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

Okay. Well hey, good morning, everyone, and welcome to day 2 of the Barclays TMT Conference. My name is Saket Kalia. I cover software here at Barclays. Very happy to have with us Brian Miller, Executive Vice President and Chief Financial Officer of Tyler Technologies. We've got about 30 minutes together today. Maybe just to frame it out a bit, maybe what we'll do is we'll take the first 15 or 20 minutes for some fireside chat with me and Brian. And then would love to make this interactive. [Operator Instructions] So with maybe all that as a preamble, Brian, thanks so much for taking the time with us today.

Yes, absolutely. Thanks for having me here.

Yes, absolutely. Brian, maybe just to start out for those of us here that may not be familiar with Tyler just yet, can you just give us a little bit of background on the company? And as CFO, of course, I mean maybe some of the points from last quarter that you were particularly proud of financially.

Yes, sure. Yes, at a high level, Tyler is an enterprise software company focused on the public sector vertical market. So we exclusively serve the public sector. Historically, that has mostly been local governments, so cities, counties, school districts, local agencies. In recent years, particularly through acquisitions, we've expanded a little bit more into the state and starting to dip our toe into the federal markets as well. While we're focused exclusively on the local on the government market, we're very broad in terms of breadth of products. We supply to governments. And the size and scope of governments that we serve, we would be the largest company solely focused on software for the public sector. Products include things like property tech systems, courts, public safety, 911, police, fire ambulance, land records, licensing and permitting, school administration; so a wide range of sort of products that automate essential functions of government. We recently back in April closed the largest acquisition in the company's history, and I'm sure we'll talk a little bit more about acquisition of NIC, which gave us a much bigger presence in the state government, but particularly through more of a transaction model rather than software, providing digital access to state government systems and facilitating payments there. We'll be -- I guess our run rate will be about 1.8 billion in revenues and significant cash flow. We've had a long string of significant growth, double-digit CAGR over the last 15 years. And last quarter, I'd say the biggest accomplishment was it's the first full quarter with NIC. We had a really strong bookings quarter, both on the Tyler and NIC side. So really a nice indication that the markets that we serve are returning to normal after some pauses during COVID. And a really good first quarter, first full quarter with NIC in our results. They performed at a high level, as did Tyler. So we feel like we're getting close to back to normal.

That's great to hear. That's great to hear. And just to the point on the breadth of your portfolio, it is staggering, just the different functions that you hit within state and local government. And maybe just building on that, I guess Brian, is in the public sector software market, again given the breadth of your product portfolio, the size of your customer base, I think that one of the things that the team has said is that Tyler has maybe only 5% market share. And so maybe you could just talk to us a little bit about, right, despite just under 2 billion in revenue run rate, maybe you can talk to us a little bit about the market dynamics here and how you think about sort of the size of Tyler's TAM?

Yes. Obviously, it's a really big vertical market. Government's obviously A big sector of the economy. Historically, this has been or continues to be a very fragmented market. Historically served, at least especially at the local level but really at all levels of the government, by a wide range of providers and typically a lot of sort of point solution providers, companies that often are very narrowly focused from a product perspective and often narrowly focused from a geographic perspective. And those kinds of companies, a lot of the systems currently being used came from those kinds of companies. So a company, for example, that just does court systems in California or property tax systems in New York and New Jersey. Tyler's strategy, that we embarked on 25 years ago but still is our strategy, is really to be a national and ultimately international provider of really all of the, or most of the, essential systems that governments use. And so initially through acquisitions and then more so through organic growth, we have accumulated this broad portfolio that really no one else has anything close to it. Most of our competitors just compete with us in one of our subverticals, maybe 2 sometimes, but there's no one with the breadth of portfolios that we have. So when we look at the market size, it's hard to -- you can kind of size the entire government IT market, but we don't really address everything. If you think about local governments and education that Gartner says that they spend about $25 billion a year on application and vertical-specific software. We think we provide somewhere around half of --- we compete in about half of that market in terms of the products we have. So we have maybe a 10% penetration in the part of the market that we serve. And then that doesn't really count state and federal. Those are both larger markets that we're newer in and that we have a smaller set of products to address. So we would -- it would be disingenuous to count all of the state and federal IT markets, but it's clear that these markets have a lot of opportunity for us. In government, these systems turn over very slowly. So governments are very different from the way they look at software and acquire software and use it. Governments don't have competition. They're not profit motivated obviously. And so they buy software because they have to. They use it until it just about dies. And so replacement cycles are much longer. The typical system we replace probably is 20-plus years old. So again, there's a small segment of the market that's turning over each year. It does create a very steady market, as you can see from Tyler's results over the years, and an opportunity. It's never explosive, but it provides a very steady market that doesn't go backwards. And there are still the majority of the systems being used today are from vendors that would not be competitive in the market today or homegrown systems that are increasingly difficult to maintain. So we continue to expand our TAM and grow the market through both higher win rates. So even though we may have 10% of the markets that we serve today, our win rates are typically north of 50%. So with our major products, we're typically winning more of the new deals than all of our competitors put together. And then we broaden our portfolio through both acquisitions and R&D. So we continue to expand our TAM by addressing more of that 50% of the TAM that we don't have solutions for today.

Yes, absolutely. I tell you, I was wondering about whether I agreed with the point about governments being profit motivated when I thought about my real estate tax bill. But very helpful. Very, very helpful.

Interesting because local governments, when we talk about the backdrop and the environment, for local governments, generally the biggest revenue source is property taxes. And often, it's more than half of the city or state a city or a county budget and school districts as well. And as you know, property values are relatively high. Property taxes are not under a lot of pressure. So they have generally had a much more stable or even positive budget backdrop than one might think coming out of COVID.

No, that's actually a really interesting point. I want to segue a little bit into the SaaS transition here that's been happening at Tyler. You mentioned this earlier as well. I mean governments are often slow to move, particularly to the cloud, right, for various reasons. But maybe you can walk us through why some governments state and local governments are -- rather just say, local governments are making that switch now, and maybe what Tyler is doing to encourage that as you shift to sort of a cloud-first approach in your engagements. Does that make sense?

Yes, absolutely. And we have had a shift in our approach in the last couple of years. Historically, well going way back, we were a license business, a traditional license on-prem installations with a significant maintenance stream. And I guess going back almost 20 years or so, we started offering a hosted model, systems hosted in the Tyler data centers paid for in a subscription, so sort of the early cloud or Tyler private cloud. And -- but we've always been up, until a couple of years ago, kind of cloud neutral or cloud agnostic. We let customers decide the pace at which they wanted to embrace the cloud. And that has been slower for the public sector than the private sector. And so there was a very gradual transition over a number of years as more of our new customers chose the cloud without us really pushing them there. And then in the last 2 or 3 years, a couple of things have happened. One, the market has started to embrace the cloud more rapidly. 2019 was the first year that more than half of our new contract value came to us in a subscription model. And last quarter, it was 75%. So it took 18 years to get to 50%, and then 75% in 2 years. Tyler also has shifted to where we have a strong preference for the cloud over the life of the customer, significantly more revenues, better margins. And so to sort of move towards that cloud-first approach, we entered into a partnership with AWS a couple of years ago. So they are now our primary cloud public cloud provider. We want to get out of the data center business and ultimately migrate existing customers out of our 2 data centers into AWS, and that's starting to be underway, and put new customers in mostly in the AWS environment. We've also done things like changing our sales compensation. So sales reps have an incentive or an added incentive to sell customers into the cloud. And an increasing number of Tyler products are only available to new customers in the cloud as well. So while I said 75% of our new customers are now choosing the cloud; in our existing customer base over our entire installed base, it's still very heavily weighted towards on-prem. We have about 23,000 on-prem installations and about between 4,000 and 5,000 that are in the cloud today. So we still have a long way to go with conversions, but most of the new customers are coming into the cloud now. We also have development projects underway to optimize our products to be deployed most efficiently in AWS, whereas historically, our products were really architected to be deployed on-prem. So they're not super efficient in the cloud. And we don't really get all the benefits. We have multiple versions of the same software. We don't upgrade everyone at the same time. And those will be changing over the next couple of years as we finish this cloud optimization product. So we expect that to be -- to give us better margins in the cloud and really to enable us to be more aggressive about migrating the existing on-prem base into the cloud and significantly increasing the revenues that we get from that customer base.

Yes, yes, absolutely.

But let me add one thing. You asked about what was motivating governments to make that change now. I'd say there's a couple of things. One, there's as it's become much more prevalent in the private sector. As a lot of aging workforce, particularly in IT, retires and moves out of the public sector, they're being replaced by the next generation, which is much more open to or has more experience in the cloud. The other thing is governments really struggle with managing that infrastructure. As you can imagine, it's a very competitive market for these highly skilled tech people, whether it's a systems administrator, database administrator, a security person. And governments find it increasingly difficult to attract those people, retain those people, pay market rates for those people. So even if they want to keep systems in-house, it's more and more difficult for them to do so. And cybersecurity is an increasing concern as well. And customers may feel more comfortable with maybe the public cloud capabilities around that than their internal ones might be. So all those are sort of factors that are helping push the market in that direction.

Yes, absolutely. I want to touch on the infrastructure, your point here because I think it's interesting. How much -- I know you talked about on-prem customers versus cloud customers, right? But I guess how do you think about bringing the cloud customers -- could be in a Tyler data center or an AWS data center. But how do you think about how much, if you've disclosed, how much of the customer base is on AWS versus your own data centers? And what does that migration look like to get more of that base on to AWS, which is it sounds like where you want to go?

Yes, absolutely. Today, it's still a pretty small fraction of our cloud customers. Of those 4,000 to 5,000 customers, it's a pretty small fraction, in the hundreds that are currently in AWS. Some products today, all the new customers are going into AWS; others -- and that's with most of our products. Others, we have started to migrate customers out. But we really over the past year or so, we've been running what we call Project Lighthouse, but it's really sort of a running test cases or pilot customers. We have a lot of products. So we're running pilots with live customers with each product to make sure we understand how that move into AWS works, what are the nuances around each product, what are the costs, and sort of proving out that each of those products works effectively in the AWS environment. And so we've been going through that over the last year or so or largely through with that. And that's sort of one of the gating items for us to start to be more aggressive about the moves. The other thing is the what I talked about the product optimization, so making the products more efficient. In some cases, it's rewriting products in the cloud-native architecture. In other cases, it's more of a tweak or an extensive tweak of some of the architectures. So that really enables us to be more efficient as we move those clients into the cloud. We said we expect by the end of 2023 for all of our major products to be optimized for deployment in AWS. And as we get there with each product that really is -- enables us to start to be more aggressive. But I think it's really a couple of years before we start a big push to get those on-prem customers over into AWS, that those ones that are currently in Tyler data centers. Until we get there, we have some duplicate costs, because there are some fixed costs around running our 2 data centers and we've got costs in AWS as well. So there's a little bit of margin pressure in the short term, a big opportunity on margins as we move them over and grow that revenue stream.

Yes, definitely. I'm going to come back to that point on gross margins in a little bit. But maybe just to make sure we shift on to other topics as well, I'd love to talk about NIC, right? Again to your point earlier, Brian, I mean Tyler's largest acquisition to date. Can you just maybe give us an overview of mix revenue model? You touched on this a little bit earlier, but also the rationale, the strategic rationale to the acquisition

Yes. NIC is a great company on its own. It's been public for a long time. It was a little bit under the radar in terms of their visibility with Wall Street. But really well-run company, incredibly compatible culture with Tyler's, both of us with all of our roots in serving government. But very complementary, not much overlap. On one hand, we do different things for government, and we generally focus on different levels of government. So while Tyler provides all the back-end software systems that run these essential functions, NIC really provides the digital front end for government, and mostly for state governments. So Tyler is about 85% local, 10% or 12% state, less than 5% federal. NIC is about 95% of their revenues are from state government arrangements and about 5% federal and almost no local. So NIC provides -- doesn't provide, for the most part, the back-end software. They have a handful of software applications. But they're really mostly facilitate -- providing the state website and then the interfaces to all of these back-end systems, so that people can access information or conduct business with a state government So NIC provides the portal services that allow that to happen. So think of when you're renewing your driver's license or your motor vehicle registration, or getting a hunting and fishing license, or applying for unemployment insurance, anything you would do with the state government would go through the NIC portal. NIC builds those interfaces. They generally are also processing the payment associated with that, if there is one. So there's a payment processing aspect to it as well. And it's a self-funding model. So they're not getting -- in general, they're not getting a payment from the government. The users are funding these portals through user fees. So you might pay your fee of your -- your auto license plates might be $70. And then you pay a $3 convenience charge that goes to NIC, and that's what funds all of these. They also get a significant amount of revenues from driver history records, providing access to the state records for insurance companies to set rates. And the state allows NIC to charge for that, which again helps provide the funds to fund these portals. They have a significant payment processing business that's sort of embedded in those transactions. So it's all a transaction model, and 95% recurring revenues. So we're very complementary in terms of the things we do together. We think there are significant cross-selling opportunities going in both directions, selling NIC payment services into Tyler's local government base, and selling Tyler's software products into NIC's state government base, leveraging those relationships. They have very broad contracts with -- there's 26 state enterprise contracts that enable -- that allow software to be sold in under those contracts. So we think in many cases, we can sort of get an earlier look, get in sooner, and often potentially bypass a full-blown competitive process and sell software under the existing NIC arrangements.

Yes, absolutely. I mean the way that I think about it is kind of a double benefit here, right? I mean NIC enables you to hit that other 50% of the TAM, or at least part of that other 50% of the TAM, by selling to state governments; but then also bringing a front-end capability that you can sell to that broad kind of local government presence that Tyler has.

Yes. Customer relationship in the -- these really long-term local government relationships and customer base where NIC really didn't have those relationships in these sales organizations. And it's the same going other way. We haven't had that, that historical presence in state governments. We don't have those relationships, although we got a lot of products that could apply to those markets. So right now we're in the -- these first few month the integration has really been around the go to market and the sales integration, and a lot of education for both sides NIC understanding the breadth of the Tyler's products and what our strengths are, and what we can potentially sell in under their arrangements. And us understanding all of their contracts, initiatives in each of their states, the priorities for the governors and the CIOs and seeing where Tyler's offerings match up with those. And we're starting to -- kind of largely through that process, and now we're starting to really go after opportunities. I think on our last call, we said there's about 40 active opportunities in the pipeline that we've identified already. But we think that's just the very, very beginning, and so now we're working together to start to surface those and pursue those.

Absolutely. I'd love to shift over to profitability here a little bit, and maybe starting with gross margins because you touched on that a little bit earlier. I think gross margins here, right, vertical SaaS company, right, kind of different customer options in terms of deployment. I think the gross margins here have been sort of in the 50% range. The question maybe for you, Brian, is how do you think about that as the mix of SaaS here increases and the mix of software licenses here decreases?

Yes. We think both on the gross margin and operating line -- operating margin line, we have a significant runway of continued growth there. The SaaS business is more profitable. Revenues roughly double from a SaaS customer versus an on-prem customer, not counting the license that we forgo up front. But the recurring revenues, the subscription is roughly 2x the maintenance. And given the very, very long-term nature of our relationships, our attrition on the software side is typically 1% to 2%. So very, very low. So over the life of the customer, it effectively is 2x the revenues. We have the hosting costs but as -- that there's a lot of leverage in that model. And as we work through this transition, which has sort of been a headwind both to revenue growth and margins over a long period of time, sort of a gradual headwind. But as that shift to now, the majority of our new customers come in through the cloud. And as we get through this transition and some of these duplicate costs and some of the investments in the product optimization, on the other side of this, we should be back on that longer-term margin trajectory. We think taking operating margins, for example, from kind of the mid- to -- in the mid-20s right now, we think there's an opportunity to take that into the mid- 30s over time. We do also have a -- there's couple of things that affect particularly our gross margin. We have a significant -- fairly significant services business. So we do most of the implementation, training, data conversion, professional services around our software with our own teams. And that's a very low-margin business. We do that so we can get to that recurring revenue stream in an effective manner, have projects that are on time and on budget. But we don't make much money on that, and so we look to continue to reduce the mix of services in engagement and deploy software with fewer services. And certainly we're able to do that through the cloud more effectively. And also, we expense a significant amount of our development expense and cost of sales. About half of our total development expenses on the R&D line, and about half of it is up in cost of sales and gross margin. Because we invest a lot in existing products that customers get through a subscription or a maintenance agreement. And so that's in cost of sales. So when you look at our margins, compared to maybe some other software companies that might have all of that down on the R&D line, the split looks a little different. Our R&D looks a little low and our cost -- our gross margins look low, but it's really just the geography where a lot of those costs fall.

Yes. That makes a lot of sense. So maybe in that sense, the operating line is really the best gauge of the profitability of the business. That makes a lot of sense. Brian, maybe just to wrap up here, just I've always got more questions from my management teams than time that I've got. But I think you said earlier, I mean -- I think Tyler said that about 2/3 of the systems used by local governments in the U.S. are legacy or outdated, whatever word you want to use. And so with that in mind, how do you sort of think about -- how do you and the team sort of think about the purchasing environment going into next year? What has the team -- What have you heard from your sales teams about just customers' overall willingness to spend in 2022? open ended.

yes, it's solid right now. Yes, the -- as I said, we certainly saw pauses during COVID, both because governments were trying to adapt to work from home and have other priorities in the short term, public health, public safety. And so a lot of buying processes didn't go away but they were stalled, particularly in 2020. We've seen those -- that activity return. We've said RFPs are generally at or above pre-COVID levels now. So there's some pent-up activity there. The budget backdrop I touched on a little bit earlier, but it's pretty good. The impacts of COVID on government budgets weren't nearly as bad as they feared. And now we haven't touched on the stimulus, but there's this massive stimulus coming. So the federal government is providing $350 billion of direct aid to state and local governments, another $167 billion for schools. And they've got until the end of 2024 to spend that. We think very little of that has been committed or spent yet, but we do think a meaningful amount will be spent on IT infrastructure and systems upgrades, and particularly as they've had more and more issues with these aging systems that haven't functioned effectively in a remote environment. So we think the backdrop is pretty good, but there are a number of tailwinds that will play out over, again over the next, call it, 3 or 4 years, not necessarily the next quarter or 2.

Of course.

But we're starting to see more activity come back, and we feel like there's some really good tailwinds and also that Tyler's in a uniquely exceptional position to take advantage of that in terms of our presence in the market, our competitive position and the investments we continue to make.

Absolutely. It sounds like a great place to be selling into right now. So well again, Brian, so many more questions than we've got time for, but maybe with that, I'll just -- really appreciate you making the time to be with us here today. Really enjoyed it. I'm sure the investors online did as well. Look forward to having you back here next year and continuing the process. So thank you so much, Brian, again.

Thank you.

Alrighty. Enjoy the rest of the day.