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

Okay. We'll kick this off. Welcome, everybody, to day 1.5 of the Deutsche Bank Technology Conference. Pleased to have Brian Miller with us today. Brian is the Chief Financial Officer of Tyler Technologies. Brian has been with the company for -- I'm not going to say how many years, since...

25.

25 years, been the CFO since 2008. Brian, why don't I turn it over to you, you've got a brief update on the business, and then we'll get into some question and answer.

Yes, I've just got a couple of overview slides to kind of let you know, if you're not familiar with us, who we are and what we do, and then we'll move into a deeper dive into some of the Q&A. Tyler is an enterprise software company, a vertical software company focused on the public sector market, mostly local governments, cities, counties, schools, local agencies, but a growing presence in state governments and as well as federal. Sean said, we've been around for a while. We've been in this space for about 25 years. And really 25 years ago, set out to build a company focused strictly on government software, but with a really broad set of products serving different levels of government. And over the last 25 years, that's kind of what we've done. We've had a really consistent long-term growth story. As you can imagine, the public sector market is never an explosive market, but provides an opportunity for really steady growth. So we've got 16% CAGR over -- since 2010. Stronger EPS growth, we're very profitable and really strong cash flow as well. I'll talk just a little bit about what we -- a little bit more about our products. Broadly, we serve a wide range of essential mission-critical functions of government. So things like ERP systems, financials, HR, payroll, property taxes, an essential function of -- and the biggest revenue generator for most local governments, Public Safety, 911 systems, police, fire and ambulance record systems. The courts market, we're the dominant provider of systems to courts, so things like case management, jails, jury, probation, prosecutor. Public safety is a new area for us but adjacent to court. And then in education, we do ERP as well as student transportation. So I think the key here is we have the broadest set of solutions by a wide range -- by a wide margin as anyone serving the public sector space. We've continued to grow our recurring revenue stream. We'll talk a little bit more about our SaaS transition. But today, we're about 80% recurring revenues, a combination of maintenance from our on-premise customer base, subscriptions from our SaaS customer base and a growing transaction business around things like payments, pulling in transactions with governments, e-filing in the courts, things like that. As Sean noted, we're going through a cloud transition. It's in a multiyear transition, and we're -- we've recently accelerated that. So we'll be moving through that over the next couple of years as we move from sort of a hybrid on-prem and cloud model to pretty much a cloud-first model. I think I'll stop there, and then we'll talk a little bit more about some of these other things.

Sure. No, that's -- thank you for that let's start off with the big picture of macro. We've had 30-plus companies present here over the last 1.5 days, and I'd say the tone been cautiously optimistic. I think that the tone around the secular software trends in certain end markets is as strong as ever. But I think we're -- there's acknowledgment out there that growth slowing customer uncertainty. I think the public sector is unique from an end market perspective with respect to IT budgets. Can you just talk about the macro, you've lived through a lot of cycles? If there's a scenario where we have some prolonged slowdown in growth, how do your customers from a budget perspective get impacted? And then talk about maybe some of the federal stimulus, I think that's unique to the public sector market and how that interplays on the demand side?

Yes. We feel really good about our end market. Government is -- there are a lot of unique characteristics, and some of them make it a tougher market if you're not already in it, but a really good market if you are in it, especially if you have a leadership position there. Generally, the public sector markets are pretty healthy. Budgets are pretty strong, even absent the stimulus. As I said, local governments, the major source of funding, often more than half of their budgets, come from property taxes. And as everybody knows, property values have been strong for a while. And even though the craziness may be slowing down, there's still really pretty strong. There's not a lot of pressure on property taxes. So from that perspective, government budgets are in good shape. But even more broadly across that, a lot of their revenue sources are -- exhibit a lot of strength. When you think about why governments buy software, it's a whole different buying process and buying decision than a lot of companies in the private sector would see. Governments really generally buy software when they have to. Governments are not profit motivated. They're not ROI-driven. They would like to provide better service to the citizens. They certainly get requests or demands for that, but they would like to be more efficient, but they don't really have to be. They don't have competition, which is really different than everybody in the private sector. So whatever city you live in, you don't have a choice of that -- you can move somewhere, but you don't have a choice about where you pay your traffic ticket or where you get your utilities or where you have -- get your animal license or whatever you have to do with government. So they tend to be very risk-averse, change resistance and they tend to use software until it's really at the end of life. There's not this 5-year or 7-year replacement cycle. It's 20 years or 25 years. So as a result, it creates a market. As I said, it's never really explosive, but it's also very, very steady. And these systems turnover over a long period of time. I'd say the average system we replace is probably at least 20 years old. It's not uncommon that we replace systems that are 40 or 45 years old mainframe systems written in COBOL in the '70s. But when it gets to that point that for whatever reason, they decide it needs to be replaced, it may no longer be supported, maybe there's no more COBOL programmers alive, and they're afraid that, that system will stop working and they can't fix it. It could be -- it runs on old hardware that has to be replaced and it doesn't run on current hardware platforms. For whatever reason, it becomes a pretty nondiscretionary decision. Generally, these are mission-critical applications. And so replacing that software becomes a really high priority regardless of whatever the budget situation is. We certainly saw that during the recession a decade ago. We saw sales cycles lengthen. We saw some people say, yes, I can get by another year with what I've got. Back then, we were mostly a license model, so it required an upfront capital spend. So it's different now that we're pretty much SaaS. Back then, we were less than 50% recurring revenues. Today, we're 80%, and those are pretty much rock solid. We have like 1% attrition. We have paying the maintenance or the subscription for the 911 system is pretty far up in the budget. So the demand is largely unaffected by outside factors. I think right now, there's a couple of things that are a little different, too. What we have seen is as a result of the pandemic and all the changes to remote work and things around that, we are seeing a little bit, and I think we'll continue to see a pull forward of demand from people who had a system that they might have thought -- they knew it was not state-of-the-art, but they might have thought had another 5 or 10 years life left on it. But they found out it doesn't work remotely. It only works if people are at their desk in the courthouse or doesn't provide for online payments or online access. So I think we're seeing a change in how. Some people are looking at some of their systems and perhaps pulling some of those decisions forward. That doesn't mean there's a flood of new business, but I think it's incrementally the timing is changing around some. And then you mentioned the stimulus. So there's -- with the ARPA Act, there's $360 billion of direct aid to state and local governments. Everybody gets something. It's pretty wide in terms of how they can use it, pretty much anything they would buy from Tyler is qualified. There's another $167 billion for schools. And they've got until the end of 2024 to commit to spend it, and they've got until the end of 2026 to spend it. We saw a survey from Brookings that indicated that as of the beginning of this year, that only about 40% of the funds had been committed by cities and counties. So we believe it's a tailwind that we'll see perhaps over the next 2, 3, maybe 4 years. It's not dramatic, but it's part of that backdrop of a really strong environment. We've talked about continuing to see our fees grow, the number of demos we're doing, the pace of deals. Last quarter, our bookings were up about 16% on an organic basis. And part of that, we think -- the stimulus is part of that. But generally, it's just a really good end market right now.

Yes. Good. Good. You've touched upon the SaaS transition in the cloud journey. Maybe we'll just double-click there a little bit. Where are we big picture from baseball analogy, early innings, middle innings? I note that last quarter, you're approaching 80% of new deals being sold in the SaaS model. I think that's up from 50% just a couple of years ago. So there's been a real effort there. Big picture, where we at? Let's start there.

Yes. It's a little bit of a mixed bag. We're probably still in the first half. So...

We're going to football here.

Yes. Okay. Fourth innings about football. The -- so we've had this long-term transition to the cloud. Historically, we were a traditional on-premise license and maintenance model. Governments, as you can imagine, are slow to adapt to new things and the cloud is one of those things, even though it's not new, but they've been certainly slower than the private sector. So we had a hybrid model, we talked about being sort of cloud-agnostic or cloud-neutral. So we offered our products really most of our major products for the last 15 years or so in either an on-premise model or cloud or a hosted model through sort of a private cloud, paid for on a subscription, hosted generally in a Tyler data center, and we have 2 of those. Over time -- and we were neutral on how we sold it. Sales reps kept the same commission regardless of which way the customer went, didn't really try to push them one way or another. But over time, more the customers chose cloud, but still pretty slowly. So all the way from early 2000s to 2019, it took till we got to 50% of our new customers choosing cloud. From 2019 to 2021, we've gone -- to early 2022, we've gone to 80%. In 2019, we really talked about a shift from cloud neutral to cloud first, that we have a strong preference for the cloud. Pretty much everything we've bought or built in the last 5 or 6 years has been cloud native. And we entered into a relationship with AWS to be our primary public cloud provider, have a strategy and a road map to get out of the data center business to move from -- out of our 2 existing data centers, move those customers into AWS. Pretty much moving our new customers who are all going into AWS. So with the new business, that shift has taken place. We have a number of products, including our biggest product, our enterprise ERP that's starting January 1 of this year, we no longer offer in the on-prem model. There's a couple of areas that are a little slower. Public safety being one of them. A lot of public safety agencies still aren't comfortable with putting a 911 system in the cloud, particularly if there's somewhere where connectivity is not that reliable. And so I think that will lag for a while. We -- but clearly, we're all in on the cloud. We have -- that's kind of in the new business market. We have 20-plus thousand on-prem customers that have their installations with systems that are installed on-prem. We've had a steady progression of those customers migrating to the cloud, but it's on the order of 100 a quarter. So we've got a long way to go. That process in the next couple of years will likely ramp up. We're laying some of that groundwork that we've -- have had development projects underway for the last couple of years to optimize our products to be more efficiently deployed in the cloud. We said those efforts will be done around the end of 2023, beginning of 2024. So that's kind of one of the gating items for us to really be -- have better hosting costs and be more efficient about it. We also have a lot of customers that are on older versions of products that we need to upgrade to the current version. So probably a couple of years away from really turning up the tap on those migrations. But again, we have 20-plus thousand customers pay us about $470 million a year of maintenance. As they move to the cloud, it typically doubles what they're paying us, so moving from a maintenance to a subscription. So there is a nice sort of built-in revenue tailwind over multiple years as we move those customers. But...

So then on that point, as you think about the puts and takes with the on-prem or the license to the SaaS, what's the steady state organic growth? You've been putting up some pretty good growth numbers here. Yes, I don't know how long, maybe 2, 3 years down the road, given this market, what do you think this company can grow at consistently on organic?

So historically, we've been, on an organic basis, we said high single digit, low double digits. So we've kind of been in 8% to 10% kind of a grower in general. And a little bit above that and a little bit below that at various times, but pretty much in that range. And obviously, supplemented by acquisitions. We've done 55 acquisitions over the 25 years I've been here. So a few large ones and a lot of tuck-ins. So there's typically a few points of growth, although it's not -- we don't have quotas or a certain amount that we're getting from acquisitions. So now we've talked about kind of high single, low double-digit growth, call it, 8% to 11%, 12% sort of growth targets. I would say that over the last 3 or 4 years, our growth has probably been -- we've probably seen a 1 to 2-point headwind from the SaaS transition, so the license is going away, being replaced by that growing stream of recurring revenues. But we've seen probably a couple of points of headwind. Just for example. So like last quarter, our organic subscription growth was about 23%. So we're seeing really -- and that's a combination of SaaS and transaction-based revenues. So we said that we expect that as we get through this transition over the next 2 or 3 years that we'd expect to see an acceleration of revenue growth as well as a return to margin improvement. And for example, our enterprise ERP product, our largest product. It was typically around a 10% grower. That slowed in the last couple of years that they've moved to 90% plus new SaaS business was 8.5% last year, 8% this year, no slowdown in the number of deals, but just the revenue. Early look at next year shows that business growing about 11%. So -- it's kind of through there. Other products aren't quite there yet. But -- so -- and then we'll talk more. I'm sure about the NIC acquisition...

Yes, let's do that.

Some opportunities there.

Maybe just follow-up on the -- we got the revenue side and the puts and takes, and that sort of seems to be selling. The margin side, you're making some investments here. People talk about cloud transitions as if you just not. It requires a new approach from a sales force perspective and also investments. Can you talk about some of those investments specifically and how the margin profile has been impacted? Maybe when we start to see the -- that run off a little bit and we can get back to more normalized margin profile?

Yes. So until really, 3 or 4 years ago, we had a decade of very consistent 100 to 150 basis points a year of operating margin expansion. There was sort of kind of core to our model. A couple of things along the way. We did a big acquisition in the public safety space and done a number of acquisitions in the last few years that have required some investments to integrate to other Tyler products. In the case of Public Safety, we made a big investment in it to scale it up to be sort of a Tier 1 player, which has been really successful. So we significantly increased our R&D spend over a couple of years. We've now kind of grown into that R&D level. But more of our margin pressures today -- last year and this year are around the cloud transition. We sort of had some artificial margin spike to the positive in 2020 around COVID and costs that went away, that quarantine and no travel went away, freight shows, health costs, a lot of things. A lot of that is kind of creeping back into the model, but we expected that. But around the transition, we've got investments in product development. And R&D, I talked about this optimization of our products for the cloud. We've got the data center transition. So as we putting new clients into AWS and over time moving our existing clients out, we've got some bubble cost or duplicate costs around keeping our data centers open. There's a bunch of fixed costs until you can get completely out of one of them and then completely out of the second one. So we've got those transition costs, and we expect to be out of the first data center around the end of next year, in the beginning of 2024. So those are kind of the major cost. Then we got the revenue impact of not just on revenue, but on margins of -- 90% margin licenses being replaced by the buildup in the subscription revenues. So those have been some of the major factors. We've said that as we look at it now that we think that, really, the margin trough is in 2023, that next year is sort of the bottom. And after that, we'll be sort of around the curve where we've now built up this recurring stream, the remaining licenses that will run off, won't have a -- we'll still have margin growth despite those. And I'd expect next year's margin impact to be relatively modest compared to this year's. We're building out right now kind of our Tyler 2030 plan around setting sort of really what are our kind of 7-year targets? Where do we think margins get to? How do we see revenue growth over that time frame?

Have you put that out? Or is it...

We have not. We're doing a lot of work on that. I think our expectation would be sometime early next year, we'll have an Analyst Day and sort of update all of those targets and those kinds of things.

Before we go into the M&A. On the organic side, as you think about the portfolio, you've got the broadest portfolio in the space, #1 leaders across categories. Can you give us a sense though of where you are going to hang your hat? What are the products that seem to be really resonating? Where is that real juice here from a solution? Is that on the public safety side? Is it on the public advent side?

We don't have anything that's really like -- we have different product. Most of these major areas were a leader or the leader and we have different competition in each of these major product groups. So it's one of the interesting things. There's not another Tyler. There's not someone else with breadth of product. We have a lot of fragmented competition companies that just do court systems or just do tax systems and sometimes just do tax systems in 2 states. So we believe we created a significant advantage and something unique in the way our systems work together and we have platforms and dashboards and things that create more value from having more Tyler products. So we don't have anything that's growing like 50% is something that's shrinking. I'd say Public Safety and the whole justice -- we are the only provider that has both Public Safety and Courts & Justice We have a completely different set of competition in those 2 areas, although they are adjacent areas. And those -- we've made a lot of investments in. We're the dominant provider of court systems. We have -- we've made really nice strides with public safety. Public safety is a really competitive market with people like Motorola Solutions and Axon and a wide range of competition. But I'd say that's an area that we think we've got a lot of opportunity for growth in public admin in the ERP space. We've been a leader with like 55%, 60% win rates for some time. So generally winning more than all of our competition put together. So -- there's not really a big thing. I'd say more functionally, I'd say, payments is an area that we're really investing in and that across all of our products, we think there are tremendous opportunities for us to anticipate in payments and make money off of that. And that's something that we're actively underway with.

So on the payment front, let's flip to sort of M&A here because you've always had a very deliberate M&A program at Tyler, and we're over a year now from the biggest deal ever, the NIC deal. Can you give us a sense of the value creation by Tyler plus NIC? What's specifically on the ground have you seen with respect to whether it's to cross-sell the payment side, various parts of the NIC business? Where is the value been over the last year? And how do you think it's great for yourself on the deal?

Yes. NIC, by far, the biggest acquisition we've ever done, there's $2.3 billion purchase we did last April. So just a little bit past the year anniversary. First time we've ever acquired a public company. So that was a different process for us. We have no debt on our balance sheet before that and have typically not had much debt. Our cash flow is really solid and has funded acquisitions, investments, pretty much everything we needed to do. So we did some financing associated with the NIC. We did a convert deal as well as some term debt. We've paid down $635 million of that debt since last April. So we've made a lot of progress. We're levered probably right at 2x on a net basis. So very comfortable balance sheet. So NIC was a great company on its own, maybe a little misunderstood. They're a little under covered, a little under the radar. We only had a couple of analysts following them, maybe a little narrow for a public company. But they -- whereas we're primarily the back-end software, things that run essential functions of government, mostly at the local level. NIC was mostly at the state level, 95% state, maybe 5% federal, almost no local. And they really provide the digital access to government or the digital front end. So they provide the website and they build interfaces and connections to these back-end systems that could be Tyler systems, most of them aren't today, to enable people to access information or conduct business with state governments primarily. So think about renewing your driver's license or your license plates or getting your hunting license or your CPA license or applying for unemployment benefits or whatever you would do with state government, insurance companies accessing driver history records to issue insurance policies, NIC builds these connections, it's a self-funded model. So they get a state contract, and they have 28 states where they have enterprise agreements with them in another 2 or 3 states where we just do payment processing. Again, an enterprise agreement, which is very broad, we're providing digital government services. They start with some sort of key services and then build more of those over time. So there's typically organic growth around these contracts. They -- and it's a self-funded model, so the state doesn't write them a check, they get paid by user fees or convenience fees. So say you renew your auto registration, you paid to stay to $70 fee, you might pay a $5 convenience fee that goes to NIC. And that helps fund all of these services, some of which generate revenues and some of which don't. They also would be the payment processor for that payment, so they would get a share of the revenues from that payment processing. And in 2 states, Texas and Florida, they just do payment processing, but they do all of the payment process for 2 really big states. So the model is more transaction-based. It's very consistent kind of have a historically about an 8% organic growth around the same-state sales. So the logic in it, one, it -- they were very complementary companies. They're more back-end, we're more front-end -- we're more back-end, they're more front-end, they're more state, we're more local. So we don't overlap much. But the big opportunity is for -- there's 2 big cross-sell opportunities, a good business on its own. And we think we got it at a very reasonable valuation. But 2 cross-sell opportunities. One is the opportunity for us to sell Tyler products. And we've got dozens of products that have applicability at the state level, but we don't have the sales organizations, the relationships at the state level the way NIC does. They're deeply embedded, as you can imagine, what CIO, what the agency has because they're really providing all of the access. So the idea of us being able to know of opportunities sooner, pinpoint needs at the state level, be able to make those introductions, be able to bypass the competitive process and add it on to an NIC contract on the software side is really attractive to us. We've only owned them for a little over a year. We've done a lot of work -- early on about learning about each other, and they have learned what our products are. We learned about their relationships. We've seen, I don't know, couple of dozen deals that we've done where we've actually crossed a wide range of pilot products that we've already sold in the states.

Specific leads from NIC?

Yes. So from NIC opportunities. For example, last quarter, we sold into the Utah contract. We sold a system that we have entellitrak that's sort of a case management or business process management system for veterans benefits into the City of Utah bypassed the competitive process. Very quick to contract because we just added on to their contract. So we did say that last quarter -- I mean, still early on, the number of opportunities in our cross-sell pipeline doubled from Q1 to Q2. So a lot of opportunities we're seeing. We're really pleased with what we've seen actually get signed in the first few months. But I'd say the level of opportunities are greater than we thought when we did the deal. The second cross-sell opportunity is around the payment side. So Tyler, historically, we've got a lot of systems that facilitate payments, things like the utility billing system at the local level, traffic court systems for paying -- where they facilitate the payment of traffic tickets, licensing and permitting, parks and recreation. But Tyler has not typically been the processor. We partnered with people like Chase Paymentech or Elavon, got a few basis points off the transaction, but basically we're a reseller. And we had those kinds of relationships for roughly $3 billion of payments last year. NIC process is on the order of $75 million a year payments. So a much more sophisticated platform. They actually are the processor. They keep more of -- it's essentially more of the deal. They've got a really sophisticated mobile platform called Gov2Go, really strong reporting capabilities. Everything designed around government as opposed to a generic payment processor. And so we want to bring those capabilities to local levels. Again, NIC doesn't have local government relationships. They don't have sales forces focused on a very fragmented market. We've got thousands of local government customers that we already know. So typically have very fragmented payment situations. So the parks and recreation department might use one process or the court uses somebody else, utilities don't take online payments at all. So the idea is that we can bring an enterprise-wide payment platform to cities and counties the way we do at the state level. We have combined our payments teams under NIC's leadership. We have a playbook and a go-to-market strategy that we're just now starting to execute on. But we think there's a tremendous opportunity around the payments base at the local level that is something that we can capture a significant part of the margins are different than the software business, but it's really a nice complement to what we do there. And they're nice recurring streams that are very reliable. You're going to pay your utility bill 12x a year. So we're excited about that opportunity over the next 2 or 3 years.

I've got a few minutes. I've got more questions, but if there's any questions, feel free to jump in.

Yes. So hang on just a second.

You got a microphone coming.

[indiscernible]

Balance sheet risk. Now the payments really got passed through us. So when we collect money on behalf of the government, it might sit on our balance sheet and our cash for a very brief period of time and goes on. But it's really just on the cash side that money is passing through we don't really have obligations that sit on our balance sheet.

Speaking of the balance sheet, you're now down to -- from a capital allocation standpoint, you've been paying down debt. It's been a re-rating of software assets. As you think about your M&A program, is that something in 2023, you'll think you'll be active in?

Yes. We've said that right now, the bar is kind of high for us for acquisitions. In addition to NIC, we did 4 other acquisitions in the last 18 months, 2 of which prior to I think would have still been pretty good-sized acquisitions. One was around the $100 million acquisition, one was $85 million or so. So and then some really smaller tuck-ins. So we're really focused on especially NIC integration, really getting it right and getting the -- realizing the benefits that we expected to get as well as the other acquisitions. So we said in the near -- and also in paying down debt. We've done a really good job of that. I think we've certainly got balance sheet capability, flexibility to do acquisitions. But we set the bar is kind of high right now. We still are looking at stuff. Valuations are also kind of at an interesting point because almost everything we acquire is private. A lot of private equity-owned assets that are out there, that are likely to be back on the market in the next year or 2 or so. But it seems like right now, we're in a period where, some at least in a couple of the situations we've seen where the sellers expectations or desire...

We're hearing that...

Not adjusted the same way the public has adjusted our multiple.

Take a little bit of time.

Where they say, no, we should be 10x driven.

Because that's what we're hearing.

Yes. And so we'll see how that shakes out. I think a little bit that has to shake out. So that's probably fine. We're a pretty disciplined acquirer. I think we're pretty disciplined about valuations and strategic fit. Sometimes we're really active, sometimes we're not, but we're pretty patient and we look for the right things. And we -- I think we've proven to be a pretty good acquirer and have a good history, but we try not to overpay like everybody. But those things change over time. But right now, it seems to be kind of still, the market is sorting out.

I think so. I think we'd agree and we're hearing that from a lot of companies. Brian, thank you. We're out of time. I appreciate you being here.

Thanks for having me. Thank you.

Appreciate it. Thank you.