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

Good afternoon, everyone. Welcome to day 2 of the Barclays TMT Conference. My name is Saket Kalia. I cover mid-cap software here at Barclays. Very happy to have the team with us from Tyler Technologies. I've got Brian Miller, Chief Financial Officer. We've got about 30 minutes together here. Let's maybe take the first 20 or 25 minutes to do some fireside chat here with Brian, which I know is going to be fun. And then let's keep this interactive. You've got a question, just pop up your hand or you're hearing the webcast, just shoot me an e-mail, and we'll try to get to as many as we can in the time that we've got. So maybe with all that as a framework, Brian, thanks so much for being with us here today.

Sounds good. Yes, thank you. Thanks for having me.

Yes, wouldn't be a conference without you, folks. So Brian, maybe just to start out for those of us here. I mean, I think we're all familiar with Tyler, but I was wondering if you could just recap some of the points from last quarter that you were particularly proud of, just so that we're all on the same page.

Yes. I think we're certainly happy that our market is holding up well and that we're continuing to report a really active end market, lots of activity on the buying side as far as fees, continuing to see those things grow. In particular, success in our federal space where we had a really large contract that we've been working on for some time with the Department of State for our low-code development.

Which contract was that?

$54 million deal with the Department of State, basically a cloud contract. So it's -- it kind of skew our cloud business in a good way. So really, really happy with that. That business is fairly recent, last 3 or 4 years acquisition. And so we're happy to see them continue to have success and expand our presence at the federal level. And I guess related to that is that we continued to see really good progress towards the cloud transition and our new business mix. And that contract was another reason that 91% of our new software business came in the cloud, which was a new high for us. And so we're happy that we're continuing to see that accelerate.

Yes, absolutely. I want to spend a lot of time on the cloud transition here because I think it's a really important part of the story. But thanks for level setting up for us, Brian. I mean, maybe even before we get into the components of the model and the portfolio, I'd like to just start high level just on the underlying health of your end market. I mean, as you mentioned, Tyler, a very big federal deal but the vast majority of the business, of course, is too local and some state governments in the U.S. And I think what you've said and Lynn, the CEO, said, I mean, the spending there is more insulated from economic swings, right? And so I was wondering if you could just talk a little bit about that and also touch on some of the federal funding that maybe your customers are getting that's helping them from that perspective.

Yes, absolutely. Yes, we are -- we tend to be more insulated just with our end market exclusively public sector. But as you said, mostly local, some state and a limited amount of federal. Both state and federal are growing pretty nicely though. So we're exposed to all levels of government but only to government. And there certainly are some differences around that market from the private sector markets, the biggest being that demand is generally driven by the replacement of aging systems and governments because they're not profit-motivated, they're not ROI driven. They're not -- they have no -- they don't have competition basically. So they're not -- their motivation for buying software is that they need it to run in a central function, but they're not buying it to -- maybe a side benefit is they become more efficient or lower expenses, but they're not buying it to gain a competitive edge or to make more money. . So as a result, they also tend to be risk-averse, and they tend not to like change a lot. So they tend to use systems much, much longer than you'd see in the private sector, really until, for some reason, they think that system is at end of life and really end of life. And then replacing it becomes an almost nondiscretionary decision. So they use it as long as they can. And when it gets to that point where they say it's not viable anymore, it may be -- it runs on an old hardware platform that's at end of life. It could be that the vendor no longer is around supporting the product. Could be a homegrown system that was written in COBOL, and there aren't any more COBOL programmers. So for whatever reason, when it gets to that point, it's a fairly nondiscretionary decision. In a tough environment, a tough budget situation, they might say, "I can put this off for another year or I can push this out for a little while." But it's typically not I can push this off for 5 years, or I just won't buy it. So a lot of the demand is reasonably inelastic. I guess the downside of that is that it's hard for us to create demand, so it's hard to make that happen faster to pull some of that forward. But it creates a market that's never explosive but really pretty steady and never goes backwards. So that demand is not really related to the broader economy or what funds are available. So we tend to be very high in the budget priority once it gets to that point. I think one of the things that also makes it easier, say, compared to the last recession, where we saw deals -- not -- again, not demand go away but deals delayed and pushed off. Back then, we were mostly a license business. And today, with new business, we're mostly a cloud business, so the kind of the bite to get in is much smaller. And so that makes it easier. Also, we're about 80% recurring revenues today. In the recession, we were only 50% recurring. And so those recurring revenues are pretty much unaffected. It's maintenance and subscriptions for essential systems. And it's transactions, payment processing, court filings, payment processing around utility bills or traffic tickets, but things that really don't...

Motor vehicle...

Motor vehicle, license plates, your driver's license, your fishing license. Most of those things aren't really -- are pretty stable regardless of the economy.

Yes, I agree. I think one of the questions that you and Lynn get probably every quarter is whether any of the federal funding out there is starting to impact deal flow. And it's always hard to know, of course, right? But how do you think about customers spending some of those funds. Maybe just walk us though...

You asked about the federal funding, I didn't touch on that. Yes, so also different now than in the recession a decade or so ago is that there is a massive federal relief for state and local governments. Initially, in the earlier part of COVID, there was the CARES Act, which provided relief to really states and really large local governments, but it was more specifically tied to making up for costs that they might have incurred directly because of COVID. Then the ARPA, the American Rescue Plan, has -- is much broader, is much bigger. It's $360 billion of direct aid to state and local governments. Everybody gets something, so it's not just for large governments. It's much more liberal about what they can spend it on versus anything they would get from Tyler certainly qualifies. But they're much more -- much broader available to use it. They have until the end of 2024 to commit the funds, and they've got until the end of 2026 to spend the funds. Research we've seen basically indicates that to date, only about half of the funds for cities and counties have been committed and certainly less than that has been spent. So we think it's a tailwind that we'll probably see effectively potentially through 2026. It's hard -- sometimes people would like to hear us say exactly how much new business was attributable to those funds. That's kind of hard. I mean clearly, we think it's part of the active market that we're seeing. It gives governments at a minimum sort of a backstop or confidence in their budgets, where there may be some uncertainty around some of the -- some items in their budgets. And they're spending on a wide range of things. We certainly think that IT modernization, digital infrastructure, those kinds of things that we provide will certainly get their fair share of those funds. In some cases, we do identify that a deal specifically funded by ARPA funds. We had a deal we called out last quarter, a public safety system for Hidalgo County, Texas that was specifically funded with ARPA funds. But that doesn't necessarily mean that, that deal wouldn't have taken place without the ARPA funds. That's just where they specifically earmarked part of those funds. In other cases, we know that the funds are being used for something else, that it's freed up money in the budget to maybe buy something incrementally from Tyler. And we've seen a lot of activity in our inside sales channel in the last year or so, and we believe some of that is attributed to the stimulus funds where we might have been engaged with a client about a potential add-on sale, something like our data and analytics platform that they liked but didn't have the budget for. And now we've circled back to those customers and said, maybe you can use some of your ARPA funds for that, and we've seen some successes there. So again, it's not the primary factor for the active market. It's certainly a factor, and we expect it to be a factor for a pretty extended period of time.

It feels like it certainly reduces friction.

Yes, absolutely.

Yes. No, it definitely greases the skin. So that's quite -- that's great to hear. I'd love to shift to the product portfolio just a little bit. I mean, the portfolio -- Tyler's portfolio is just so broad, and so I won't ask you to dig into every product here. But how would you sort of size maybe the 2 or 3 biggest product families here on a revenue basis? And then maybe through another lens, right, size versus growth, another words, which segments are maybe the fastest growers either from a bookings or ARR revenue perspective, how do you want to define it?

Yes, that's certainly a strength of Tyler and what we think is a pretty significant competitive advantage is that we're unique in the market in terms of the breadth of our product portfolio. The public sector market has historically been served and still is served, to a large extent, by niche providers or narrow solution providers, companies that may have a narrow solution set and sometimes even a narrow geographic focus within a narrow solution set. Just on -- just as court systems or maybe but just as court systems in California. And so we are, by far, the broadest set of solutions for the public sector, spanning a wide range of product portfolios. And a lot of those products work closely together, integrated, share a lot of common foundational elements, like common workflow engines or payment engines or security and sign on. So all of that creates more of a suite effect and gives each of our products a competitive advantage, why that next product should come from Tyler. Within those products, those broad suites, public administration, which is kind of ERP, financials, payroll, licensing and permitting, kind of all those sorts of applications, that would be our biggest single sort of set of products, and those account for somewhere around 1/3 of our total revenues. And we have multiple products within there in some...

Things like Munis, for example, like...

We've changed names, it's a naming convention, but our enterprise ERP, and we have ERP Pro for the lower end of the market, but those kinds of tools. Courts & Justice is probably our next biggest suite of products, and there are things like case management, prosecutor, probation, jury, those sorts of applications. That's probably also our most dominant product set where we -- and our biggest market share. We have about 55% of the U.S. courts and have very high win rates, like in the 80% range in that space. And that's about 15% of our business. And then when you get into smaller individual product sets, probably not counting NIC with its state government portal and transaction business, probably the fastest growing right now would be our enterprise low-code development platform for case management, which came from our MicroPact acquisition 3 or 4 years ago. That's a low-code development platform designed specifically for the public sector market. Most of our business there is in the state and federal markets, so that's the product, for example, that had the $54 million Department of State contract this quarter. So it's a platform for managing different cases or business processes, similar kind of to a ServiceNow or a Pegasystems, but just for government and a number of prebuilt accelerators for things like the Department of State's background checks and security clearances. We manage EEOC claims, a lot of licensing and permitting applications, those sorts of things with that platform. And we've seen really nice growth this year in the -- particularly in the federal sector. That market has been really strong. Competitively, we're doing really well. But we've also seen some good sell-throughs, cross-selling with that product into NIC clients, which was one of the cross-sell opportunities we thought was significant coming out of that acquisition. So that's probably one of the ones that's really performing well right now. And we're happy to see federal markets newer to us through that acquisition and happy to see us having a lot of success there right now.

Yes, sure. I'd love to dig into the SaaS transition here a little bit because again, I just think that's such an important part of the story. Now that we're at the end of the year, Brian, and -- or close to the end of the year and can look mostly back, right? I mean, I guess the question is, how has the pace of the SaaS transition trended here in 2022, maybe compared to your expectations at the beginning of the year? Why do you think that is?

Yes, I'd say it's trended -- it's moving faster than -- fast in government terms is relative, but it's moving faster than we would have thought at the beginning of the year. And by that, I'm mostly talking about the adoption of SaaS and our new client and how that mix is between SaaS and the traditional license business. And just for some kind of set the background, for a long time, Tyler was a license-based business, license and maintenance. And then for a long time, we've been a hybrid business, probably the last 15 to 20 years, where we offered most of our products in either a license maintenance model or a subscription cloud or private cloud sort of a hosted model. And we let -- we were neutral. We let customers decide which way they wanted to acquire the software. We didn't really try to push them one way or another, and that adoption and acceptance of SaaS and adoption by our new clients was very, very gradual over a long period of time. And so it took probably 15 years until 2019 for us to get to where 50% of our new business was choosing cloud. And then in 2019, we really signaled a change to a cloud-first approach. And we said we really want our business to come in the cloud. That's where our future is. And even though government is sort of lagging behind the private sector in adopting it, that's where we need to be. We entered into a partnership with AWS to move from our own internal data center hosting to moving to the public cloud with AWS. And we made the number of changes, for example, changing sales compensation. So the sales reps got compensated more highly for a cloud deal. We're actually, starting this year, announced a number of products no longer even available on-prem. And so from 2019 to this year, we've gone from 50% of our new business to 80%, round numbers, in coming this through the cloud. And even through this year, across a number of products, that cloud percentage in the new mix has been higher than we planned. For our Enterprise pro, for example, our lower-end ERP Pro, we started the year thinking 70%, 75% would be cloud. It's been more like 80% to 85%. For enterprise permitting and licensing, we thought 80% to 85%, it's north of 95%. So we've also changed our expectations about next year to elevate how fast we think the new business will continue to move. That's certainly a good thing. That's what we want to achieve. We want that business coming there through the cloud. But obviously, it has some impacts on revenues and margins in the short term. The couple of areas that are sort of laggards, if you will, would be public safety, and that's things like 911 systems, computer dispatch, police, fire and ambulance record systems. There's been certainly much slower adoption, and in some cases, almost resistance to the cloud. In some cases, those agencies really aren't comfortable with putting those systems in the cloud. And that's changing, but that's been a much slower market. That market even today has been almost all license and on-prem, although we do have a cloud product. And then the low-code development platform, especially in federal and state has been more of a licensed business this year. It's, I think, in the 20%, 25% SaaS range. Next year, I think we're thinking it's more like 50%. And actually, next year, we think public safety may be as much as 25% or 30% cloud. So even though the slower adopting areas are showing progress towards moving to the cloud. So yes, it's consistent with what we're trying to achieve. And the public sector, like with a lot of things, they've been slower to adopt new ways of doing things. But there's certainly the same benefits that the private sector has, sometimes magnified quite a bit, in the public sector apply. So there's a lot of reasons why governments want to move to the cloud, and we're happy to be on the front.

And it's happening more and more which is great to see. Maybe on that point, I mean, I think the success with landing new business, right, as SaaS is very evident, right, based on 91% last quarter. Maybe a little bit of that was higher from that federal deal but still well over 80%, right, kind of consistently before that. Can you just maybe talk about how the process is going on flipping existing maintenance customers to SaaS? Do you have any incentives for salespeople to do that? And I think very importantly, talk to us about the revenue dynamics for when a customer does flip for maintenance to SaaS?

Yes. So we talked about the new business mix and the percentages there, but we have this huge base of installed base of on-premises customers. And that, by far, outweighs the current base of customers that are in the cloud, something like, I don't know, 6,000 or 7,000 that are in the cloud and in the 20,000, 25,000 range that are on-prem. So we've got a lot of actually sort of built-up revenue growth that's in that maintenance. So we have about $470 million a year of maintenance from our on-prem customers. And as those customers flip to the cloud, typically our annual or recurring revenue stream comes close to doubling. So if they're paying us $100,000 in maintenance, it can be from 1.5 to 2.2x but it probably averages 1.7, 1.8x what they would pay us in a subscription, which part of that goes to pay for the hosting, part of it basically is just a relicensing each year. So the revenue is roughly double over the life of the customer, and the margins are higher. So we've got a big sort of built-in, both revenue growth and margin improvement as those customers flip from on-prem to the cloud. To date, we've been, I'd say, pretty slow about the flips. Each quarter, we do -- our current pace is 75 to 100 a quarter, most of those driven by customers actually coming to us and wanting to move to the cloud often because they're struggling with managing their own infrastructure, where they're struggling to hire or retain systems administrators, applications administrators. They have concerns about cybersecurity in their own networks. So those are the primary motivations for moving. But I think we're probably a year or 2 away from significantly accelerating that pace. I think we'll see a higher rate of flips next year, maybe 2x what we did this year. But we're still probably a couple of years away from where we're doing hundreds a quarter or thousands a year. A couple of gating items there. One, we also launched in 2019 a series of development projects to optimize our products to be more efficiently deployed in the cloud, because a lot of our products were originally designed to be deployed on-premises. So they're not super-efficient in the cloud. They have a heavy footprint. They take up a lot of resources, and they're more expensive to host. So we're making changes to the underlying products to improve or optimize that efficiency, and we want to have that done before we start moving thousands of customers on to them. And we've said those efforts will largely be done by the end of next year. We also have, in many cases, clients that are not on the current version of the software. Sometimes, we support 2 or 3 versions of a product, sometimes 8 or 10 versions. And when you multiply that times a lot of products, it's -- there's a lot of inefficiencies in our support organization and in our development because of the resources required around that versions' fall. So that will get cleaned up as we move to the cloud, and customers will generally be on the current version of the software, so we get margin improvements and operational efficiencies. But in order to get there, a lot of our current on-prem customers need to upgrade to the current version of the software. And so that will also kind of govern the pace of that. So we're probably looking at sort of an 8- to 10-year time frame to get all those thousands of customers over. But I think you'll start to see that accelerate and be somewhat of a bell curve here a year or 2 down the road. But the pace should continue to accelerate. It's a big opportunity for us. It's something we're really focused on.

Yes, absolutely. Just a very loyal maintenance base there that can see that value over time. I'd love to move to the cost side of the SaaS business. Can we just talk a little bit about Tyler's shift to the public cloud? And how that shift in infrastructure is maybe impacting Tyler's margins near term and longer term?

Yes. I touched on a little bit of the longer-term margin opportunity around the shift, around version control and around just the uplift in revenues and the higher margins that come with that. The -- around the infrastructure, so historically, our cloud customers or hosted customers have been hosted in Tyler proprietary data centers. We have 2 primary data centers, 1 in our own facility in Yarmouth, Maine and 1 in the colo facility in Dallas. And historically, that was less expensive than the public cloud but also not as easy to scale. And so the combination of our SaaS business, really an acceleration and the growth of that, the need to spend more CapEx, security and almost unending spend on security around those data centers, and we're not going to match Amazon or Microsoft in that world. So -- and then also the competitiveness of the public cloud market with a number of providers so the pricing became more attractive. And so as I said, in 2019, we entered into a partnership with AWS and started the process of moving from our own proprietary private cloud and our own data centers into AWS and the public cloud. It's not exclusive to AWS but they clearly are our primary partner, so our products will work in Azure or other models. But most of our customers are moving into AWS. And so we have -- today, we're putting most of our new cloud customers directly into AWS. Our flips are going into AWS. And then we have a strategy around lifting and shifting our existing customers out of our data centers in AWS. Until we get to that point where we can get completely out of 1 data center and then out to the second one, there are some duplicate costs or bubble cost because there's a certain amount of fixed costs around operating the center, whether there's 5,000 customers or 100 customers in it. We've said that the timetable for exiting the first one is around the end of next year and the second one about a year after that. So those are the primary bubble costs or duplicate costs. We're seeing costs in AWS while we have still some ongoing costs in our own data centers. We've also got some development costs around things like the product optimization. And so there's some set of costs around that, that probably in the range of -- we've said sort of this year, the combination of the bubble costs and the mix shift or the change in licenses was about 150 basis points of operating margin for us. And that will continue next year until we -- and probably even be a greater number next year because the bubble costs continued to grow until we exit a data center, and then they'll start to mitigate after that. So as a result, we've said that in terms of operating margins, that next year, we think is the trough in terms of margins and then we will see acceleration after that. And the fact that we now have an expectation of a bigger decline in licenses next year, maybe deepens that trough but also makes the upside on the other side, the recovery a little steeper. So after next year, we'd expect to be back on a path of margin improvement and certainly making a lot of progress on the infrastructure and the data center moves.

Yes, absolutely. So very helpful just to kind of get that frankly, short-term item, right, just around the bubble cost for next year. But what are maybe some of the other puts and takes for margins next year? I mean, clearly, COVID, right, has had a little bit of an impact for not just you but for a lot of other companies. As some of those maybe programs start to wind down on the top line, anything else that we should think about? I understand you're not guiding, right? Just conceptually what we should be thinking about that?

Yes, and we've talked about some of that. So on the top line, on the revenue side, we talked about an expectation of a faster shift in mix or more. So we've said that we expect licenses to decline by perhaps in the 40% range next year. This year, they're declining about 10%. So the impact of that faster shift, so that's in the ballpark of $25 million of licenses that would go away and be replaced by higher recurring revenue streams.

Sure. High-margin licensing...

High-margin -- yes, the licenses are almost 100% incremental margin. There's cash flow impact. There's a margin impact and a revenue impact, certainly in the long term that's made up by higher recurring revenues. But that's part of -- contributes to that trough. On the COVID side, we had -- with the NIC acquisition, which we did in April of '21, they had a couple of revenue streams that were specifically tied to COVID, where they were working with some of their state partners to administer these big COVID testing sites. And in Virginia, where they were administering a rent relief program, and both of those we knew would come to an end. They dragged on longer than we thought but they have come to an end this year. But this year, we had about somewhere in the range of $49 million of revenues from those programs that won't be there next year. Those were typically lower-margin revenues than our overall revenue. So that's not a bad thing for margins, but there's a -- and we have not included those revenues in organic growth since we bought the company. So -- but those revenues do create certainly a hole on the top line. We've also -- in the payment side, also through NIC, we've got a couple of customers that are shifting from the gross model to the net model. So rather than us having a bigger revenue number and then paying credit card interchange fees, the customer is responsible for those fees and we just get a net number, so higher margin, but there's about a $9 million revenue headwind from that. So a few revenue headwinds that -- some of which impact margins, some of which don't. But we want people to be aware of some of that noise around.

Yes, absolutely, all transitory as well, right?

Yes.

Yes, absolutely. Well, I've got so many more questions here for Brian just on the SaaS transition. I think it's a really interesting story, but unfortunately, that's about all the time that we've got. Brian, thanks so much for being with us today.

You bet. I really appreciate it. Appreciate it.

Thanks very much.

You bet.