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

All right. Thank you everyone. I'm Sami Badri with Crédit Suisse, and I want to welcome right now Brian Miller from Tyler Technologies. Thank you very much for joining us.

Thanks for having me here.

Yes. Brian is the CFO of Tyler. There are some slides that you want to run through before we get started?

Yes. I'll just give a quick introduction for those who may not be as familiar with Tyler. We're an enterprise software company focused exclusively on the public sector. We have a very wide range of back-office software products that power essential functions of government, really at all levels, primarily focused on local government historically, but has more recently expanded into state governments and to some extent, the federal. We believe we're the largest company focused solely on public sector software. We're around 80% recurring revenues. You can see the breakdown across the different product suites with ERP being our biggest suite, Courts & Justice, Public Safety, Property Taxes, licensing and permitting, those sorts of things are the products we provide to local -- to governments. Strong cash flow characteristics of the company, very, very strong customer retention, 98% to 99%. Very sticky customers, as you can imagine, with -- in the public sector space. We're like many software companies are going through a transition from a historical on-premise model to the cloud. It's been a long transition as we've had a hybrid model offering both licenses and subscription offerings for a number of years. But really, since 2019, we've had a focus of being cloud first. And have accelerated that transition and are particularly seeing that movement accelerate in the new business mix over the last couple of years and on into next year. We have continued to integrate our products more tightly to create what we call our Connected Communities vision and really providing more value to our customers from having multiple Tyler products, and that's proven to be a significant competitive advantage for us. I'll stop there and we can jump on into the Q&A.

All right. So that was a good overview. So I'd have to ask you the overview question. One thing I wanted to kick off with is when we look at Tyler's gross margins and we compare and contrast that to other software companies in this space, why are Tyler's gross margin is a little bit different? So -- and maybe when we're talking about that, maybe we can also discuss how government customers and the typical traditional enterprise customers differ, right? And how that actually impacts or influences the gross margin profile of the company?

Yes. There are some differences there. I think a couple of major things in our margin profile. One is that we have a pretty significant professional services business. Sort of core to our model is that we provide most of the professional services around the implementation of our software, training, data conversion, consulting services, rather than using third-party integrators or consultants. And we do that really to control the quality of our engagements to complete engagements and installations on time and on budget, and not to chew up a lot of the customers' budget with a onetime services engagement. Those services are basically a no-margin business. But it's how we get to a recurring revenue stream as quickly and efficiently as possible with successful implementations. Obviously, with a no-margin business, we don't want to grow it any faster than we have to. And so we're continuing to do things through the ongoing development of our products to make them more easily deployable with fewer services. The cloud helps. So it's more efficient deploying in the cloud. And so there's marginally less services involved in the cloud deployment. And we pretty much discourage excessive modifications and customizations to try to keep that down. I think the other major difference between us and a lot of software companies is that we actually expense a lot of our development costs and cost of sales. So we spent about $200 million a year on software development. About half of that is expensed on the R&D line, and about half of that is up in cost of sales. And generally, the development related to existing products, new features, functionality, things that customers get as part of their subscription or their maintenance, we expense in cost of sales. I think a lot of software companies would have all of that on -- in an R&D line, and that's a change we're looking at. But that's about 5 points of gross margin from the impact of that. I'd say, generally, we have some costs today that are associated with the cloud transition. We've talked about some of our bubble costs as we're moving from in-house data centers to AWS. And we've got some duplicate costs until we get out of -- completely out of our first data center and then our second data center over the next 2 to 3 years that are sort of elevating our cost right now. So I'd say those are the major differences. And certainly, as we complete our transition to the cloud, we expect that to have a margin uplift and to be margin positive. We've said that from an operating margin perspective that we expect that 2023 next year would be the trough in terms of margins and that from there forward, we would expect to see both revenue growth acceleration and be back on a path of margin improvement.

Got it. Got it. Thank you for going through that. One thing perhaps that's so unique to Tyler and probably a very select few of technology companies is the demand and budgetary environment that's enabling customers to renew, spend more money or grow scope of their services and needs. Can you walk us through what the budgetary or kind of state and local budget type dynamic is having on Tyler? I think you guys recently announced a really large deal, right?

A federal deal, yes.

That's right. A federal deal, which I think basically just increases the TCV size that you guys are typically used to seeing. How are these demand drivers really impacting you guys?

Yes. I mean throughout this year, really, the last several quarters and certainly last quarter, we've really been talking about a really active market and a really strong backdrop for our customers. Generally, government budgets really at all levels, they're in pretty good shape. They're pretty strong. At the local level, where property taxes are generally the biggest single revenue stream. Property taxes aren't under much pressure even though real estate markets may be slowing down and not growing exponentially, like they were for a while. They're still at really historically pretty high levels. So there's not a lot of pressure on property taxes. Generally, really, across all levels, the budget backdrops are strong. And that's certainly supplemented by the federal stimulus, the ARPA funds. It's roughly $360 billion that's being provided to state and local governments and I think another $160 billion for schools. They've got until the end of 2024 to commit those funds until the end of 2026 to spend them. So we believe that that's part of that active market. It's not -- certainly not the sole reason. Just in general, governments and kind of going back to your last question, governments are buying new systems or subscribing to new systems from us generally because they have to because they've used the system until it's really at end of life. Governments -- you asked about differences, Governments are not profit motivated. They're not ROI driven. They don't have competition effectively. So those aren't -- they're not buying a new system to -- or replacing an old system to have a competitive advantage over someone or even necessarily to be more efficient or make more money. They would like to be more efficient, they'd like to provide better services to the public, but they don't really have to. So they tend to use systems as long as they possibly can. It's not uncommon, probably -- I bet the average system we replace is probably 20-plus years old. It's not uncommon that we see 40-plus year old systems that we're replacing. So that creates a pretty stable backdrop kind of regardless of the economic conditions. When it gets to that point, for whatever decision -- whatever reason they've made the decision that, that system has to be replaced, it's generally a pretty nondiscretionary decision. They may be able to say, it's kind of a tough budget this year, I'm going to push it out a year, but they're typically not saying, I'm just not going to do it or I'm going to wait 5 years. So in previous economic downturns or the recession, for example, from 2008 to 2009, kind of that time frame, we've seen really fairly limited impact on demand. We may have seen sales cycles change a little bit, but the demand is pretty solid. And we're -- as I said earlier in the introduction, we're 80% recurring revenues today. And those are subscriptions or maintenance on mission-critical systems and those just really are almost unaffected by the macro environment.

And then some companies have been able to come out and pencil in direct contribution from ARPA funds. Have you guys been able to pencil and outline exactly what you've really seen?

Yes, that's harder than you'd like it to be. It's not always -- in most cases, there aren't deals that are actually specifically identified as this is being funded by ARPA. There are some of them. We talked about one last quarter on our call, a public safety deal in Hidalgo County, Texas, that was specifically funded with ARPA funds. But in a lot of cases, it's just part of their overall budget and part of kind of what's contributing to cushion in their budget or funds that are available, but it's not specifically identified or ARPA funds may be used for something else and that frees up money for something from Tyler. So again, I'd say it's a factor in a very active market, but it's not the primary driver. And we really can't say definitively that it's responsible for 20% of our new business or -- but I'd say it's not at the level of 20% of the new deals that are directly, I'd say, attributable to ARPA. Where we have seen a lot of activity is in inside sales, and we believe a fair amount of that is being stimulated by ARPA funds, where we've already had an engagement with a client about a potential add-on sale. For example, we have a data and analytics platform, our Socrata platform. It's a subscription that provides additional sort of BI or analytics capabilities on top of our core products. We might have been engaged with the client about that and they liked it, had interest in it but didn't have the budget for it. And so we've circled back to those people. And in a lot of cases, they said, yes, we can use some of our ARPA funds and execute on that. But in terms of like replacing a whole new suite of product, like a whole court system or a whole ERP system, does still have generally fairly long sales cycles. So I think probably some of those in process, ARPA is a factor in them but not the only factor.

Got you. Got you. I want to shift gears to the NIC acquisition and maybe kind of go through cross-selling opportunities. And I think you've been asked this question since the acquisition was actually even announced. But one is, could we go through the cross-selling opportunities that you guys do have in front of you because you talked about inside sales as being kind of a key driver here. But also how well do you think the investor base actually understands the cross-selling opportunities that are going on with NIC?

Yes. So NIC for those that aren't familiar with it, it was an acquisition we did in April of 2021, largest acquisition in the company's history. It was a $2.3 billion purchase price. Actually, the only time we've ever acquired another public company as well. So NIC have been public for a long time, probably a little bit under the radar in terms of their profile with investors. But NIC is a very complementary company to Tyler. They solely serve the public sector, but really serve different levels of government and different -- provide different offerings than Tyler historically did. So NIC is primary where Tyler provides sort of essential back-office software systems, NIC really provided the digital sort of front end to government mostly at the state level. So Tyler was 85% local. NIC was about 95% state. And NIC provides the websites and the portals at the state level, they have 28, I think, state enterprise contracts, and they build these connections to back-end systems, which could be Tyler systems, but in most cases aren't, and facilitate transactions or the exchange of information with state government. So think about renewing your motor vehicle registration, getting your license plates, renewing your driver's license or getting a fishing license, insurance companies accessing driver history records to issue insurance policies, those sorts of things. And NIC's model is mostly sort of a self-funded model. So those services are funded by convenience fees paid by the users, so the state typically isn't writing them a check for -- to provide services. And NIC also has a big payment processing business. So when there's a payment associated with one of these transactions, NIC is generally doing the payment processing there. And in 2 states, Texas and Florida, 2 very big states, NIC just as payment processing, but there's all the payment processing for those 2 states. So very complementary in that they do different things than us, also got us a significant presence at the state level. So good business on its own, but really tremendous cross-sell opportunities because there's really not much overlap. So there's sort of cross-sell opportunities in 2 directions. The first is being able to sell Tyler software products in the state governments through NIC's relationships and actually through their contract vehicles. So Tyler has dozens of applications or software products that have applicability at the state level, but we don't have a lot of business at the state level because we traditionally don't have big sales force is focused there. We haven't had a lot of those relationships. NIC does. So through the NIC contracts, there, as you can imagine, they're very deeply embedded with the CIOs, with the agency heads because they are providing the access to all these transactions. So they know where there are pain points, what the strategic initiatives are, sort of what's coming down the road. So we think we can get in sooner that we can bring solutions -- that we can identify needs and bring Tyler solutions in often without a competitive process taking place because the NIC contract vehicle is a very broad and enable us to provide digital government services, including software as sort of add-ons to those contracts. We've seen -- in the first 18 months or so, we've seen really good traction there. We've seen a number of deals, 3, 4, 5 deals a quarter that have actually closed. We had a pretty good sized deal in Colorado, where we sold our licensing and permitting application for sort of all the state licensing functions. We sold our corrections product VendEngine in a statewide deal in Arkansas that came through NIC. So we've seen a lot of opportunities across multiple Tyler products, but more importantly, we're building a really nice pipeline. We said that the pipeline of opportunities to cross-sell Tyler products into NIC states, doubled from Q1 to Q2. We said that it grew another 16% in Q3. So some of these are near term, some of these are longer-term opportunities, but we're really pleased with the traction we're getting there with the cross-sell in that direction. There's also cross-sell going in the other direction. So NIC, as I said, provides a lot of payments processing but pretty much exclusively at the state level. So they haven't had relationships at the local level or a sales force focused on the local level. We've got thousands of local government customers, many of whom use Tyler software products that actually facilitate payments like utility billing or municipal courts for traffic tickets or licensing and permitting. Tyler has not had a payment processing offering, but we've partnered with third parties like Chase and Elavon to bring them to our customers and we get a few basis points of transactions. And that was relatively new in the last few years offering that we started to build. So our opportunity really is to take the NIC payment platform and drive it down into local governments. And not only just with Tyler back-end systems, but on an enterprise-wide basis to go to a city. They might have a very fragmented payments set up. They might have one payment processor for the court. It's a different one for the utilities, a different one for parks and recreation. And really to bring them together under NIC, we think we've got a really compelling offering in terms of economics, reporting really strong mobile platform. And so there's a really compelling story for a city or a county customer to bring those payment offerings altogether under Tyler. We're really just starting to go after that market. We spent the last few months consolidating our payments organizations sort of building out our go-to-market playbook and now starting to execute on that. So we think that overall, the total payment volume or total payment opportunity at the local level is greater than the state level in aggregate. So we're excited about the opportunities. But again, that will be an ongoing sales opportunity for us.

And then would you say with the data points you guys have released, has that met investor expectations in line? Is it kind of -- how would you kind of characterize the receptivity of the data points you guys have released?

Yes. I mean I think it's resonated with investors. I think, again, another common characteristic of local governments is they move slowly. So sales cycles are long. It takes a long time to make decisions. We're -- as a company, we tend to be very patient. So I think we're starting to have concrete examples of successes in the kinds of opportunities we outlined at the time we made the acquisition. But again, these things play out over time, like with payments, we're just now starting to get to market. So we've done a lot of the groundwork. So I think people probably still are looking to see more real announcements and real deals. But as I said, we've -- I think, throughout the last year, I've commented that we're sort of ahead of where we thought we would be or where we hoped we would be when we made the acquisition.

Got it. I want to shift gears over to margins. So are you guys currently on track with 290 basis points of impact to FY '22 margins? And how would you say the transition is actually going as far as margin impact? Is it going slower, faster than expectations when you started out the year and maybe you could unpack that a little bit?

Yes. I think generally, we're in line with our expectations that we had at the beginning of the year. We didn't actually -- I guess we guided embedded in our guidance as a margin. We didn't actually give a specific margin impact for this year. But we did say that for a number of reasons as we came into this year, we expected to see more of a margin -- more pressure on margins. And I mentioned a couple of those earlier. One is the just the acceleration of the transition of our new business mix. So as I said, we -- for a number of years, we had a hybrid offering. We offered our products either in on-prem or cloud. For the last 2 or 3 years, we've said -- we've had a significant focus on trying to drive more new customers to the cloud. 2019 was the first year that more than half of our new business came to us through the cloud. Now it's around 80%. So it took probably close to 20 years to get from 0 to 50% and then 3 years to get from 50% to 80%. We've said that, that mix is even through this year is shifting more rapidly than we had thought at the beginning of the year, which is a good thing for us. That's what we want people to do. But a couple of our products like our licensing and permitting product, for example, we had said entering the year, we thought we would be 80% to 85% cloud. It's really about 95% cloud, and that carries over into next year as well. Public safety is an area that has certainly lagged in terms of receptiveness to the cloud, and in some cases, has been almost resistant to the cloud. So jurisdictions have been less comfortable moving a 911 system into the cloud, for example, especially if they're in a rural area with maybe unreliable connectivity. But we're even starting to see some traction there and some expectations around next year for greater adoption. So that revenue mix is part of the reason. So licenses, as you know, have a almost 100% incremental margin subscriptions, you have to build up a recurring revenue stream, which typically will be -- the subscription would be about 2x what the maintenance would have been. So you've got a much higher recurring revenue stream, but there's about a, call it, 3, 3.5 year sort of to get to the breakeven on revenues. So the impact of that higher mix of new subscriptions this year we've layered in payments. Payments has a lower margin. It's a nice complementary business to this core software business, but think about margins more like in the 25% range on a gross margin basis. So the impact of bringing those in as -- had put some pressure on our margins overall. And then the bubble costs or transition costs related to the cloud transition. So we've historically operated our own data centers. We're migrating to AWS. So we're moving -- we're putting new customers into AWS, but also lifting our existing customers that are in the cloud from our data centers over to AWS. And until we kind of complete that evacuation of our data centers, we've got some duplicate costs. There's some fixed costs around running the data center until you get completely out of it. And we've said we expect to be out of the first data center around the end of next year and the second one probably a year or so after that. So all those things have put pressure on margins and some of those things will continue into next year. On our last call, we said our outlook for next year, our early outlook, we haven't given guidance, but we said we believe licenses will decline more significantly next year because of that mix change, not because of a lack of new business, but just because of the mix. And we think that public safety may be as much as 25% or 30% cloud next year. So -- and then the bubble costs as well. So we've said that 2023 from an operating margin standpoint, we believe, will be the trough and then that we'll be back on a margin expansion trajectory after that. And generally, all that's playing out the way we expected the transition of the data centers, the investments we're making in the products. I don't think there have been any big changes around that since -- as we came into the year.

Got it. Thank you for all that color. I wanted to shift gears to hiring because I know that's been a topic of conversation, specifically your professional services division. Now since we are starting to see some large-cap tech companies start to make some changes about hiring, in fact, most of them are restructuring at this stage, is this making it a more conducive environment for Tyler to hire? Or has the dynamic relatively been unchanged since the beginning of the year?

No, it seems to be getting a little better. So we've talked about like every software company and kind of every company almost about the employment environment and challenges around higher turnover, and we're not only replacing turnover. And our turnover is over the last year has been above -- certainly above pre-pandemic levels. We believe it's better than industry but certainly higher than we've historically experienced. And that's in our professional services teams and development teams as well, where there's been a lot of pressure on hiring and on wages when you hire new people. And we're not only replacing turnover, but we're growing, and so we're expanding our workforce. And in the professional services side, we said in particular, where we've seen higher turnover, it's put some pressure on our Pro services revenues. Now those revenues are no margin. So it really hasn't had much of a margin impact. But we are not staffed up to our plan. We had pretty large group that hired at the end of the third quarter -- or the second quarter, another group in the third quarter and another group in the fourth quarter. So we're getting back on track, and it does seem that attrition is starting to moderate with some of the factors you talked about with other companies, actually laying off people, hiring freezes. So there's not quite as much of people being hired away, some of the startups are having more trouble with funding and aren't hiring at the same rate. So that does seem to be moderating. And so we think some of the pressure we've seen on Pro services revenues, we think, over the next 3 or 4 quarters, there's a certain sort of ramp up time from the time we hire someone to the time they're really billable. That's typically around 6 months. So we're sort of in that stage with a bunch of our team, but kind of getting back caught up in terms of being back in full capacity. So at some point next year, I think will be -- that pressures will go away.

All right. One thing I want to hit, especially before we run out of time is your $1.8 billion record backlog that you guys reported in 3Q of '22. Could you give us kind of characteristics on your backlog? Is it cancelable? How -- have you ever seen -- what has been the cancellation rate of that just because in tech, the backlog levels have been a big focus area for a lot of investors. Can you tell us a little bit about your backlog?

Yes. With us in the government space, it's probably a little different than some of the private sector companies. Our backlog is pretty much basically the value of noncancelable contracts that -- for which the revenue hasn't been recognized. So it would have -- a small part of licenses in it that haven't been delivered and they have Pro services that haven't been delivered yet. It would have -- the biggest chunk is the unexpired portion of either subscription arrangements or maintenance agreements. Maintenance agreements are typically 1 year renewable annually. So there's, on average, 6 months of maintenance and backlog. Subscriptions can be 3 to 10 years long. Our average is around 4 years for new contracts. So -- and again, that -- they only go in if they're noncancelable. For example, we talked -- the deal you referenced earlier, we signed our largest deal last quarter it was a $54 million SaaS deal with the Department of State. And it's, I think, an 8-year deal. And -- or it's a multiyear deal, I think it's 8 years. But it has a termination for convenience clause in it, which is somewhat unusual, but we wouldn't expect that, that would be executed. In fact, the Department State already was an existing client, so this was a pretty significant expansion of that relationship. But because of that, we only put 1 year into a backlog. So of that $54 million contract, only $8 million, I think, went into backlog. So pretty much what's in backlog, we expect to be realized, but in some cases, it certainly understates our visibility of revenue. Transaction revenue whether it's payment processing or NIC portal, there's basically no backlog for that because even though we have a highly visible recurring revenue stream around those, again, there's not a sort of fixed fee associated with that. So it's -- that wouldn't be reflected in our backlog.

All right. So we're rounding out with time. Brian, thank you very much for joining us.

You bet. Thanks for having me.

Absolutely.

Appreciate it.

All right. Thanks, everyone.