Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Overview
This Management's Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our condensed consolidated financial statements and the notes contained in Item 1 of this Quarterly Report on Form 10-Q. The following discussion contains forward-looking statements. The forward-looking statements do not include the potential impact of any mergers, acquisitions, or divestitures of business combinations that may be announced after the date hereof. For this purpose, any statement that is not a statement of historical fact should be considered a forward-looking statement. We often use the words "believes," "anticipates," "plans," "expects," "intends" and similar expressions to help identify forward-looking statements. There are a number of important factors that could cause our actual results to differ materially from those indicated or implied by forward-looking statements. Factors that could cause or contribute to such differences include those referred to in Part II, Item 1A, under the heading "Risk Factors," as well as those discussed elsewhere in this quarterly report.
We develop and market a comprehensive suite of e-commerce software products, as well as provide related services in conjunction with our products, including support and maintenance, professional services, managed application hosting services, e-commerce optimization services for enhancing online sales and support. We primarily derive revenue from the sale of software products and related services. Our software licenses are priced based on the size of the customer implementation. Our recurring services revenue is comprised of managed application hosting services, e-commerce optimization services, and support and maintenance. Managed application hosting revenue is recognized monthly as the services are provided based on a per transaction, per CPU or percent of customer's revenue basis. e-commerce optimization services are priced on a per transaction basis and recognized monthly as the services are provided. Support and maintenance arrangements are priced based on the level of support services provided as a percent of net license fees per annum. Under support and maintenance services, customers are generally entitled to receive software upgrades and updates, maintenance releases and technical support. Professional and educational service revenue includes implementation, technical consulting and educational training. We bill professional service fees primarily on a time and materials basis. Education services are billed as services are provided. Shift to increasing ratably recognized revenue Before 2007, most of our revenue from arrangements involving the sale of our software was derived from perpetual software licenses and in most circumstances was recognized at the time the license agreement was executed and delivery of the software occurred provided that the other criteria of revenue recognition was met. Beginning in the first quarter of 2007, some of our perpetual software licenses also included the sale of our managed application hosting services or e-commerce optimization services. As a result of applying the requirements of U.S. generally accepted accounting principles ("GAAP") to our evolving business model, the revenue from an increasing number of our arrangements is being recognized on a ratable basis over the estimated term of the contract or arrangement, commencing with the "go-live" date for providing the managed application hosting services or e-commerce optimization services.
The addition of e-commerce optimization services and managed application hosting services solution offerings introduced new products in our portfolio for which we do not have vendor-specific objective evidence (or "VSOE") of fair value. As a result, when we sell e-commerce optimization services and managed application hosting services in conjunction with e-commerce software, we defer all up-front fees, such as those for licenses, support and maintenance and professional services, received prior to the delivery of the managed application hosting services or e-commerce optimization services. We recognize these fees as revenue ratably over either the term of the contract or estimated life of the arrangement depending on the specific facts of the arrangement, commencing with the "go-live" date for providing the managed application hosting services or e-commerce optimization services. In addition, when professional services revenue is deferred in connection with these arrangements and other instances in which there are undelivered elements to a transaction for which we do not have VSOE of fair value, we defer the direct costs related to performing the professional services prior to delivery of the element related to these services. These amounts are recognized ratably to cost of revenue in the same manner as the related revenue.

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ART TECHNOLOGY GROUP, INC. In the longer term, we expect this transition to result in greater stability and predictability in our revenues, and a pattern of growth in our total GAAP revenue that is more reflective of our sales cycle. In the interim, however, the effect of this shift in our business model has been to adversely affect our near term revenue growth and earnings.
Key measures that we use to evaluate our performance:
The change to our business model has required our management to re-consider the measures that we use to evaluate our business results. In addition to the traditional measures of financial performance that are reflected in our results of operations determined in accordance with GAAP, we also monitor certain non-GAAP financial measures of the performance of our business. A "non-GAAP financial measure" is a numerical measure of a company's historical or future financial performance that excludes amounts that are included in the most directly comparable measure calculated and presented in the GAAP statement of operations. Among the GAAP and non-GAAP measures that we believe are most important in evaluating the performance of our business are the following:
• We use product license bookings, a non-GAAP financial measure, as an important measure of growth in demand for our ATG e-commerce platform and the success of our sales and marketing efforts. We define product license bookings as product license revenue as reported on our statement of operations plus the contract value of licenses executed and whose recognition was deferred in the current period less revenue that was recognized from license contracts executed and deferred in prior periods. We believe that this measure provides us with an indication of the amount of new software license business that our direct sales team has added in the period. Product license revenue associated with a particular transaction may be deferred for reasons other than the presence of a managed application hosting or e-commerce optimization services arrangement, such as the presence of credit risk or other contractual terms that, under GAAP, require us to defer the recognition of revenue. The deferred revenue for such a transaction may be recognized in a single future period when the conditions that originally required deferral have been resolved, rather than ratably. We include all additions to deferred product license revenue in our calculation of product license bookings.

• We use cash flow from operations as an indicator of the success of the business. Because a significant portion of our revenue is deferred in the near term, our net income may be significantly different from the cash that we generate from operations. Cash flow from operations is typically higher in the quarters following our seasonally stronger product license bookings quarters, which have historically been the fourth and second quarters.

• We use recurring services revenue, as reported in our statement of operations, to evaluate the success of our strategy to deliver site-independent online services and the growth of our ratable revenue sources. We expect that recurring services revenue will continue to increase as a percentage of total revenue in future periods. Recurring services revenue includes e-commerce optimization services, application hosting services and support and maintenance related to ATG e-commerce platform sales.

• We use revenue and gross margins on our various lines of business to measure our success at meeting cash and non-cash cost and expense targets in relation to revenue earned.

• We use days sales outstanding ("DSO"), calculated by dividing accounts receivable in the period by revenue and multiplying the result by the number of days in the period. We also use a modified DSO that adjusts our revenue by the change in deferred revenue during the period to provide us with a more accurate picture of the strength of our accounts receivables and related collection efforts. The percentage of accounts receivable that are less than 60 days old is an important factor that our management uses to understand the strength of our accounts receivable portfolio. This measure is important because a disproportionate percentage of our product license bookings often occurs late in the quarter, which has the effect of increasing our DSO and modified DSO.

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ART TECHNOLOGY GROUP, INC. Trends in On-Line Sales and our Business Set forth below is a discussion of recent developments in our industry that we believe offer us significant opportunities, present us with significant challenges, and have the potential to significantly influence our results of operations.
Trend in on-line sales. The growth of e-commerce as an important sales channel is the principal driver for demand for our products and services. According to Forrester Research and Gartner, e-commerce sales grew 21% to $175 billion in 2007 and they are projected to grow to $335 billion by 2012. Online holiday sales grew 19% in 2007, five times the rate of growth for offline stores. As online sales continue to outpace store growth and the importance of this channel grows, we believe that retailers require more sophisticated e-commerce optimization services in order to stay competitive on-line and increase conversion rates, order size and revenue.
E-commerce "replatforming." Enterprises periodically upgrade or replace the network and enterprise applications software and the related hardware systems that they use to run their e-commerce operations in order to take advantage of advances in computing power, system architectures and enterprise software functionality that enable them to increase the capabilities of their e-commerce systems while simplifying operation and maintenance of these systems and reducing their cost of ownership. In the e-commerce software industry, we refer to these major system upgrades or replacements as "replatforming." We believe that on average, customers in our market replatform or refresh their e-commerce software approximately every five years. In large part due to the increased significance of the on-line sales channel, industry analysts believe that e-commerce is currently in a period of increased replatforming activity, with increased corporate spending on e-commerce optimization services across many of our markets.
Emergence of the "on demand" model of Software as a Service. An important trend throughout the enterprise software industry in recent years has been the emergence of "Software as a Service," or SaaS. SaaS is a software delivery model whereby a software vendor that has developed a software application hosts and operates it for use by its customers over the Internet. The emergence of SaaS has been driven by customers' desire to reduce the costs of owning and operating critical applications software, while shifting the risks and burdens associated with operating and maintaining the software to the software vendor, enabling the customer to focus its resources on its core business.
Rapidly evolving and increasingly complex customer requirements. The market for e-commerce is constantly and rapidly evolving, as we and our competitors introduce new and enhanced products, retire older ones, and react to changes in Internet-related technology and customer demands. The market for e-commerce has seen diminishing product differentiators, increasing product commoditization and evolving industry standards. To succeed, we need to enhance our current products and develop new products on a timely basis to keep pace with market needs, satisfy the increasingly sophisticated requirements of customers and leverage strategic alliances with third parties in the e-commerce field who have complementary products.
International expansion. We have seen an increase in sales and pipeline growth in Europe and India. We seek to invest resources into further developing our reach internationally. In support of this initiative we have entered into partnership agreements abroad that will support our continued growth. As the international market opportunity continues to develop we will adjust our strategy.
Competitive trend. The market for online sales, marketing and customer service software is intensely competitive, subject to rapid technological change, and significantly affected by new product introductions by large competitors with significantly greater resources and installed customer bases. We expect competition to persist and intensify in the future. Recent Events
In early October 2008, we internally announced proactive steps to more efficiently align our cost structure with the uncertainties around fourth quarter IT spending resulting from changes to the macroeconomic environment that occurred during the third quarter of 2008. We have continued those steps into the fourth quarter. We expect the initiative will have the effect of lowering operating expenses for the foreseeable future but will not impact our ability to meet our revenue guidance as previously communicated. This initiative includes a "hiring pause" where all additional and replacement staffing will be evaluated on a selective basis, prioritized by direct revenue generation and critical function backfill. The project also limits other spending that is not directly related to customer, partner and investor activities.

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ART TECHNOLOGY GROUP, INC. Critical Accounting Policies and Estimates This management's discussion and analysis of financial condition and results of operations discusses our consolidated financial statements, which have been prepared in accordance with United States generally accepted accounting principles.
The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the 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. On an ongoing basis, management evaluates its estimates and judgments, including those related to revenue recognition, deferral of costs, the allowance for accounts receivable, research and development costs, the impairment of long-lived assets and goodwill, income taxes and assumptions for stock-based compensation. Management bases its estimates and judgments on historical experience, known trends or events and various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
We define our "critical accounting policies" as those that require us to make subjective estimates about matters that are uncertain and are likely to have a material impact on our financial condition and results of operations or that concern the specific manner in which we apply GAAP. Our estimates are based upon assumptions and judgments about matters that are highly uncertain at the time the accounting estimate is made and applied and require us to assess a range of potential outcomes.
For a description of the critical accounting policies that we consider to be both those most important to the portrayal of our financial condition and those that require the most subjective judgment, see our Annual report on Form 10-K for the year ended December 31, 2007, under the heading "Management's Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies and Estimates." As of the date of this report there has been no material change in any of the critical accounting policies and estimates described in that Annual Report on Form 10-K.

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ART TECHNOLOGY GROUP, INC. Results of Operations The following table sets forth statement of operations data as percentages of total revenue for the periods indicated: Three Months Ended Nine Months Ended September 30, September 30, 2008 2007 2008 2007 Revenue: Product licenses 26 % 22 % 27 % 21 % Recurring services 58 54 57 57 Professional and education services 16 24 16 22 Total revenue 100 100 100 100 Cost of Revenue: Product licenses 1 2 1 2 Recurring services 21 17 21 17 Professional and education services 16 21 17 21 Total cost of revenue 38 40 39 40 Gross profit 62 60 61 60 Operating Expenses: Research and development 19 18 18 19 Sales and marketing 30 33 31 34 General and administrative 12 12 12 13 Restructuring - 0 - 0 Total operating expenses 61 64 61 66 Income (loss) from operations 1 (4 ) 0 (6 ) Interest and other income, net 1 2 0 2 Income (loss) before provision for income taxes 2 (2 ) 0 (4 ) Provision (benefit) for income taxes (0 ) 0 0 0 Net income (loss) 2 % (2 %) 0 % (4 %)

The following table sets forth, for the periods indicated, the cost of product license revenue as a percentage of product license revenue and the cost of services revenue as a percentage of services revenue and the related gross margins:

Three Months Ended Nine Months Ended September 30, September 30, 2008 2007 2008 2007 Cost of product license revenue 5 % 7 % 4 % 8 % Gross margin on product license revenue 95 % 93 % 96 % 92 % Cost of recurring services revenue 37 % 32 % 38 % 30 % Gross margin on recurring services revenue 63 % 68 % 62 % 70 % Cost of professional and education services 97 % 88 % 101 % 95 % Gross margin on professional and education services 3 % 12 % (1 )% 5 %

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ART TECHNOLOGY GROUP, INC. Product license bookings Product license bookings is a non-GAAP term that we define as product license revenue as reported in our statement of operations plus the net change in deferred product license revenue during the period. We believe that this measure provides us with an indication of the amount of new business that our direct sales team has added in the period. The following table summarizes our product license bookings for the three and nine months ended September 30, 2008 and 2007: Three Months Ended September 30, Nine Months Ended September 30, 2008 2007 2008 2007 (in thousands) Product license bookings $ 9,485 $ 9,374 $ 36,626 $ 30,357 Product license bookings deferred (4,078 ) (2,146 ) (19,441 ) (10,495 ) Product license deferred revenue recognized 5,357 645 15,136 1,135 Product license revenue $ 10,764 $ 7,873 $ 32,321 $ 20,997

Product license bookings increased $0.1 million to $9.5 million in the three month periods ended September 30, 2008 from $9.4 million for the three months ended September 30, 2007. The lower than expected increase reflects the delay in the completion of the sales cycle on a few sales opportunities resulting from general concerns related to the global credit crisis that occurred during the end of the third quarter 2008. Product license bookings increased $6.2 million or 20% to $36.6 million in the nine month periods ended September 30, 2008 from $30.4 million for the nine months ended September 30, 2007, respectively. This increase reflects growth in the e-commerce market and the success of our sales and marketing initiatives partially offset by the impact of the global credit crisis during the third quarter of 2008.
Product license bookings deferred were 43% and 53% of our total product license bookings for the three and nine months ended September 30, 2008, respectively, compared to 23% and 35% for the three and nine months ended September 30, 2007, due to the inclusion of e-commerce optimization services, application hosting and other elements in our contracts. Deferred revenue will be recognized in future periods when delivery of the service occurs or as contractual requirements are met. During the three and nine months ended September 30, 2008 we recognized previously deferred revenue of $5.4 million and $15.1 million, respectively, compared to $0.6 million and $1.1 million for the three and nine months ended September 30, 2007.
Product license deferred revenue recognized of $5.4 million and $15.1 million in the three and nine months ended September 30, 2008 included approximately $2.4 million and $5.2 million, respectively, that was from ratably recognized revenue due to the change in our business model. The remainder related to resolution of contractual elements that precluded revenue recognition in prior periods.
We expect full year 2008 product license bookings to increase approximately 10% to 20% from 2007.

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ART TECHNOLOGY GROUP, INC. Three and Nine Months ended September 30, 2008 and 2007 Revenue Three Months Ended September 30, Nine Months Ended September 30, 2008 2007 2008 2007 (in thousands) Total revenue $ 40,794 $ 35,886 $ 119,244 $ 97,734

Total revenue increased $4.9 million or 14% to $40.8 million for the three months ended September 30, 2008 from $35.9 million for the three months ended September 30, 2007. Total revenue increased 22% to $119.2 million for the nine months ended September 30, 2008 from $97.7 million for the nine months ended September 30, 2007. Revenue is derived from (1) perpetual software licenses,
(2) recurring services, which is comprised of support and maintenance services, application hosting services, and e-commerce optimization services, and
(3) professional and education services. The increase in revenue for the three month period ended September 30, 2008 is primarily attributable to growth in recurring services revenue and product license revenue. Recurring services revenue increased $4.1 million, or 21%, for the three months ended September 30, 2008 and product license revenue grew $2.9 million, or 37%, for the three months ended September 30, 2008. The increase in revenue for the nine month period ended September 30, 2008 is primarily attributable to growth in the recurring services revenue and product license revenue. Recurring services revenue increased $12.0 million, or 22%, for the nine months ended September 30, 2008. Product license revenue grew $11.3 million, or 54%, for the nine months ended September 30, 2008. Revenue generated from international customers declined to $10.9 million, or 28%, of total revenues, and $34.2 million, or 29% of total revenue, for the three and nine months ended September 30, 2008, from $13.8 million, or 39% of total revenues, and $30.7 million, or 31% of total revenue, in the comparable prior year periods. No customer accounted for 10% or more of total revenue in the three and nine-month periods ended September 30, 2008 and 2007. We expect full year 2008 revenues in the range of $159 million to $162 million.

Product license revenue Three Months Ended September 30, Nine Months Ended September 30, 2008 2007 2008 2007 (dollars in thousands) Product license revenue $ 10,764 $ 7,873 $ 32,321 $ 20,997 As a percent of total revenue 26 % 22 % 27 % 21 %

Product license revenue increased 37% to $10.8 million for the three months . . .