PROS provides big data software applications that are designed to help companies outperform in their markets by using big data to sell more effectively. We apply 27 years of data science experience to unlock buying patterns and preferences within transaction data to reveal which opportunities are most likely to close, which offers are most likely to sell and which prices are most likely to win. PROS offers big data software applications to analyze, execute, and optimize sales, pricing, quoting, rebates and revenue management. We also provide professional services to implement our software applications as well as business consulting. Since inception, PROS has completed over 600 implementations of our solutions, across more than 30 industries in more than 50 countries.

Opportunities, trends and uncertainties
We have noted opportunities, trends and uncertainties that we believe are particularly significant to understand our financial results and condition.

• Growth opportunities. We believe the market for our big data software application is underpenetrated. Market interest for our software has increased over the past several years providing us with growth opportunities. We have and will continue to invest in our business to more effectively address these opportunities through significant investment in professional services, research and development, sales, marketing and back office. In addition to organic growth, we may acquire companies or technologies that can contribute to the strategic, operational and financial growth of our business. We expect to continue to explore both organic and other strategic growth opportunities.

• Uncertain global economic conditions. The current global economic conditions have been challenging in recent years, and continue to be somewhat uncertain. The uncertain economic conditions have had and may have a negative impact on the adoption of big data software and may increase the volatility in our business. Due to the uncertain economic conditions, we continue to experience long sales cycles, increased scrutiny on purchasing decisions and overall cautiousness taken by customers. In addition, certain foreign countries are still facing significant economic and political crises and it is possible that these crises could result in economic deterioration in the markets in which we operate. We believe our solutions provide value to our customers during periods of economic growth as well as in recessions, but it is uncertain the extent to which the current uncertain economic conditions will further affect our business.

• Variability in revenue. Our revenue recognition policy provides visibility into a significant portion of our revenue in the near-term quarters, although the actual timing of revenue recognition varies based on the nature and requirements of our contracts. For the majority of our arrangements, we have not historically recognized license revenue upon customer contract signature and software delivery. We evaluate our contract terms and conditions as well as our implementation performance obligations in making our revenue recognition determination for each contract. Our contractual performance obligations in the future may differ from historical periods impacting the timing of the recognition of revenue. For example, growth in our term license and SaaS service offerings may result in the deferral of revenue over the contractual term, whereas growth in perpetual license arrangements that meet the criteria for separation may result in the recognition of license revenue on delivery, provided revenue recognition criteria are met. Our revenue could also vary based on our customer mix and customer geographic location. We sell our software solutions to customers in the manufacturing, distribution, services and travel industries. From a geographical standpoint, approximately 56%, 64% and 60% of our consolidated revenues were derived from customers outside the United States for each of the years ended December 31, 2012, 2011 and 2010, respectively. Our contracts with customers outside the United States are predominately denominated in U.S. dollars. The economic and political environments around the world could change our concentration of revenue within industries and across geographies.

• Income taxes. For the year ended December 31, 2012, our effective income tax rate was 38% as compared to the federal rate of 34%. Our effective tax rate is higher than the federal rate due to nondeductible share based compensation expense and the impact of the nonrenewal of the Research and Experimentation ("R&E") tax credit in 2012, partially offset by a favorable return-to-provision adjustment attributable to higher than expected 2011 R&E tax credits recorded in 2012. In January 2013, Congress passed the American Taxpayer Relief Act of 2012 which, among other things, made the R&E tax credit retroactive to January 1, 2012 and extended the R&E tax credit until December 31, 2013. As a result of the retroactive reinstatement of the R&E tax credit, the full benefit of the 2012 R&E tax credit will be recorded in the first quarter of 2013.

Discussion of consolidated financial information Revenue
Our revenue is derived from the licensing of software solutions, associated software maintenance and support, and implementation and consulting services. To a lesser extent, our revenue includes nonsoftware related hosting and cloud services. Our arrangements with customers typically include: (a) license fees paid for the use of our solutions either in perpetuity or over a specified term and implementation fees for configuration, implementation and training services and (b) maintenance and support fees related to technical support and software updates.
License and implementation revenue. We derive the majority of our license and implementation revenue from the sale of perpetual licenses and related implementation services. We evaluate the nature and scope of implementation services for each arrangement and have concluded that, generally, our implementation services are essential to our customers' usability of our licensed software solutions, and therefore, we recognize revenue from these perpetual software license and related implementation services together as the services are performed using the percentage-of-completion method provided other revenue recognition criteria have been met. We also recognize revenue associated with billable expenses when the expenses are billed.
Our contractual arrangements typically include implementation services to configure and implement our solutions to meet the integration and process needs of our customers. We have historically recognized revenue from the majority of our software sales on a percentage-of-completion basis, which has provided visibility into a significant portion of our revenue in the near-term quarters, although the actual timing of recognition of revenue on these types of arrangements will vary based on the nature and requirements of our contracts. Under percentage-of-completion method of accounting, our revenue recognition generally begins when efforts are expended during the implementation, which helps alleviate pressure to enter into license agreements at the end of any particular quarter as we are typically not able to recognize the corresponding revenue during the period in which the agreement is signed except to the extent we provide implementation services during the period. As a result of our revenue recognition policy, revenue from license arrangements is generally recognized over the implementation period, which typically ranges from four to fifteen months.
The percentage-of-completion computation is measured by the percentage of man-days expended on an implementation during the reporting period as a percentage of the total man-days estimated to be necessary to complete the software implementation. We measure performance under the percentage-of-completion method using the total man-day method based on current estimates of man-days to complete the software implementation. Management believes that for each such software implementation, man-days expended in proportion to total estimated man-days at completion represents the most reliable and meaningful measure for determining a software implementation's progress toward completion. In addition, under our fixed-fee software implementation arrangements, should a loss be anticipated on a contract, the full amount is recorded when the loss is determinable. See Critical accounting policies and estimates for additional information regarding revenue recognition. We also license software under term license agreements that typically include maintenance and support during the contractual license term. Our term license agreements typically range from two to five years. Revenue and the associated costs are deferred until the delivery of the licensed solution and recognized ratably over the remaining contractual license term. Revenue from term license agreements, which are included in license and implementation revenue in the Consolidated Statements of Comprehensive Income, represented 4.8%, 5.8%, and 2.3% of total revenue for the years ended December 31, 2012, 2011 and 2010, respectively.
For arrangements that include hosting services we allocate the arrangement consideration between the hosting service and other elements and recognize the hosting fee ratably beginning on the date the customer commences use of our services and continuing through the end of the contractual term. Revenue from hosting services, which is included in license and implementation revenue in the Consolidated Statements of Comprehensive Income, represented 2.6%, 2.3% and 0.5% of total revenue for the years ended December 31, 2012, 2011 and 2010, respectively.
Maintenance and support revenue. We generate maintenance and support revenue from the sale of maintenance and support services on our software solutions. Our maintenance and support arrangements are sold with terms generally ranging from one to two years. Maintenance and support fees are invoiced to our customers either monthly, quarterly or on an annual basis. Maintenance and support revenue includes customer support and the right to unspecified software updates and enhancements on a when and if available basis. Approximately 97% of the maintenance and support arrangements by our customers were renewed for the years ended December 31, 2012 and 2011.

Cost of revenue
Cost of license and implementation revenue. Cost of license and implementation revenue includes those costs related to the implementation of our solutions, principally (a) personnel costs, which include our employees and third party contractors, (b) billable and nonbillable travel, lodging and other out-of-pocket expenses, (c) hosting and cloud-related expenses and (d) an allocation of depreciation, facilities and IT support costs and other costs incurred in providing implementation services to our customers. License and implementation costs may vary from quarter to quarter depending on a number of factors, including the amount of implementation services required to deploy our solutions.
Cost of maintenance and support revenue. Cost of maintenance and support consists largely of personnel related expenses and an allocation of depreciation, facilities and IT support costs and other costs incurred in providing support and services to our customers. Operating expenses
Selling, marketing, general and administrative. Selling, marketing, general and administrative expenses principally consist of (a) personnel costs, which include our employees and third party contractors and sales commissions related to selling, marketing and administrative personnel, (b) sales and marketing programs such as lead generation programs, company awareness programs, conferences, hosting and participation in industry trade shows, and other sales and marketing programs, (c) travel and other out-of-pocket expenses,
(d) accounting, legal and other professional fees and (e) an allocation of depreciation, facilities and IT support costs and other costs.

Research and development. Research and development expenses principally consist of (a) personnel costs, which include our employees and third party contractors, comprised of software developers, scientists and product managers working on enhancements of existing solutions, the development of new solutions, scientific research, quality assurance and testing and (b) an allocation of depreciation, facilities and IT support costs and other costs. Income taxes
We are subject to income taxes in the United States and abroad, and we use estimates in determining our provision for income taxes. We estimate separately our deferred tax assets, related valuation allowances, current tax liabilities and deferred tax liabilities. At December 31, 2012, our deferred tax assets consisted primarily of temporary differences related to noncash share based compensation. We assess the likelihood that deferred tax assets will be realized and we recognize a valuation allowance if it is more likely than not that some portion of the deferred tax assets will not be realized. This assessment requires judgment as to the likelihood and amounts of future taxable income. Although we believe that our tax estimates are reasonable, the ultimate tax determination involves significant judgment that is subject to audit by tax authorities in the ordinary course of business.
We record our deferred tax assets and liabilities at an amount based upon a U.S. federal income tax rate of 34% and appropriate statutory tax rates of various state and local jurisdictions in which we operate. If our tax rates change in the future, we may adjust our deferred tax assets and liabilities to an amount reflecting those income tax rates. Any change will affect the provision for income taxes during the period that the determination is made.
Our effective tax rate was 38% and 26% for the years ended December 31, 2012 and 2011, respectively, and a tax benefit of 54% for the year ended December 31, 2010. Our federal effective tax rate historically has been lower than the federal rate of 34% largely due to the application of general business tax credits. In January 2013, Congress passed the American Taxpayer Relief Act of 2012 which, among other things, made the R&E tax credit retroactive to January 1, 2012 and extended the R&E tax credit until December 31, 2013. As a result of the retroactive reinstatement of the R&E tax credit, the full benefit of the 2012 R&E tax credit will be recorded in the first quarter of 2013. Deferred revenue and unbilled receivables For our license and implementation service fees, we invoice and are paid based upon contractual payment schedules in each customer arrangement which may include payments linked to contractual milestones. We record as deferred revenue any invoices that have been issued before implementation services have been performed and before the corresponding license and implementation revenue is recognized. We record as unbilled receivables any recognized license and implementation revenue in excess of the amount invoiced to the customer. We generally invoice for our maintenance and support services on a monthly, quarterly or annual basis through the maintenance and support period. Deferred revenue does not reflect the total contract value of our customer arrangements at any point in time as we only record deferred revenue as amounts are invoiced in advance of the

performance of implementation services. As a result, there is little correlation between the timing of our revenue recognition, the timing of our invoicing and the amount of deferred revenue.
Results of operations
Comparison of year ended December 31, 2012 with year ended December 31, 2011 Revenue:

                                              For the Year Ended December 31,
                            2012                                      2011
(Dollars in                                As a percentage of                     As a percentage of
thousands)                 Amount             total revenue          Amount          total revenue         Variance $       Variance %
License and
implementation       $     77,656                   66 %          $   62,975               65 %          $     14,681            23 %
Maintenance and
support                    40,135                   34 %              33,664               35 %                 6,471            19 %
Total                $    117,791                  100 %          $   96,639              100 %          $     21,152            22 %

License and implementation. License and implementation revenue increased $14.7 million to $77.7 million for the year ended December 31, 2012 from $63.0 million for the year ended December 31, 2011, representing a 23% increase. The increase in license and implementation revenue was principally the result of a 23% increase in the number of implementations from 108 to 133, which increased the number of man-days expended by 15% and a 7% increase in the average revenue recognized per man-day as compared to the corresponding period of 2011.

License and implementation revenue includes revenue from both term licenses and hosting services. Revenue from term licenses represented approximately 4.8% and 5.8% of total revenue for the year ended December 31, 2012 and 2011, respectively. Revenue from hosting services represented approximately 2.6% and 2.3% of total revenue for the year ended December 31, 2012 and 2011, respectively.
Maintenance and support. Maintenance and support revenue increased $6.5 million to $40.1 million for the year ended December 31, 2012 from $33.7 million for the year ended December 31, 2011, representing a 19% increase. The increase in maintenance and support revenue was principally the result of an increase in the number of customers for which we are providing maintenance and support services. Total Revenue. Total revenue increased $21.2 million to $117.8 million for the year ended December 31, 2012 from $96.6 million for the year ended December 31, 2011, representing a 22% increase. Revenue from the manufacturing, distribution and services ("MDS") industries increased $19.0 million to $66.2 million for the year ended December 31, 2012 from $47.1 million for the year ended December 31, 2011 representing a 40% increase. The increase in MDS revenue was due to an increase in demand from our business-to-business ("B2B") customers. Revenue from Travel increased $2.1 million to $51.6 million for the year ended December 31, 2012 from $49.5 million for the year ended December 31, 2011 representing a 4% increase.

Cost of revenue and gross profit:

                                          For the Year Ended December 31,
                                    2012                                   2011
                                       As a percentage                       As a percentage
(Dollars in                              of related                            of related
thousands)              Amount             revenue             Amount            revenue            Variance $       Variance %
Cost of license and
implementation      $     25,830             33 %           $   19,627             31 %           $      6,203            32 %
Cost of maintenance
and support                7,955             20 %                6,675             20 %                  1,280            19 %
Total cost of
revenue             $     33,785             29 %           $   26,302             27 %           $      7,483            28 %
Gross profit        $     84,006             71 %           $   70,337             73 %           $     13,669            19 %

Cost of license and implementation. Cost of license and implementation revenue increased $6.2 million to $25.8 million for the year ended December 31, 2012 from $19.6 million for the year ended December 31, 2011, representing a 32% increase. The increase in cost of license and implementation revenue was principally attributable to an increase of $4.5 million of personnel costs. Personnel costs, which include our employees and third party contractors, increased primarily as a result of an increase in headcount needed to support the increased number of active and anticipated implementations. Included in the increase in personnel costs is an increase of $0.2 million of noncash share based compensation expense. In addition, there was an increase of $0.8 million of travel expenses due to the increase in the number of implementations, an increase of $0.7 million in expenses related to hosting and our cloud-based service offerings and an increase of $0.2 million of third party recruiting expenses.
License and implementation gross margins were 67% for the year ended December 31, 2012 compared with 69% for the year ended December 31, 2011. The decrease in the license and implementation gross margin was principally the result of a 32% increase in license and implementation costs due to the increase in the level of implementations in 2012 compared to 2011. License and implementation gross margins may vary from period to period depending on different factors, including the amount of implementation services required to deploy our solutions relative to the total contract price and additional headcount needed to support anticipated future implementations.

Cost of maintenance and support. Cost of maintenance and support revenue increased $1.3 million to $8.0 million for the year ended December 31, 2012 from $6.7 million for the year ended December 31, 2011, representing a 19% increase. The cost of providing maintenance and support services consists largely of personnel related expenses. The increase in cost of maintenance was principally attributable to an increase of $1.0 million of personnel costs associated with the continued growth in our customer maintenance and support function commensurate with maintenance and support revenue growth. Maintenance and support gross margins were 80% for both the year ended December 31, 2012 and 2011.
Gross profit. Gross profit increased $13.7 million to $84.0 million for the year ended December 31, 2012 from $70.3 million for the year ended December 31, 2011, representing a 19% increase. The increase in overall gross profit was principally attributable to a 22% increase in total revenue. Operating expenses:

                                      For the Year Ended December 31,
                                  2012                               2011
(Dollars in                          As a percentage                   As a percentage
thousands)              Amount       of total revenue      Amount      of total revenue     Variance $       Variance %
Selling, marketing,
general and
administrative      $     48,215             41 %       $   35,891             37 %       $     12,324            34 %
Research and
development               27,611             23 %           25,671             27 %              1,940             8 %
Total operating
expenses            $     75,826             64 %       $   61,562             64 %       $     14,264            23 %

Selling, marketing, general and administrative expenses. Selling, marketing, general and administrative expenses increased $12.3 million to $48.2 million for the year ended December 31, 2012 from $35.9 million for the year ended December 31, 2011, representing a 34% increase. The increase was principally attributable to an increase of $9.9 million in sales, marketing, general and administrative personnel costs as a result of an increase in headcount to support our current and future growth objectives and higher commission expenses resulting from higher revenue levels. Included in the increase in personnel costs is an increase

of $2.2 million of noncash share based compensation. In addition, there were increases of $1.1 million of travel expenses primarily a result of increased sales activity, $1.0 million of third party professional fees, $0.9 million of overhead and other expenses and $0.3 million in third party recruiting expenses. These increases were partially offset by a $0.7 million decrease in sales and marketing expenses resulting from decreases in certain marketing initiatives and a $0.3 million decrease in bad debt expense.
Research and development expenses. Research and development expenses increased $1.9 million to $27.6 million for the year ended December 31, 2012 from $25.7 million for the year ended December 31, 2011, representing a 8% increase. The increase in research and development expenses was principally attributable to an increase of $3.9 million in personnel costs as a result of increased headcount to support work on new projects and initiatives, offset by $2.0 million of personnel costs that were capitalized related to the development of our cloud-based service offerings. Included in the increase in personnel costs is an increase of $0.3 million of noncash share based compensation. Other (expense) income, net:

                                          For the Year Ended December 31,
                                     2012                                   2011
(Dollars in                          As a percentage of                    As a percentage of
thousands)             Amount          total revenue          Amount         total revenue         Variance $       Variance %
Other (expense)
income, net             (163 )               -  %               (141 )             -  %                   22             -  %

Other (expense) income, net. Other (expense) income, net consists of interest expense which includes debt issuance cost amortization on the $50 million revolving credit facility ("Revolver) we entered into with Wells Fargo in July 2012, foreign currency exchange gains and losses on transactions denominated in currencies other than the functional currency and interest income on our cash and cash equivalents. The increase in the expense was principally attributed to $0.1 million of interest expense from the Revolver, partially offset by decreases in foreign currency losses in 2012.

Income tax provision:

                          For the Year Ended
                             December 31,
(Dollars in thousands)     2012         2011       Variance $      Variance %
Effective tax rate            38 %         26 %            n/a         12 %

Income tax provision. Our income tax provision increased $0.8 million to $3.1 million for the year ended December 31, 2012 from $2.3 million for the year ended December 31, 2011. Our effective tax rates were 38% and 26% for the years ended December 31, 2012 and 2011, respectively. The increase in our effective tax rate relative to federal tax rate for the year ended December 31, 2012 is due to nondeductible share based compensation expense and the impact of the nonrenewal of the R&E tax credit in 2012, partially offset by a favorable return-to-provision adjustment attributable to higher than expected 2011 R&E tax credits recorded in 2012. The effective tax rate of 26% in 2011 was lower than the federal tax rate due to the application of R&E tax credits, which expired at the end of 2011.

Comparison of year ended December 31, 2011 with year ended December 31, 2010 Revenue:

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