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

I wasn't sure how we're going to let the Texas [indiscernible]. But Brian, thanks for joining us today. So Day 2 of the Wells Fargo TMT Summit. I'm Michael Turrin, the software analyst here. We're pleased to have Brian Miller, EVP and CFO since 1997, if I have that right, for Tyler Technologies. So a lot of good historical perspective to provide. I think Tyler is getting a little bit more attention just given some idiosyncratic business characteristics. So maybe we can just start high level for those that do not have the benefit of having spent significant amounts of time, and you can start with just the overview, Tyler solution portfolio, the customers, the types of markets you serve and then I can follow on from there.

Sure. Yes, Tyler is an enterprise software company focused exclusively on the public sector. So we're narrowly focused on the public sector, but it's a very big vertical market, as you can imagine. And we're very broad in terms of the breadth of products we offer for the public sector and the levels of government we serve. We serve local government, which is historically sort of where we grew up and still the majority of our business, but also have a growing presence in state governments. A lot of that came through a large acquisition we did about 1.5 years ago. And then a small but growing presence in the federal space as well. So we provide essential back-office software that governments use to run essential functions. So things like public administration, so ERP systems, accounting, human resource, payroll, utility, billing, licensing and permitting, property tax systems, public safety systems, 911, police, fire and ambulance systems, Courts & Justice, so the whole justice process from the beginning of a trial through probation. And we have a data and analytics platform that sits on top of a lot of our products. We have a low-code development platform that's used primarily in the federal and state space. We have a really wide range of products. By far, the broadest offering of software solutions for the public sector. We've had an increasing growth in a transaction-based business as well layered on top of our software around payments and other transaction revenue sources, convenience fees for transacting business with government through our portal, electronic filing in the courts. So that's -- and a lot of that payment business came from the NIC acquisition in 2021. And then, I guess, lastly, from a high level, we're going through a SaaS transition. So it's been a multiyear SaaS transition for Tyler. As you can imagine, in the government space, governments are slow to do about everything, and that includes moving to the cloud. So it's been a long transition in which we've, for a long time, have sort of a hybrid model where we offered our products either in a traditional on-premise license-based business or in a subscription hosted private cloud business. About 3 years ago, we've changed from that cloud-neutral to a cloud-first approach, entered into a partnership with AWS to do most of our hosting of our cloud customers and really have made a lot of changes around our business model to drive customers to the cloud. And so over that last 3 years, we've gone from about half of our new business being cloud-based to now north of 80% of our new business. And over the next couple of years, we expect that to continue to accelerate to where licenses become a very, very small piece of our new business. But that's created a little bit more of the complications around the business as we -- as our model shifts around.

We'll get to those. And the good news is software investors know this fairly well at this point. There's more comfort and confidence around this. But before we get into that, I mean, just hearing you [ will stop ] the number of types of products and customers you're serving across local, state and federal level, it sounds like a fragmented market. Your characterizations of what you're most often replacing and how you think about penetration of the market today from a Tyler perspective and maybe from a cloud perspective also?

Yes, it is super fragmented. And historically, this space has been served by a lot of niche players. So generally, companies that are narrowly focused from a product perspective and often narrowly focused from a geographic perspective. So companies that may do court systems in California or tax systems in New Jersey. So some very narrow companies. So part of our strategy 25 years ago was really to create something that didn't exist, to create a single company providing multiple solutions, the one source of solutions, and ultimately to make those systems integrated to work better together and to create more value out of each of those point solutions by being part of an overall suite of products. So most of our customers have 1 or 2 products from us and could have 7 or 8. So there's a tremendous cross-selling opportunity that plays out over a long period of time. So just sort of stepping back a little bit, what drives demand in the public sector? It's mostly a replacement of systems that are at end of life. So governments are different than the private sector in how they buy software in that they're not profit-motivated. They're not ROI-driven. They'd like to provide better service to the public and be more efficient, but they don't really have to because they don't have competition. So that's what drives the private sector to replace software to creating ROI and have a competitive edge or manage some aspect of your business better. So governments tend to use software as long as they possibly can. And when it gets to the end of life, and there are different things that could cause them to decide it's at end of life from just being -- at the extreme, we replaced some systems that are 40 or 45 years old that are mainframe Cobalt systems from the '70s that there literally are no more Cobalt programmers around to systems that run on old hardware platforms that don't exist anymore or systems that just are no longer supported by vendors that have gone away or have gone into legacy mode. But when it gets to that point, that replacement is a fairly nondiscretionary decision. So it creates a market that tends to be very, very steady, never has explosive growth, but doesn't really go backwards. And we've built, even though it's a very big market that's still very fragmented, so we have different competitors in each of our sort of sub-verticals. But we're, by far, the largest vendor in the space and really the only company that has a wide range of products. So that creates what we think is a pretty significant competitive advantage.

One of the topics of discussion clearly throughout the conference has been the macro environment. I suspect your answer is a little bit different than a lot of what we're hearing elsewhere just given some of the attributes you've highlighted already. But from a macro perspective, are you seeing changes in RFP activity, the demand environment? Any change in terms of how your prospective customers are addressing software?

Not in a negative way. So we've commented in our last few calls and certainly on our last third quarter call that the leading indicators around demand are continuing to improve, generally are back at least to pre-COVID levels. But when we look at sort of things like the pipeline, specifically the number of RFPs we're responding to, number of demos we're doing, so the pace at which deals are moving through the pipeline, all of those things are either continuing to grow or at least are stable at pretty elevated levels. So it's a really active market in the public sector. Generally, the budget backdrop from really kind of all levels of government is really pretty strong. At the local level, property taxes are a major revenue source. And even though the housing market may be slowing down somewhat, there's still property values that are pretty elevated. A lot of pressure on property taxes, but most of their revenue streams are really pretty strong. And then there's the federal stimulus ARPAs providing $360 billion of direct aid to state and local governments that kind of is working its way through the system over the next 3 or 4 years. So yes, we're continuing to see things be very solid in terms of the market conditions. I would say that, typically, in our past experience, the government does sort of react more slowly. So often, macro changes don't appear until there's a lag from the private sector, but there are some differences this time around kind of what's causing some of the slowdowns and how they don't really affect government much.

Just a couple of follow-ons from that. On the property tax side, can you just speak through what a stress test of that would look like? At what point would property value changes have a ripple effect toward -- into Tyler?

Yes, it's pretty far down the road. Property taxes, as you know, there's 2 pieces to the equation. There's the rate and the value. So typically, they're supposed to solve for what they need. So if the values go up, the rate should decline. On the upside, that typically doesn't really happen that way, the rate may go down, but not as much as the value went up. And on the downside, it's also not very efficient. It's certainly not real-time. A lot of places revalue properties every 5 years or 6 years or 10 years with interim adjustments. But broadly, they don't go through them, look at those values every day. So even if your property is worth less, your house, your tax bill likely doesn't go down next year, and there's a big lag to it, so it's really -- they tend to be really a pretty stable revenue source even though they may move around in a narrower range.

Okay. That's helpful. And then on the stimulus side, any observations, indications that, that is something that you're seeing some degree of RFP support behind? Or what's your view on how that could flow through to Tyler?

Yes, we definitely think it's part of that active environment. It's not the sole reason or even the biggest reason. Everybody would like us to -- we get lots of questions on our calls every quarter. People would like us to say that X dollars of new business was directly related to ARPA, but it just doesn't quite work that way. In some cases, we do have deals that we know are specifically funded by ARPA funds. We had a public safety deal in Hidalgo County, Texas last quarter. That was one that was specifically paid for with ARPA funds, but it doesn't mean that deal wouldn't have happened without those funds. And in some cases -- in a lot of cases, ARPA funds are used for something else, but it frees up money for something they might buy from Tyler. They've got until the end of 2024 to commit the funds and they got until the end of 2026 to spend them. So even if they've allocated some funds to buying a system from Tyler, they might still be in the early stages -- or a system that could come from Tyler, they might be in the early stages of that buying process. So you might not actually see that for another year or 2. So we think it's a tailwind over really the next 3 or 4 years. It's not -- it's really hard to exactly quantify it, but it's, again, part of that.

Part of the healthy background. Excellent. Shifting gears a little bit, just in terms of 3Q earnings and the highlights from your perspective, key takeaways you think investors should be focused on, I'm sure we'll go into the cloud transition as this evolves. But just the high-level takeaways that you'd like investors to frame the conversation around?

I mean I think it was similar to kind of what we've seen through the years, we had a strong quarter, really good bookings quarter, reflective of that active market really across all of our product areas. So there's not one area that's really driving things. We did see a higher percentage of the new mix comes to the cloud. It was north of 90%. That was skewed a bit by we had a really large $54 million deal with the Department of State and the federal space, so the largest deal we've ever done for our federal -- for our low-code development platform that has a lot of activity in the federal space. So really, really nice SaaS deal there. But even around other products, we continue to see a higher percentage of cloud, and we have some commentary about what that means for next year as well in terms of a greater expectation for a faster acceleration of that shift from license to cloud. One of the things you've pointed out, as we move through this year and move into next year around the NIC acquisition, which was 1.5 years ago, continues to perform really, really well, exceeding our expectations, especially around the cross-sell opportunities that we're identifying. But within NIC, they had a pretty specific couple of offerings that were directly related to COVID around managing COVID testing programs and rent relief programs related to COVID. And those are coming to an end as we expected. We actually expected them to end some time ago, but it creates about $49 million of revenues this year that won't be there next year, and we've continued to point that out to investors as a model next year. Those are relatively low-margin revenues, but it creates a little bit of a comparison complication that you got to be aware of.

Just expanding on the cloud transition and the impacts given the shift towards subscription seems like it's happening even quicker than previously anticipated. First, what is it that's driving? Do you have a sense of what's driving the quicker mix in this direction just from a -- is there something from a customer perspective or your own go-to-market perspective that's driving the shift?

Yes. And with government, like I said, it's been certainly slower than the private sector has embraced the cloud. But I think the primary reasons, and it's been the case for the last several years, but it continues to be more and more impactful with local governments, a lot of it is around their ability to manage their own IT infrastructure. So just like we and probably every company here that has challenges around the employment market these days, seems to be moderating a bit, particularly in the tech space, but a lot of challenges around hiring, retaining, paying for field people, particularly on the IT side. And for governments, especially if you think about a city or a county, it's really been a challenge for them. They've got a lot of aging workforces, especially in IT. And as those people retire that have lots of skills and wear lots of hats, to find people with those skills to pay the market rates which might be more than the city manager or the police chief makes and to just attract them to come work for the county government as opposed to someone that's here at this conference, it's a challenge. And so they really struggle with managing their infrastructure. And then cybersecurity, ransomware concerns, and their confidence and their ability to manage those things, being able to offload at least a good portion of that by moving to the cloud becomes more and more attractive to them. And even in some of our product areas that have been almost actively resistant to moving to the cloud, particularly public safety, so in a people -- a lot of governments have been just really cautious about moving something like a 911 system to the cloud. They're becoming more confident around that, and we even expect that we'll see a pretty nice uptick in our cloud business in public safety next year from almost nothing to maybe 25% or 30%.

That's great. So before we go into the long-term benefits, maybe just on the near-term impacts for us to be mindful of in the model. If the shift continues at this more pronounced rate, you've at least provided some shades in terms of license declines and some of the things we should see. But what are some of the things that should be top of mind for investors as we're thinking through the growth margin profile near term, and then we can go into the longer term.

Yes. We haven't given full guidance for next year. But in our third quarter commentary, we did talk about our outlook for licenses next year around that shift. And so this year, our licenses will be, call it, in the $65 million to $70 million range out of north of $1.8 billion in revenues, so already a pretty small piece of the revenues, but high margin. And this will decline about 10%-ish in '22. '23, our sort of preliminary look, we're estimating that licenses will decline about 40% from the current level, which would put them to say somewhere around $40 million. Again, still not a big impact relative to revenues, a little more impactful for -- on margins. And that's certainly what we're trying to achieve, and we're happy that that's happening a little bit faster, but that's a greater decline than we would have previously estimated and it's around those things that are driving that shift faster. We have already said that we expect that 2023 would be the trough in terms of margins for Tyler, that trough being driven by the compression in margins this year and next year being driven by that shift in the mix and moving from the licenses going away and building up that revenue stream of SaaS revenues from some bubble costs around the transition. We've got some development costs around optimizing our products to be more efficiently deployed in the cloud. And we've got some duplicate costs around our data centers. So we currently host most of our cloud customers in Tyler proprietary data centers, and we're moving that to AWS. And -- but until we get out of our data centers, we have some fixed costs that are kind of duplicating some stuff at AWS. And a chunk of that we expect to be finished with at the end of '23 and then the rest of it after that. So we still think '23 is kind of the trough, and it's maybe a little bit deeper now because of the margin or because of the mix shift being a little faster, but that also means the return to margin improvement and to accelerate revenue growth happens a little bit faster and maybe a little bit steeper in '24 and beyond.

And then thinking through the conversion of what that license -- the economics of what that license shift means for you, I think you've referenced 2x LTV on a cloud customer like-for-like versus on-prem. So how well tested in the market is that currently? Can you just talk about observations of the cloud customers you've seen and then the comfort level of government customers moving to AWS versus Tyler managed and just what your observations are there?

Yes. Yes, that roughly 2x lifetime value is -- has been pretty much proven up over the last several years as we move customers. So with our on-premise customers as we flip those or migrate those to the cloud, it's kind of a range of, I'll call it, 1.5 to 2.2x, but probably 1.7, 1.8x for most of those, depending on where they kind of are with maintenance today. And we convert 75 to 100 a quarter. We've got 25,000 of them. So we've got a long way to go. And that on-prem conversion really will start to accelerate, I'd say, again, a couple of years down the road as we finish the optimization of our products and make them more efficient and less expensive to host it in the cloud. But there's a significant revenue uplift built in there in that we -- we currently have about $470 million a year of maintenance from on-prem customers that we'll see that uplift over multiple years. And with new customers, the breakeven is typically kind of in, from a revenue perspective, 3.5 to 4 years where we've recovered that license, but then we've got the sort of 2x subscription versus maintenance going forward. So not only in the long are they higher revenue value, but the margins are better. AWS has been a great partner. We went through a lot of thorough process deciding who our primary partner would be. It's not exclusive, but the vast majority of our customers going to AWS. They've got a sophisticated government cloud and FedRAMP offerings, so they've been a great partner working with around our transition of our products and moving from our data centers. And we have some customers that are hosted elsewhere, but the vast majority of our customers are happily going in to AWS.

You touched on NIC, I want to flip gears and just talk about capital allocation a little bit, given you run a fairly balanced playbook there. Maybe you can just start in framing NIC, given that's the largest acquisition, what that brings and just the cross-sell opportunity and if there are initial case studies or observations you can share?

Yes. So people that aren't totally familiar with it, NIC was an acquisition we made in April of '21, by far the largest acquisition we've ever made, the first time we've acquired another public company. NIC, the purchase price was about $2.3 billion. They were doing north of $400 million a year in revenues, very complementary company. They exclusively serve government as well. They probably were a little under the radar, under-followed and maybe a little misunderstood, but they -- whereas Tyler provides the back-end software solutions for government, NIC really provides the digital front end to government. So they have 28 state enterprise contracts that -- where they manage the website. They built connections into these back-office systems, which could be Tyler systems, most of them are, to provide access to information or transactions with government at the state level. So things like renewing your driver's license or getting a fishing license or insurance companies accessing driver history records to issue policies. And their model is really sort of a self-funding model that the customer and state doesn't typically pay them, they get paid by convenience fees and payment processing and so they typically process the payments around those transactions and might get, say, a $5 fee for issuing a driver's license, and that sort of stuff. And then 2 states, Texas and Florida, we have payment-only contracts. So we do all the payment processing for those 2 states. So very complementary to what we do, but they're mostly state. We're mostly local. We both have a little bit of federal. We have sort of different ends of government. So 2 big cross-selling opportunities. One is the opportunity to sell Tyler software products into state governments, where we haven't typically had those sales channels or those customer relationships. NIC is very, very deeply embedded with the CIOs, with the agency heads. So we've got an opportunity to know about needs earlier to get in with our products, to avoid competitive processes because they can be sold through the existing NIC contracts. And we believe we have dozens of applications that those opportunities exist for. And we have a really nice pipeline that we've been able to build just kind of in this first year post acquisition. And we've had a number of deals -- several deals each quarter that have actually come out of cross-selling opportunities. The other cross-selling opportunities kind of going in the other direction, and that NIC has a really robust payments platform. They're clearly the leader in government payment processing and great reporting that's specific for government, a really nice mobile platform called Gov2Go. So we have an opportunity to take that and drive that down to the local level where NIC didn't have sales channels or customer relationships, but Tyler has thousands of those. And a lot of those customers use systems like -- from Tyler like utility billing systems or tax or municipal court systems for traffic tickets that have a lot of payments associated with them. So we've combined our payments teams. We've built out sort of our playbook for go-to-market. And we're just now starting the process of going to local government market with this payment platform. Previously, Tyler's had some payment processing revenues from reselling other processors and getting a few basis points based on this. But really, we've got an opportunity to capture more of that revenue and to really embed it with our customers. And we think that's a -- we've got a great value proposition for our customers and a pretty compelling story, and we look forward to really growing that payments business.

You have a strong track record of M&A. I think there is a series of acquisitions to help Tyler move into this cloud-first direction. Can you just speak to the muscle memory you've built on the M&A side? How well integrated are these solutions? How well integrated do they need to be? And just what informs your framework going forward in evaluating the M&A landscape?

Yes. Just for perspective, I'm in my 25th year with Tyler, and we've done about between 55 and 60 acquisitions over that time frame. So average a couple a year. We're a little more active. We did 5 or 6 in 2020-'21 time frame, including NIC and a couple of other decent-sized deals. We generally are looking at acquisitions that broaden our TAM or broaden our product portfolio. We typically aren't doing consolidation-type acquisitions and rolling up more businesses that have the same products we have. Sometimes those products are integrated more tightly like when we got into the public safety space through an acquisition that was -- there was a lot of development around integrating that with our Courts & Justice solutions. Others like NIC don't really have that, and more of our acquisitions, really all of our acquisitions in the last few years. On the software side have been native-cloud applications that integration is much easier. Or kind of touching on what you asked about earlier, our balance sheet is really strong. We typically -- we generate a lot of cash, and we've typically had little or no debt. With the NIC acquisition, we did incur about $1.6 billion of debt and used about $700 million of cash on hand. $600 million of that is in the convert that -- the convert market was really hot then. And so we've got to convert it 0.25 point of interest in a conversion price that unfortunately is well above where we're trading today. And we've got the balances, term debt, which Wells Fargo led that process. And we've been paying that down pretty aggressively. So we've paid down more than $600 million of that. And so it's really manageable. Our leverage is under 2x. So we got a lot of flexibility around our balance sheet. So we'll continue to look for acquisitions that broaden our offerings, either from a product perspective, what level of government those products serve. We've said the bar is kind of high right now because we're really focused on integrating the deals we've done in the last year or so. And also because in the private markets, it seems that valuations haven't reset the same way the public software valuations have reset, so a lot of sellers still have expectations, whether they're reasonable or not of evaluations that may be well in excess of where Tyler's evaluation is. So generally, we're looking for acquisitions that are accretive. And so I think that will all sort of sort itself out at some point. But right now we did do an acquisition this quarter of a company called Rapid Financial that's in the payment space that complements what NIC does, but brings us some capabilities around the payment issuing side as opposed to the payment acquiring side. And we think that's a really nice complement to what we already do.

We have time for just one more. So besides just leaving you with closing thoughts, I think it's useful to hear you just touch on the historical perspective of Tyler. You've seen multiple cycles before, just your confidence in your ability to operate this business regardless of what the macro brings over the foreseeable future and maybe just pointing back to the resilience factors or any other closing thoughts that you have for investors.

Yes, because I think that's a real strength to Tyler. And not just -- I'm not the only one that's been around 25 years. Our CEO started a year after me. A lot of our management team has been around through the last recession, was here in 2000. So we've seen some different cycles. And Tyler is a bit different and built a little bit differently to do well in an economic downturn, and our customer base is very stable. Our customers don't go out of business and they don't get acquired. Their needs, as I described earlier, when they need to replace the system, it's kind of a nondiscretionary decision. Everything we do is essential. We're about 80% recurring revenues, a combination of maintenance, SaaS and transactions. And those, we believe, are just about not affected. Paying the maintenance or the subscription for the 911 system is not a discretionary item. And most of the transactions we process are kind of nondiscretionary. Somebody is going to pay 12 utility bills a year. They're going to renew their license plates every year. So with that 80% recurring revenue, it gives us a really, really stable base that doesn't really get affected much. Our customer attrition is, on a dollar perspective, as about 1%. So really stable there. We're 98% domestic and the 2% [ domestic ] candidates. So we don't have FX exposure or international exposure. And again most of the new business, we could see and what we did see in the last recession is timing. So demand doesn't go away, but sometimes someone says, "This is a really tough time. I've got to wait another year." But they're typically not going to wait 5 years. And today, with the SaaS model, it's much easier and less of an upfront capital outlay than 10 years ago when we were a license model. So we did really well through the recession in 2008 through 2010. And we feel like we're much better positioned today with our revenue mix with the cloud model. We do feel really confident about our ability to perform well even in a tougher time.

It's a great point to close on. Brian, thanks very much for joining us. Appreciate the time.

Thank you for having me.