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

Let's get started here. Hello. My name is Clarke Jeffries, I'm a Senior Research Analyst at Piper Sandler. I'm joined today by Brian Miller, EVP and CFO of Tyler Technologies. Thanks for coming from Nashville.

Great to be here. Nice location.

I guess for maybe some of the investors in the room that need a refresh, could you just go over what is the company's mission, what does the business look like today from a size and scale perspective?

Sure. We are an enterprise software company focused exclusively on the public sector. So we provide mission-critical back-end systems that power essential functions of government. Historically, primarily focused on the local government level, cities and counties, but increasingly we have expanded into the state and even a little bit into the federal levels. This year, we'll be about between $1.8 billion and $1.9 billion in revenues. And roughly 25% free cash flow margin. So we're very profitable, we generate a lot of cash. We grow sort of high single, low double digits organically and then supplement that with acquisitions regularly. And our mission is to make government more efficient, provide better service to the public and help them in that process.

Yes. Excellent. Given we're coming out of the pandemic, this is the first conference, the technology conference that Piper Sandler has hosted since COVID. I want to frame for investors how we should think about how the last 2 years expected Tyler in the demand environment? How was the demand environment pre-COVID? How did COVID affect the demand environment during the last 2 years? And how would you characterize demand at the current moment?

Sure. Demand at the current moment is really strong. And we've said, it has generally returned -- at least returned to pre-COVID levels and in most cases, is well beyond that. When you think about demand for our products, governments buy differently than the private sector. Governments are not profit motivated, they're not ROI driven, they don't have competition. So their motivation to buy software is different. They would like to be more efficient, they'd like to provide better services to citizens, but they don't really have to. Whereas the private sector, someone who might buy a new ERP system to create efficiencies, manage something better, have better data and business information, ultimately, have a competitive edge. Governments tend to be risk averse. They don't like change. And so they tend to use systems much longer than the private sector would and really until they're just about dead, until they have to replace them. So on one hand, it's sometimes difficult for us to create demand or pull that demand forward, that also creates a very steady market and one where the demand -- once it gets to the point that they decide that they need to replace the system, it's a somewhat nondiscretionary decision. They do sometimes say, well, this is a bad year. I'm going to push it off for a year or so. But rarely can they say, I'm just not going to do it. So what we saw during COVID really wasn't a change in demand, but more a slowdown in sales processes because they were obviously distracted with other things. They were figuring how to work remotely. And I think generally, governments probably struggled with that more than the private sector. And they were concerned about impacts that COVID might have on their budget situations, which turned out not to be that significant. So we saw positives in sales activities as we shifted to doing those things, like demos and site visits remotely. But most of that kind of got back on track last year and that demand has -- in the sales cadence activity in the market, we've said in the last few quarters, the number of RFPs we're seeing, continues to increase the number of demos we're doing. So really strong activity in the market. We do believe that some of those replacements have been or will be pulled forward a bit because of the changing needs around remote work, someone that had a system that they might have thought was good for another 5 or 10 years that turned out not to work effectively when they needed to shift to remote work. So we do believe there's some sort of pulling forward of business. I don't think that's a major factor in the activities, either it's one of the factors. Generally, government budgets are in really good shape. They're -- local governments tend to be a -- well, the majority of their budgets tend to come from property taxes or at least a significant part. Right now, in most places, property values are really strong. There's not a lot of pressure on property taxes and a lot of other revenue sources. And then there's a massive federal stimulus point to take local government and tools that we believe is a tailwind really probably for the next 3 years as they've got time to send that.

I wanted to touch on that. As we think about government budgets as being one of the primary factors that does work in the background with a otherwise secular move towards modern technology, could you give us some background on which major government stimulus programs were applicable to you, how that's affecting things and really what those stimulus programs effectively mean in terms of budget?

Sure. The first relief program, the Cares Act sort of early on in COVID was smaller. It was more narrow in terms of scope. It really went to states and large local governments, it was fairly narrow in what they could spend it on. The ARPA, the American Rescue Plan Act, much bigger, $360 billion of aid to state and local government, pretty much everybody gets something and then there's another $167 billion for schools. It's not very restrictive on what they can spend it on, certainly pretty much anything they would buy from Tyler qualified. They can't use it to like fund pension deficits and that kind of stuff, it's pretty much any kind of technology modernization qualifies. They've got half of the money last year and half of it this year. They've got until the end of 2024 to commit the funds and they've got until the end of 2026 to spend them. Saw a booking study earlier this year that indicated that coming into this year that only about 40% of the funds have been committed yet and certainly not even that much spent. So we think it will continue -- it's a factor in the current strong environment. I don't think it's the biggest factor, but it's certainly -- and a minimum provides governments with sort of an additional layer of confidence in their budgets. And they're still, for the most part, partially allocating it or figuring out where they're going to spend it. We're certainly doing our best to find ways to work with them to use some of that with Tyler. But again, we think that contributes to a tailwind over the next 2 or 3 years as they've got time to spend it.

Yes. And you've certainly talked about in the recent quarter, working through a meaningful backlog of some of this activity in this good demand environment. Actually needing to ramp up hiring compared to, I think, the headlines of a lot more workforce reductions across the broader technology space. So as you think about taking advantage of this strong demand environment, what are the things you want to execute on? What are the impediments that you have to work through? Just how are you working to increase capacity and address the demand?

Yes. Around capacity, the hiring environment, the people still is a very challenging environment. Seems to be getting a little bit better turnover, seems to be moderating. I think part of that is around some of the slowdowns elsewhere in tech where you're actually seeing something either with hiring freezes or even reducing staff. We're seeing some boomerangs where people left us in the last couple of years and have come back. So I guess the grass is not always green on the other side. But it's a challenge because we're not just hiring to replace turnover, but we're growing our staff and coming into the year, we had plans to add 8% or 10% total personnel growth net. So they're doing a lot of hiring, and that continues to be a challenge. We talked about last quarter, we were probably $3 million or $4 million light on professional services revenues as a result of just not being fully staffed to where our plan is. But we've had a couple of big professional services classes start in the last few months, and so building up that capacity. Again, the demand is pretty solid. But we're continuing to ramp up our ability to deliver that development. We seem to grow our development teams as well and again, challenges around that, but we're finding the people, it's just more work to find in the first place.

Before I delve into the next topic, any questions from the audience? Well, I wanted to put a little bit of a lens on the cloud-first transition. This strategy that you really pivoted to in 2019 with the AWS agreement. And just it feels to me that the background is during 2017, 2018 subscription was 40%. It was a minority of the business that's progressively risen to over 70% in the last year and year-to-date. So can you tell us about the changes you've made in the cloud-first approach? What are the items that you're still in process in terms of advancing that cloud-first strategy?

Sure. Yes. We clearly have shifted from a number of years we were in sort of a cloud neutral or cloud agnostic approach. So we offered most of our products, either in an on-premise traditional license and maintenance model. Or in a subscription really a private cloud model, primarily hosted at 1 of 2 Tyler data centers and paid for on a subscription basis. Like a lot of things, government has been slower to embrace the cloud and move to the cloud. So that transition really over almost 20 years until now has been -- up through 2019 was pretty gradual. So here, a higher percentage of our new business chose the cloud, but still the minority. And pretty much everything we've bought or built in the last 5 or 6 years has been cloud native, cloud only. We have continued to see that percentage of the new mix shift more and more to the cloud. 2019 was the first year that more than 50% of our new contract value came to the cloud. From 2019 until now, that's expanded to between 75% and 80% of our new business now. We've made changes around that cloud-first approach. So we got from cloud neutral to clearly cloud-first. Sales compensation has changed. So sales reps get paid more for a cloud deal. Even starting this year in a number of our products, including our biggest product, our enterprise ERP product, we no longer offer new RFPs in an on-prem model. So the market has kind of moved along with us. As you said, we entered into a partnership with AWS to be our primary public cloud provider in 2019. That's picked at some other changes. So we want to get out of the data center business. We don't want to continue to grow our 2 data centers. So we have had really since 2019, some major development projects underway to optimize our products to be efficiently deployed in the cloud or more efficiently deployed in the cloud. Those projects will be done around the end of next year. We have started lifting existing customers out of our data centers and moving into AWS and putting most new customers into AWS. We do have some margin headwinds around all that. We've got some duplicate costs or bubble costs from maintaining our data centers while we're also using AWS. And so that's why we have pretty well-defined road map to get out of our data centers over these next few years. And like I said, the development projects are pretty much on track to make our products more efficient around the cloud. And we'll continue to make sort of the carrot approach. So while we'll have -- we'll continue to support on-premise customers, we've got a lot of on-premises customers that will continue to support, but we'll ultimately make new features available only in the cloud. We've got more than 20,000 on-premise installations that currently pay us about $470 million a year in maintenance and as those migrate over multiple years, that revenue generally doubles from maintenance to a subscription arrangement. So we've got some built-in revenue growth as we migrate those customers. We also have some efficiency opportunities because in our current model, whether they're on-prem or in the cloud in our data centers, with a lot of products, we support multiple versions. And as we move to the cloud, we'll get those down to one version and everyone upgrades at the same time. So it's inefficient currently from a support standpoint and a development standpoint to have as many -- with some products as many as 10 or 12 versions of the product out there. So as we make this transition over these next few years, that's going to create more efficiencies as well.

Absolutely. And you definitely touched on the sort of revenue opportunities, some of the leverage opportunities by moving to cloud. Just briefly drilling down on the cost consideration over the intermediate term. What have you messaged in terms of how long that sort of margin headwinds will last in terms of the cloud transition? And historically, I believe it's 100 bps or 300 bps of operating leverage year-over-year, I believe, but prior to the transition...

Yes, prior to really the cloud transition, we had a pretty good cadence for a number of these really about a decade where we averaged about 100 basis points a year of operating margin improvement. That took a bit of a step back around a couple of things, some significant increases in our R&D expense, particularly around some acquisitions. Most of that's aimed at driving growth and then around the cloud transition. So we've had a margin impact from the revenue mix change. So those high-margin licenses going away and being replaced by a growing stream of recurring revenues. And then what I described around the bubble costs, some of these costs associated with product development and with the data center migration that have put pressure on margins in the short term. I guess there's also been an impact. We did a larger acquisition last year, NIC, which is a little bit more of a transaction-based model and a heavy-payment processing business with margins that are a couple of points below Tyler's historical margins. So there's a little bit of an impact there as well. We've said that our current expectations are that the margin trough is next year so that there's likely to be some -- likely relatively modest and some compression from where we are this year. And then after that, we currently expect that we'd be back on the margin improvement trajectory as well as potentially accelerated revenue growth as we kind of get around that curve from the transition and effectively, the bubble costs and the revenue mix headwind is offset now by the recurring revenue stream that we have. So we're working on -- I think our CEO, Lynn talked about on the last call, our Tyler 2030 plan and being able to more clearly define kind of what our targets are over the next 7 to 8 years, where we see margins going, how we see revenue growth, how we see things like a significant increase in our payments business factoring into all those things and kind of providing more clarity around that beyond next year, but kind of over the next 6, 7, 8 years. And so we'll have an Analyst Day and lay all those things out somewhere in the not-too-distant future, yes.

Looking forward to it and certainly with increasing subscription concentration, there might be some opportunities for a tailwind to growth compared to the historic growth rate?

Yes, we do believe there's been a headwind of probably 1 or 2 points of growth over the last, say, 3 years as that may have shifted from 50% to 80% of the new business. Now we're down to word licenses. I think this should be around $70 million out of $1.8 billion, $1.9 billion of revenues. So relatively insignificant, but also high margin. Our subscription business has been growing in the 20% plus range very consistently for quite a while. So it's really kind of building up. But yes, there is some headwinds and some opportunity to share tailwind there.

I wanted to talk about something that I think is very interesting from a broader perspective about Tyler which is something that I think you've coined as the Connected Communities vision, but it's really about this evolution from the system of record, suite to workflow tools, analytics and now a payment platform, ultimately, you're able to serve much more of an end-to-end level of functionality for those governments. But I wanted to get what -- for you, what the view of Connected Communities vision means for you? What kind of opportunities does that open up for the business? And maybe some examples of how the assets that you've developed or acquired over the last few years have really led to growth in terms of some of the large opportunities at the share of government?

Yes. So we believe Connected Communities is not a product or an initiative. It's really a vision and sort of a vision that we believe -- Tyler is the only company that is able to deliver on it. We have -- we're unique in terms of the breadth of our products. We compete with a lot of point solutions. We don't have -- there's no one in the market that's even close to having the breadth of products that we do to expand really almost every essential function of the government we have and in terms of serving different levels of government. We have the biggest customer base by far of anyone in the space with, I think, 37,000 installed systems across something like 15,000 different distinct jurisdictions. And so really the vision around Connected Communities is not just providing a bunch of software solutions, but really being able to tie those together and be able to bring together departments and agencies within a jurisdiction. So government is not surprisingly operate in a lot of silos. And so within a city or within a county or within the state, there's not a lot of ability to access data, to put data together, to use data from different systems and different agencies, to make good decisions with the concept of BI is a little bit new to government. And then even across agencies or jurisdictions within a region, so to be able to share data across a region or make data available to citizens in an area without regard to kind of boundaries. So for example, we have a prime mapping solution that is part of our Socrata Data, the analytics platform, it came from an acquisition a few years ago. So we have the ability -- if you live in a town and you draw a 5-mile radius around where you live that might cross 3 or 4 different towns, maybe a couple of different counties, but you'd like to know what's going on around there, what are the primes and so we have a prime mapping application that can pull that data from multiple agencies. They don't even have to be Tyler clients and create that sort of regional information and make it available to citizens to kind of know what's going on. So we believe -- so there have been a couple of things. We've invested a lot in development and in bringing together a lot of foundational technology elements across our products so that we have a common payment engine and workflow and document management and service to us and one sign-on in security. So whether you're a citizen or employee that's using these systems that you have a lot of common elements across them. So creating more value from having those other products, all be Tyler products, creating dashboards and data -- access to data. Socrata, the acquisition we did in the data and analytics space, we have integrated that across virtually all of our products to create and what we think gives us a really good competitive advantage around those capabilities. And then the acquisition of NIC last year has dramatically increased our capabilities around payments and digital access to government. So that's what their entire business was around not providing the back-end systems but providing the digital front end. And bringing their capabilities together with Tyler's back-end systems is another way we've advanced the connected communities vision. So again, it's something we think Tyler is really unique in terms of our ability to provide those kinds of benefits to governments and to citizens and provide a better experience for all of them.

Yes. I wanted to touch on NIC. It seems like just capturing the payment processing opportunity for governments by itself would be compelling, but it seems more compelling to have the payment processing technology but also be involved in the reporting invoicing and billing systems on the other side of the transaction. Just near term, what are the opportunities with NIC and then long term, what could that evolve as we use that technology to sort of embed into the vision of end-to-end?

Yes. So NIC really, there's a great business on its own. Largest acquisition we've ever done, first time we've ever required a public company, but almost totally complementary. We do the back-end systems, mostly at the local level. They do the front-end digital access, mostly at the state level. So we've got some pretty compelling cross-sell opportunities kind of going both ways. So one is the opportunity to sell Tyler software products into state governments through NIC's relationships and contract vehicles. So NIC has these very broad contracts with 28 state governments for enterprise, digital government services. Generally, that means that they provide interfaces and portals, so people can transact business, access information at the state level. So renewing your auto registration or your driver's license or getting your hunting and fishing license, those sorts of things. And so they process those transactions, they process the payment, and they generally get a convenience fee for providing that access or facilitating that transaction and so it's sort of a self-funding model. As a result of that, they're, I think, the largest processor of payments at the state level. And we have a couple of contracts in Texas and Florida where we just do payments, but we do all of the payment processing for each of those states, the 2 really big states. So Tyler has a lot of software products that have state applicability, but we haven't historically had sales channel relationships that NIC does have. And so we've got the ability to sell Tyler products into state governments and accelerate that growth at the state level. And we've seen some really good examples of that just in the first year or so of owning NIC. We said last quarter, our pipeline of new cross-sell opportunities doubled from Q1 to Q2. And then going the other way, NIC has a very robust payments platform and we look to take that and bring that down to the local government level where we have relationships. And we have a lot of systems that present bills, utility billing, traffic courts, parks and rec, licensing and permitting, but we haven't really had the payment processing platform. And so bringing those two together, we think is a tremendous opportunity to grow their payments business across the local space.

Well, Brian, I think we're out of time. We enjoyed the conversation. Look forward to more results to come.

Thanks a lot.

Yes.