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

Thank you for joining us today. My name is Joe Goodwin. I'm a software analyst here at JMP. Today, we have CFO of Tyler Technologies, Brian Miller. Brian, thanks so much for joining us.

You bet. Glad to be here.

Yes. So I guess, first of all, I think most people know about Tyler, but if you could just give us a quick overview of the company, that would be great.

Sure. We're an enterprise software company focused exclusively on the public sector. So we saw a wide range of software products that automate essential back-office functions of government, really at all levels, historically, mostly focused on local governments, cities, counties and school districts but has significantly expanded in the state governments and have dipped our toe into federal government. So a wide range of products, the broadest set of offerings for government of any company that's focused on government software by far, the biggest customer base of anyone and really kind of -- I'm sure we'll talk about this a little bit on the latter stages of the cloud transition. And also significantly expanding our payments business as well through an acquisition we did a couple of years ago, doing a lot more in transactions and payments.

We'll definitely get to that. But I guess, first things first, how is business what you say?

Business is really good. We've talked about the -- for the last few quarters, the kind of the general activity in the market, the backdrop, government budgets, all really in very good shape, really governments at pretty much all levels, have generally can vary from place to place, but generally pretty solid budget situations for local governments where property tax is generally a big piece of their revenue stream, not a lot of pressure on those right now. So generally, budgets are in good shape. There's a big federal stimulus, the ARPA Act that is providing $360 billion today to state and local governments, another $180 billion for schools. That's a factor in the active market. We've got -- they've got until the end of 2024 to commit those funds into 2026 to spend them. So we think that's a tailwind for multiple years. And all the demand indicators we see the pipeline, but more importantly, the number of RFPs we're seeing and responding to the number of demos we're doing, the pace at which deals are moving through the pipeline. Those are all very stable, but at a very elevated level. So we're seeing a really active market and good demand.

Got it. Okay. Great. And then I guess on the federal stimulus money, you've talked about how it's kind of difficult to actually see your measure how much is there. Why is it difficult to do so?

Yes, we'd love to be able to say every quarter that X amount of business was because of the stimulus, but it's just not necessarily that clear. In some cases, we know that a project or a purchase is being funded specifically. They've had money allocated from their ARPA funds. But even that doesn't mean that, that deal still wouldn't have taken place even without the ARPA funds. In other cases, the funds are used for something else, but it can free up money for something they buy from Tyler. So it's hard a little bit to tie both of them together. We have seen a really active inside sales pipeline, so selling additional products back into our installed base. Some of that, we think we've been successful in capturing some ARPA funds where we might have already been engaged with the client about an add-on that they liked but didn't have the budget for and we've circled back and they've been able to get some of their ARPA funds to fund that. But as I said, it's generally, I think it's part of the active market, but it's hard to identify exactly how much.

Understood. And then you touched on it earlier, but you do serve -- obviously, it's largely state and local, you do serve the federal market. I believe it's still a single-digit percentage of the total, but it sounds like there's good optimism there, momentum there in 3Q, you had the Department of State deal. How do you view that market evolving over the next few years?

Yes, we really got into the federal market through an acquisition 3 or 4 years ago in come MicroPact and that's become our case management development platform. So they have a low-code development platform similar to a Pegasystems or ServiceNow, but focused just on government with the number of prebuilt modules for government functions and their business is almost all federal and state kind of 50-50. And so in the aggregate with Tyler, Federal is less than 5% of our revenues, but it's growing. The platform has enabled us to expand our presence in the federal government, but still through an off-the-shelf model and not building custom systems that a lot of federal agencies have looked for in the past. It's the one part of our business where we have a pretty robust partner network. So a lot of the deals and we'll have the implementations take place through partners. And so that's enabled us to grow it a bit faster. But that -- our platform is used for things like [indiscernible] Well, the big deal you mentioned, actually it was our largest deal of the year last year. It was a $55 million SaaS deal with the Department of State and our platform will be used to manage all of the background checks and security clearances for the Department of State. So it's interesting that a lot of these federal applications that every agency does background checks and security clearances, but they don't have a federal system to do that. So we have the ability to sell that system multiple times to different agencies also used for things like managing EOC claims in the majority of the federal agencies, managing veterans benefits or licensing and permitting applications. So it's a -- we really expect to pretty meaningfully grow our federal business through that product over the next few years, but also be able to use that product to leverage our state business our state relationships through the NIC acquisition. So that's one of the big beneficiaries of cross-sell through that acquisition as well.

Got it. And you touched on it, obviously, there's a lot of partnership type deals. That's a key part of that motion. I guess, how have your relationships evolve within that kind of federal partner ecosystem?

Yes, we've really been able to expand it. I mean, MicroPact before we acquired them already had started to grow their partner network, and it's really expanded into really pretty much all the big names you'd expect to see with federal integrators and IT firms. And so it's really enabled us to expand sales without aiming to expand our own sales organization at the same rate. And because of the nature of the product, it's pretty easy implementable through partners. So that's something that we also -- on the rest of Tyler, we do most of our implementations and pro services with our own teams and don't make money on that. So it's sort of how we control the quality of the engagements and get to the recurring revenue stream as quickly as possible. But there may be possibilities throughout Tyler to expand the use of partners over time and certainly what we've the experience we're getting through the federal relationships is helpful there.

Got it. Okay. And then let's talk about the payments opportunity. Obviously, it's an area of focus for you. You're a material player there now. But I guess how do you see that opportunity evolving over the next few years, what makes you most excited about the payments?

Yes. Payments is clearly a big focus for Tyler going forward and the acquisition of NIC just coming up on 2 years ago, really gave us the technology and the platform and the experience to be able to start to advance that strategy quite a bit. So when you think about -- and Tyler is certainly not the first software company that's realized that there's a lot of payments going on around our software and that there might be an opportunity to capture revenue from those. So Tyler has always had a lot of software products that facilitate payments that present bills and allow for the acceptance of payments, but we haven't been the processor. So you think about things like utility billing systems, municipal court systems that manage traffic tickets, licensing and permitting systems, parks and recreation, property taxes. All of those are places where we have a big presence in the back-end software. And we, over the last few years, had developed a strategy around capturing part of that payments business but mostly through partnerships. So bringing in a partner like a Chase or Elavon and getting a revenue share, so getting a small piece of the payment processing revenues that they get. The NIC acquisition really changed that. So NIC, really their whole business is around payments and transactions, so facilitating access to government mostly at the state level. So they provide the -- not the back-end systems like Tyler Wood, but the front end sort of digital front door to government at the state level. So providing the portal, the state website and building links or integrations into these back-end systems so that you can do things like payer your motor vehicle registration or your driver's license or get a fishing license, providing access for insurance companies to access driver history records to issue insurance policies. So NIC builds those connections and typically gets paid a convenience fee. So when you renew your driver's license, you might pay whatever the fee of the state is and then pay a $5 convenience fee that we keep and we would process that transaction. So we're actually the payment processor. And so NIC -- between the NIC payment processing and portal revenues and Tyler's much smaller rev share payments revenues, it's almost 1/3 of Tyler's overall revenues today. So the real opportunity for us is, one, to continue to grow that at the state level as volumes continue to increase as people look to do more stuff online with government. Nobody wants to go down to the DMV to do anything. So we continue to see activity pick up there, certainly post-pandemic. But the real opportunity or one of the bigger opportunities is for us to drive that same platform down into local governments. So we have thousands of local government customers that use our software and we -- while we've typically tried to attach and we're still in the early days of attaching a payment processing to those software products. But really, we can take the NIC platform and go for enterprise-wide payment, capturing all of the payments at a local government, just like NIC does at the state level. So for example, a lot of cities or towns would have multiple payment relationships. The utility uses Chase because Tyler brought them in, the parks and recreation uses something else. The courts only take checks. So they've got -- we've got an opportunity really to bring that together to simplify it for the customer providing them with better economics, better reporting, just a better experience. And we're really just kind of on the early stages of that. Over the last year, we've combined our payments teams with NIC and Tyler. We've created our go-to-market strategy now really just starting to execute. But we've just scratched the surface of payment processing at the local level. We had a nice win in Q4 at City Milwaukee, which is a Tyler software customer signed up with us to do all of their payment processing, adding more than $1 million a year in revenues for us from that. So we think that's a big growth opportunity as we move forward. Now we've got all the pieces in place and a different margin profile than the software side but a really nice complement to it nice cash flow and adds nice margin dollars to the business.

Yes, definitely exciting. And then kind of within that, I know there's different -- there's kind of the gross and net dynamics that you talked about on 4Q. Can you just remind us kind of what that looks like, some of the key points there. and how that mix should trend going forward?

Yes, there's a couple of different models and we don't necessarily control which one the customer chooses, Different customers have different philosophies about how they want to approach it. So they're merchant fees that are paid out to Mastercard and Visa and Fiserv for the rails that the payment process is on. In some cases, we have gross accounting where we assume responsibility for the merchant fees. So we have more revenues, but pretty thin margins on those. They can vary. But generally, if it's a pure payments deal, we're getting maybe call it, a low to mid-teens markup on the merchant fees. Other customers, so like the state of Texas, we do all the processing for the state of Texas. We get 2% of the transaction plus $0.10 a transaction, and then we pay merchant fees out, and so we might keep $0.25 out of that. On other clients like the state of Florida, it's a net basis. So the state pays or the customer pays the merchant fees and we just get a per transaction fee. So lower revenues but higher margins. And it just depends on the philosophy of whether the customer wants to bear the risk of what the variance in the merchant fees can be based on what kind of cards used or whether they just want a flat number. So we've had some customers that have switched. We talked about 2 of our states switched from gross to net this coming -- this year. So it's about a $10 million headwind to revenues, but positive for margins. I'd say most of the deals take place on the gross basis. So we'll be looking to provide a little bit more color around that as we go forward, maybe break out the margins and on payments and be more clear about breaking those out from the rest of our subscription business so that investors can understand how that is growing and not have it sort of blended in with our SaaS business. We did talk about in this last quarter overall. So last year, we paid about $145 million in merchant fees. So if you take those out of both costs and revenues to basically put it back to the net basis, just leave what we keep, it has a 200 basis point impact on our operating margin, Tyler-wide. So it has -- you have to kind of look at that at -- when you look at our margins going forward, there's sort of 2 pieces. There's the software business and payments business, both good businesses, but different margin profiles.

Understood. I guess we're about halfway through. So I'd love to open it up to the audience if anyone has any questions. I guess -- so obviously, you're in the critical point of the transition right now. 2023 is expected to be the trough for operating margins. Can you just remind investors the elements like bubble costs that are pressuring the margins this year? And then what expansion may look like in the years beyond 2023?

Yes. So yes, this is a pivotal year for us. We've been going through a multiyear cloud transition, like a lot of things in the public sector. Things tend to move more slowly in the public sector. And so there, the speed at which our market has embraced the cloud has been very different than the private sector. So for -- we've really been offering a subscription model or a hosted model kind of a private cloud for more than 20 years. But up until 2019, we really described ourselves as cloud neutral or cloud agnostic. So we offered both on-prem with a license hosted in a subscription, let customers decide didn't really try to push people one way or another, capture the business, however, it wanted to come to us. And over almost 20 years until 2019, it took up until that point for 50% of our new business to choose the cloud. Since 2019, it's really accelerated. And that 2019 also was when we switched and said, okay, we're cloud first now. We want customers to come to us from the cloud. We're going to pay different commissions for a cloud deal than an on-prem deal. We started to lay out a road map for migrating also from our data centers. We said we don't want to be in the data center business anymore. And we entered into a partnership with AWS as our primary public cloud provider and started to develop a road map to get out of our data centers. So we just don't have the ability to scale those. The -- and we also started talking to customers about the transition and that we were kind of going to cloud first and then ultimately, products would no longer be available on-prem. So from 2019 to current state, we've gone from 50% of our new business being cloud to roughly 85% should be north of 90% this year. A couple of product areas are a little bit stragglers. Public safety, where some agencies really aren't comfortable putting a 911 system or a police system in the cloud yet. And then some of our federal and state business on the platform is still license-based. But even those are starting to move along. So we -- most of our products by the end of this year, most of our big products now are no longer offered in a license model. But that's had a big impact on margins in -- particularly in the last 3 years. So margins have gone backwards because we've gone from a peak of $100 million in annual licenses down to this year should be in the $40 million ballpark is all of that margin. We now have built up this recurring revenue stream where SaaS revenues have been growing north of 20% for several years now. So this year is really the inflection point where after this year, the -- it's no longer a headwind that we've now have eaten away enough of the licenses and have built up a big enough recurring revenue stream as well as the revenues from on-prem customers converting that it offsets that. And so we've said this year is the trough for the margins. Our guidance implies sort of a 50 to 100 basis point compression of margins this year. But we've said that going forward after this year, we'd expect to see consistent margin expansion over multiple years, and we said we would expect that to be at least 50 to 100 basis points a year, but in some years could be higher than that. really, again, getting around the curve from the lost licenses being a headwind. And then we've got currently, the vast majority of our existing customers are still on-prem. And so we have about $470 million a year of maintenance that as those customers convert to the cloud, there's an uplift of 1.5x to 2.2x. It averages about 1.75x. So got the ability to turn that $470 million of maintenance into something closer to $900 million a year in subscription revenue, and that will take place over perhaps an 8- to 10-year period. So that will be margin -- that will be accretive to margins as well as to revenue growth. So again, we haven't really talked about ultimately where this settle out. We -- before really the transition accelerated. I think our operating margins were in the high 20s, 28%. We certainly expect to get back and beyond that level. I'd say over the next 5 to 7 years. And we'll be looking to have an Investor Day a little bit later this year and talk more about sort of what that midterm model is and what our targets are, but I'd certainly say that'd be -- our longer-term targets would be probably in the mid- to upper 30s. So there's significant margin improvement opportunity. How the payments growth layers into that, that's really kind of talking about the software side, the payments growth, we're if we had a lot of gross revenue payments into that, that will impact that blended margin we'll be talking about those separately.

Right. Okay. Got it. And then, I guess, yes, you mentioned it, the flips moving from maintenance to cloud. So last year, you had about 340 flips up from 239. I guess, were you pleased with that number. And then two, when we're thinking about organic growth over the next 5, 7 years or so, how large of a component do you think that uplift is within that organic growth?

Yes. It's hard to tell exactly how that timing is going to fall out. We kind of know what the number is. As I said, there's about $470 million of maintenance. Our experience is that right now, it's about 1.75x. For a new customer, it's the subscription is roughly 2x what the maintenance would have been for an existing customer, it kind of depends on how long they've been a customer, if they bought a license from us 3 or 4 years ago, made a big capital spend with us, there's a credit for that, and so they come in at a discounted rate and build their way up over time to sort of the list price. So if they've been a customer for a really long time, then that doesn't not a factor. So I think, as I said, it's kind of a an 8- to 10-year time frame we're thinking about for migrating those well north of 20,000 installations we have on-prem that make up that maintenance space. Yes, we would expect this year, yes, we were happy with the number of flips. It's been increasing pretty much every year. But if you think about 300, 400, that's just a drop in the bucket of how many customers we have. I think that number maybe comes close to doubling this year. but we're still probably a year or 2 away from really, really turning up the pace of those. And there's a couple of things that govern that. One of those is the product optimization for the cloud. So a lot of our major core products were originally developed to be deployed on-prem and so they're not really efficient in the cloud. So they consume a lot of resources, they're expensive to host. So since 2019, we've had development projects underway to modify the architecture of our products to be cloud efficient or cloud optimized. So reduce the hosting footprint and lower our hosting costs. A lot of those projects have been completed so we really expect to be completely finished by around the end of this year. So we really need to have the cloud efficient versions of the software before we start migrating a lot of customers to those. One of the big benefits we get from migrating those customers to the cloud over time is that today, not only do we have a lot of products, which is a strength of Tyler that we have tremendous cross-sell opportunities and the ability for all these products to work together and create more value for our clients. But within a lot of products, we have a lot of versions of products. So sometimes 2 or 3, sometimes 7 or 8 versions of the same product. So it's really expensive from a support standpoint and from a development standpoint to keep all those versions. And so as we move to the cloud, we're able to ultimately get down to one version of each product, everybody on the same version, everybody upgrading at the same time. But in order to get there, a lot of our clients that aren't on the current version of software need to upgrade to that either before or when they make that migration. So that's one of the things that sort of governs the pace of this and makes it a multiyear project. But I think we're probably a year or 2 away from seeing us really significantly increase that pace, which then will increase the growth rate and increase the margin opportunity.

Got it. Okay. And then I guess last a few seconds here. But I guess when you think about your internal software spend, will that be up, down or flat versus last year?

So like our R&D spend?

What you spend on software solutions.

What we spent on software, yes, broader so -- it's actually going to be -- we're actually implementing a new ERP system this year. So we have a spend around that. as well as some other initiatives. We have -- we had a new CIO joined us a couple of years ago and are working through a number of initiatives there. But that will be one of our bigger spend. So it's going to be up a bit. Ultimately, we think we've got a lot of opportunity to consolidate a lot of disparate systems we have today. And work to improve the efficiency of our internal IT organization. But this year, you our spend will be up a bit.

Great. Thank you so much. We're going from Epicor and we are going to Microsoft Dynamics 365.

Awesome. Thank you.

Thank you so much.

You bet.