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

Thanks, everyone, for joining Wells Fargo TMT Summit here in Sunny SoCal. Pleased to have Tyler Technologies with us for the next session. Brian Miller been with the company as CFO since 1997. Does that sound right?

Been with the company since '97. It's '98 for the all-time.

Got you. So clearly know the business well.

I think maybe we'll just start with the high-level introduction. If there are any here who don't know the company, just the profile of customers you serve, the evolution of Tyler, and then we'll get into the cloud transformation and some of the other pieces.

Sure. Yes. We're a vertical software company focused on the public sector vertical, pretty much exclusively serves the public sector. Within the public sector, we're very broad in terms of both the levels of government we serve. Historically, we were primarily focused on local governments, the East County School District. Then in recent years, we've expanded more into state and a little bit into federal. So today, we're probably 75% state and -- local, 20% state and roughly 5% federal. We have -- we're also very broad in terms of the breadth of products we have. We have, by far, the broadest portfolio of solutions for public sector. It's still a very, very fragmented market. And our model starting back 25 years ago when we entered this market was sort of to bring together leading niche providers that focused on different parts of public sector software and create a national brand and a company that had this broad product portfolio and over time, integrate those products, make them work more effectively together and create a more compelling offering by having this breadth of product. So we have, by far, the largest customer base of anyone serving the public sector on the software side and by far, the largest product portfolio. And then more recently, in the last 3 years, we've gotten much more into the payments and transaction side, some of that through big acquisitions. So that's kind of the high level, we're approaching $2 billion in revenues and growing.

We'll get into the targets in a minute, Brian, don't worry. Just in terms of the market opportunity and what's brought the company into state and into federal as well. How much of that is push pool? And if you could just talk through the size of the market opportunity for Tyler. Are you expecting a mix between local, state, federal to evolve over time?

Yes, we expect that to evolve just like we grew within the local government market to continue to expand in the state and probably less rapidly in the federal market, but also expect to see nice growth there. So we expect through all those segments of the business. We've always been a company that was just focused on public sector, and that's not going to change. But through the acquisitions we've done, we've created a lot of cross-sell opportunities. And so one of the key opportunities around the NIC acquisition was to take their state relationships and on the transaction side and sell more Tyler software into those relationships. So we're having early success with that, but that's a big long-term opportunity. So we do expect to leverage this cross-sell opportunities and to continue to grow all the segments of the business. But still the public, the local level is probably where the majority of our business will be for a long time.

Got you. And maybe just in terms of what you're replacing and if the competitive landscape is different across those various subsegments. I mean, by far, the game in town in local, but how does that change as you move into some of the other?

And you asked about market size, too. And on the software side, the state and local and education market is roughly $35 billion for software, federal is a little north of $40 billion, so $75-ish billion of total software market. We think the part that we address today is roughly $15 billion of that market. So we don't have everything, even though we have more than anyone else. We don't have everything that government needs on the software side. And so we're -- we address about 20% of that market. And so our share is less than 10%, which really kind of shows how fragmented it still is today. When we're looking at a new opportunity, generally, we're replacing an aging system. And by aging, I mean, really aging. I mean, governments are not profit motivated. They're not ROI driven. They don't have competition effectively. So they also tend to be very risk averse and move slowly, all the kinds of things that aren't probably surprising to anyone. So they tend to use software as long as they possibly can and put off replacing aging software as long as they can because again, they don't have that ROI drive. Now they would like to provide better service to citizens, they'd like to be more efficient. They do have a need -- a constant need to do more with less resources and technologies usually how they do that, but they still are slow to replace aging systems. So probably the average system we replace today is 20 years old or more. It's not unusual that we replace 40-plus-year-old mainframe systems, especially in really large jurisdictions. So for example, we've replaced Cook County, Illinois court systems, second largest county in the country. It was a 43-year-old mainframe system written in Cobol in the '70s, and they probably still wouldn't have replaced this except there aren't Cobol programmers around anymore, so they really were afraid that it could die, and they couldn't fix it. And these are all mission-critical applications for the kinds of things we provide. Our court systems, Public Safety, 911 systems, property tech systems, financial systems, licensing and permitting. So those kinds of things. So everything we do is really essential to government. So it's mostly replacement sort of a situation. But usually, by the time they decide they need to replace it, it's a fairly nondiscretionary decision. So we tend to be fairly recession-resistant because those -- when it's time to replace that system, they might be able to put it off for a little bit, but not just pass on it.

Yes. That's -- so it's going to follow on around. I mean, I think investors appreciate the resilience of Tyler, particularly in times like this. And so the way that you're characterizing the market, maybe you can also characterize the past year for Tyler. Across a lot of software, we've heard many anecdotes of sales elongation or more cost-constrained decision-making. But given the way that you're characterizing your customers, it doesn't necessarily seem like there's nearly as much of a shift. Did you see any behavioral change from the way that customers were approaching?

Only in a positive way. We've had a pretty consistent commentary over these last 3 or 4 quarters about a very, very active market. Generally, government budgets are pretty strong right now. The economic backdrop is strong for local governments, property taxes are often the biggest, if not a majority, but certainly the biggest single revenue source. There's not a lot of pressure on property taxes right now. Values tend to be kind of high and rate's high and they've moved slowly on the downside. The sales taxes to the extent those are factored, generally pretty strong right now. So generally, it's a strong backdrop. There's also a federal stimulus out there in our back that provided, I think, $360 billion of direct to state and local government. Another, I think, $160 billion to education. They've got until the end of '20. It's very broad what they can spend it on, including almost anything from Tyler. They've got until the end of 2024 to commit those funds in the end of 2026 to actually spend them. So that's, I think, a factor in the active market, not the biggest factor, but it's certainly providing some [ discomfort ] there. So we said that leading indicators, things like RFPs, a number of demos we're doing, how deals are moving through pipelines, they're all at certainly back to pre-COVID levels, but in most cases, kind of an all-time high for us.

Wow. Is that a potential stimulus money that needs to be earmarked by 2024? Is it something that you have telemetry into? Is it something that you have a sense, customers are considering, or public sector clients might be thinking about or not?

Yes. We have a sense. It's hard to quantify it. It's really hard to identify it. I mean we have deals certainly every quarter where they're actually identify them as they're using some ARPA funds to pay for it, but it doesn't necessarily mean that, that deal wouldn't have happened otherwise. We've got other deals that maybe the ARPA funds were used for something else, and that freed up for an incremental purchase from Tyler. So it's hard to quantify the impact that we think is part of it, but certainly not the biggest reason. And we think it will continue to be a factor for the next couple of years. We've seen strong inside sales where we're selling additional things back into our customer base, and we've certainly -- where customers have had an interest in something that may be in trouble budgeting it. We've gone back to them and talk to them about using ARPA funds for that. So it's hard to say how much it is, but it's definitely a factor.

Understanding the profile of talent, you're looking for might be somewhat different than broader software. The labor market has softened, the characteristics you're describing sounds quite strong. So is that at all changing or influencing your decision around bringing on talent if you have this potential kind of upswing and business activity is more than healthy, is that...

Yes. We've continued to add head count ever since COVID. We like everyone else, had higher turnover during COVID. And interestingly had a forecast call this morning and our Chief HR Officer was talking about that our current turnover is almost at an all-time low, which is 2 years ago. It's an all-time high. So with changes in the market and the other parts of the tech market, we're not quite facing the same kind of competition or drawing people away from us or turnover is lower. We continue to add heads. I think we're being very thoughtful about where we're at heads and not just automatically replacing turnover with the same role, but looking at how our business is evolving and particularly around our cloud transition and where we're creating opportunities to lower head count in certain areas. We've talked about version consolidation, which is a margin headwind for us right now, but as we work through that, that should free up some roles. So yes, but the market has been good for us. On the other side, with our clients in the public sector, public sector was really hit hard by people leaving for private sector during COVID, and they have not recovered their workforce levels. So it's helpful to us also to the extent that we help governments automate and do things that they might have done with manual processes or with antiquated automated processes that helps them solve issues they have around staffing. And that's also driving more interest in our on-premise customers moving to the cloud to help them with issues they have around managing their infrastructure.

I mean it's a great sector. That's what I was going to go next is just on the cloud transition. So maybe you can level set where you are in that journey today? And what brought Tyler there in the first place? And just the resistance you're fighting just from public sector customers being slower to move in terms of...

Yes. So there's kind of 2 pieces of the puzzle, the existing customers that are currently on-prem and the new business side. So historically, Tyler, for a long time, was traditional on-premise model license maintenance. Most of our customers were deployed on-prem. And then we had a very long sort of transition to sort of a hybrid model where we offered most of our products either in a license and maintenance model or in a subscription or SaaS model, which was hosted as a Tyler data center. And it probably through early 2000s through 2019, a little bit more of our new business chose the cloud, but at a very slow pace. And so it was actually kind of a -- we got a good head start on the transition without it being disruptive. The government, as I said, are very slow to change the way they do things. And so that adoption was slow. And 2019 was the first year that more than half of our new business chose the cloud in the hybrid model. 2019 was also the year that we said we are all in on the cloud that we're cloud first. We're not cloud-neutral anymore. We entered into a partnership with AWS. We also said we want to get out of the data center business. We didn't want to keep trying to scale that. And so start putting new clients in AWS and built a plan to transition our existing clients that were in our data centers out. We also launched a bunch of product optimization projects because most of our products were built to be deployed on-prem, so they weren't really efficient in the cloud. And so those projects are very far along most of our products. Now we have cloud optimized or cloud efficient versions of them that we're deploying in AWS. So from 2019 to now, we've gone from about half of our new business to mid-80%, 85-or-so percent of our new business choosing the cloud. And most of our products we no longer offer on-prem. There are a couple of exceptions, Public Safety, 911 systems, police systems. They've been a little much more reluctant to move to the cloud, but they're coming around. We're seeing actually this year a pretty nice increase in that and some of the federal business still has a preference for licenses. So that's kind of the new business. We're pretty much cloud now in the new business. And then with the existing customer base, we have the big customer base of roughly $470 million a year of maintenance from on-prem customers. So today, if you look at the total mix of our customers sort of on a dollar-weighted basis, about 40% are in the cloud and about 60% are still on-prem. The number is a little -- client is a little bit different business than dollars. And we've said that we have a road map for migrating those on-prem customers to the cloud. And we've said that by 2030, we expect 75% to 80% of our -- 75% to 85% of our on-prem customers to have moved to the cloud by then. And today, it's kind of between 15% and 20% of moved. So that's a big revenue uplift opportunity. We typically see for new customers, the subscription is roughly 2x what the maintenance was for our on-prem customers depending on when they bought their license. They typically get an initial discount, so we're averaging about 1.7x uplift as our on-prem customers move to the cloud. So you can see there's a big revenue uplift opportunity over the next several years as these customers move. We think we're still a year or so away from that pace really accelerating as we get -- we want to move to those customers to the cloud optimized version. So as we get those in place, we're able to start to move people more rapidly. And then I mentioned versions for all and version consolidation. With a lot of our products, we currently support multiple versions of individual products. And that's really expensive from a development standpoint and from a support standpoint. So as we move customers into the cloud, we want to have one version in the cloud, and everyone stays on the same version upgrades at the same time. But in order to get on-prem -- existing customers to that, if they're not on the current version, they need to upgrade either before or when they migrate. And so we've got all these projects going on to start to eliminate a sunset older versions and move clients to the current version, so they're in a position to migrate to the cloud. So there's a lot of different work streams going on, all of which get us to the 75% to 80% of our customers in the cloud by 2030. And that pace is different for each product, but we've got a plan in place that we're executing it yet.

Are there incentives you have in place? What are the ways that you incentivize customers to make that move, particularly on the version side, but in general, with existing customers, like what are the sort of carrots and sticks that you have to influence that trajectory to 2030?

On the version side, it's more of a stick. We just say the 8-year old version was no longer supported.

We're turning on.

You have to move the issue, but we have a plan. I mean we don't -- we -- for example, this year, we -- in our court case management customers, which are some of our biggest customers, places like Chicago and L.A. and Dallas and Miami, 17 statewide court systems. We said we'll only support after this year, the 2 most recent versions. So we did a lot of heavy lifting this year to move some of those biggest customers to the current version. And the bigger the customer, the harder -- the more complicated the shift to the cloud is. But I think we're probably -- in the next couple of quarters, we'll probably have our first statewide court customer that will flip to the cloud. So we're doing some of that. But in terms of just broadly incentivizing customers to move to the cloud. Right now, there's a lot of demand for our customers that want to move to the cloud. As I mentioned, they've got infrastructure issues. They really struggle with hiring, retaining, paying market rates for IT skills, database administrators, application administrators, security people. So they may have budget and open jobs but can't fill them and they're doing -- having trouble managing their infrastructure to the extent they can move that to the cloud that takes some of those pressures off. And then security, lever security, ransomware, you read about just like in the private sector, but maybe more so in the public sector, you read about ransomware attacks. There's a lot that's happening you don't read about. But their -- I think their confidence around their cybersecurity abilities and the skills and that they have in place around their own networks is not high in a lot of government. So their desire to move to the cloud to take -- to at least alleviate some of that pressure is high. So right now, we have a lot of demand from customers that want to move to the cloud, and we're helping them map that out. The carrot that we're using mostly now is that we're telling customers for most products that going forward, the new features -- we'll support their on-prem version, they'll still work, but new features and functionality will just be available in the cloud. And then over time, we have a couple of potential sticks, raising maintenance more aggressively to create an economic incentive. And then ultimately, just saying this product is no longer supported on-prem. Again, I think those are -- those things are probably still a ways away. But right now, the demand seems to be kind of in line with our plans to move customers.

Okay. Great. I want to spend some time on the targets. You've given us a good line of sight into how you're thinking about 2025 and 2030 from the recent Investor Day. So maybe you can just -- we can start by just what underpins the growth assumptions, and then I will dovetail into margin, we can spend some time on a few of the moving pieces underneath this as well.

Sure. Yes. We talked about some sort of midterm kind of through '25 and then longer term through 2030 targets for both revenue growth and margins. We've talked about revenue growth in our recurring revenues of kind of 9% to 12% over that time period, which is a couple of points above where we've historically been. In our recurring revenues, there's kind of -- there's 2 categories. We have our SaaS revenues and software, and then we have our transaction revenues, which are mostly payment processing and state transaction portals that came through the NIC revenue. And those transaction revenues, we expect to grow kind of in the 10% to 13% range over that time -- through 2030, and the SaaS revenues growing in the high teens over that time period. And then, of course, maintenance will decline. So the decline in maintenance and the growth in SaaS give us that 9% to 12% overall growth. We also expect that margins -- we talked about targets right now, we're kind of in high 23% operating margin range, we've talked about 30% plus operating margin target by 2030. That won't be totally linear, and that will accelerate probably after next year. But we have said that this year, '23 is the year that is the trough in our margins, where we really have that impact of we're going to get past that inflection point on the impact of losing licenses and building up the SaaS revenues. So there's 400 to 500 points of that margin improvement comes from our cloud operations and from the SaaS transition from the flips of on-prem customers to the cloud from the version consolidation margin impact and from exiting our data centers and moving into AWS. Right now, as we're working through this transition from our data centers to AWS, we have a lot of, what we call bubble costs, a lot of fixed costs around operating our data centers. And as we move customers over the AWS, we start paying AWS, but we don't really eliminate our cost until we can completely close the data center. And we've said our timetable is our first data center will close in mid-'24 and the second one at the end of '25. So we'll get some relief next year, more relief in '25 and '26, and that's a pretty meaningful part of it. There's bubble cost around 130 basis points of operating margin this year on Tyler as a whole.

Okay. You've been pretty consistent in characterizing the margin trough as this year. I think the trough that we've seen has been shallower than maybe we were bracing for expected. Is that -- was that all surprising to you? Or are there factors that you would point to that have led to kind of just a more gradual curve than maybe we've seen in other cloud transitions.

Yes, our margins this year -- and like I said, our -- in our cloud transition has been very long term. There's a lot of moving parts around it. Our margins this year have been a little bit ahead of plan, though. So we raised our guidance factor, I guess, Q2 and Q3 for earnings since most of that around better margins and most of that around our cloud operations. On one hand, although we have added head count, we're operating with fewer heads than we initially had in our plan. Some of that also dovetails with the impact of our cloud optimization and releasing cloud efficient versions. So we're seeing those operate more efficiently than we had anticipated. And also our AWS hosting costs have been lower. So it's all volume driven, the more capacity you buy from them, lower the unit costs, and they've worked very closely with us to keep things as efficient as possible, and we're finding that the costs have been a little bit lower. So we're starting out a little bit ahead of where we were last year. Yes, the trough is still this year, but it's a little bit shallower than we thought.

Good. Good, good. We have around 10 minutes left. I have a plethora of questions, but I want to open it up to the audience as well, if anyone has a question that they'd like to ask Brian, you can raise your hand. I think we have mic runners.

What are the factors [indiscernible] what's driving? People are wanting to [indiscernible].

Yes. Geographic sectors are different partners. Yes. We serve a lot of different kinds of clients, serving nationwide. We're about 98% domestic in the U.S., only a couple of percent international. But there's not really a lot of difference in demand. I mean the biggest driver still are the aging systems. I think -- we think that if you looked at all the systems that all the governments across the country, have you'd find that only 1/3 of them came from a vendor that's a competitive vendor in the market today, and 2/3 of them are either homegrown systems or legacy systems. I think one of the things we have seen in different governments or different levels of how progressive they are in terms of looking to see new ways of doing things and -- but generally, I think one of the things we've seen since COVID is that there's been some -- and I think we're still in the early days of it, but some pull forward of replacements and the desire to replace some systems a little sooner than they might have otherwise thought because a lot of the systems that they knew weren't state-of-the-art or have features they needed or wanted, but they thought they could get by with another -- get them for another decade maybe, but they don't support remote work. And with the mainframe court system, you can't have a remote trial, you can't pick a jury remotely. So if the court house was closed or people want to work from home 2, 3 days a week, it's not possible with those systems. So that and, I think, an increasing desire for better data. The idea of sort of business intelligence or data platforms, and we provide a very robust data platform that sits on top of our software and it has been sort of a newer concept for government. So government even within a given city or a county can be very siloed. They by systems, by department, they don't talk to each other very well. They have trouble extracting data from multiple systems to make decisions. And so we provide both through the integration of our different suites of products. And then with the data layer on top of them, we provide them with the ability to have better usable data. And that, I think, has become much more important over the last few years. So I'd say those are the things on top of just the normal system side, we've got to replace it that are driving an active market.

Great. There's one in the back, too.

This is [indiscernible]. Brian, I wanted to ask about the more horizontal ERP vendors. First, just in general, how you view them as competitors and where they may or may not actually overlap with you? And then secondarily, I think in the ecosystems, the Oracles and the Workdays of the world, some of the partners that are really focused on the SLED industries have highlighted, I guess, historically good pipelines, especially in state and local government. So when they talk about that, I guess, how does that actually manifest for Tyler? Is that just jump all like RFPs where you're both in the room for new customers? Or are they actually also trying to go in and rip out Tyler to put their platforms in?

Yes. I'll start with the end, less of that, someone replacing us. Our attrition is very low historically, and it's kind of across all of our products and all of our markets, but we typically have between 1% and 2% annual attrition and more like 1% of the dollars. ERP is our biggest single product area. It's probably 1/3 of our business. And that is the one area where we really see a lot of horizontal competition. We do compete with niche companies that just do public sector ERP, but we compete with some of the names you mentioned SAP, Oracle, Workday, Infor. Our approach is a little bit different. So accounting, human resources, payroll are gotten very similar. We have -- really our strong selling point is that we have the very -- it's a vertical offer company. So we have a lot more depth in terms of functionality that governments need as opposed to -- they have a lot of stuff that a retail company or a manufacturing company or a health care company needs that a government doesn't need. We go a lot deeper in government. So in our -- sort of our public admin suite of products, we have the traditional ERP products, but we have licensing and permitting. We have utility billing, we have parks and recreation, cemetery management. So all these applications that a government needs that Oracle and SAP and Workday don't have. So they would sell more from a point solution standpoint that you want the best HR system out there, maybe they convince you that that's Workday. But you still have to buy a utility billing system and the licensing and permitting system and all those other applications and that could be from Tyler. You've got to integrate them, you've got to kind of keep working together. And ours are all integrated out of the box. So someone might not buy those all at once, but they do all work together. And so especially when you get down below the top tier, there's much more of, I'd say, a desire to have these things integrated and they have one throat to choke and have them work together out of the box. At the top tier, the New York and Chicago and L.A., although we have a lot of products we sell into those markets. ERP, we don't really compete there. They want multiyear, highly customized sort of endless integration projects, and that's not really our model. But we do see those companies from time-to-time dip down a bit. Workday is a really strong competitor. We see the others from time to time. Really, are they replacing us. But in new business, we see them. But again, it's sort of a different approach. If the customer is really looking for a point solution approach, then there'll be stronger competitors, not as much as they're looking for the whole suite. We -- in ERP in general, our win rates are kind of mid 50% to 60%, so we win more business than everybody else put together in those parts of the market that we compete in. We're really, really strong in the mid-market. And -- but yes, we do see -- it also seems like their commitment to public sector isn't necessarily there, whether it's certainly they have some partners. And again, we do the integration services ourselves, we kind of provide the whole project with services and software. But it seems like over the years that their interest in public sector sort of ebbs and flows a bit. If other markets are strong, they're more active there. If public -- if other markets are slower, they kind of turn the public sector is a nice, steady market. But we have long sales cycles for a midsized ERP project, a year, 18 months, 2 years could be a normal sales cycle, and they tend not to have as much patience for that kind of a sales cycle if they have other opportunities elsewhere.

Great. One more.

Talk about how your sales coverage and go-to-market approach [indiscernible].

Sales coverage and go-to-market approach. Yes, one of the nice things about public sector is that our sales process is pretty efficient because, one, we know where all the governments are, so you know where all the prospects are. You know what they currently use, when they bought it, you know how much they pay for maintenance because it's all public. So you can really kind of narrow down the market to those areas that are probably actionable. So you know who has a system from Central Square and ERP system that they bought in 1999 because of Y2K. And that likely will be replaced maybe this year, maybe 3 years from now, but it's a reasonably actionable opportunity. So those will be people you'd be focused on. You'll be building relationships ideally, you'll shape in RFP or bypass an RFP. But you won't be chasing after someone that bought Workday last year. But you know who all those are. And so it's a pretty efficient sales process. We talked at Investor Day quite a bit about cross-selling, too. So we have a big customer base. But our average customer has 2 to 3 products from Tyler and could have 8 to 10 products. So sort of getting ahead of that and being ready when they -- or when or before they decide they need that next suite of products and then selling additional products within an existing suite of products into existing customers. So we've talked about cross-selling being a much more important part of our growth factors going forward, but we've got this huge opportunity in this customer base, it's taken decades to acquire. And in a market that moves slowly, it really does take decades to acquire a customer base like we have.

Yes. We're running up on time. It's counting down. So I'll leave it to you to close this out. I think just higher-level takeaways, thoughts that swing factors that keep you steady on the course for 2025 and 2030 target?

Yes. They're pretty fresh, Investor Day was midyear. We hadn't done a full-blown Investor Day since 2019, and a lot of change in the company with the acquisition, with the payments growth. So setting those kind of longer-term targets was important to us to make sure people really understood where we thought we were going and how we plan to get there. We feel good about those that they won't -- like I said, everything is not linear to get there. And as we move forward, we'll clarify around how that all plays out. But yes, as I mentioned, we're in a strong market. We -- a lot of the things that affect a lot of other companies don't affect us as much, mostly domestic. We're if not recession proof, pretty recession-resistant, especially we're 85% recurring revenues now. And so this has really been a sort of an inflection year a transition year for us, and we're really excited about what the next few years hold for us.

That's great. It's been a breath of fresh air for Tyler this year. Appreciate the time, Brian.

Yes, you bet. Thank you.

Thanks.