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

Hopefully less virtual, more physical in the coming years. But I am extremely pleased to be joined by Brian Miller from Tyler Technologies. I think Brian is one of the longest if not the longest tenured CFO in the NASDAQ at this point and one of the first companies I ever covered as a research analyst. So Brian, thank you so much for being here.

Great. It's great to be here. I can't even remember which firm you were at but it's great to be here with you at Wolfe.

Hopefully, 5 years from now, you'll never remember I ever worked anywhere else. So guys, look, you'll hear this as a consistent message across the day today. We've got a lot of firesides, and we're going to spend every minute of it wisely. We're going to ask every company 3 to 4 questions where appropriate, they are the same so that we can basically have like an impromptu real-time survey for you all to evaluate the health of these businesses across the board. And I've -- with that in mind and also as I always do in firesides, I do ask for audience participation. If you have a question, put it in the forum, just remember, we will -- the company will know who's asking the question because there are records of such things. So ask wisely, and I will ask it in the context of the fireside.

The first question, as I will -- you see -- as you will see, I will ask during the day is how is the current demand environment, Brian, what's the right way to think about it?

Our demand environment is really pretty strong. We exclusively serve the public sector. So we're in a very big, but a narrow vertical. And the public sector is really doing pretty well right now. The economic backdrop, their budget backdrops are pretty strong. The impacts of COVID, I think over the last couple of years were not as severe as they might have feared at the beginning of 2020. So a lot of projects that paused in the, I guess, early days of COVID because of those uncertainties, because they were focused on other higher priorities and because they had concerns around budgets have pretty much back on track. And we've said over the last few quarters that the indicators of demand and activity in the market, the number of RFPs we're seeing, which did drop during 2020 pretty significantly, has continued to rebound the number of sales demos we're doing, the pipeline. All those things are at or above pre-COVID levels at this point and continuing to strengthen. Local government budgets or government budgets, but particularly local governments, which make up most of our customer base are pretty solid. Their biggest revenue stream is property taxes. And most places, certainly, San Francisco is one of them, property values continue to be pretty strong. And so there's not a lot of pressure on property taxes. And then we've got the American Rescue Plan Act, which has -- is providing $350 billion of aid to state and local governments, another $167 billion of aid to schools, and they've got until the end of 2024 to spend that. So we haven't seen a lot of that spending yet, but we think it's certainly a tailwind over the next 2 to 3 years that will help push the market along.

Perfect. The second question I'm asking everybody is, how would you characterize the demand environment pre-COVID? How did COVID affect your demand environment and as you're coming out of it, which you've seemingly addressed in the first answer, what should we expect over the next 12 months from either a headwind or a tailwind?

Yes. So pre-COVID, it was pretty good. So we think back to what our guidance was going into 2020 for those -- that month or so before -- between the time we gave guidance in February and the world changed in March. We were -- we've typically talked about organic growth in sort of the 8% to 10% range. And we were certainly on the high end of that. I think the midpoint of our guidance was maybe 10.5%, something like that. So we were expecting a pretty strong year going into the year. As I said, there were a lot of -- the demand didn't go away. People were generally buying something from us because they sort of have to because they have an old system that they've used maybe for decades, that's at end of life. But they were able to put off things. And so we saw those delays. We saw, as I said, activity drop in the market, but the demand was still there, but things slowed down. We had to shift to doing things remotely. And so all that put together, we grew about 2% in 2020, which we still grew. That, as we said over the last several quarters, has been continuing to return to normal. And as we come out of COVID, I think we're -- the activity in the market is really good. There's some pent-up demand. And I think the other thing that really we think provides us a lot of optimism over the next 2 or 3 years in terms of the market is that as a result of the challenges the government saw during COVID, much like the private sector saw, having to shift to remote work, I think governments in a lot of cases were less prepared than the private sector and encountered a lot of trouble. And I think systems that they thought were old, but had a lot of -- still had life left in them, still were viable for 5 or 10 years into the future, didn't work remotely. You have a mainframe court system that was written in COBOL 40 years ago that only works if the users are at their desks in the courthouse. And when that wasn't possible, the courts really could barely operate. So we have solutions that help facilitate that. And I think you're seeing governments increasingly rethink how soon they might need to replace some of these systems. And so even though the sales cycles are long, I think we expect to see some pull forward of business as a result of governments thinking about different priorities and different needs and flaws that were exposed in some of these systems.

Got it. The next question is, how should we think about the puts and takes on your business in either more -- well, in both, to be honest, a more recessionary potential environment and an inflationary environment? And are there times in history, you guys have been around for multiple cycles. Any points in history that you would refer us to as a guide point?

Yes. It's -- we've seen recessions before, and we think back to kind of 2008 to 2010 in that timeframe, most of our leadership team was around at Tyler then. As I said, generally, demand is pretty stable. Our demand, it's hard to accelerate it, but it stays very consistent because there's this constant replacement of very old systems, much older than the private sector would use a system. So probably the average system we replace is 20 years old. Some of them literally are 40 or more. And so when it gets to the point that it needs to be replaced, it's kind of a nondiscretionary decision, although they can delay it sometimes, not delay it for 5 or 10 years, but delay it for a year or something. This seems to be a little bit different because the backdrop for governments is really pretty solid right now. Inflation doesn't -- has not typically had a major impact on us. I think our shift, which I'm sure we'll talk about a little bit later, our shift to the cloud makes that a little bit easier than when governments had -- would face a big capital outlay to replace a major system. And now with it being a pro rata subscription type payment, it's a little bit easier for them. So we don't really see a significant impact in this current economic environment. I would say one of the things, as we look back over the last couple of years, which is consistent with what we saw in 2008 and '10 is that we've had the ability, because of our financial strength and our balance sheet and our still record cash flow last year, to be able to continue to invest through down cycles. So we didn't lay off anybody doing COVID, we continued all of our investments, especially our investment in the cloud transition. We've continued to spend on R&D. We did 5 acquisitions last year. So we've continued to move the company forward. Not all of our competitors, especially some of the smaller ones have been able to do that. And so we think we've continued to widen the competitive gap. And that's what we saw in 2008 and '10. As we came out of the recession that we had significantly improved our competitive position, and we saw win rates increase. We saw some competitors that had been sort of on the fringe of viability become not much of a factor anymore. And we certainly feel really good about our competitive position now.

Got it. Maybe just one on that topic. You mentioned property taxes, obviously, or funding vehicle. Is there -- how long would it take if there was an impact on property values caused by a recession for you guys to actually see it in a budget that would impact you?

Yes, like a lot of things in government, it's slow. It's definitely not immediate. In a lot of jurisdictions, they revalue properties every 5 years or every 6 years. So kind of going in both directions, there's a lag. They tend to revalue them upward faster than they revalue them downward. And there's really kind of 2 pieces of the equation. There's the value and there's the tax rate. And within limits, in most cases, they can raise the tax rate if the values go down. So they kind of solve for a number. It seems like often when the values go up, the rate doesn't go down at the same rate, but there is a lag. And so going in both directions.

Got it. Before we go to the topic du jour of cloud, the fourth question I ask, I'm going to ask everybody today is what do you feel, given your dialogue with investors, that's pretty consistent and constant, is the most misunderstood aspect of the Tyler story today?

I think there's probably -- we've had a lot of moving parts in our business over the last couple of years, particularly with the acquisition of NIC, which was the largest acquisition in our history last year, which opened some new markets to us, has provided some new types of transaction-based revenue streams for us. But it's changing our margin profile a little bit. There's -- it's just more stuff to learn about us. I think people are still gaining an understanding of what those opportunities are for us, how the 2 companies fit together. And we certainly believe there are really significant cross-sell opportunities and sort of a one plus one equals something much bigger than 2 aspects to the story. But I think people are still learning that, and we've been talking about that a lot. And we've also had a very long cloud transition over a number of years, but it's clearly accelerated in the last couple of years. And so we're trying to give more clarity around what that means for our model. I think we talked about some of the margin impacts in the short term in the next couple of years and what we're doing in terms of accelerating that transition. But we're looking forward to giving more clarity as we move through this year in terms of what our kind of 3- to 5-year outlook is and what our sort of vision of the ultimate model is.

So let's talk about the -- from a not understanding the margin, the incremental complexity that NIC brought to the business, what's the best way you framed it -- framed that answer for investors in terms of what it does to the business, both from a gross margin, operating margin perspective and layering in a pretty meaningful transactional component. You've always had transactional revenue, but obviously not to the degree and scale that you have it. Is it a growth accelerator, that 8% to 10% that you've historically commented on, is that higher over the course of the next few years ex the cloud transition?

Yes. Yes. So NIC has -- so just a little bit of background about NIC if people aren't familiar with it, it was a public company. Actually, the first time we've ever acquired a public company. But I think they were a little bit under the radar. They only had a couple of analysts that followed them, Alex didn't follow them. So they didn't -- have quite the same visibility their business -- whereas we really provide all these essential back-office systems that run essential functions of government. We're more focused on the back end with the software. NIC was more of a -- really provides the digital gateway to government or provides the digital front end. So they provide the websites, the interfaces to all of these back-end systems, mostly at the state level. So they have 30 state enterprise-level contracts. And so they'll provide the interface to facilitate either access information or transacting business with state governments. Think about renewing your driver's license or your motor vehicle registration, getting a hunting and fishing license, applying for an unemployment claim, those kinds of things. So they create those interfaces if there's a transaction, they process that transaction and generally, they're processing the payment as well. So they have a pretty significant payment processing business and a very robust platform around government payments. So they're mostly transactional. They get a fee. If you renew your driver's license, you might pay a $3 fee or a $5 fee that goes to NIC that helps fund all of these digital gateways. So particularly around the payments business, their margins have historically been, I wouldn't say, drastically lower than ours, but a few points lower than ours, particularly where they have, in most instances, the accounting for the payments is on a gross basis. So they have the fee they get, but they pay the interchange and credit card fees out of that. So it tends to be high volume and lower margin on it. They do have some software applications, 3 or 4, mostly in outdoor recreation, cannabis regulation, prescription drug monitoring. So it's a pretty small part of their business, but growing and we expect to grow that further. And I see historically, their, what they call, same-state growth or basically, once they get a state, how those revenues in that state grow is around 8% a year over the last decade. So kind of think of that as their organic growth rate. So it'd be within the range of ours, but on the lower end. And so a little bit lower growth, a little bit lower margin. We think both of those things can accelerate within Tyler. We think there's some opportunities for efficiencies around how they do things maybe differently across different states and certainly some software tools that we can use to help them standardize how they provide these services to states. The biggest thing is around cross-selling. We think they're cross-selling opportunities going both ways. The opportunity to sell Tyler products that have applicability at the state level, but where Tyler hasn't had those relationships with the sales organizations. Tyler is about 85% local government, 10% or 12% state, 3% or 4% federal. NIC is about 95% state and about 5% federal. So we're looking to leverage those relationships that they're deeply embedded with these state CIOs, agency heads and to sell more Tyler software products under these NIC master agreements. And then going the other way, we've had an initiative to expand our payments processing or our participation in payment processing for our local government customers. And NIC brings us the platform, the expertise, we bring the customers and the relationships. So we've got a very active plan to push NIC payment processing down into the local government level. So both of those things should increase growth for the combined companies and help bring margins up for the combined companies as well.

Got it. I'll take a quick pause just to remind people, don't be shy, ask some questions in the forum. I will close with them if you ask them. With that, I would say, Brian, let's talk about the, not the tough question, but the question is you always give guidance for the full year, you update your annual guidance quarterly. This year feels a bit different because from -- at least from a -- in general, your visibility because of that accelerated move to the cloud, you've always had one, but you haven't really used carrots and sticks before. It seems like you're starting to. And then obviously, with the amount of ransomware, with the COVID impact, there feels like much more of a normalization and a rush to the cloud as a safer place, as a easier to manage, as a risk mitigation strategy. So let's talk about that, all of those points, but also given the amount of moving pieces in your business what gives you this ability to even guide, I guess, for the full year? And then as you think about what investors are going to use or should use to evaluate your performance quarterly, what are the one or two kind of guiding metrics or key metrics to focus on to evaluate the health of the business over this period?

Okay. Yes, your initial comments there are accurate. We are -- there is an acceleration there, both driven by us and driven by the market. So as with a lot of things in the public sector, they've been slower to embrace or accept the move to the cloud. And we have kind of paced our move to the cloud with the market. So for, well, really about 20 years now, we've been offering a hosted version of most of our products, but we've been cloud neutral or cloud agnostic. We'd like customers to decide if they want a traditional on-prem license and maintenance or a hosted sort of private cloud subscription-based arrangement. And the shift has been very gradual, but some of the factors you talked about just a minute ago have certainly contributed to increasing our market's desire to move to the cloud and really move from -- to having a strong preference for the cloud. I think I'd say one other factor there is really government's ability to manage their infrastructure, particularly people, especially when you think about local government, small- and medium-sized places that might have 2 or 3 people in IT that manage -- wear a lot of hats, manage applications and databases and security. And as that workforce ages and those people retire, governments really struggle competing with as we do with the private sector to hire people with those skills and particularly governments to pay them market rates and to attract them. And so even if they want to keep things on-prem, which in most cases, they don't, they're struggling with being able to do that. So that's helping accelerate it. So we've moved in the last couple of years to a clear cloud-first approach from a cloud-neutral approach. We entered into a partnership with AWS to be our primary public cloud hosting provider, I guess, 2.5 years ago. We have historically had run our own data centers and hosted our cloud customers in those data centers. We want to get out of that data center business. We have -- and last -- we've also embarked on a number of development projects to optimize our products for the cloud because some of our major products weren't initially architected to be deployed in the cloud. So they're single tenant and not really efficiently deployed in the cloud. And we typically have multiple versions of the same product that we support. And so we want to move to one version. So a number of things to help increase efficiency. We've said that we expect that our product development efforts, our cloud optimization efforts will be done around the end of 2023, the beginning of 2024, and we're on track for that. So a couple of the things we've done in the last few months. We've changed commission structures. So now sales reps get paid more on a cloud deal, the same deal in the cloud than they would on-prem. We have a number of products that we now have announced that we only offer in the cloud. So we don't offer an on-prem version anymore, including some of our major products like enterprise ERP and enterprise licensing and permitting. Now those were already -- ERP last year was 90% cloud in terms of new sales already, but we're kind of pushing it across the line. And then going forward, we'll continue to support on-prem products, but we will make new features and functionality only available in the cloud. So your product will still work on-prem, but it won't get better. And so in terms of adoption, 2019 was the first year that more than half of our new business chose the subscription or cloud model. Last year, it was about 75%. This year, we expect it to be north of 80%. Public Safety is one area where they haven't quite embraced the cloud yet. So that changed, the market clearly is moving there. We're kind of pushing it across the line. So we're already about 80% recurring revenues, whether it's maintenance, from on-prem subscription, from cloud customers or transaction-based revenues. So that -- your question about how do we guide. We have a lot of recurring very stable, very predictable revenues. We don't know exactly what the mix will be this year. We think it will continue to move towards more cloud. We expect that licenses will decline this year and decline more significantly next year given our change in approach to the market. but we're not exactly sure what that pace is. So sort of our range encompasses how we expect that to come out. But that's sort of the puts and takes. We also have talked about with respect to margins. There's a couple of impacts. One is the declining licenses while we build up the new subscription pipeline or stream. And then secondly, we've got some, what we call bubble costs. So as we maintain our 2 data centers and have a lot of fixed cost around those, until -- and we start putting new customers in AWS, we have some duplication of those hosting costs. And until we can get out of one of those data centers, we'll have some of those duplicate costs that will have an impact on margin and that's part of the reason that we said over the next couple of years, we'll continue to see some pressures on margin and then expect the trough in 2023 and then start to see some upside.

What about a metric? Like is there typically doing transitions? Is it ARR or is there a new thinking inside the company of kind of where to focus investor attention? So that's not like -- the good news is bad news, bad news is good news kind of thing.

Yes. I think ARR certainly becomes more and more important. And we give a lot of breakdown of that. We break down the transaction versus the SaaS. SaaS subscription revenues but I think continuing to focus on ARR and ARR growth and bookings. I mean both the amount of bookings and -- but the mix, particularly how that affects it, and we want that mix to continue to shift more and more towards subscription and that's a good thing even though it may cause some short-term pressures. So I'd say those are probably a couple of the key metrics.

I promised I'd ask some investor questions, so I'm going to do that now. First question, and they're kind of related. But any additional color or nuance related to the stimulus programs that are benefiting Tyler customers? Was there any benefit from CARES and infrastructure bills and how much is remaining? Or is ARPA the main driver looking forward?

Yes. The ARPA is the main driver. The CARES Act had -- it was smaller, I mean it was $154 billion. It's hard to say that's a small number, but it was a smaller number. And it was really -- I think it was $125 billion. And it was for states and large cities and counties basically. So -- and it was much more restrictive than what they could use it for. We saw some people make cases to use it for software, but I don't think there was a big impact from that. The impact, I think it had and also the CARES Act or the ARPA Act does is that it relieved the pressures on their budgets and took away the concerns they had that they were going to have big shortfalls. So that, I think, helped us get back to the normal activity. ARPA is much broader. There's not really much restrictions on what they can use it for. They can't use it for things like funding pension deficits. But in terms of spending, they can certainly almost anything they could buy from Tyler would fall under their guidelines. And I think, again, there's also an indirect effect, whether they use ARPA money to buy something from Tyler or whether they use it for something else and it frees up money. We're trying to track exact deals that are specifically identified as funded from ARPA funds. And it's a handful in each of the last couple of quarters. Our sense is a lot of it has not been allocated or spoken for or -- and certainly not spent yet particularly because they got until the end of 2024. So I'd say where we're really seeing sales are mostly inside sales, where we already may have been engaged with someone, they liked something, maybe our Socrata Data and analytics platform. But they didn't have the money for it. And so now we're kind of going back where we've already -- they're already familiar with something, but -- and so now we're kind of reengaging on some of those things. As far as a whole new ERP system or a new court system, those are still long sales processes. So even if they've decided to spend that money, we're engaged with them, you won't see that show up for some time. But it's clearly a tailwind. It's just kind of hard to quantify how big, but we think it -- they're still in the pretty early stages of spending it.

The next question, what is the best case scenario of sales acceleration related to ARPA funding? Is this an incremental 1- to 2-point tailwind? Or can it feasibly be more than that?

We tend to be kind of conservative until we see it. So if we're talking about the next 2 or 3 years, I would think it would be more in that range potentially of 1 or 2 points. It's a lot of money. And if you do math and say, IT might be 5% to 10% of the government's budget, and it's going to get at least its fair share, and Tyler is going to get some share of that. You come up with some big numbers. But again, we're in the pretty -- we're certainly being very aggressive about working with customers and prospects about trying to have them spend that with us. But I don't think we've seen anything yet that points to 5% tailwind or something like that.

Got it. The last question I'll ask you, I always ask this question, but I'll do it in a more open format, which is if you think about the balance of capital allocation between M&A and share buybacks over the course of the next 12 to 18 months. What's the right way to think about that for Tyler at the moment?

Yes. And I'll throw a third thing in there, well maybe 2 more things in there. There's a pay down of debt. Typically, we have not had debt. But with the NIC acquisition, we did put some debt on the balance sheet. We've got some convertible debt that will be out there for a while and a quarter of a point of interest. We've got some term debt that's prepayable, and we have prepaid some of that during the last year. Also, at pretty attractive rates even as rates go up, but we've got some debt. And we're investing heavily in our own business, but that we expense most of our development expense. So that's already kind of coming out as cash flow. I'd say right now the bar is kind of high for M&A in addition to the NIC acquisition last year, we did 5 other acquisitions, and we've done one this year. The one this year actually was interesting because it folds into NIC. So it's a software business that complements NIC's outdoor recreation business, but that was north of $100 million. So we -- but I think we're mostly focused on getting the integrations right, making sure we realize the benefits that we anticipated from those combinations that we've already done. So we may see some tuck-in acquisitions, but I'd say, unlikely right now that we do a big acquisition in the next year, but I think we'll still have some small deals. We've typically been opportunistic about buybacks. We sometimes use debt to buy stock back. And today, we're leveraged about 2x. So we're not heavily leveraged, and we'll have really good cash flow this year. So I think this is one of those dips that we've seen in the last few months that would be in that range where we've been active with buybacks. But for right now, we're kind of letting things settle in a little bit. So buybacks are certainly something that we talk about a lot that are under consideration to say the -- we've done those in similar kinds of situations in the past.

Perfect. Brian, as always, you are great as a guest, thank you for joining us, and thank you, everybody, for participating, surveys inbound in your inbox. Please fill them out. They should take no more than 30 seconds, and they are invaluable both to myself and to management. So thank you, everybody.

Thanks. We appreciate the opportunity to be here.

Thanks, everybody. Have a good set of meetings.

Thanks.