Tyler Technologies, Inc. (TYL) Earnings Call Transcript & Summary

Welcome, everybody, to my fireside chat with Brian Miller, CFO of Tyler Technologies. My name is Alex Zukin, equity research analyst, covering software for RBC. Brian, thank you for being here. And I know neither one of us is happy to do this virtually. We've done this too many times over the years in a physical setting. But nevertheless, we're going to do a good job here.

Okay. Good to be here, even virtually.

Brian, one of the main questions I get is, what is the general health of state and local government budgets today? Do we yet know what these budgets might look like next year with or without material federal stimulus?

The second part, I don't think we know what they may look like next year. As you know, we primarily serve local governments, although it's probably 80% to 85% of our business, about 5% federal and 10% to 15% state. And each of those different levels of government have very different budget sources and revenue streams, but primarily focused on local governments where property taxes are generally the biggest revenue stream and often more than half of their budgets. And that is a pretty stable revenue stream. But certainly, there are a lot of other revenue sources that have been impacted by the pandemic, whether it's licensing, permitting or sales taxes or court fees. And there's just a lot of uncertainty rather because we really don't know how long it will last and we don't know when normal volumes will come back. And there's also questions around uncertainties around some of their expenses, where they've had very unusual expenses dealing with the pandemic. So there's, I'd say, a lot of uncertainty around budgets, even those that have gone into play with the July 1 budget year or October 1 budget year or those that will go into place January 1. So it's clear they're impacted. It's clear there are pressures that are very unusual, but it's not clear how long they will last. And it's not clear what additional federal stimulus may be coming to help them deal with that. The first round, the CARES Act, had a significant amount of funding for state and local government, mostly focused on dealing with direct impact of COVID-19, and most of it focused on larger counties and cities. There's a pretty clear expectation that there will be additional significant stimulus. I know McConnell, I think, the week before last since the election, has said he thinks it's important to get additional stimulus passed before the end of the year. I saw presentations from the Goldman Sachs analyst last week that indicated that he thought there would be -- if the Republican told the Senate that there'd be around $1 trillion of additional stimulus and that if the Democrats control both houses that it's likely to be above $2 trillion. Embedded in that stimulus, there is expected to be a significant amount of funding specifically for state and local government IT upgrades. So there's a bipartisan proposal that I think has been out there since August that would provide $28 billion to I think, state and local government IT modernization plan. So kind of right up our alley. And it would provide $28 billion over a 5- year period to specifically upgrade state and local government IT systems. There has been a very clear understanding that there's significant weaknesses in the systems that governments are using. Not a surprise to us, but a lot of that has become very apparent as unemployment systems, for example, have tried to deal with increased volumes. And a lot of these systems have tried to accommodate remote work and not done so successfully.

Brian, maybe just remind us also, when you think about the core Tyler value proposition, the core competitive differentiation in the market right now, and then I want to follow-up with what has been the impact of COVID on the business, how many points of growth has it shaved off, do you think, this year?

Yes. Well, the core value proposition is that we're -- generally, we're replacing -- at the core, we're replacing an aging system that is reaching end of life. And in the public sector, where our clients are not ROI-driven, they're not profit-motivated, they don't have competition effectively, and they tend to resist change. So they use systems much, much longer than you'd see systems replaced in the private sector and really until they get to end of life. And so when they get to that point, it could be because it runs on an aging hardware platform that has to be replaced. It could be that it's the mainframe system from the '70s that they don't have Cobol programmers around anymore to keep the system running. It could be that the system is no longer supported by a legacy vendor. So when it gets to that point, it tends to be a somewhat nondiscretionary decision to replace that system. These are all mission-critical applications, things like property taxes, courts, jail, 911, payroll. So the underlying demand tends to be very consistent and not really affected by the economic conditions, the broader macroeconomic situation, because they get to that point that it needs to be replaced. It's not driven by them having some extra money or just wanting something a little nicer. What we do find is we put back at our experience during the recession 10 years ago that they certainly -- that some governments would be able to put it off for a little while is that I really need to replace the system. I was going to do it this year, but I'm going to have to get by another year. Rarely are they able to say, I'm just not going to do it or I can get by another 5 years. So we would expect that we'll see some processes delayed until there's a little more clarity around the budget or until things somewhat return to normal or -- and so it just gets to the point where they absolutely have to replace it. We do believe that there will likely be some acceleration of replacement of systems as a result of the environment that come about because of COVID, primarily remote work, where a lot of these systems just are not structured to enable remote work efficiently, where you've got court that can't hold trials because the system doesn't accommodate remote work. It's a mainframe that only works if you're at a terminal tied to the mainframe in the court. So we have a virtual court offering that helps address that. And -- but I do think that some of these systems will, over the next, I don't know, call it, 2 to 5 years will be replaced more rapidly than they would have because of some of these loss that have been exposed. And for us, the impact of COVID on revenue is really -- we came into this year, we had -- and through the early part of the first quarter, we were on track, we have low double-digit organic growth, kind of on the high end of the targets we've set. We now expect that, that growth will be closer to 3% for the year, still growing. We -- the second quarter, we didn't -- with the first quarter and I think I don't know, 12 years or something that we didn't have growth, but back on -- at least in the growth mode in Q3. Most of the revenues that have gone away are low or no margin revenues. Things like billable travel, which is about a $20 million revenue stream growth in a year. Our user conference, which was around $6 million of no margin revenues. And some professional services that have been pushed out because of delays in projects. So as a result, even though our growth is much lower, our margins have actually expanded.

And so then, the follow-up question to that is, obviously, we're -- this has been dubbed the vaccine conference, given it's the same week as a number comes right after a few announcements on the vaccine front. How do you see a potential for a vaccine to impact your demand in calendar '21? And is it -- if you look back at that, going back to double-digit growth scenario, do you need -- is it possible to see it in '21? Or do we really need to wait until the following year?

I think it's probably more likely to be in the following year. Where we sit today, again, we haven't given guidance for next year, we haven't finished our planning process for next year. But we'd expect that we're going to -- our growth would be better than it was this year, but not all the way back to sort of what a normal year would be, what our targets would be more in the very high single digits or low double digits. So I guess somewhere in the 5% to 7% range with what we'd be looking at with what we know today. I think the combination -- to the extent there's a vaccine that return things to normal more rapidly and give customers, our customers, more confidence around their fiscal situation that -- and to the extent that it's more stimulus as well, but both of those would positively impact it and sort of get processes moving again. But given the length of our sales cycles, which often for just a normal midsize deal, may be 1 year or longer, that there's likely to be a bit of a ramp-up period. And we'd expect -- from where we sit today, we'd expect it probably would be something would impact 2021 -- or 2022 to a greater extent.

Well, let's walk through that a little bit. Let's walk through that a little bit, right? Because if you look at the last recession, you talk about a delaying sales cycles because people could sweat their situation for an additional year. With this -- have you seen those dynamics, the conversations that you're having with these state and local municipalities, the pain that they're feeling as a result of an inability to function in the current environment. Is there -- and you talked about an acceleration in digital transformation. In an environment where there is a vaccine, there is incremental stimulus and there is a real pain point that has been held through the crisis, what does that new sales -- potentially sales cycle look like? Is there a faster shift to the cloud? Is there a faster sales cycle that was consummated? Is there more dollars that is now set aside for these systems versus in prior period, so the actual proportion of the budget allocated is changing? How do you see -- walk through that picture? I know it's not reality today. But I do think that it is important just to understand this is a different crisis, and therefore, you can have a really kind of a different outcome because you're well positioned on the outset or on the follow through.

Yes, I think that's true. And we haven't had -- our management team was here through the recession, and we've been through other difficult economic situations before, but this one is a little bit different, being precipitated by the pandemic. I do think, as I said earlier, that there will be some acceleration of digital transformation and more funds over the long term allocated to critical software systems and some of those systems are replaced sooner. But if the core government still move relatively slowly and they still have processes to go through to allocate the funds and simply go through one or often extended procurement processes. So even if those things take place a little faster, it's still a long process. And so we would expect that, that -- and then that's what we saw in the recession, that deals were pushed out, the pipeline remains very active and very full, just slowed down the sales cycle. And then on the recovery side, in 2000 -- the year 2010 was our worst year. 2011, we went back to kind of, I think, 7% growth. And then 2012, I think we had 17% growth and a lot of the pent-up demand really kind of came back into the market. That sort of cycle could be maybe a little more compressed because of the nature of this situation. But there still, I think, is some sort of a ramp-up time. So maybe it doesn't go down as much, maybe the processes and people are able to reengage sooner and issue new RFPs faster. But I still think you're looking at -- in our space, kind of long cycles. From a competitive standpoint, though, we think that we're -- as we were in 2010, but to a much greater extent, we're really well positioned that -- to sort of ride it out and to continue to -- especially to continue to invest at a high level. We have significantly increased our R&D over the last 2 years, sort of growing into that new R&D level but still growing R&D, I think, 9% this year. And we're not cutting back on any initiatives. We've got an incredibly strong balance sheet, a lot of cash, a lot of resources. We didn't lay off a person, we actually continued to hire through this year, although at a bit slower pace, particularly on the development side. And so we're moving ahead full steam, particularly with investments around our cloud transformation. And so we would expect that -- we believe that not all of our competitors are in that same position and are able to continue to invest at a high level. So when we look at a year, 2 years, 3 years down the road, when there is a potential acceleration of demand, we think we're going to be competitively positioned better than most to be able to take advantage of that.

What area -- so I want to get to margins in a second. But what areas -- you mentioned this potential for increased or accelerated digital transformation, maybe some pent-up demand kind of resulting from this crisis. You're not a typical company where, okay, now I need to go hire a bunch of reps ahead of that to fulfill that. But what -- is there anything -- is there any area that you do see yourself increasing hiring in to take advantage of that demand curve inflection potential next year? And then we'll probably talk about margins. This year, you saw margin leverage obviously benefited from some of the elements you discussed, but there does seem to be structural changes that could be tailwinds for margin over the next few years coming out of this as well.

Yes. I think the biggest there, it's really across all of our product areas where we're investing is in the ongoing sort of cloud transformation and not moving from a really a cloud-neutral approach where we've offered products in both the on-prem traditional license and maintenance model as well as through the cloud, through our hosted model. And we've really -- going back 1 year ago, as we entered into a significant partnership with AWS signal to shift to a cloud-first approach and are investing significant funds and hiring around accelerating that transformation of our products to optimize them to be more efficiently deployed in the cloud, as well as partnering with AWS to increasingly host our -- or host our client systems in the AWS cloud as opposed to our own data centers. From a margin perspective, we've talked about, going back to the increase in R&D, we historically said that if we're growing kind of in the -- around 10%, that we should be getting 50 to 100 basis points a year of operating margin expansion. And that's what we've historically done over a long period of time. We took a step back from that in 2018 and 2019 with 30% -- increases in R&D in the 30% range, and we expect virtually all of our R&D. So that pulled down margins a bit. But we believe that those were important long-term investments and stepping back a bit from our traditional margin expansion profile was the appropriate thing to do. Coming into 2020, pre-COVID, we expected that we've started to grow into this new level of R&D. We looked to have a strong growth here in the low double-digit, a lot of that increased investment was around the acquisitions we made in 2018 and 2019 and some of that was now behind us. And so we expect it to have kind of flattish margins in 2020 and to be back on that margin expansion trajectory in 2021. As I said, we've lost a lot of low and no margin revenues. So that had a positive impact on our margin profile. And I think last quarter, we were up about 300 basis points year-over-year. For the year, I think the year is going to kind of fall out where we're going to see up -- somewhere around, call it, 125 basis points of operating margin. So we're going to be finished this year ahead of where we thought we would finish 2021, probably more like where we would have been in 2022. I think some of that we give back next year, because I think some of those -- we expect that we will have some travel come back. We expect that -- for example, some of these really unusual onetime savings, health claims have been significantly lower during this year. That's not a permanent basis. But we do expect that we will -- because of some of the changes in our business, we will have a margin tailwind, particularly around how we deliver professional services and then shifted to doing those remotely. We expect that a large portion of those services that used to be delivered on-site will be delivered remotely with greater efficiencies and eliminating a lot of that travel time. So I would think that as we go into next year, it's going to be difficult to expand margins from where we are today. We likely will take a little bit of a step back from where we finished this year. But I think when we finish 2021, we'll still be ahead of where we would have finished 2021 pre-COVID, if that makes sense. So -- and then likely, as we move forward from there, that we get back on this kind of 50 to 100 basis point year trajectory that is sort of our normal target.

Got it. A question from the forum. Is Tyler taking market share or losing? What percent of the market has Tyler penetrated, and what products are performing the best and worst?

Generally, we're taking market share. So our win rates are certainly part of the reason that we, historically, over a long period of time, have above market growth rate, that our win rates are higher than our competitors in general. Now we have different competition across each of our product areas. One of our strengths, certainly is the breadth of our product offering, which is broader than anyone we compete with. So we have different competitors in each product area. But generally, we're going to be -- in our core products, we're going to be the leader in those markets and generally continuing to gain market share. A lot of the existing systems that are in place are some vendors who are no longer competitive in the market, not necessarily out of business but people who had a significant market presence, 10 or 15 or 20 years ago, didn't invest in the next-generation of technology sales or R&D and have become effectively legacy providers. They're still in business, still collecting maintenance. They don't have products that anyone would buy in the market today. We certainly have good viable competitors in each of our product areas. We don't have any monopoly, but in some of our areas, particularly Courts & Justice, it's probably our most dominant product. We have the case management, which is the hub of the courts. We have about a 55% market share and about an 85% win rate. In ERP, a bit more broad set of competition where we compete with horizontal players. We probably have about a -- maybe among the mid-teens market share but win rate typically north of 50%, in the 50% to 60% range. So the systems turnover, we're winning a large portion of those. Public Safety is, I'd say, maybe one of our strongest products today. It's the market we got into 5 years ago on the at exactly 5 years ago through the acquisition of New World Systems and it made really significant investments over that last 5 years. We have significantly broadened the TAM that we address in the public safety market, now able to compete at the upper end of the market where we previously were really focused on the mid-market. We're having a lot of success that we're starting to show this year. I think that we said on our call a couple of weeks ago that our average deal size and public safety is up 94% over last year. We've won Tier 1 awards like Jacksonville, Florida, the largest city in Florida. So really effectively competing there. I'd say that's not an area that we would expect to continue to be growing above Tyler's average growth rate. But it really does illustrate the patience you need to have, the pace at which this market moves, the length of the development cycles, the length of the sales cycles and how you have to continue to make these investments to get to this point. So it's not a real SaaS process, but being focused on it, we've been able to produce that success. So generally, I think across the board...