements under the Partners for Life program is based on the percentage of completion method associated with implementation milestones achieved.

Cost of Revenues Cost of revenues primarily consists of the costs of recurring and services revenues. Cost of recurring revenues primarily consists of costs to provide maintenance and technical support to Ultimate's customers, the cost of providing periodic updates and the cost of recurring subscription revenues, including hosting data center costs and amortization of capitalized software. Cost of services revenues primarily consists of costs to provide implementation services and training to Ultimate's customers and, to a lesser extent, costs related to sales of payroll-related forms and Form W-2 services, as well as costs associated with certain client reimbursable out-of-pocket expenses.

Total cost of revenues increased 20.9% to $35.8 million for the three months ended September 30, 2012, from $29.7 million for the three months ended September 30, 2011. Total cost of revenues increased 22.7% to $105.8 million for the nine months ended September 30, 2012, from $86.2 million for the nine months ended September 30, 2011.

Cost of recurring revenues increased 17.4% to $19.4 million for the three months ended September 30, 2012 from $16.5 million for the three months ended September 30, 2011, and 23.5% to $57.7 million for the nine months ended September 30, 2012 from $46.8 million for the nine months ended September 30, 2011. The increases in the cost of recurring revenues for the three- and nine-month periods were primarily due to increases in both SaaS costs and customer support and maintenance costs, as described below: i) The increase in SaaS costs was principally as a result of the growth in SaaS operations and increased sales, including increased labor costs, increased hosting data center costs and, to a lesser extent, costs related to our payment services (as we continue to grow that business).

ii) The increase in customer support and maintenance costs was primarily due to higher labor costs commensurate with the growth in the number of customers serviced.

Cost of services revenues increased 25.9% to $16.5 million for the three months ended September 30, 2012 from $13.1 million for the three months ended September 30, 2011, and 22.3% to $47.8 million for the nine months ended September 30, 2012 from $39.1 million for the nine months ended September 30, 2011. The increases in cost of services revenues for the three- and nine-month periods were primarily due to an increase in the cost of implementation. The increased cost of implementation was primarily from higher labor and related costs (particularly in association with increased number of billable consultants) and increased costs of third-party consulting partners.

Sales and Marketing Sales and marketing expenses consist primarily of salaries and benefits, sales commissions, travel and promotional expenses, and facility and communication costs for direct sales offices, as well as advertising and marketing costs.

Sales and marketing expenses increased 14.8% to $17.2 million for the three months ended September 30, 2012 from $15.0 million for the three months ended September 30, 2011 and by 11.9% to $53.3 million for the nine months ended September 30, 2012 from $47.6 million for the nine months ended September 30, 2011. The increases in sales and marketing expenses for the three- and nine-month periods were primarily due to increased labor and related costs (including higher sales commissions related to increased live units for SaaS sales), and, to a lesser extent, higher advertising and marketing expenses.

Commissions on SaaS sales are amortized over the initial contract term (typically 24 months) commencing on the Live date, which corresponds to the related SaaS subscription revenue recognition.

Research and Development Research and development expenses consist primarily of software development personnel costs. Research and development expenses increased 6.1% to $14.1 million for the three months ended September 30, 2012 from $13.3 million for the three months ended September 30, 2011 and by 21.7% to $45.8 million for the nine months ended September 30, 2012 from $37.6 million for the nine months ended September 30, 2011. The increases in research and development expenses for the three- and nine-month periods were principally due to higher labor and related costs associated with the ongoing development of UltiPro and Optional Features, including the impact of increased personnel costs (predominantly from additional headcount), net of capitalized labor costs, and increased third-party consulting costs. During the three and nine months ended September 17-------------------------------------------------------------------------------- Table of Contents 30, 2012, we capitalized a total of $2.6 million for internal-use software costs for a development project that will be offered exclusively as SaaS when it is eventually ready for its intended use. The majority of these capitalized costs were direct labor costs associated with the development project. There were no capitalized labor costs for the three and nine months ended September 30, 2011.

General and Administrative General and administrative expenses consist primarily of salaries and benefits of executive, administrative and financial personnel, as well as external professional fees and the provision for doubtful accounts. General and administrative expenses increased 24.6% to $6.2 million for the three months ended September 30, 2012 from $5.0 million for the three months ended September 30, 2011. General and administrative expenses increased 13.0% to $18.5 million for the nine months ended September 30, 2012 from $16.4 million for the nine months ended September 30, 2011. The increases in general and administrative expenses for the three- and nine-month periods were primarily due to higher labor and related costs, partially offset by a lower provision for doubtful accounts.

Income Taxes Income taxes for the three months ended September 30, 2012 and September 30, 2011 included a consolidated provision of $4.5 million and $3.7 million, respectively. The effective income tax rate for the three months ended September 30, 2012 and September 30, 2011 was 49.1% and 77.4%, respectively. Income taxes for the nine months ended September 30, 2012 and September 30, 2011 included a consolidated provision of $8.2 million and $6.1 million, respectively. The effective income tax rate for the nine months ended September 30, 2012 and September 30, 2011 was 49.5% and 72.4%, respectively. The decrease in the effective income tax rate for the three and nine months ended September 30, 2012 was principally due to a benefit attributable to a decrease in nondeductible expenses, primarily related to compensation, and a lower ratio of expected nondeductible expenses to pre-tax income.

At December 31, 2011, we had approximately $113.0 million of net operating loss carryforwards for Federal income tax reporting purposes available to offset future taxable income. The $113.0 million was attributable to deductions from the exercise of non-qualified employee, and non-employee director, stock options and the vesting of restricted stock units and restricted stock awards, the tax benefit of which will primarily be credited to paid-in-capital and deferred tax assets when realized. As a result, the tax benefit associated with stock-based compensation is included in net operating loss carryforwards but not reflected in deferred tax assets. The carryforwards expire from 2012 through 2031.

Utilization of such net operating loss carryforwards may be limited as a result of cumulative ownership changes in Ultimate's equity instruments. As of December 31, 2011, we did not have any net operating loss carryforwards for foreign income tax reporting purposes available to offset future taxable income. The Company's U.S. Federal income tax return for the year ended December 31, 2010 is currently under review by the Internal Revenue Service.

We recognized $21.0 million of deferred tax assets, net of deferred tax liabilities, as of September 30, 2012. If estimates of taxable income are decreased, a valuation allowance may need to be provided for some or all deferred tax assets, which will cause an increase in income tax expense. Management continues to apply the exception to the comprehensive recognition of deferred income taxes to the undistributed earnings of our foreign subsidiary, The Ultimate Software Group of Canada, Inc. ("Ultimate Canada"). Accordingly, deferred income taxes were not recognized on the cumulative undistributed earnings of Ultimate Canada, and were not deemed material.

Liquidity and Capital Resources In recent years, Ultimate has funded operations from cash flows generated from operations.

As of September 30, 2012, we had $82.9 million in cash, cash equivalents and total investments in marketable securities, reflecting a net increase of $27.6 million since December 31, 2011. This $27.6 million increase was primarily due to cash provided by operations of $32.3 million and proceeds from the issuance of Common Stock from employee and non-employee director stock option exercises of $7.6 million, partially offset by cash purchases of property and equipment (including principal payments on financed equipment) of $14.7 million and cash used to settle the employee tax withholding liability for vesting of restricted stock awards and restricted stock units of $5.1 million.

Net cash provided by operating activities was $32.3 million for the nine months ended September 30, 2012, as compared with $23.6 million for the nine months ended September 30, 2011. This $8.7 million increase was primarily due to an increase in cash operating results of $8.4 million, an increase in accrued expenses of $3.3 million associated with expenses that will be primarily paid in the near term, a decrease in prepaid expenses and other current assets of $2.2 million principally 18-------------------------------------------------------------------------------- Table of Contents related to the amortization of prepaid expenses, partially offset by an increase in accounts receivable, net of the change to deferred revenue, of $4.5 million and higher vendor payments of $1.8 million.

Net cash used in investing activities was $38.4 million for the nine months ended September 30, 2012, as compared with $39.2 million for the nine months ended September 30, 2011. The decrease of $0.8 million was primarily attributable to a decrease in funds received from and held on behalf of Ultimate's customers using the UltiPro Payment Services offering ("UltiPro Payment Services") of $2.3 million, partially offset by an increase in cash purchases of property and equipment of $1.5 million. During the three and nine months ended September 30, 2012, we capitalized software development costs related to a SaaS development project, totaling $2.6 million, which was classified as property and equipment in accordance with the applicable accounting guidance. With the exception of the stock-based compensation that was capitalized of $0.2 million, the capitalized software costs were paid in cash, since the majority of these costs were direct labor costs.

Net cash provided by financing activities was $32.8 million for the nine months ended September 30, 2012, as compared with $17.1 million for the nine months ended September 30, 2011. The $15.7 million increase was primarily related to an increase of $17.3 million attributable to a decreased amount paid for purchases of Common Stock under our stock repurchase plan and a $3.2 million increase in excess tax benefits from stock option exercises and a decrease of $1.2 million in cash used to settle employee tax withholding liability for vesting of restricted stock awards and restricted stock units, partially offset by a decrease of $2.3 million in UltiPro Payment Services, and a $0.9 million decrease in proceeds from the issuance of Common Stock from stock option exercises.

Days sales outstanding, calculated on a trailing three-month basis, as of September 30, 2012 and September 30, 2011, were 64 days and 63 days, respectively.

Deferred revenues were $85.1 million at September 30, 2012, as compared with $86.6 million at December 31, 2011. The decrease of $1.5 million in deferred revenues was primarily due to decreased deferred maintenance revenues, partially offset by increased deferred SaaS revenues and, to a lesser extent, increased deferred services revenues. The majority of the total balance in deferred revenues is related to future recurring revenues, including deferred revenues related to SaaS.

During the nine months ended September 30, 2012, we purchased perpetual licenses with third-party vendors totaling $6.5 million, payable over a three-year period, of which payments totaling $2.5 million were made.

We believe that cash and cash equivalents, investments in marketable securities, equipment financing, other borrowings and cash generated from operations will be sufficient to fund our operations for at least the next 12 months. This belief is based upon, among other factors, management's expectations for future revenue growth, controlled expenses and collections of accounts receivable.

We did not have any material commitments for capital expenditures as of September 30, 2012.

Off-Balance Sheet Arrangements We do not, and as of September 30, 2012 we did not, have any off-balance sheet arrangements (as that term is defined in applicable SEC rules) that are reasonably likely to have a current or future material effect on our financial condition, results of operations, liquidity, capital expenditures or capital resources.

Quarterly Fluctuations Our quarterly revenues and operating results have varied significantly in the past and are likely to vary substantially from quarter to quarter in the future.

Our operating results may fluctuate as a result of a number of factors, including, but not limited to, increased expenses (especially as they relate to product development, sales and marketing and the use of third-party consultants), timing of product releases, increased competition, variations in the mix of revenues, announcements of new products by us or our competitors and capital spending patterns of our customers. We establish our expenditure levels based upon our expectations as to future revenues, and, if revenue levels are below expectations, expenses can be disproportionately high. A drop in near term demand for our products could significantly affect both revenues and profits in any quarter. Operating results achieved in previous fiscal quarters are not necessarily indicative of operating results for the full fiscal year or for any future periods. As a result of these factors, there can be no assurance that we will be able to maintain profitability on a quarterly basis. We believe that, due to the underlying factors for quarterly fluctuations, quarter-to-quarter comparisons of Ultimate's operations are not necessarily meaningful and that such comparisons should not be relied upon as indications of future performance.

19-------------------------------------------------------------------------------- Table of Contents Forward-Looking Statements The foregoing Management's Discussion and Analysis of Financial Condition and Results of Operations and the following Quantitative and Qualitative Disclosures about Market Risk contain certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). These forward-looking statements represent our expectations or beliefs, including, but not limited to, our expectations concerning our operations and financial performance and condition. Words such as "anticipates," "expects," "intends," "plans," "believes," "seeks," "estimates," and similar expressions are intended to identify such forward-looking statements. These forward-looking statements are not guarantees of future performance and are subject to certain risks and uncertainties that are difficult to predict. Ultimate's actual results could differ materially from those contained in the forward-looking statements due to risks and uncertainties associated with fluctuations in our quarterly operating results, concentration of our product offerings, development risks involved with new products and technologies, competition, our contractual relationships with third parties, contract renewals with business partners, compliance by our customers with the terms of their contracts with us, and other factors disclosed in Ultimate's filings with the SEC. Other factors that may cause such differences include, but are not limited to, those discussed in this Form 10-Q and the Form 10-K, including the risk factors set forth in Part I, Item 1A of the Form 10-K. Ultimate undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

Non-GAAP Financial Measures Item 10 (e) of Regulation S-K, "Use of Non-GAAP Financial Measures in Commission Filings," defines and prescribes the use of non-GAAP financial information. Our measure of Non-GAAP Operating Income, which excludes non-cash stock-based compensation and amortization of acquired intangibles, meets the definition of a non-GAAP financial measure.

Ultimate believes that this non-GAAP measure of financial results provides useful information to management and investors regarding certain financial and business trends relating to Ultimate's financial condition and results of operations. Ultimate's management uses this non-GAAP result to compare Ultimate's performance to that of prior periods for trend analyses, for purposes of determining executive incentive compensation, and for budget and planning purposes. This measure is used in monthly financial reports prepared for management and in quarterly financial reports presented to Ultimate's Board of Directors. This measure may be different from non-GAAP financial measures used by other companies.

This non-GAAP measure should not be considered in isolation or as an alternative to such measures determined in accordance with generally accepted accounting principles in the United States (GAAP). The principal limitation of this non-GAAP financial measure is that it excludes significant expenses that are required by GAAP to be recorded. In addition, it is subject to inherent limitations as it reflects the exercise of judgment by management about which expenses are excluded from the non-GAAP financial measure.

To compensate for these limitations, Ultimate presents its non-GAAP financial measure in connection with its GAAP result. Ultimate strongly urges investors and potential investors in Ultimate's securities to review the reconciliation of its non-GAAP financial measure to the comparable GAAP financial measure that is included in the table below and not to rely on any single financial measure to evaluate its business.

We exclude the following items from the non-GAAP financial measure, Non-GAAP Operating Income, as appropriate: Stock-based compensation expense. Ultimate's non-GAAP financial measures exclude stock-based compensation expense, which consists of expenses for stock options and stock and stock unit awards recorded in accordance with Accounting Standards Codification 718, "Compensation - Stock Compensation." For the three and nine months ended September 30, 2012, stock-based compensation expense was $4.9 million and $14.1 million, respectively, on a pre-tax basis. For the three and nine months ended September 30, 2011, stock-based compensation expense was $3.7 million and $11.4 million, respectively, on a pre-tax basis. Stock-based compensation expense is excluded from the non-GAAP financial measures because it is a non-cash expense that Ultimate does not consider part of ongoing operations when assessing its financial performance. Ultimate believes that such exclusion facilitates the comparison of results of ongoing operations for current and future periods with such results from past periods. For GAAP net income periods, non-GAAP reconciliations are calculated on a diluted weighted average share basis.

Amortization of acquired intangible assets. In accordance with GAAP, operating expenses include amortization of acquired intangible assets over the estimated useful lives of such assets. There was no amortization of acquired intangible 20-------------------------------------------------------------------------------- Table of Contents assets for the three and nine months ended September 30, 2012. For the three and nine months ended September 30, 2011, the amortization of acquired intangible assets was $27 thousand and $83 thousand, respectively. Amortization of acquired intangible assets is excluded from Ultimate's non-GAAP financial measures because it is a non-cash expense that Ultimate does not consider part of ongoing operations when assessing its financial performance. Ultimate believes that such exclusion facilitates comparisons to its historical operating results and to the results of other companies in the same industry, which have their own unique acquisition histories.

For the Three Months Ended For the Nine Months Ended September 30, September 30, 2012 2011 2012 2011 Non-GAAP operating income reconciliation: Operating income $ 9,281 $ 4,842 $ 16,761 $ 8,651 Operating income, as a % of total revenues 11.2 % 7.1 % 7.0 % 4.4 % Add back: Non-cash stock-based compensation expense 4,900 3,740 14,117 11,359 Non-cash amortization of acquired intangible assets - 27 - 83 Non-GAAP operating income $ 14,181 $ 8,609 $ 30,878 $ 20,093 Non-GAAP operating income, as a % of total revenues 17.2 % 12.7 % 12.9 % 10.2 %

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