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

Welcome to the Wells Fargo TMT Summit 2020. Your session will start momentarily. Please note, this session will be recorded.

Good morning, again, everyone. Thanks for sticking with us. This is day 2 of the Wells Fargo TMT Summit. I'm Michael Turrin with the software team. And up next, we have CFO of Tyler Technologies, Brian Miller. Thanks, Brian, for joining us here today. The company has been around for quite a long time. It's now more than $16 billion in market cap. But for any investors who are less familiar, you don't have to go all the way back to the beginning, but maybe we could start off with an overview of Tyler today and just the market that you serve in the state, local and extending into federal government software market.

Sure. Yes. As you said, we're an enterprise software company focused on the public sector market. So our vertical is public sector, but we view the public sector pretty broadly. We have, by far, the largest and broadest set of products that automate mission-critical, essential functions of government. We are a little north of $1 billion, $1.1 billion or so in revenues. As you said, $16 billion market cap. Our space is -- has historically been very fragmented, served by a lot of sort of niche providers or point solution providers. So we occupy sort of a unique space in the market in terms of having a broad set of products that work together and address multiple needs of governments. We've historically been primarily focused on local governments that today still makes up 80% to 85% of our business, cities, counties, school districts, local agencies. 10% to 15% of our business is with state governments, often providing systems to a state that are used at the local level but bought statewide, like a court system. And then about 5% federal. And most of that has come through a couple of acquisitions we've done in the last couple of years, primarily MicroPact, which has a significant presence in the federal space with its platform for managing business processes. So we -- as I said, we have the broadest product offering in the public sector space. But we, by no means, address every need of a public sector entity. So we have a lot of runway ahead to continue to expand our TAM, whether it's through acquisitions or internal builds.

That's a good segue. I think there are a couple of points that would be good to touch on. But maybe just starting with your definition of the market. I mean you mentioned more than $1 billion in scale, which is significant. But obviously, the market here is super far reaching too, both in number of use cases and just the number of government entities. So when you look at those penetration rates today and what the overall market opportunity looks like, can you help with just sizing in context of where you are versus where you could be heading?

Yes. According to Gartner, local governments and education spend a little less than $20 billion a year on application and vertical-specific software. So that kind of broadly defines the space that we're in. We think our current product set addresses maybe half of those needs. So we're probably addressing a $10 billion, $11 billion space, and so we have somewhere around 10% share. So we have a lot of space left to go in the market that we address today. But as I said, whether it's through acquisitions or our internal development, we look to continue to broaden our product offerings to address the gaps in the market that we don't serve today. That doesn't count state and federal. So those are both significant markets that we have a much smaller presence in today, but certainly look to grow our presence in both of those markets as well. So we're also about 98% domestic today. And we've been, I'd say, pretty opportunistic and pretty targeted about very specific international opportunities that we've gone after. But we do believe that a number of our products have international opportunities that down the road will be a bigger part of our business as well.

Okay. Okay. That's great. Obviously, a discussion that a number of us have been having with investors and with various executives in software was 2020 was an atypical year for all of us. For your end markets, in particular, I'm sure there were some puts and takes. I'm wondering if you can help summarize some of what you've seen. Were there any use cases that saw sort of a bigger push towards software and digital? Is that something that could be coming? And then if there were just headwinds to contextualize the past year as well. I think all of that is just useful in summarizing the year as it comes to an end.

Yes. And there are a lot of puts and takes there. So just to step back a little bit, when you talk about sort of the demand drivers for our business, I mean, generally, customers or prospects are looking at buying something or subscribing to something from us because they're replacing a system that's at end of life. And governments are different than the private sector. They're not profit motivated or ROI-driven. They don't have competition effectively. So they use systems -- they're not motivated to buy a new system for the same reasons that a private enterprise would. So they tend to use systems much longer than you would see in the private sector, really kind of until they're close to dying. Probably the average system we replace across the board is more than 20 years old, but we've replaced systems that are 40-plus years old. We're replacing, for example, today, the court system in Cook County, Illinois, second largest county in the country, and that was a 43-year-old system when we started the project. It will -- it's a 45-year-old system today. Mainframe COBOL, custom written decades ago. So that's generally kind of the impetus. They're not buying a system because they've got some extra money or because they -- I mean, they would like to be more efficient. They'd like to provide better service to the public. And in this environment, they'd like to be able to work remotely even if the courthouse is closed. But they're basically buying a new system because they feel like they have to. So the underlying demand isn't really driven so much by the economy or by budgets as by just that need to replace an essential system. They do sometimes have flexibility around the timing. They can say, I can get by another year with what I've got or I'm going to push this out a budget cycle. But rarely can they say, I'm just not going to do it or I'm going to wait 5 years. So I think what we're typically -- what we're mostly seeing this year is that processes that were underway pre-COVID had some delays. I'd say governments broadly were less prepared to work remotely than private sector. So there have been a lot of adapting they've had to do. So processes slowed, projects that were underway slowed until we shifted to remote delivery of pro services, sales processes slowed. But things that were kind of underway pre-COVID have now pretty much all back on track. I mean sales have moved forward. We had a really strong bookings quarter last quarter. We're effectively delivering services remotely. We've had hundreds of go-lives during the year, all kinds of things that have been done remotely that really a year ago we couldn't have imagined that we would be doing remotely. So from -- we're kind of back to business as usual from that standpoint. We've seen some revenues go away, mostly lower, no margin revenues. So billable travel is a significant sort of pass-through for us, and that's not happening this year. Services are down as a result of some of the delays, but our margins are up because the low-margin revenue has gone away. We're being more efficient about delivering services because we can do them remotely. Some of those things, I think, will be sustainable, not all of those. Health costs are lower. A lot of our sales and marketing, things are lower because we're not going to trade shows, and I expect that some of those will come back, maybe not all of them. So we've had a really strange year with significantly off in terms of revenues from our original guidance, but significantly above the margin expectations we had. And earnings -- at the end of the day, the EPS aren't that much off from what we expected, and we've had 2 quarters in a row of best cash flow ever. I do think that as we look forward though, we're seeing some slowdowns in terms of the number of RFPs that we've seen in the last quarter or so compared to last year. And that's kind of what we expect that there's going to be -- there are governments that have budget pressures that are -- don't have a lot of confidence in their current budgets and likely that some of those will sort of delay the start of new projects until they have more confidence in that. And that's more likely to affect us a few quarters down the road. But as I said, most projects move forward because they're a very high priority for the government. The other thing is we're about 70 -- pushing 75% recurring revenues today, either maintenance or subscriptions. And those are pretty rock solid. We have very, very low attrition, 1% to 2% attrition. We've got normal pricing increases, and those have continued to grow kind of in the mid-teens.

That was a very insightful answer. I think you're right when you said there are a lot there. But I think you touched on a number of things that are interesting. One thing that becomes pretty clear when you're talking about the replacement cycle and some of these systems that might be decades or many decades old in some instances, just domain expertise and the competitive advantage that you must have, it certainly seems like it would be hard to come out of that field and help solve those problems or trust someone who doesn't have the domain expertise that someone like Tyler does. So I'm wondering if you can talk more about just the benefits of domain expertise and scale that you're able to bring with all of these solutions packaged together as well.

Yes, that really is the core of our strength. And whether it's public safety or property taxes or ERP or Courts & Justice, in each of those areas, Tyler or predecessors to Tyler companies we've acquired had been in those businesses for decades. And we've developed this really, really deep understanding in each of these sort of functional areas of government, and it's reflected in our products as well as our people. About 40% of Tyler's employees have worked in the public sector at some point, so they bring a lot of that experience to Tyler. And it's reflected in our products, it's reflected in how we support those products, how we sell them and just everything in our DNA is tied to the public sector. And that's not necessarily the case with some of the competitors we have that might either be horizontal companies or start-ups or people that just haven't built up that depth of functionality. As you can imagine, our market moves kind of slowly. It's a nice, steady market, but it's hard to accelerate that replacement. So it's hard to create demand. But we think we're highly innovative in this space, and we're thinking ahead trying to anticipate needs that customers will have further down the road that they haven't thought of yet. And then we're doing a lot of work in terms of tying these systems together and creating these foundational elements that are common across all Tyler products so that we have a common payment engine and payment portal. We're able to expand our payments business. That we have common dashboards, that common security and the ID. So all these things that make it more valuable to have that next product and that next product come from Tyler and be integrated to your other solutions out of the box or integrated even to systems that are in other jurisdictions. So -- I mean, I think that is the real core strength of Tyler is the deep domain expertise, and it is hard to replicate that. You can build software. We have some competitors that are start-ups or venture capital-backed companies. But it does take a long time to really accumulate that and to really create the integration of products and have them truly work together in a way that creates value for our customers.

You mentioned it's a patient market, which makes sense, I think. And thinking through the growth drivers, you touched on pricing and the potential impacts there. I'm wondering how you think about the trade-offs between organic and inorganic growth of the product suite and product development as you use new products as a vector towards growth. You've done a number of acquisitions historically to take advantage of some of the things we've touched on. But when you're balancing or thinking through build versus buy, what's the general philosophy there?

Yes. We have kind of a pretty extensive and ongoing whitespace analysis where we constantly look at all of our products and where do we have products that are industry leaders like our court system, which has 55% market share and maybe 85% win rate. What do we need to invest in those products to maintain that leadership position. We've got other products that aren't industry leaders, where we haven't had the same investment. And what should we be doing to get those products to industry leadership positions, and that could be internal investment or it could be acquiring a product that brings us capabilities. And then we look at the areas where we don't have a presence at all, the gaps in our offerings. And we try to look at what the competitive landscape is, how closely those areas might touch other Tyler products, what the recurring revenue opportunities are and prioritize those. And then we look there at build versus buy. We look at who is in that space? Are there companies that would be good acquisition candidates? Or is there nobody there or nobody that can be acquired at a reasonable valuation and shift towards the build side. And I think a lot of that was helped drive the significant kind of 30% range growth in our R&D in both '18 and '19. Even though we've done several acquisitions, we also had a number of areas that we invested in as an alternative to buying things. Typically, when we buy someone, there's also some investment around that in terms of integrating products, maybe accelerating initiatives they've had. And we've seen that as well around our public safety product, around our Socrata data and analytics platform where we've made significant investments post acquisition. We're in a period where valuations generally are kind of high, and there's a lot of private equity money that has competed for a lot of deals. So we've seen a lot more PE activity in our space. That -- long term, that's not necessarily a bad thing. We tend to go at the market with different ways. We have different views of long-term investments in this space. And we generally feel pretty good where we're competing against PE-owned businesses, but they have created competition for acquisitions. I'd say we're in a pretty good space with our balance sheet. We've got no debt. We've got $725 million in cash on the balance sheet and really solid cash flow. So I expect we'll continue to be active, both from an M&A standpoint and investing at a really high level in internal development.

Okay. Okay. I mean another thing that becomes apparent when you describe the potential life cycle that customers have seen with previous systems, and you touched on this a little bit with attrition rate is pretty darn sticky once you get in there. There's a high, probability governments, like you said, are effectively monopolies, are making long decisions. And so I'm just wondering if you can talk more about how you think about the lifetime value of a customer and the margin profile. You've talked about longer-term margins of 35-plus percent. You mentioned that you've seen good margin uplift more recently from a few different phenomenon. But it certainly has to give you some comfort on the mature margin structure of this business. But I'd just be curious to hear more from the CFO side there.

Yes. We do believe there's a lot of margin runway ahead of us. Like I said, we took a step backwards from an operating margin perspective in 2018 and 2019, but that really was all related to R&D and what we viewed as really growth R&D. And so we expected as we came into 2020 that we would have flat -- pre-COVID that we would have flattish margins with 2019. And that would be kind of a major step towards getting back, say, in 2021 to that normal kind of 50 to 100 basis point annual margin expansion opportunity as we talk about going through kind of the mid- to upper 20s to the mid-30s and potentially beyond that in terms of an operating margin. We're ahead of that now because of all of those impacts that I talked about earlier. I think we likely take a little bit of a step backwards in 2021 from a margin perspective as some of those short-term things come back. So I think we'll still finish 2021 ahead of where we would have thought we would have finished it from a margin perspective pre-COVID and that we'll see expansion from there. The -- you're right. It's super sticky business in the government space. And part of it is governments don't go out of business and they don't get acquired. So some attrition from most companies is not their fault. It comes from M&A or people going out of business. That doesn't happen in our space. So we -- but we also think we're really good, and we provide a high level of not only good products but really great support. And we invest in those products and our customers get that whether they're an on-prem customer paying maintenance or a subscription customer. They get upgrades and new releases. And all of the investments we make in products, they get as part of their recurring revenue stream. So we think we should keep all of our customers forever. And our attrition really is kind of, call it, overall, 1% of the dollars, maybe a little more than that in terms of names, but it's very low. And as long as we continue to invest at a high level and provide a high level of service, we don't see why that changes. And so I think the other thing around the margins is we are in sort of a long transition from primarily a license business to primarily a subscription business. That has also moved kind of slowly over time because governments have been slower about moving to the cloud, but that's changing. We have shifted to a cloud-first approach and are actively promoting the cloud business more aggressively, and our customers are embracing the cloud more. So the mix is shifting. That's put some short-term pressure on both margins and growth. But our subscription revenues, our ARR growing at a really strong rate. And long term, that also will contribute to higher margins as well.

Okay. That's great. Is there anything else you can tell us just around where you are in the transition to cloud today? Any additional expectations for the pace of that? Appreciating that governments are somewhat unique in their tolerance or their willingness to change quickly.

Yes. We still have a mix. We still offer all of our core products in either a cloud or an on-prem offering for a lot of our core products that were originally designed to be deployed on-premises. The cloud model is a hosted model, single tenant. Each client has its own instance of the software, but it's in a Tyler data center as opposed to their own servers. 2019 was the first year that more than half of our new contract volume shows subscription. This year, in general, that has continued that trend towards a greater percentage. And we expect that, that will continue to accelerate, that more than half of our business and an increasing percentage of our new business will choose cloud. We've also added a number of transaction-based revenue streams like e-filing for the courts. We have a growing payments business that also kind of fall in that subscription line. So -- and I think governments -- not only are they just more -- broadly more willing to accept or embrace the cloud, but they -- it solves problems they have. They struggle with internal IT resources as their -- a lot of their employee base that's been around for a long time retires. They struggle to attract and pay market rates for highly skilled IT professionals. They face a lot of challenges around security and ransomware attacks and cybersecurity incidents. So they're, I think, less comfortable about their ability to continue to address security needs and look to the cloud as a way to address that. So all of those things, I think, add up to more of our customers moving to the cloud. Now our existing customer base is -- we've got about 23,000 on-premise installations, and we're a little shy of 4,000 cloud installations. So we still have this huge base that currently is on-prem that we expect that over a number of years will shift to the cloud. And that roughly doubles the revenues when they move to the cloud as opposed to being on-prem and paying maintenance. We entered into an extensive partnership with AWS about a year ago, and they're our primary public cloud partner now. We expect that most of -- that over time, most of our new customers will go into the AWS cloud as opposed to a Tyler data center, and we'll get out of the data center business. And that provides us with the capacity we need to migrate a large number of on-prem customers over time to the cloud and with a positive revenue and a positive margin impact.

That's excellent. It may be difficult for you to choose, but if I asked you to kind of pick 1 or 2 key areas that you think could become bigger initiatives from the product side, you mentioned MicroPact earlier, I'm looking at the data as a service opportunity as well. But I'm wondering what you're looking at, what the team might be more excited about or just views as kind of a slightly different new and exciting opportunity relative to the recent past?

Yes. I'd say right now, public safety is really strong for us, and again, that's something we acquired 5 years ago. We've invested in. And given kind of, again, that pace of both sales cycles and investment cycles, now we're seeing the benefit of that. And that's something we're really excited about, where we are competitively, what the growth opportunities looking forward are and the integration to our already strong Courts & Justice business. Going forward, yes, I think the 2 acquisitions that we've made a year -- in the last couple of years, MicroPact and Socrata, are both areas that we're really excited about. Socrata with the data and analytics capabilities, we're starting to see the benefits of the investments we've made in integrating those to our ERP, our public safety, our tax products to give us really strong competitive advantage around the analytics and transparency and making our systems more valuable because they provide an easier way for our customers to use data to make better decisions. And I think there's still a lot of runway there. And then MicroPact, we've -- our first year, 1.5 years in the federal space has been something we've been really happy with. They've got a great product and great partner network. And we look to really expand -- to use that as a base to expand in the federal and state markets beyond what we have today. So both of those areas we're investing in and that we're excited about. I'd say the third area is really payments. A lot of software companies are looking at ways they can be involved in payment cycles. And again, our customer base, I think we've got a lot of customers that don't have really good cohesive payment strategies and that we can make that much easier for them and participate in those. Right now, we do $30 million a year in payments revenues, mostly in traffic tickets and utility bills. But we believe that we can get involved in a lot more payment streams with a lot more of our customers and provide them with solutions that provide value to them and provide nice revenue growth for us.

That's great. I mean that sounds like a lot to work on. I think we're coming up on time here. So I'm going to leave it at that. Brian, I think this was great. Certainly insightful. Appreciate you spending time with us here virtually, not in Las Vegas, but certainly appreciate the time, regardless. Thank you.

I appreciate the opportunity to be here. Thank you.

Yes. Take care. Thanks all.