The Ultimate Software Group Inc.
Table of Contents

 
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
     
þ   QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2006
     
o   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from _______ to _______
Commission file number: 0-24347
THE ULTIMATE SOFTWARE GROUP, INC.
(Exact name of Registrant as specified in its charter)
     
Delaware   65-0694077
     
(State or other jurisdiction of
incorporation or organization)
  (I.R.S. Employer Identification No.)
     
2000 Ultimate Way, Weston, FL   33326
     
(Address of principal executive offices)   (Zip Code)
(954) 331-7000
(Registrant’s telephone number, including area code)
None
(Former name, former address and former fiscal year, if changed since last report)
     Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o
     Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer o      Accelerated filer þ      Non-accelerated filer o
     Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ
     As of July 20, 2006, there were 24,184,182 shares of the Registrant’s Common Stock, par value $.01, outstanding.
 
 

 


Table of Contents

THE ULTIMATE SOFTWARE GROUP, INC. AND SUBSIDIARY
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Certifications
       
 EX-10.36 OFFICE LEASE AGREEMENT
 EX-31.1 SEC 302 CHIEF EXECUTIVE OFFICER CERTIFICATION
 EX-31.2 SEC 302 CHIEF FINANCIAL OFFICER CERTIFICATION
 EX-32.1 SEC 906 CHIEF EXECUTIVE OFFICER CERTIFICATION
 EX-32.2 SEC 906 CHIEF FINANCIAL OFFICER CERTIFICATION

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Item 1 — Financial Statements
PART 1 — FINANCIAL INFORMATION
THE ULTIMATE SOFTWARE GROUP, INC. AND SUBSIDIARY
UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS

(Dollars in thousands, except share and per share data)
                 
    As of   As of
    June 30,   December 31,
    2006   2005
ASSETS
               
 
               
Current assets:
               
Cash and cash equivalents
  $ 19,834     $ 17,731  
Accounts receivable, net of allowance for doubtful accounts of $500 for 2006 and 2005, respectively
    19,043       18,126  
Short-term investments in marketable securities
    16,825       14,422  
Prepaid expenses and other current assets
    6,356       5,526  
 
               
Total current assets
    62,058       55,805  
 
               
Property and equipment, net
    11,363       10,026  
Capitalized software, net
    1,030       238  
Long-term investments in marketable securities
          613  
Other assets, net
    4,283       2,899  
 
               
Total assets
  $ 78,734     $ 69,581  
 
               
 
               
LIABILITIES AND STOCKHOLDERS’ EQUITY
               
 
               
Current liabilities:
               
Accounts payable
  $ 2,439     $ 2,613  
Accrued expenses
    7,151       6,832  
Current portion of deferred revenue
    31,315       29,385  
Current portion of capital lease obligations
    1,271       1,393  
Current portion of long-term debt
    506       338  
 
               
Total current liabilities
    42,682       40,561  
 
               
Deferred revenue, net of current portion
    4,941       3,646  
Capital lease obligations, net of current portion
    966       966  
Long-term debt, net of current portion
    445       862  
Other long-term liabilities
    795        
 
               
Total liabilities
    49,829       46,035  
 
               
 
               
Stockholders’ equity:
               
Preferred Stock, $.01 par value, 2,000,000 shares authorized, no shares issued or outstanding
           
Series A Junior Participating Preferred Stock, $.01 par value, 500,000 shares authorized, no shares issued or outstanding
           
Common Stock, $.01 par value, 50,000,000 shares authorized, 24,605,819 and 23,786,097 shares issued in 2006 and 2005, respectively
    246       238  
Additional paid-in capital
    118,338       110,245  
Accumulated other comprehensive loss
    (40 )     (31 )
Accumulated deficit
    (84,820 )     (85,852 )
 
               
 
    33,724       24,600  
Treasury stock, 421,637 and 257,647 shares, at cost, for 2006 and 2005, respectively
    (4,819 )     (1,054 )
 
               
Total stockholders’ equity
    28,905       23,546  
 
               
Total liabilities and stockholders’ equity
  $ 78,734     $ 69,581  
 
               
The accompanying Notes to Unaudited Condensed Consolidated Financial Statements are an integral part of these financial statements.

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THE ULTIMATE SOFTWARE GROUP, INC. AND SUBSIDIARY
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share amounts)
                                 
    For the Three Months   For the Six Months
    Ended June 30,   Ended June 30,
    2006   2005   2006   2005
Revenues:
                               
Recurring
  $ 15,531     $ 12,141     $ 29,969     $ 23,729  
Services
    8,335       6,389       16,562       12,565  
License
    4,472       2,778       6,458       5,162  
 
                               
Total revenues
    28,338       21,308       52,989       41,456  
 
                               
 
                               
Cost of revenues:
                               
Recurring
    4,325       3,367       8,437       6,436  
Services
    6,404       4,786       13,369       9,820  
License
    391       176       647       299  
 
                               
Total cost of revenues
    11,120       8,329       22,453       16,555  
 
                               
Gross Profit
    17,218       12,979       30,536       24,901  
 
                               
 
                               
Operating expenses:
                               
Sales and marketing
    7,548       5,267       14,490       10,457  
Research and development
    5,273       5,184       10,646       9,986  
General and administrative
    2,556       1,948       4,998       3,756  
 
                               
Total operating expenses
    15,377       12,399       30,134       24,199  
 
                               
Operating income
    1,841       580       402       702  
 
                               
Interest expense
    (60 )     (61 )     (100 )     (116 )
Interest and other income
    390       170       730       303  
 
                               
Net income
  $ 2,171     $ 689     $ 1,032     $ 889  
 
                               
 
                               
Net income per share:
                               
Basic
  $ 0.09     $ 0.03     $ 0.04     $ 0.04  
 
                               
Diluted
  $ 0.08     $ 0.03     $ 0.04     $ 0.03  
 
                               
 
                               
Weighted average shares outstanding:
                               
Basic
    24,078       22,952       23,894       22,751  
 
                               
Diluted
    27,311       26,023       27,211       25,730  
 
                               
The accompanying Notes to Unaudited Condensed Consolidated Financial Statements are an integral part of these financial statements.

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THE ULTIMATE SOFTWARE GROUP, INC. AND SUBSIDIARY
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)
                 
    For the Six Months
    Ended June 30,
    2006   2005
Cash flows from operating activities:
               
Net income
  $ 1,032     $ 889  
Adjustments to reconcile net income to net cash provided by operating activities:
               
Depreciation and amortization
    2,403       2,212  
Provision for doubtful accounts
    440       346  
Non-cash stock-based compensation expense
    2,713       85  
Changes in operating assets and liabilities:
               
Accounts receivable
    (1,357 )     (1,227 )
Prepaid expenses and other current assets
    (830 )     (1,868 )
Other assets
    (1,384 )     (277 )
Accounts payable
    (174 )     442  
Accrued expenses and other long term liabilities
    1,114       (981 )
Deferred revenue
    3,225       304  
 
               
Net cash provided by (used in) operating activities
    7,182       (75 )
 
               
 
               
Cash flows from investing activities:
               
Purchases of marketable securities
    (11,308 )     (6,559 )
Maturities of marketable securities
    9,509       9,181  
Capitalized software
    (782 )      
Purchases of property and equipment
    (3,002 )     (1,588 )
 
               
Net cash (used in) provided by investing activities
    (5,583 )     1,034  
 
               
 
               
Cash flows from financing activities:
               
Repurchase of Common Stock
    (3,765 )      
Principal payments on capital lease obligations
    (847 )     (577 )
Net payments on long term debt
    (249 )     416  
Net proceeds from issuances of Common Stock
    5,365       3,618  
 
               
Net cash provided by financing activities
    504       3,457  
 
               
 
               
Net increase in cash and cash equivalents
    2,103       4,416  
Cash and cash equivalents, beginning of period
    17,731       14,766  
 
               
Cash and cash equivalents, end of period
  $ 19,834     $ 19,182  
 
               
 
               
Supplemental disclosure of cash flow information:
               
Cash paid for interest
  $ 56     $ 51  
 
               
Supplemental disclosure of non-cash financing activities:
               
 
               
- The Company entered into capital lease obligations to acquire new equipment totaling $725 and $1,195 for the six months ended June 30,
     2006 and 2005, respectively.
The accompanying Notes to Unaudited Condensed Consolidated Financial Statements are an integral part of these financial statements.

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THE ULTIMATE SOFTWARE GROUP, INC. AND SUBSIDIARY
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

(In thousands)
                                                                 
        Additional   Accumulated               Total
    Common Stock   Paid-in   Comprehensive   Accumulated   Treasury Stock   Stockholders’
    Shares   Amount   Capital   Loss   Deficit   Shares   Amount   Equity
Balance, December 31, 2005
    23,786     $ 238     $ 110,245     $ (31 )   $ (85,852 )     258     $ (1,054 )   $ 23,546  
 
                                                               
Net income
                            1,032                   1,032  
Unrealized loss on investments in marketable securities available-for-sale
                      (9 )                       (9 )
 
                                                               
Comprehensive income
                                              1,023  
 
                                                               
Repurchase of Common Stock
                                  164       (3,765 )     (3,765 )
Issuances of Common Stock from exercises of stock options and warrants
    820       8       5,357                               5,365  
Non-cash stock-based compensation
                2,736                               2,736  
 
                                                               
 
                                                               
Balance, June 30, 2006
    24,606     $ 246     $ 118,338     $ (40 )   $ (84,820 )     422     $ (4,819 )   $ 28,905  
 
                                                               

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THE ULTIMATE SOFTWARE GROUP, INC. AND SUBSIDIARY
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
1. BASIS OF PRESENTATION
     The accompanying unaudited condensed consolidated financial statements of The Ultimate Software Group, Inc. and subsidiary (the “Company”) have been prepared, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”). Certain information and footnote disclosures normally included in financial statements in accordance with accounting principles generally accepted in the United States have been condensed or omitted pursuant to such rules and regulations. The information in this report should be read in conjunction with the Company’s audited consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2005 filed with the SEC on March 15, 2006 (the “Form 10-K”).
     The unaudited condensed consolidated financial statements included herein reflect all adjustments (consisting only of normal, recurring adjustments), which are, in the opinion of the Company’s management, necessary for a fair presentation of the information for the periods presented. The preparation of financial statements in conformity with accounting principles generally accepted in the United States 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. Interim results of operations for the three and six months ended June 30, 2006 and 2005 are not necessarily indicative of operating results for the full fiscal years or for any future periods.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Investments in Marketable Securities
     The Company classifies its investments in marketable securities with readily determinable fair values as securities available-for-sale in accordance with Statement of Financial Accounting Standards No. 115, “Accounting for Certain Investments in Debt and Equity Securities” (“FAS 115”) and FASB Staff Position Financial Accounting Standards No. 115-1 and FAS 124-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” (“FSP FAS 115-1 and FAS 124-1”). The Company has classified all investments as available-for-sale. Available-for-sale securities consist of debt and equity securities not classified as trading securities or as securities to be held to maturity. Unrealized holding gains and losses on securities available-for-sale are reported as a net amount in accumulated other comprehensive loss in stockholders’ equity until realized. Gains and losses on the sale of securities available-for-sale are determined using the specific identification method. Included in accumulated other comprehensive income at June 30, 2006 and 2005 are $39,874 and $31,114, respectively, of unrealized losses on trading securities held at each such date.

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     The amortized cost and market value of the Company’s investments in marketable securities available-for-sale at June 30, 2006 are shown in the table below (in thousands).
                                 
            Gross   Gross    
    Amortized   Unrealized   Unrealized   Market
    Cost   Gain   Loss   Value
Investments in marketable securities:
                               
U.S. Agency — non callable
  $ 898     $     $ 7     $ 891  
U.S. Agency — discount notes
    865             1       864  
Commercial paper.
    2,806             3       2,803  
Corporate debentures — bonds
    10,497             31       10,466  
Certificates of deposit
    1,799       4       2       1,801  
 
                               
Total investments, available-for-sale
  $ 16,865     $ 4     $ 44     $ 16,825  
 
                               
     The amortized cost and estimated fair value of the available-for-sale securities by contractual maturity at June 30, 2006 are shown below (in thousands):
                 
    Amortized   Estimated
    Cost   Fair Value
Due in one year or less
  $ 16,865     $ 16,825  
 
               
 
  $ 16,865     $ 16,825  
 
               
Property and Equipment
     Property and equipment is stated at cost, net of accumulated depreciation and amortization. Property and equipment is depreciated using the straight-line method over the estimated useful lives of the assets, which range from two to twenty years. Leasehold improvements and assets under capital leases are amortized over the shorter of the life of the asset or the term of the lease over periods ranging from two to fifteen years. Maintenance and repairs are charged to expense when incurred; betterments are capitalized. Upon the sale or retirement of assets, the cost, accumulated depreciation and amortization are removed from the accounts and any gain or loss is recognized.
     Property and equipment consists of the following (in thousands):
                 
    As of   As of
    June 30, 2006   December 31, 2005
Property and equipment
  $ 36,163     $ 32,453  
Less: accumulated depreciation and amortization
    24,800       22,427  
 
               
 
  $ 11,363     $ 10,026  
 
               
Rental Costs Incurred during a Construction Period
     Effective January 1, 2006, the Company adopted FSP FAS 13-1, “Accounting for Rental Costs Incurred during a Construction Period,” which addresses the accounting for rental costs associated with operating leases that are incurred during a construction period. Rental costs incurred during and after a construction period are for the right to control the use of a leased asset during and after construction of a leased asset. Since there is no distinction between the right to use a leased asset during the construction period and the right to use that asset after the construction period, rental costs associated with ground or building operating leases that are incurred during a construction period shall be recognized as rental expense on a straight-line basis. The adoption of FSP FAS 13-1 did not have a material impact on the Company’s unaudited condensed consolidated financial statements.

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Stock-Based Compensation
     Effective January 1, 2006, the Company adopted the provisions of SFAS No. 123 (revised 2004), “Share-Based Payment” (“SFAS No. 123R”), using the modified prospective method (with the Black-Scholes fair value model), which requires the Company to recognize expense related to the fair value of stock-based compensation awards. Under the modified prospective method, stock-based compensation expense for the three and six months ended June 30, 2006 includes compensation expense for all stock-based compensation awards granted prior to, but not yet vested as of, January 1, 2006, based on grant date fair value estimated in accordance with the original provisions of SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS No. 123”), and compensation expense for all stock-based compensation awards granted subsequent to January 1, 2006, based on the grant date fair values estimated in accordance with the provisions of SFAS No. 123R. In addition, stock options granted to certain members of the Board of Directors (“Board”) as payment for services rendered as board members (“Board Services”) recorded in accordance with SFAS No. 123R and the issuance of restricted stock awards and stock units to certain employees are also included in stock-based compensation for the three and six months ended June 30, 2006. Accordingly, prior period amounts presented herein have not been restated to reflect the adoption of SFAS No. 123R.
     Prior to January 1, 2006, the Company accounted for its stock-based compensation plan as permitted by SFAS No. 123, using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB No. 25”), and made the pro forma disclosures required by SFAS No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure” (“SFAS No. 148”) for the three and six months ended June 30, 2005. Except for options granted to certain members of the Board for Board Services, all options granted under the Plan and Prior Plan (discussed in Note 3) had exercise prices equal to the fair market value of the underlying Common Stock on the date of grant. Accordingly, for the three and six months ended June 30, 2005, stock-based compensation is related to options granted to certain members of the Board for Board Services and the issuance of restricted stock awards to certain employees recorded in accordance with APB No. 25.
     In accordance with SFAS No. 123R, the Company capitalizes the portion of stock-based compensation expense attributed to research and development personnel whose labor costs are being capitalized pursuant to SFAS No. 86, “Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed,” for the development of UltiPro Canadian HR/payroll (“UltiPro Canada”) functionality. UltiPro Canada is being built from the existing product infrastructure of UltiPro (e.g., using UltiPro’s source code and architecture). UltiPro Canada will provide HR/payroll functionality which includes the availability of Canadian tax rules, as well as Canadian human resources functionality, taking into consideration labor laws in Canada and including changes to the language where necessary (i.e., English to French).The following table summarizes stock-based compensation related to the development of UltiPro Canada (in thousands):
                                 
    For the Three Months   For the Six Months
    Ended June 30,   Ended June 30,
    2006   2005   2006   2005
Stock-based compensation — Statement of operations
  $ 1,097     $ 51     $ 2,713     $ 85  
Stock-based compensation — Capitalized software (UltiPro Canada)
    10             23        
 
                               
Stock-based compensation — Statement of stockholders’equity
  $ 1,107     $ 51     $ 2,736     $ 85  
 
                               

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Earnings Per Share
     SFAS No. 128, “Earnings Per Share,” requires dual presentation of earnings per share — “basic” and “diluted.” Basic earnings per share is computed by dividing income available to common stockholders (the numerator) by the weighted average number of common shares outstanding (the denominator) for the period. The computation of diluted earnings per share is similar to basic earnings per share, except that the denominator is increased to include the number of additional common shares that would have been outstanding if the potentially dilutive common shares had been issued.
     The following is a reconciliation of the shares used in the computation of basic and diluted net income per share (in thousands):
                                 
    For the three months   For the six months
    ended June 30,   ended June 30,
    2006   2005   2006   2005
Basic weighted average shares outstanding
    24,078       22,952       23,894       22,751  
Effect of dilutive equity instruments
    3,233       3,071       3,317       2,979  
 
                               
Dilutive weighted average shares outstanding
    27,311       26,023       27,211       25,730  
 
                               
 
                               
Other common stock equivalents (i.e., stock options, restricted stock awards, stock units and warrants) outstanding which are not included in the calculation of diluted income per share because their impact is antidilutive
    402       2,692       311       2,784  
 
                               
Comprehensive Income
     SFAS No. 130, “Reporting Comprehensive Income,” establishes standards for the reporting and display of comprehensive income and its components in the Company’s unaudited condensed consolidated financial statements. The objective of SFAS No. 130 is to report a measure (comprehensive income) of all changes in equity of an enterprise that result from transactions and other economic events in a period other than transactions with owners. Accumulated other comprehensive income, as presented on the accompanying unaudited condensed consolidated balance sheets, consists entirely of unrealized gains on available-for-sale securities.
     Comprehensive income for the three and six months ended June 30, 2006 and 2005 was as follows (in thousands):
                                 
    For the three months   For the six months
    ended June 30,   ended June 30,
    2006   2005   2006   2005
Net income
  $ 2,171     $ 689     $ 1,032     $ 889  
Other comprehensive income:
                               
Unrealized income (loss) on investments in marketable securities available-for-sale
    (5 )     10       (9 )     (16 )
 
                               
Comprehensive income
  $ 2,166     $ 699     $ 1,023     $ 873  
 
                               

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Guarantees
     The Company adopted FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others,” (“FIN 45”) on January 1, 2003. The provision for initial recognition and measurement of liability is applied on a prospective basis to guarantees issued or modified after December 31, 2002. FIN 45 expands previously issued accounting guidance and disclosure requirements for certain guarantees and requires recognition of an initial liability for the fair value of an obligation assumed by issuing a guarantee. As an element of standard commercial terms in its standard sales contracts for UltiPro, the Company includes an indemnification clause that indemnifies the customer against certain liabilities and damages arising from any claims of patent, copyright, or other proprietary rights of any third party. Due to the nature of the intellectual property indemnification provided to its customers, the Company cannot estimate the fair value, or determine the total nominal amount, of the indemnification until such time as a claim for such indemnification is made. In the event of a claim made against the Company under such provision, the Company evaluates estimated losses for such indemnification under SFAS No. 5, “Accounting for Contingencies,” as interpreted by FIN 45, considering such factors as the degree of probability of an unfavorable outcome and the ability to make a reasonable estimate of the amount of loss. To date, the Company has not had any claims made against it under such provision and, accordingly, has not accrued any liabilities related to such indemnifications in its consolidated financial statements.
3. STOCK-BASED COMPENSATION
Summary of Plans
     The Company’s 2005 Equity and Incentive Plan (the “Plan”) authorizes the grant of options to directors, officers and employees of the Company to purchase shares of the Company’s common stock, par value $0.01 per share (the “Common Stock”). The Plan also authorizes the grant to such persons of restricted and non-restricted shares of Common Stock, stock appreciation rights, stock units and cash performance awards (collectively, and together with stock options, the “Awards”). The Plan was approved by the Company’s stockholders at the annual meeting of stockholders on May 17, 2005. Prior to that date, options to purchase shares of Common Stock were issued under the Company’s Nonqualified Stock Option Plan (the “Prior Plan”). Effective May 17, 2005, no additional options may be granted under the Prior Plan. However, options previously granted under the Prior Plan remain outstanding to the extent they have not been exercised and have not expired. The total number of shares authorized under the Plan and the Prior Plan is 9,000,000. As of June 30, 2006, the aggregate number of shares of Common Stock that were available to be issued under all Awards granted under the Plan was 1,028,257 shares. Options granted to officers and employees under the Plan and the Prior Plan generally have a 10-year term, vesting 25% immediately and 25% on the anniversary of the grant date for each of the following three years. Options granted to non-employee directors under the Plan and the Prior Plan generally have a 10-year term and vest immediately on the grant date. However, options granted to non-employee directors under the Plan first become exercisable on the earliest of (i) the fifth anniversary of the date of grant, (ii) the date on which the director ceases to be a member of the Board of Directors or (iii) the effective date of a change in control of the Company.
Fair Value
     On January 1, 2006, the Company adopted the provisions of SFAS No. 123R, which requires the Company to recognize expense related to the fair value of stock-based compensation awards. The Company elected the modified prospective transition method as permitted by SFAS No. 123R and therefore has not restated the financial results for prior periods. Under the modified prospective method, stock-based compensation expense for the three and six months ended June 30, 2006 includes

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compensation expense for all stock-based compensation awards granted prior to, but not yet vested as of, January 1, 2006, based on grant date fair value estimated in accordance with the provisions of SFAS No. 123 and compensation expense for all stock-based compensation awards granted subsequent to January 1, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS No. 123R. In addition, options granted to certain members of the Board of Directors for Board Services recorded in accordance with SFAS No. 123R and the issuance of restricted stock awards and stock units are also included in stock-based compensation for the three and six months ended June 30, 2006. The Company recognizes compensation expense for restricted stock awards and restricted stock units on a straight-line basis over the requisite service period of the award.
     The following table sets forth the stock-based compensation expense resulting from share-based arrangements that is recorded in the Company’s unaudited condensed consolidated statements of operations for the periods indicated (in thousands):
                                 
    For the Three Months   For the Six Months
    Ended June 30,   Ended June 30,
    2006   2005   2006   2005
Cost of recurring revenues
  $ 80     $     $ 200     $  
Cost of service revenues
    149             448        
Cost of license revenues
    1             4        
Sales and marketing
    517             1,246        
Research and development
    102             296        
General and administrative
    248     $ 51       519     $ 85  
 
                               
Total
  $ 1,097     $ 51     $ 2,713     $ 85  
 
                               
     Included in capitalized software on the Company’s unaudited condensed consolidated balance sheet at June 30, 2006 was $23 thousand in stock-based compensation incurred in the development of UltiPro Canada during the first six months of 2006. This amount would have otherwise been charged to research and development expense for the six months ended June 30, 2006.
     Net cash proceeds from the exercise of stock options and warrants were $3.1 million and $5.4 million for the three and six months ended June 30, 2006, respectively, and $2.3 million and $3.6 million for the three and six months ended June 30, 2005, respectively. No income tax benefit was realized from stock option exercises during the three and six months ended June 30, 2006 and June 30, 2005.
     Prior to January 1, 2006, the Company accounted for its stock-based compensation plan as permitted by SFAS No. 123, using the intrinsic value method prescribed in APB No. 25, and made the pro forma disclosures required by SFAS No. 148 for the three and six months ended June 30, 2005. Except for options granted to certain members of the Board for Board Services, all options granted under the Plan and Prior Plan had exercise prices equal to the fair market value of the underlying Common Stock on the date of grant. Accordingly, for the three and six months ended June 30, 2005, stock-based compensation is related to options granted to certain members of the Board for Board Services recorded in accordance with APB No. 25.

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     The following table illustrates the effect on net income (loss) after tax and net income (loss) per share of Common Stock as if the Company had applied the fair value recognition provisions of SFAS No. 123 to stock-based compensation during the three and six months ended June 30, 2005 (in thousands, except per share amounts):
                 
    For the Three   For the Six
    Months Ended   Months Ended
    June 30, 2005   June 30, 2005
Net income:
               
As reported
  $ 689     $ 889  
Deduct: Stock-based compensation expense, pro forma
    (732 )     (1,500 )
 
               
Net loss, pro forma
  $ (43 )   $ (611 )
 
               
 
               
Net income (loss) per share, basic:
               
As reported
  $ 0.03     $ 0.04  
Stock-based compensation expense, pro forma
    (0.03 )     (0.06 )
 
               
Net loss per share, basic and diluted, pro forma
  $     $ (0.02 )
 
               
 
               
Net income (loss) per share, diluted:
               
As reported
  $ 0.03     $ 0.03  
Stock-based compensation expense, pro forma
    (0.03 )     (0.06 )
 
               
Net loss per share, basic and diluted, pro forma
  $     $ (0.03 )
 
               
     The fair value of stock-based awards was estimated using the Black-Scholes model with the following weighted-average assumptions for the three and six months ended June 30, 2006 and June 30, 2005 (dollars in thousands):
                                 
    For the Three Months   For the Six Months
    Ended June 30,   Ended June 30,
    2006   2005   2006   2005
Expected term (in years)
    4.5       4.0       4.5       4.0  
Volatility
    40 %     43 %     40 %     43 %
Interest rate
    4.75 %     3.6 %     4.75 %     3.6 %
Dividend yield
                       
Forfeiture rate (1)
    5.40 %           5.40 %      
Weighted average fair value at grant date
  $ 11.17     $ 5.52     $ 8.89     $ 5.39  
 
(1)   The application of an estimated forfeiture rate was not applicable under SFAS No. 123 as the true-up of the pro forma compensation expense was applied based upon actual forfeitures of options.
     The Company’s computation of the expected volatility for the three and six months ended June 30, 2006 is based primarily upon historical volatility and the expected term of the option. The expected term is based on the historical exercise experience under the share-based plans of the underlying award (including post-vesting employment termination behavior) and represents the period of time the share-based awards are expected to be outstanding. The interest rate is based on the U.S. Treasury yield in effect at the time of grant for a period commensurate with the estimated expected life. The forfeiture rate is based on historical data.

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Restricted Stock Awards
     Under the provisions of the Plan, the Company may, at its discretion, grant restricted stock awards to certain officers and employees (“Restricted Stock Awards”). The shares of Common Stock issued under Restricted Stock Awards are subject to certain vesting requirements and restrictions on transfer. During the three months ended June 30, 2006, there were no grants of Restricted Stock Awards. During the six months ended June 30, 2006, the Company granted Restricted Stock Awards for 105,000 shares of Common Stock of which none has been forfeited as of June 30, 2006. During the three and six months ended June 30, 2005, the Company granted Restricted Stock Awards for 35,000 shares of Common Stock of which none has been forfeited as of June 30, 2006. Compensation expense for Restricted Stock Awards is measured based on the closing market price of the Company’s Common Stock at the date of grant and is recognized on a straight-line basis over the vesting period. Holders of Restricted Stock Awards have all rights of a stockholder including the right to vote the shares and receive all dividends and other distributions paid or made with respect thereto. Each Award becomes vested on the fourth anniversary of the respective date of grant, subject to the grantee’s continued employment with the Company or any subsidiary on each such vesting date and subject further to accelerated vesting in the event of a change in control of the Company, the Executive Officer’s death or disability or the termination of his employment by the Company without cause. Included in the Company’s financial results for the three and six months ended June 30, 2006 was $0.3 million and $0.6 million, respectively, of compensation expense for the Restricted Stock Awards. There was $17,000 of compensation expense included in the Company’s financial results for the three and six months ended June 30, 2005 for Restricted Stock Awards.
Stock Unit Awards
     The Company may, at its discretion, make awards of stock units under the Plan (“Stock Unit Awards”) to certain officers and employees. A Stock Unit Award is a grant of a number of hypothetical share units with respect to shares of Common Stock that are subject to vesting and transfer restrictions and conditions under a stock unit award agreement. The value of each unit is equal to the fair market value of one share of Common Stock on any applicable date of determination. The payment with respect to each unit under a Stock Unit Award may be made, at the discretion of the compensation committee of the Board of Directors, in cash or shares of Common Stock or in a combination of both. The grantee of a Stock Unit Award does not have any rights as a stockholder with respect to the shares subject to a Stock Unit Award until such time as shares of Common Stock are delivered to the grantee pursuant to the terms of the related stock unit award agreement.
     As provided for in the Plan, the Chief Executive Officer and the Chief Operating Officer (collectively, the “Executive Officers”) deferred receipt of one-half of their cash performance awards under the Plan for 2005 in exchange for the grant of Stock Unit Awards under the Plan (the “Elected Deferral”). Upon this election, the Company provided a matching contribution equal to one-half of the amount deferred (the “Company Match”). The number of stock units subject to such Stock Unit Award is determined by dividing the total amount deferred (including the Company Match) by the fair market value of a share of the Company’s Common Stock on the date of payment of the non-deferred portion of the cash performance awards. The Stock Unit Awards resulting from the Elected Deferral were granted on a fully vested basis, with a deferred payment date of four years after the grant date. The Stock Unit Award resulting from the Company Match vests on the fourth anniversary of the date of grant, subject to the Executive Officer’s continued employment with the Company, or any subsidiary, on such vesting date and subject further to accelerated vesting in the event of a change in control of the Company, the Executive Officer’s death or disability or the termination of his employment by the Company without cause. There were no grants of Stock Unit Awards during the three months ended June 30, 2006. During the six months ended June 30, 2006, the Company granted 28,518 stock units to the Executive Officers,

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of which none has been forfeited as of June 30, 2006. During the three and six months ended June 30, 2005, no Stock Unit Awards were granted. Included in the Company’s financial results for the three and six months ended June 30, 2006 was $11 thousand and $23 thousand, respectively, of compensation expense from Stock Unit Awards. There was no such expense for the three and six months ended June 30, 2005.
Stock Option and Restricted Stock Activity
     The following table summarizes stock option activity for the six months ended June 30, 2006 as follows (in thousands, except per share amounts):
                                 
                    Weighted    
                    Average    
            Weighted   Remaining   Aggregate
            Average   Contractual   Intrinsic
Stock Options   Shares   Exercise Price   Term (in Years)   Value
Outstanding at December 31, 2005
    5,490     $ 7.77              
Granted
    414       21.85              
Exercised
    (812 )     6.57              
Forfeited or expired
    (15 )     16.22              
 
                               
Outstanding at June 30, 2006
    5,077     $ 9.09       5.63     $ 52,265  
 
                               
 
                               
Exercisable at June 30, 2006
    4,066     $ 7.35       4.84     $ 48,303  
 
                               
     The aggregate intrinsic value of stock options in the table above represents total pretax intrinsic value (i.e., the difference between the closing price of the Company’s Common Stock on the last trading day of the reporting period and the exercise price, times the number of shares) that would have been received by the option holders had all option holders exercised their options on June 30, 2006. The amount of the aggregate intrinsic value changes, based on the fair market value of the Company’s Common Stock. Total intrinsic value of options exercised was $8.1 million and $14.1 million for the three and six months ended June 30, 2006, respectively. Total fair value of options vested during the three and six months ended June 30, 2006 is $0.4 million and $2.0 million, respectively.
     As of June 30, 2006, $4.5 million of total unrecognized compensation costs related to non-vested stock options is expected to be recognized over a weighted average period of 1.8 years.
     The following table summarizes restricted stock activity for the six months ended June 30, 2006 as follows (in thousands, except per share amounts):
                 
            Weighted
            Average
            Grant Date
Restricted Stock   Shares   Fair Value
Outstanding at December 31, 2005
    169     $ 16.86  
Granted
    134       21.60  
Vested
           
Forfeited or expired
           
 
               
Outstanding at June 30, 2006
    303     $ 18.68  
 
               
     As of June 30, 2006, $4.5 million of total unrecognized compensation costs related to non-vested Restricted Stock Awards and stock units is expected to be recognized over a weighted average period of 3.4 years.

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4. RECENT ACCOUNTING PRONOUNCEMENTS
     In June 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes,” (“FAS No. 48”). The interpretation clarifies the accounting for uncertainty in income taxes recognized in a company’s financial statements in accordance with Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes.” Specifically, the pronouncement prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The interpretation also provides guidance on the related derecognition, classification, interest and penalties, accounting for interim periods, disclosure and transition of uncertain tax positions. The interpretation is effective for fiscal years beginning after December 15, 2006. The Company is currently evaluating the impact of this new pronouncement on its unaudited condensed consolidated financial statements.
     In March 2006, the Emerging Issues Task Force (“EITF”) reached a consensus on EITF Issue No. 06-3, “How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (That Is, Gross versus Net Presentation),” (“EITF No. 06-3”), that entities may adopt a policy of presenting taxes in the income statement either on a gross or net basis. Gross or net presentation may be elected for each different type of tax, but similar taxes should be presented consistently. Taxes within the scope of this EITF would include taxes that are imposed on a revenue transaction between the seller and a customer (e.g., sales taxes, use taxes, value-added taxes, and some types of excise taxes). EITF No. 06-3 is effective for the Company’s financial statements for interim and annual reporting periods beginning after December 15, 2006. The Company is currently evaluating the impact of this new pronouncement on its unaudited condensed consolidated financial statements.
     In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections” (“SFAS No. 154”), which replaces APB Opinion No. 20, “Accounting Changes” (“APB No. 20”) and FASB Statement No. 3, “Reporting Accounting Changes in Interim Financial Statements” (“SFAS No. 3”). APB No. 20 required that changes in accounting principles be recognized by including the cumulative effect of the change in the period in which the new accounting principle was adopted. SFAS No. 154 requires retrospective application of the change to prior periods’ financial statements, unless it is impracticable to determine the period-specific effects of the change. SFAS No. 154 also provides that a change in method of depreciating or amortizing a long-lived non-financial asset be accounted for as a change in estimate effected by a change in accounting principle, and also provides that correction of errors in previously issued financial statements should be termed a “restatement”. The FASB identified the reason for the issuance of SFAS No. 154 to be part of a broader attempt to eliminate differences with the International Accounting Standards Board (“IASB”). SFAS No. 154 is effective for the Company’s fiscal year ending December 31, 2006. The adoption of this statement did not have an impact on the Company’s unaudited condensed consolidated financial statements.

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ITEM 2.   Management’s Discussion and Analysis of Financial Condition and Results of Operations
     The following discussion of the financial condition and results of operations of The Ultimate Software Group, Inc. (“Ultimate Software” or the “Company”) should be read in conjunction with the unaudited Condensed Consolidated Financial Statements and Notes thereto included elsewhere in this Form 10-Q.
Executive Summary
     Ultimate Software’s UltiPro Workforce Management Software (“UltiPro”) is a Web-based solution designed to deliver the functionality businesses need to manage the employee life cycle, from compensating and managing benefits to recruiting and hiring to terminating, whether the customers’ processes are centralized at headquarters or distributed across multiple divisions or branch offices. The Company’s main sources of revenues include sales from the Intersourcing Offering (defined below), sales of perpetual software licenses for UltiPro (and the related annual maintenance) and sales of services (mostly implementation) related to both Intersourcing and license sales.
     The Company’s primary business strategy was originally centered on sales of perpetual software licenses of UltiPro. In an effort to reduce the volatility and unpredictable nature of a business strategy predominantly focused on license sales, the Company introduced Intersourcing as an additional revenue source during 2002.
     In 2002, Ultimate Software began offering hosting services, branded “Intersourcing” by the Company, whereby Ultimate Software provides the hardware, infrastructure, ongoing maintenance and back-up services for its customers at a data center located in Miami, Florida and managed by International Business Machines (“IBM”). In August 2005, the Company opened a second data center in Atlanta, Georgia, also managed by IBM. Intersourcing is designed to appeal to those customers that want to minimize their internal technology support requirements for the application and hardware.
     After the introduction of Intersourcing in mid-2002, the sales mix gradually began to shift towards Intersourcing. Management believes the shift in sales mix has helped to produce a more predictable revenue stream by providing recurring revenue and cash from Intersourcing over the related contract periods, typically 24 months. As Intersourcing units are sold, the recurring revenue backlog associated with Intersourcing grows, enhancing the predictability of future revenue streams. Intersourcing sales include a one-time upfront fee, priced on a per-employee basis, and ongoing monthly fees, priced on a per-employee-per-month (“PEPM”) basis. Upfront fees associated with the Intersourcing sale are recognized as recurring subscription revenues ratably over the term of the related contract beginning when the related customer processes its first live payroll (or goes “Live”). Ongoing monthly PEPM fees are recognized as recurring subscription revenues each month commencing when the related customer goes Live.
     In connection with the Company’s business strategy, which has a significant focus on Intersourcing sales, a financial metric used by the Company in measuring future financial performance is new annual recurring revenues. New annual recurring revenues (“ARR”) represent the expected one-year value from (i) new Intersourcing sales from the Company’s hosted model (including prorated one-time fees); (ii) maintenance revenues related to new license sales; (iii) recurring revenues from new business service providers (“BSPs”), as well as recurring revenues from new sales by existing BSPs; and (iv) recurring revenues from additional sales to Ultimate Software’s existing client base. New annual recurring revenues attributable to sales during the second fiscal quarter of 2006 were $5.7 million as compared to $4.5 million for the same period in 2005. New annual recurring revenues attributable to

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sales during the first six months of 2006 were $11.4 million as compared to $7.5 million for the same period of 2005. The main contributors to the increase in new ARR were new Intersourcing sales from the Company’s hosted model (including prorated one-time fees) and, to a lesser extent, an increase in annual recurring maintenance revenues related to new license sales.
     In addition to Intersourcing, another major component of recurring revenues is subscription revenues generated from the Company’s BSP channel. The BSP contributing the most revenues from the BSP channel during each of the three and six months ended June 30, 2006 and 2005 was Ceridian Corporation (“Ceridian”) under the Original Ceridian Agreement (defined below). See also “Overview—Original Ceridian Agreement.”
Critical Accounting Policies and Estimates
     The preparation of financial statements in conformity with accounting principles generally accepted in the United States 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.
Revenue Recognition
     Sources of revenue for the Company include:
    Sales of the right to use UltiPro through “Intersourcing” (the “Intersourcing Offering”), which includes Hosting Services;
 
    Sales of perpetual licenses for UltiPro in conjunction with services to host the UltiPro application (“Hosting Services”);
 
    Sales of Hosting Services on a stand-alone basis to customers who already own a perpetual license or are simultaneously acquiring a perpetual license for UltiPro (“Base Hosting”);
 
    Sales of perpetual licenses for UltiPro;
 
    Recurring revenues derived from (1) maintenance revenues generated from maintaining, supporting and providing periodic updates for the Company’s software and (2) subscription revenues generated from PEPM fees earned through the Intersourcing Offering, Base Hosting and the BSP sales channel, amortization of Intersourcing or Hosting Services’ one-time fees, and revenues generated from the Original Ceridian Agreement; and
 
    Sales of services including implementation, training (also known as knowledge management) and other services, including the provision of payroll-related forms and the printing of Form W-2’s for certain customers, as well as services provided to BSPs.

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Sales Generated from the Intersourcing Offering
     Subscription revenues generated from the Intersourcing Offering are recognized in accordance with Emerging Issues Task Force (“EITF”) No. 00-21, “Revenue Arrangements with Multiple Deliverables” as a services arrangement since the customer is purchasing the right to use UltiPro rather than licensing the software on a perpetual basis. Fair value of multiple elements in Intersourcing arrangements is assigned to each element based on the guidance provided by EITF No. 00-21.
     The elements that typically exist in Intersourcing arrangements include hosting services, the right to use UltiPro, maintenance of UltiPro (i.e., product enhancements and customer support) and professional services (i.e., implementation services and training in the use of UltiPro). The pricing for hosting services, the right to use UltiPro and maintenance of UltiPro is bundled (the “Bundled Elements”). Since these three Bundled Elements are components of recurring revenues in the unaudited condensed consolidated statements of operations, allocation of fair values to each of the three elements is not necessary and they are not reported separately. Fair value for the Bundled Elements, as a whole, is based upon evidence provided by the Company’s pricing for Intersourcing arrangements sold separately. The Bundled Elements are provided on an ongoing basis and represent undelivered elements under EITF No. 00-21; they are recognized on a monthly basis as the services are performed, once the customer processes its first live payroll (i.e., goes “Live”).
     Implementation and training services (the “Professional Services”) provided for Intersourcing arrangements are typically priced on a time and materials basis and are recognized as services revenue in the unaudited condensed consolidated statements of operations as the services are performed. Under EITF 00-21, fair value is assigned to service elements in the arrangement based on their relative fair values, using the prices established when the services are sold on a stand-alone basis. Fair value for Professional Services is based on the respective Implementation Valuation and Training Valuation. If evidence of the fair value of one or more undelivered elements does not exist, the revenue is deferred and recognized when delivery of those elements occurs or when fair value can be established.
     The Company believes that applying EITF 00-21 to Intersourcing arrangements as opposed to applying SOP 97-2 is appropriate given the nature of the arrangements whereby the customer has no right to the UltiPro license.
Sales of Base Hosting Services
     Subscription revenues generated from Base Hosting are recognized in accordance with EITF No. 00-3, “Application of AICPA Statement of Position 97-2 to Arrangements that Include the Right to Use Software Stored on Another Entity’s Hardware,” which provides guidance as to the application of SOP 97-2 to hosting arrangements that include a license right to the software. The elements that typically exist for Base Hosting arrangements include hosting services and implementation services. Base Hosting is different than Intersourcing arrangements in that the customer already owns a perpetual license or is purchasing a perpetual license for UltiPro and is purchasing hosting services subsequently in a separate transaction, whereas with Intersourcing the customer is purchasing the right to use (not license) UltiPro. Implementation services provided for Base Hosting arrangements are substantially less than those provided for Intersourcing arrangements since UltiPro is already implemented in Base Hosting arrangements and only needs to be transitioned to a hosted environment. Fair value for hosting services is based on the Hosting Valuation. The fair value for implementation services is based on the Implementation Valuation in accordance with guidelines provided by SOP 97-2.

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Perpetual Licenses for UltiPro Sold With or Without Hosting Services
     Sales of perpetual licenses for UltiPro and sales of perpetual licenses for UltiPro in conjunction with Hosting Services are multiple-element arrangements that involve the sale of software and consequently fall under the guidance of Statement of Position (“SOP”) 97-2, “Software Revenue Recognition,” for revenue recognition.
     The Company licenses software under non-cancelable license agreements and provides services including maintenance, implementation consulting and training services. In accordance with the provisions of SOP 97-2, license revenues are generally recognized when (1) a non-cancelable license agreement has been signed by both parties, (2) the product has been shipped, (3) no significant vendor obligations remain and (4) collection of the related receivable is considered probable. To the extent any one of these four criteria is not satisfied, license revenue is deferred and not recognized in the unaudited condensed consolidated statements of operations until all such criteria are met.
     For multiple-element software arrangements, each element of the arrangement is analyzed and the Company allocates a portion of the total fee under the arrangement to the elements based on vendor-specific objective evidence of fair value of the element (“VSOE”), regardless of any separate prices stated within the contract for each element. Fair value is considered the price a customer would be required to pay when the element is sold separately.
     The Residual Method (as defined below) is used to recognize revenue when a license agreement includes one or more elements to be delivered at a future date and VSOE of the fair value of all undelivered elements exists. The fair value of the undelivered elements is determined based on the historical evidence of stand-alone sales of these elements to customers. Undelivered elements in a license arrangement typically include maintenance, implementation and training services (the “Standard Undelivered Elements”). The fair value for maintenance fees is based on the price of the services sold separately, which is determined by the annual renewal rate historically and consistently charged to customers (the “Maintenance Valuation”). Maintenance fees are generally priced as a percentage of the related license fee. The fair value for implementation services is based on standard pricing (i.e., rate per hour charged to customers for implementation services), for stand-alone sales of implementation services (the “Implementation Valuation”). The fair value for training services is based on standard pricing (i.e., rate per training day charged to customers for class attendance), taking into consideration stand-alone sales of training services through year-end seminars and historically consistent pricing for such services (the “Training Valuation”). Under the residual method (the “Residual Method”), the fair value of the undelivered elements is deferred and the remaining portion of the arrangement fee attributable to the delivered element, the license fee, is recognized as license revenue. If VSOE for one or more undelivered elements does not exist, the revenue is deferred on the entire arrangement until the earlier of the point at which (i) such VSOE does exist or (ii) all elements of the arrangement have been delivered.
     Perpetual licenses of UltiPro sold without Hosting Services typically include a license fee and the Standard Undelivered Elements. Fair value for the Standard Undelivered Elements is based on the Maintenance Valuation, the Implementation Valuation and the Training Valuation. The delivered element of the arrangement, the license fee, is accounted for in accordance with the Residual Method.
     Perpetual licenses of UltiPro sold with Hosting Services typically include a license fee, the Standard Undelivered Elements and Hosting Services. Fair value for the Standard Undelivered Elements is based on the Maintenance Valuation, the Training Valuation and the Implementation Valuation. Hosting Services are delivered to customers on a PEPM basis over the term of the related customer contract (“Hosting PEPM Services”). Upfront fees charged to customers represent fees for the hosting infrastructure, including hardware costs, third-party license fees and other upfront costs incurred by the Company in relation to

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providing such services (“Hosting Upfront Fees”). Hosting PEPM Services and Hosting Upfront Fees (collectively, “Hosting Services”) represent undelivered elements in the arrangement since their delivery is over the course of the related contract term. The fair value for Hosting Services is based on standard pricing (i.e., rate charged PEPM), taking into consideration stand-alone sales of Hosting Services through the sale of such services to existing customers (i.e., those who already own the UltiPro perpetual license at the time Hosting Services are sold to them) and historically consistent pricing for such services (the “Hosting Valuation”). The delivered element of the arrangement, the license fee, is accounted for in accordance with the Residual Method.
     The Company’s customer contracts are non-cancelable agreements. The Company does not provide for rights of return or price protection on its software. The Company provides a limited warranty that its software will perform in accordance with user manuals for varying periods, which are generally less than one year from the contract date. The Company’s customer contracts generally do not include conditions of acceptance. However, if conditions of acceptance are included in a contract or uncertainty exists about customer acceptance of the software, license revenue is deferred until acceptance occurs.
Recurring Revenues
     Recurring revenues include maintenance revenues and subscription revenues. Maintenance revenues are derived from maintaining, supporting and providing periodic updates for the Company’s software. Subscription revenues are principally derived from PEPM fees earned through the Intersourcing Offering, Base Hosting and the BSP sales channel, as well as revenues generated from the Original Ceridian Agreement. Maintenance revenues are recognized ratably over the service period, generally one year. Maintenance and support fees are generally priced as a percentage of the initial license fee for the underlying products.
     To the extent there are upfront fees associated with the Intersourcing Offering, Base Hosting or the BSP sales channel, subscription revenues are recognized ratably over the minimum term of the related contract upon the delivery of the product and services. In the cases of Intersourcing and Base Hosting sales, amortization of the upfront fees commences when the customer processes its first Live payroll, which typically occurs four to six months after the sale, and extends until the end of the initial contract period. In the case of BSP channel sales, amortization of the upfront fee typically commences when the contract is signed, which is when the BSP’s rights under the agreement begin, continuing until the initial contract term ends. Ongoing PEPM fees from the Intersourcing Offering, Base Hosting and the BSP sales channel are recognized as subscription revenue as the services are delivered, typically on a monthly basis.
     Commencing on August 28, 2002, subscription revenues generated from the Original Ceridian Agreement are recognized ratably over the minimum term of the contract, which extends until March 9, 2008 (7 years from the effective date of the Original Ceridian Agreement). Subscription revenues of $642,000 per month are based on guaranteed minimum payments from Ceridian of approximately $42.7 million over the minimum contract term, including $31.7 million received to date. The amount of subscription revenue recognized under the Original Ceridian Agreement during the three and six months ended June 30, 2006, totaling $1.9 million and $3.9 million, respectively, was the same as that recognized in the same periods of 2005. The Company expects to continue to recognize $642,000 per month (or $7.7 million per annum) as recurring subscription revenue until March 9, 2008 when the Original Ceridian Agreement terminates.
     Maintenance services provided to customers include product updates and technical support services. Product updates are included in general releases to the Company’s customers and are distributed on a periodic basis. Such updates may include, but are not limited to, product enhancements, payroll tax updates, additional security features or bug fixes. All features provided in general releases are unspecified

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upgrade rights. To the extent specified upgrade rights or entitlements to future products are included in a multi-element arrangement, revenue is recognized upon delivery provided fair value for the elements exists. In multi-element arrangements that include a specified upgrade right or entitlement to a future product, if fair value does not exist for all undelivered elements, revenue for the entire arrangement is deferred until all elements are delivered or when fair value can be established.
     Subscription revenues generated from the BSP sales channel include both the right to use UltiPro and maintenance. The BSP is charged a fee on a PEPM basis and, in several cases, is subject to a guaranteed monthly minimum amount for the term of the related agreement. Revenue is recognized on a PEPM basis. To the extent the BSP pays the Company a one-time upfront fee, the Company accounts for such fee by recognizing it as subscription revenue over the minimum term of the related agreement.
Services, including Implementation and Training Services
     Services revenues include revenues from fees charged for the implementation of the Company’s software products and training of customers in the use of such products, fees for other services, including services provided to BSPs, the provision of payroll-related forms and the printing of Form W-2’s for certain customers, as well as certain reimbursable out-of-pocket expenses. Revenues for implementation consulting and training services are recognized as services are performed to the extent the pricing for such services is on a time and materials basis and the payment terms are within the Company’s ordinary and customary payment cycle. In the event payments for services are outside the ordinary and customary period for the Company, the related revenues are recognized as payments come due based on their relative fair values. Other services are recognized as the product is shipped or as the services are rendered depending on the specific terms of the arrangement.
     Arrangement fees related to fixed-fee implementation services contracts are recognized using the percentage of completion accounting method, which involves the use of estimates. Percentage of completion is measured at each reporting date based on hours incurred to date compared to total estimated hours to complete. If a sufficient basis to measure the progress towards completion does not exist, revenue is recognized when the project is completed or when the Company receives final acceptance from the customer.
     The Company recognizes revenue in accordance with the Securities Exchange Commission (“SEC”) Staff Accounting Bulletin No. 101, “Revenue Recognition in Financial Statements” (“SAB No. 101”) and the SEC Staff Accounting Bulletin No. 104, “Revenue Recognition” (“SAB No. 104”). Management believes the Company is currently in compliance in all material aspects with the current provisions set forth in SOP 97-2, SOP 98-9, EITF 00-21, EITF 00-3, SAB No. 101 and SAB No. 104.
Allowance for Doubtful Accounts
     The Company maintains an allowance for doubtful accounts at an amount estimated to be sufficient to provide adequate protection against losses resulting from collecting less than full payment on accounts receivable. In assessing the adequacy of the allowance for doubtful accounts, the Company considers multiple factors including historical bad debt experience, the general economic environment, and the aging of its receivables. A considerable amount of judgment is required when the realization of receivables is assessed, including assessing the probability of collection and current credit-worthiness of each customer. If the financial condition of the Company’s customers were to deteriorate, resulting in an impairment of their ability to make payments, an additional provision for doubtful accounts may be required.

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Deferred Taxes
     The Company provides a valuation allowance for that portion of deferred tax assets which is not likely to be recognized due to the Company’s cumulative losses and the uncertainty as to future recoverability. Any reversal of the deferred tax valuation allowance is made when the Company believes that it is more likely than not that this portion of the deferred tax asset will be realized. The computation of the deferred tax assets and related valuation allowance is based on taxable income expected to be earned over future periods which will include the utilization of previously accumulated net operating tax losses. Each quarter, the Company will continue to evaluate the amount, if any, of additional reduction or increase of the valuation allowance that should be made. This will be based on management’s estimate and conclusions regarding the ultimate realization of the deferred tax assets, including but not limited to the Company’s recent financial results as well as projected earnings over future periods. While the Company has considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the deferred tax valuation allowance, in the event the Company is able to determine that it would be able to realize the deferred tax assets in the future, a reduction in the deferred tax asset valuation allowance would increase income in the period the determination was made.
Overview
     Ultimate Software designs, markets, implements and supports payroll and workforce management solutions.
     Ultimate Software’s UltiPro Workforce Management Software (“UltiPro”) is a Web-based solution designed to deliver the functionality businesses need to manage the employee life cycle, from compensating and managing benefits to recruiting and hiring to terminating, whether the customers’ processes are centralized at headquarters or distributed across multiple divisions or branch offices. UltiPro’s human resources (“HR”) and benefits management functionality is wholly integrated with a flexible payroll engine, reporting and analytical decision-making tools, and a self-service Web portal for executives, managers, administrators, and employees to review and update work-related and personal information. Ultimate Software believes that UltiPro helps customers streamline HR and payroll processes to significantly reduce administrative and operational costs, while also empowering executives and staff to access critical information quickly and perform routine business activities efficiently.
     UltiPro is marketed both through the Company’s direct sales team as well as through alliances with business service providers (“BSPs”) that market co-branded UltiPro to their customer bases. Ultimate Software’s direct sales team focuses primarily on companies with more than 500 employees and sells both a license model (typically in-house) and a service model (typically hosted and priced on a PEPM basis). The Company’s BSP alliances focus primarily on companies with under 500 employees and, since 2004, very large companies, generally those with over 10,000 employees, as well. The Company’s BSP alliances typically sell an Internet solution, which includes UltiPro, priced on a monthly/service basis. When the BSP sells its Internet solution, incorporating UltiPro in the offering, the BSP is obligated to remit a fee to the Company, typically measured on a PEPM basis and, in some cases, subject to a guaranteed monthly minimum amount.
     The Company’s direct sales force markets UltiPro as an in-house human resources, payroll and workforce management solution and alternatively as a hosted offering branded “Intersourcing” (the “Intersourcing Offering”). Intersourcing provides Web access to comprehensive workforce management functionality for organizations that need to simplify the information technology (“IT”) support requirements of their business applications. Ultimate Software believes that Intersourcing is attractive to companies that want to focus on their core competencies to increase sales and profits. Through the Intersourcing model, introduced in 2002, the Company provides the hardware, infrastructure, ongoing

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maintenance and backup services for its customers at two data centers located in Miami, Florida and Atlanta, Georgia (opened in August 2005), both managed by IBM.
Intersourcing Offering
     In 2002, the Company began offering a hosting service, branded Intersourcing, whereby the Company provides the hardware, infrastructure, ongoing maintenance and back-up services for its customers at a data center located in Miami, Florida, which is managed by IBM. In August 2005, the Company opened a second data center, which is located in Atlanta, Georgia and is also managed by IBM. Different types of hosting arrangements include the sale of Hosting Services as a part of the Intersourcing Offering, discussed below, and, to a lesser extent, the sale of Hosting Services to customers that license UltiPro on a perpetual basis. Hosting Services, typically available in a shared environment, provide Web access to comprehensive workforce management functionality for organizations that need to simplify the IT support requirements of their business applications and are priced on a PEPM basis. In the shared environment, Ultimate Software provides an infrastructure with applicable servers shared among many customers who use a Web browser to access the application software through the data centers.
     The Intersourcing Offering is designed to provide an appealing pricing structure to customers who prefer to minimize the initial cash outlay associated with typical capital expenditures. Intersourcing customers purchase the right to use UltiPro on an ongoing basis for a specific term, typically in a shared environment. The pricing for Intersourcing, including both the hosting element as well as the right to use UltiPro, is on a PEPM basis.
Original Ceridian Agreement
     During 2001, Ultimate Software and Ceridian reached an agreement, as amended in 2002, which granted Ceridian a non-exclusive license to use UltiPro software as part of an on-line offering that Ceridian can market primarily to businesses with under 500 employees (the “Original Ceridian Agreement”). Ceridian marketed that solution under the name SourceWeb.
     Under the agreement, Ceridian is required to pay the Company a monthly license fee based on the number of employees paid using the licensed software. These payments are subject to a minimum monthly payment of $500,000 per month with increases of 5% per annum, compounded beginning in January 2006. The aggregate minimum payments that Ceridian is obligated to pay Ultimate Software under the Original Ceridian Agreement over the minimum term of the Agreement are $42.7 million. To date, Ceridian has paid to Ultimate Software a total of $31.7 million under the Original Ceridian Agreement.
     Effective March 9, 2006, Ceridian provided Ultimate Software with a two years’ advance written notice of termination of the Original Ceridian Agreement, as permitted under the terms of the Agreement. Pursuant to such notice, the Original Ceridian Agreement will terminate on March 9, 2008 (unless terminated earlier for an uncured material breach).
     During December 2004, RSM McGladrey Employer Services (“RSM”), an existing BSP of Ultimate Software, acquired Ceridian’s SourceWeb HR/payroll and self-service product and existing SourceWeb base of small and midsize business customers throughout the United States (the “RSM Acquisition”). The financial terms of the Original Ceridian Agreement have not changed as a result of the RSM Acquisition. Ceridian continues to be financially obligated to pay Ultimate Software a minimum fee of $500,000 per month with increases of 5% per annum, compounded beginning in January 2006. Therefore, the minimum monthly fee payable to Ultimate Software from Ceridian in 2006 is $525,000.

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     Ultimate Software expects to continue to recognize a minimum of $642,000 per month, or $7.7 million per year, in recurring subscription revenues from the Original Ceridian Agreement until its termination on March 9, 2008.
Items Affecting Comparability between Periods
     Prior to January 1, 2006, the Company accounted for share-based plans under the recognition and measurement requirements of APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and related Interpretations, as permitted by Statement of Financial Accounting Standards (SFAS) No. 123, “Accounting for Stock-Based Compensation.” Prior to January 1, 2006, stock-based compensation expense was recognized only for grants of restricted stock awards, stock units and stock options which were granted at exercise prices less than the fair market value of the underlying Common Stock on the grant date. During the three and six months ended June 30, 2005, while there were no grants of stock units, there were grants of restricted stock awards. In addition, stock options that had exercise prices less than the fair market value of the Common Stock on the grant date were granted to certain members of the Board of Directors for Board Services and fully vested on the grant date. Therefore, stock-based compensation expense for the three and six months ended June 30, 2005 is related to both restricted stock awards granted and the options granted to certain members of the Board for Board Services, recorded in accordance with APB No. 25.
     Effective January 1, 2006, the Company adopted the fair value recognition provisions of SFAS No. 123R, “Share-Based Payment,” using the modified-prospective transition method. Under this transition method, compensation was recognized beginning January 1, 2006 and includes (a) compensation expense for all share-based employee compensation arrangements granted prior to, but not yet vested as of, January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123, and (b) compensation expense for all share-based employee compensation arrangements granted subsequent to January 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of SFAS No. 123R. Results of prior periods have not been restated.
     The following table sets forth the stock-based compensation expense resulting from share-based arrangements that is recorded in the Company’s unaudited condensed consolidated statements of operations for the periods indicated (in thousands):
                                 
    For the Three Months   For the Six Months
    Ended June 30,   Ended June 30,
    2006   2005   2006   2005
Cost of recurring revenues
  $ 80     $     $ 200     $  
Cost of service revenues
    149             448        
Cost of license revenues
    1             4        
Sales and marketing
    517             1,246        
Research and development
    102             296        
General and administrative
    248     $ 51       519     $ 85  
 
                               
Total
  $ 1,097     $ 51     $ 2,713     $ 85  
 
                               
     As of June 30, 2006, $4.5 million of total unrecognized compensation costs related to non-vested stock options is expected to be recognized over a weighted average period of 1.8 years. As of June 30, 2006, $4.5 million of total unrecognized compensation costs related to non-vested restricted stock awards and stock units is expected to be recognized over a weighted average period of 3.4 years.

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     Included in capitalized software on the Company’s unaudited condensed consolidated balance sheet at June 30, 2006 was $23 thousand in stock-based compensation incurred in the development of UltiPro Canada during the first six months of 2006. This amount would otherwise have been charged to research and development expense for the six months ended June 30, 2006.
Results of Operations
     The following table sets forth the statements of operations data of the Company, as a percentage of total revenues, for the periods indicated.
                                 
    For the Three Months   For the Six Months
    Ended June 30,   Ended June 30,
    2006   2005   2006   2005
Revenues:
                               
Recurring
    54.8 %     57.0 %     56.5 %     57.2 %
Services
    29.4       30.0       31.3       30.3  
License
    15.8       13.0       12.2       12.5  
 
                               
Total revenues
    100.0       100.0       100.0       100.0  
 
                               
Cost of revenues:
                               
Recurring
    15.3       15.8       15.9       15.5  
Services
    22.5       22.5       25.2       23.7  
License
    1.4       0.8       1.2       0.7  
 
                               
Total cost of revenues
    39.2       39.1       42.3       39.9  
 
                               
Operating expenses:
                               
Sales and marketing
    26.7       24.8       27.4       25.2  
Research and development
    18.6       24.3       20.1       24.1  
General and administrative
    9.0       9.1       9.4       9.1  
 
                               
Total operating expenses
    54.3       58.2       56.9       58.4  
 
                               
Operating income (loss)
    6.5       2.7       0.8       1.7  
Interest expense
    (0.2 )     (0.3 )     (0.2 )     (0.3 )
Interest and other income
    1.4       0.8       1.3       0.7  
 
                               
Net income (loss)
    7.7 %     3.2 %     1.9 %     2.1 %
 
                               
Revenues
     The Company’s revenues are derived from three principal sources: recurring revenues, services revenues and software licenses (“license revenues”).
     Recurring revenues include annual maintenance on software license agreements for the Company’s products and subscription revenues. Maintenance revenues are derived from maintaining, supporting and providing periodic updates for the Company’s software. Subscription revenues are principally derived from fees earned through the Intersourcing Offering, Base Hosting and the BSP sales channel, as well as revenues generated from the Original Ceridian Agreement. Maintenance revenues are recognized ratably over the service period, generally one year. To the extent there are upfront fees associated with the Intersourcing Offering, Base Hosting or the BSP sales channel, subscription revenues are recognized ratably over the term of the related contract upon the delivery of the product and services. Per-employee-per-month (“PEPM”) fees from the Intersourcing Offering, Base Hosting and the BSP sales channel are recognized as subscription revenues as the services are delivered. All of the Company’s customers that purchased software during the three and six months ended June, 2006 and 2005 also purchased maintenance and support service contracts. Maintenance and support fees are generally priced as a percentage of the initial license fee for the underlying products.

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     Services revenues include revenues from fees charged for the implementation of the Company’s software products and training of customers in the use of such products, fees for services provided to BSPs, the provision of payroll-related forms and the printing of Form W-2’s for certain customers and certain reimbursable out-of-pocket expenses. Revenues for training and implementation consulting services are recognized as services are performed to the extent the pricing for such services is either on a time and materials basis or the payment terms are within the Company’s ordinary and customary payment cycle. In the event payments for services are outside the ordinary and customary period for the Company, the related revenues are recognized as payments come due based on their relative fair values. Other services are recognized as the product is shipped or as the services are rendered.
     License revenues include revenues from software license agreements for the Company’s products, entered into between the Company and its customers in which the license fees are non-cancelable. License revenues are generally recognized upon the delivery of the related software product when all significant contractual obligations have been satisfied. Until such delivery, the Company records amounts received when contracts are signed as customer deposits which are included with deferred revenues in the unaudited consolidated balance sheets.
     Total revenues, consisting of recurring, services and license revenues, increased 33.0% to $28.3 million for the three months ended June 30, 2006 and by 27.8% to $53.0 million for the six months ended June 30, 2006.
     Recurring revenues increased 27.9% to $15.5 million for the three months ended June 30, 2006 and by 26.3% to $30.0 million for the six months ended June 30, 2006. The increases in recurring revenues for the three and six months ended June 30, 2006 were primarily due to increases in Intersourcing revenues, maintenance revenues, and, to a lesser extent, subscription revenues. Intersourcing revenues increased due to incremental recurring subscription revenues generated from additional previously sold Intersourcing units which went “live” (i.e., when the underlying customer processes its first live payroll for its employees) since June 30, 2005. Recognition of recurring subscription revenues for Intersourcing unit sales commences upon “live” date. Maintenance revenues increased due to additional maintenance fees resulting from cumulative increases in the customer base subsequent to June 30, 2005. Maintenance revenues are recognized over the initial term of the related license contract, which is typically 12 months.
     Services revenues increased 30.5% to $8.3 million for the three months ended June 30, 2006 and by 31.8% to $16.6 million for the six months ended June 30, 2006. The increases in the three- and six- month periods were primarily due to additional billable hours stemming from an increase in the number of revenue-generating consultants and incremental units sold, and a higher rate per hour. Additional license and Intersourcing units sold in late 2005 and the six months ended June 30, 2006 resulted in more billable hours for product implementations.
     License revenues increased 61.0% to $4.5 million for the three months ended June 30, 2006 and by 25.1% to $6.5 million for the six months ended June 30, 2005. The increases in the three and six month periods were primarily due to a higher average sales price per unit (excluding the impact of one larger deal) and the sale of one larger than average license unit during the three months ended June 30, 2006.
Cost of Revenues
     Cost of revenues consists of the cost of recurring, services and license revenues. Cost of recurring revenues consists of costs to provide maintenance and technical support to the Company’s customers, the cost of providing periodic updates and the cost of subscription revenues, including, to a lesser extent,

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amortization of certain capitalized software. Cost of services revenues primarily consists of costs to provide implementation services and training to the Company’s customers and costs to provide services to BSP’s and, to a lesser degree, costs related to sales of payroll-related forms and costs associated with certain reimbursable out-of-pocket expenses. Cost of license revenues primarily consists of fees payable to third-parties for software products distributed by the Company. UltiPro includes third-party software for enhanced report-writing purposes, and, to a lesser extent, certain product initiatives, such as employee recruitment and time and attendance. When UltiPro licenses are sold, customers pay the Company on a per user basis for the license rights to the third-party software.
     Total cost of revenues (including $0.2 million in stock-based compensation for the three months ended June 30, 2006) increased 33.5% to $11.1 million for the three months ended June 30, 2006. Total cost of revenues (including $0.7 million in stock-based compensation for the six months ended June 30, 2006) increased 35.6% to $22.5 million for the six months ended June 30, 2006
     Cost of recurring revenues increased 28.5% to $4.3 million for the three months ended June 30, 2006 and by 31.1% to $8.4 million for the six months ended June 30, 2006. The increases in cost of recurring revenues for the three and six months ended June 30, 2006 (which included stock-based compensation of $0.1 million and $0.2 million for the three and six months ended June 30, 2006, respectively), was primarily due to the increases in both Intersourcing costs and maintenance costs. The increase in the Intersourcing costs was principally due to the growth in Intersourcing operations and increased sales, including increased labor costs and higher operating costs such as depreciation and amortization of related computer equipment supporting the operations and costs associated with the operations of the Company’s two data centers, including the impact of opening the second data center in August 2005. The increase in maintenance costs was primarily related to increased labor costs commensurate with the growth in the number of customers.
     Cost of services revenues increased 33.8% to $6.4 million for the three months ended June 30, 2006 and by 36.1% to $13.4 million for the six months ended June 30, 2006. The increase in cost of services revenues for the three and six month periods ended June 30, 2006 (which included stock-based compensation of $0.1 million and $0.4 million for the three and six months ended June 30, 2006, respectively), was primarily due to an increase in costs of implementation, which was predominantly related to an increase in labor costs resulting from additional billable consultants hired to support the growth in the number of units sold and, to a lesser extent, the use of third-party consultants.
     Cost of license revenues increased 122.2% to $391,000 for the three months ended June 30, 2006 and by 116.4% to $647,000 for the six months ended June 30, 2006. The increase in cost of license revenues for the three and six months ended June 30, 2006 was principally due to higher royalties paid to third-party vendors for products sold in conjunction with UltiPro, including new UltiPro product offerings such as time and attendance.
Sales and Marketing
     Sales and marketing expenses consist primarily of personnel costs, including sales commissions, as well as travel and promotional expenses, facility and communication costs for direct sales offices and advertising and marketing costs. Sales and marketing expenses increased 43.3% to $7.5 million for the three months ended June 30, 2006 and by 38.6% to $14.5 million for the six months ended June 30, 2006. The $2.2 million increase in the three-month period ended June 30, 2006 and the $4.0 million increase in the six-month period ended June 30, 2006 were principally due to increased sales commissions and other additional labor costs (including $0.5 million and $1.2 million of stock-based compensation for the three- and six- month periods ended June 30, 2006, respectively), partly attributable to hiring additional personnel for the sales organization associated with the new UltiPro product offerings such as time and

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attendance as well as expected sales of UltiPro Canada, once developed. Sales commissions increased on both license revenues as well as Intersourcing revenues, correlating with the growth in those revenue sources. Sales commissions on license sales are recognized when the license revenues are recognized, which is typically when the product is shipped. Sales commissions on Intersourcing sales are amortized over the initial contract term (typically 24 months) commencing on “live” date, which corresponds to Intersourcing revenue recognition. Increased sales commissions also resulted from a higher percentage of sales being made by salespeople in the direct sales force whose year-to-date performance placed them at higher commission rates.
Research and Development
     Research and development expenses consist primarily of software development personnel costs. Research and development expenses of $5.3 million for the three month period ended June 30, 2006 were comparable to the expenses during the same period in the prior year. Research and development expenses increased 6.6% to $10.6 million for the six months ended June 30, 2006. Excluding the impact of capitalized costs associated with UltiPro Canada (defined below), which totaled $0.5 million and $0.8 million for the three- and six-month periods ended June 30, 2006, research and development expenses increased $0.5 million and $1.4 million, respectively, in 2006 in comparison to the same periods last year, principally due to higher labor costs, including the impact of increased staffing needs related to the ongoing development of UltiPro Canada, as well as annual merit increases and, to a lesser extent, $0.1 million and $0.3 million of stock-based compensation expense for the three and six month periods ended June 30, 2006, respectively.
     In accordance with SFAS No. 86, “Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed,” the Company capitalized certain research and development personnel costs for the development of UltiPro Canadian HR/payroll (“UltiPro Canada”) functionality. UltiPro Canada is being built from the existing product infrastructure of UltiPro (e.g., using UltiPro’s source code and architecture). UltiPro Canada will provide HR/payroll functionality which includes the availability of Canadian tax rules, as well as Canadian human resources functionality, taking into consideration labor laws in Canada and including changes to the language where necessary (i.e., English to French). The Company expects to capitalize additional research and development costs relative to the UltiPro Canada project during the remainder of 2006 and the first half of 2007 as it anticipates a general release of UltiPro Canada approximately toward the end of the first half of 2007, at which time capitalization would cease under SFAS No. 86 guidelines.
General and Administrative
     General and administrative expenses consist primarily of labor costs for executive, administrative and financial personnel, as well as external professional fees and the provision for doubtful accounts. General and administrative expenses for the three months ended June 30, 2006 increased 31.2% to $2.6 million and by 33.1% to $5.0 million for the six months ended June 30, 2006. The increases in general and administrative expenses for the three- and six- month periods ended June 30, 2006 were primarily due to higher labor costs (including annual merit increases and $0.2 million and $0.5 million of stock-based compensation expense) for the three- and six- month periods ended June 30, 2006, respectively.
Interest Expense
     Interest expense of $0.1 million for the three- and six- month periods ended June 30, 2006 were comparable to interest expense during the same periods in the prior year.

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Interest and Other Income
     Interest and other income increased 129.4% to $390 thousand for the three months ended June 30, 2006 and by 140.9% to $730 thousand for the six months ended June 30, 2006 The increases in interest and other income for the three- and six- month periods ended June 30, 2006 were primarily due to interest income on increased cash and cash equivalents available for investment, excluding investments in marketable securities available for sale. See Note 2 to the unaudited condensed consolidated financial statements included herein for further discussion on investments in marketable securities available for sale.
Income Taxes
     No provision or benefit for federal, state or foreign income taxes was made for the three months ended June 30, 2006 or 2005 due to the operating loss carryforwards from prior periods incurred in the respective periods. Net operating loss carryforwards available at December 31, 2005 which expire at various times through the year 2025 are available to offset future taxable income were $67.0 million. The timing and levels of future profitability may result in the expiration of net operating loss carryforwards before utilization. Additionally, utilization of such net operating losses may be limited as a result of cumulative ownership changes in the Company’s equity instruments.
Liquidity and Capital Resources
     The Company has historically funded operations primarily through the private and public sale of equity securities and, to a lesser extent, equipment financing and borrowing arrangements.
     As of June 30, 2006, the Company had $36.7 million in cash, cash equivalents and total investments in marketable securities, reflecting a net increase of $3.9 million since December 31, 2005. This increase is due to cash generated from operations of $7.2 million and cash proceeds from employee stock option exercises of $5.4 million, partially offset by repurchases of Common Stock of $3.8 million and an increase in capital expenditures, including $3.0 million for cash purchases of property and equipment, as well as principal payments on financed equipment of $1.1 million.
     Net cash provided by operating activities was $7.2 million for the six months ended June 30, 2006 as compared to net cash used in operating activities of $0.1 million for the six months ended June 30, 2005. The $7.3 million increase in net cash provided by operating activities was primarily due to the increase in funds generated from operations as well as an increase in deferred revenues principally related to additional sales of Intersourcing units.
     Net cash used in investing activities was $5.6 million for the six months ended June 30, 2006 as compared to net cash provided by investing activities of $1.0 million for the six months ended June 30, 2005. The $6.6 million increase in net cash used in investing activities was primarily due to an increase in net purchases of marketable securities of $4.4 million, increased purchases of property and equipment of $1.4 million and an increase in capitalized software costs associated with UltiPro Canada of $0.8 million.
     Net cash provided by financing activities was $0.5 million for the six months ended June 30, 2006 as compared to $3.5 million for the six months ended June 30, 2005. The $3.0 million decrease in net cash provided by financing activities was primarily related to Company repurchases of Common Stock of $3.8 million (whereas no such repurchases were made in the prior year comparable period), partially offset by an increase in net proceeds from exercises of employee stock options and warrants of $1.7 million.

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     Days sales outstanding, calculated on a trailing three-month basis (“DSO”), as of June 30, 2006 and 2005, were 61 days and 58 days, respectively. The increase in DSO’s as of June 30, 2006 was related to the increase in accounts receivable principally from incremental revenues generated, including increased license revenues.
     Deferred revenues were $36.3 million at June 30, 2006 as compared to $33.0 million at December 31, 2005. The increase of $3.3 million in deferred revenues for 2006 was primarily due to increased sales from Intersourcing operations (which originate deferred revenues upon contract execution for the upfront fees and initial PEPM fees). Approximately 50% of the total balance in deferred revenues is related to the Company’s Intersourcing offering.
     The Company had a credit facility (the “Credit Facility”) with Silicon Valley Bank, which was secured by the Company’s eligible accounts receivable. The Credit Facility was comprised of a revolving line of credit (the “Revolver”) and an equipment term loan (the “Equipment Loan”). The Credit Facility’s Revolver expired on May 27, 2006. The Company chose not to renew the Credit Facility upon its expiration. The Credit Facility’s Equipment Loan, while still effective, did not have any future borrowing capacity after May 27, 2006. The outstanding balance of $1.0 million under the Equipment Loan as of June 30, 2006 is payable on or before December 31, 2008 under the payment terms of such agreement. The Company is currently in the process of securing a line of credit to replace the expired Credit Facility (the “Replacement Credit Facility”) with another financial institution but there can be no assurance that the Replacement Credit Facility will be obtained or as to the terms of the Replacement Credit Facility. As of June 30, 2006, the Company was in compliance with all covenants included in the terms of the Credit Facility.
     The Company believes that cash and cash equivalents, investments in marketable securities and cash generated from operations will be sufficient to fund its 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.
Issuer Purchases of Equity Securities
     On October 30, 2000, the Company announced that its Board of Directors authorized the repurchase of up to 1,000,000 shares of the Company’s outstanding Common Stock (the “Stock Repurchase Plan”). Stock repurchases may be made periodically in the open market, in privately negotiated transactions or a combination of both.
     For purposes of mitigating the expected dilution created by stock-based compensation, during the fourth quarter of 2005, the Company’s Board of Directors authorized the Company to resume repurchasing its Common Stock under the Stock Repurchase Program, commencing in 2006. The Company did not repurchase any shares of its Common Stock under the Stock Repurchase Plan in 2003, 2004 or 2005. As of June 30, 2006, an aggregate of 578,363 shares of common stock remained authorized for repurchase under the Stock Repurchase Plan. The extent and timing of these repurchase transactions will depend on market conditions and other business considerations.

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     There were 163,990 shares of the Company’s Common Stock repurchased during the six months ended June 30, 2006 but no repurchases during the six months ended June 30, 2005. As of June 30, 2006, the Company had purchased 421,637 shares of the Company’s Common Stock under the Stock Repurchase Plan. The details of Common Stock repurchases for the six months ended June 30, 2006 were as follows:
                                 
                    Total Number of   Maximum Number of
                    Shares Purchased as Part   Shares That May Yet
    Total Number of   Average Price   Of Publicly Announced   Be Purchased Under the
Period   Shares Purchased   Paid per Share   Plans or Programs   Plans or Programs
January 1 — 31, 2006
                      742,353  
February 1 — 28, 2006
                      742,353  
March 1 — 31, 2006
    43,800       22.84       301,447       698,553  
April 1 — 30, 2006
                      698,553  
May 1 — 31, 2006
    120,190       22.69       421,637       578,363  
June 1 — 30, 2006
                      578,363  
 
                               
Total
    163,990     $ 22.77       421,637       578,363  
 
                               
Off-Balance Sheet Arrangements
     The Company does 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 the Company’s financial condition, results of operations, liquidity, capital expenditures or capital resources.
Quarterly Fluctuations
     The Company’s quarterly revenues and operating results have varied significantly in the past and are likely to vary substantially from quarter to quarter in the future. The Company’s 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 and sales and marketing), timing of product releases, increased competition, variations in the mix of revenues, announcements of new products by the Company or its competitors and capital spending patterns of the Company’s customers. The Company establishes its expenditure levels based upon its expectations as to future revenues, and, if revenue levels are below expectations, expenses can be disproportionately high. A drop in near term demand for the Company’s 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 years or for any future periods. As a result of these factors, there can be no assurance that the Company will be able to maintain profitability on a quarterly basis. The Company believes that, due to the underlying factors for quarterly fluctuations, period-to-period comparisons of its operations are not necessarily meaningful and that such comparisons should not be relied upon as indications of future performance.
Forward-Looking Statements
     The foregoing Management’s Discussion and Analysis of Financial Condition and Results of Operations contains 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 the Company’s expectations or beliefs, including, but not limited to, statements concerning the Company’s 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. The Company’s actual results could differ materially

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from those contained in the forward-looking statements due to risks and uncertainties associated with fluctuations in the Company’s quarterly operating results, concentration of the Company’s product offerings, development risks involved with new products and technologies, competition, the Company’s 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 this quarterly report on Form 10-Q and the annual report on Form 10-K for the year ended December 31, 2005, including Exhibit 99.1 thereto, filed with the SEC on March 15, 2006. The Company undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise .
ITEM 3.   Quantitative and Qualitative Disclosures About Market Risk
     In the ordinary course of its operations, the Company is exposed to certain market risks, primarily interest rates. Uncertainties that are either non-financial or non-quantifiable, such as political, economic, tax, other regulatory or credit risks are not included in the following assessment of the Company’s market risks.
     Market risks. The Company manages market risk in accordance with its investment guideline objectives, including:
    Maximum safety of principal
 
    Maintenance of appropriate liquidity for regular cash needs
 
    Maximum yields in relationship to guidelines and market conditions
 
    Diversification of risks
 
    Fiduciary control of all investments
     The Company targets its fixed income investment portfolio to have maturities of 24 months or less. Investments are held to enhance the preservation of capital and not for trading purposes.
     Interest rates. Cash equivalents consist of money market accounts with original maturities of less than three months. Short-term investments include obligations of U.S. government agencies and corporate debt securities. Corporate debt securities include commercial paper which must carry minimum short-term ratings of P-1 by Moody’s and A-1 by Standard & Poors. Other corporate debt obligations must carry a minimum rating of A-2 by Moody’s or A by Standard & Poor’s. Asset-backed securities must carry a minimum AAA rating by Moody’s and Standard & Poor’s with a maximum average life of two years at the time of purchase.
     Interest on the Credit Facility, which expired on May 26, 2006, was based on Prime Rate per annum. The Company chose not to renew the Credit Facility upon its expiration. The Company was charged a weighted average interest rate of 6.5% per annum during the first six months of 2006 under the Credit Facility. As of June 30, 2006, there was no amount outstanding under the Credit Facility’s Revolver and $1.0 million outstanding under the Credit Facility’s Equipment Loan, with no future availability to draw on the Equipment Loan and payment of the outstanding balance of such Equipment Loan due on or before December 31, 2008.
     As of June 30, 2006, total investments in available-for-sale marketable securities were $16.8 million. The Company is subject to financial market risks, including changes in interest rates and the valuations of its investment portfolio. Changes in amounts borrowed or interest rates could impact the Company’s anticipated interest income from interest-bearing cash accounts, or cash equivalents and investments in marketable securities, as well as interest expense on borrowings under the Credit Facility.

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     Interest rate risk. As of June 30, 2006, virtually all of the investments in the Company’s portfolio were at fixed rates (with a weighted average interest rate of 4.8% per annum). In addition, the Credit Facility is a variable rate borrowing facility.
     To illustrate the potential impact of changes in interest rates, the Company has performed the following analysis based on its June 30, 2006 unaudited condensed consolidated balance sheet and assuming no changes in its investment and borrowing structure. Under this analysis, an immediate and sustained 100 basis point increase in the various base rates would result in a decrease in the fair market value of the Company’s total portfolio of approximately $77 thousand over the next 12 months. An immediate and sustained 100 basis point decrease in the various base rates would result in an increase of the fair market value of the Company’s total portfolio of approximately $77 thousand over the next 12 months.
ITEM 4. Controls and Procedures
     (a) Evaluation of disclosure controls and procedures. The Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Chief Executive Officer (the “CEO”) and the Chief Financial Officer (the “CFO”), of the effectiveness of the design and operation of the Company’s disclosure controls and procedures as of the end of the period covered by this report pursuant to the Exchange Act Rule 13a-15. Based on that evaluation, the Company’s management, including the CEO and CFO, concluded that the Company’s disclosure controls and procedures are effective to ensure that information required to be disclosed by the Company in reports that the Company files or submits under the Exchange Act is recorded, processed, summarized and timely reported as specified in the SEC’s rules and forms and accumulated and communicated to the Company’s management, including the CEO and CFO, to allow timely decisions regarding disclosure. It should be noted that the design of any system of controls is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions, regardless of how remote.
     (b) Changes in internal control over financial reporting. In connection with the evaluation required by Exchange Act Rule 13a-15, the Company’s management, including the CEO and CFO, concluded that no changes occurred during the quarter ended June 30, 2006 in the Company’s internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
PART II — OTHER INFORMATION
ITEM 4.   Submission of Matters to a Vote of Security Holders
     The Company held its Annual Meeting of Stockholders on May 16, 2006. The principal business of the meeting was to (i) elect three directors to serve for a three-year term or until their successors are duly elected and qualified and (ii) the ratification of KPMG LLP as the Company’s independent registered public accounting firm for the fiscal year ending December 31, 2006.

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     The names of the nominees for directors whose terms expired at the 2006 Annual Meeting of Stockholders of the Company and who were elected to serve as directors until the 2009 Annual Meeting of Stockholders are as follows:
                 
Nominee   For   Withheld Vote
Marc D. Scherr
    13,429,520       6,617,941  
James A. FitzPatrick, Jr.
    13,529,197       6,518,264  
Rick A. Wilber
    18,822,571       1,224,890  
     The names of each other director whose term of office as a director continues after the 2006 Annual Meeting of Stockholders and their respective term expirations are as follows:
     Term Expires in 2007:
     Scott Scherr
     Term Expires in 2008:
     LeRoy A. Vander Putten
     Robert A. Yanover
     The results of the vote for ratification of KPMG LLP as the Company’s independent registered public accounting firm for the fiscal year ending December 31, 2006 are as follows:
             
For   Against   Abstain   No Vote
19,957,494
  64,557   25,410  
ITEM 6.   Exhibits
         
Number   Description
       
 
  10.36    
Galleria Atlanta office lease agreement between Galleria 600, LLC, a Delaware limited liability company, and the Company, dated April 27, 2006 *
       
 
  31.1    
Certification Pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act of 1934, as amended
       
 
  31.2    
Certification Pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act of 1934, as amended
       
 
  32.1    
Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
       
 
  32.2    
Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 
*   filed herewith

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Signatures
     Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
         
  The Ultimate Software Group, Inc.
 
 
Date: August 8, 2006  By:   /s/ Mitchell K. Dauerman    
    Mitchell K. Dauerman   
    Executive Vice President, Chief
Financial Officer and Treasurer
(Authorized Signatory and Principal
Financial and Accounting Officer) 
 

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