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

Awesome. Hi, everyone. My name is Rich Hilliker, and I'm a software analyst here at UBS. Thanks, everyone, for joining us. We're excited you're hearing and thanks to everyone tuning in online. We've got Tyler Tech here today, Brian Miller, Chief Financial Officer. Thanks for coming down, being with us and looking forward to have a great discussion.

Yes, you bet. Happy to be here.

So why don't we start at a high level, talk a little bit about macro, about budgets. We've been seeing some mixed results from software companies still continuing to hear some incremental signs of caution, macro pressure. Wondering if you could maybe characterize what you're hearing and seeing across your customer base? What do the conversations sound like? And then maybe can you kind of remind us of the state and local budget type dynamic that is specific to Tyler?

Yes. I mean we are a little bit different there because we serve exclusively the public sector, multiple levels of the public sector, maybe 70%, 75% local. 25% state and about 5% or less, federal but all public sectors. So some different dynamics there. We've actually have seen over the last few quarters and continue to see a really strong backdrop and not seeing slowdowns here. Generally, budget environments at all levels of government are pretty strong. The local level of property taxes remain not a lot of pressure on those. They're in a pretty strong revenue stream. But really, our customers are seeing really strong budget environment. It's being helped by the stimulus funds. So there's a large stimulus from the ARPA Plan that they've got until the end of 2024 to commit at the end of 2026 to spend. So that's providing some of the confidence in funding, which I think IT monetization is getting at least a fair share of. So we've talked about in our calls that the sort of leading indicators we're seeing at the top end of the funnel are very, very strong. A number of RFPs and number of demos we're doing are all definitely back to pre-COVID levels but in many cases, kind of at almost at an all-time high. So -- and it's really stable at that elevated level. So we're seeing a really good environment.

Great. Okay. That's encouraging. Stable study. I guess maybe what would be helpful, it could be like double click into where customers are prioritizing within your portfolio right now? And maybe how is their strategic road map evolve as we've moved through this year? We have a stable budget levels? It seems like there's a lot of interest.

Yes. I think definitely, in government, digital transformation has been full swing. In our space, still the core of what we do, where we sell mission-critical essential back-end systems, the power things that they have to do, court, 911, property taxes, financials, licensing and permitting, those sorts of things. So they're all essential functions and essential software that you provide. And governments tend to use systems much longer than the private sector and they [indiscernible] because they are not profit motivated or ROI driven and they don't have competition, that doesn't drive their software purchases. It's really, for the most part, replacing systems that are at end of life, that they've used maybe for 20 years, maybe for 30 or 40 years. And have gotten to the point where either they're no longer supported, where they're homegrown systems that are difficult to maintain or they don't have COBOL programmers anymore. So those are the kinds of things that kind of drive the core demand, and that's very stable. It doesn't -- not -- it becomes sort of a nondiscretionary decision when it gets to that point. It creates a market that really never has explosive growth, but it always has very consistent demand characteristics. But I think what we are seeing sort of layered on top of that are changes around government and their desire to accelerate some of those purchases, make things -- make purchases that may have a little bit more of an ROI kind of approach or that solve problems that they didn't previously had. One of the things is in sort of kind of an outgrowth of the pandemic. But in general, governments are really challenged with staffing and with people, just like the public sector or the private sector, governments lost a lot of employees during the pandemic. They tend to have aging workforces that are retiring. A lot of those are in their technology and their IT side, but really kind of across the board. They're operating with thin staff. They're having trouble paying market rates to attract new people. Typically, not very flexible about remote work and those sorts of things. You usually have to be there to do what you're doing. So they're really struggling with people. And so to the extent they have to provide all these services using technology to accomplish what they have to do in the face of a tough hiring environment really is driving, I think, some of the decisions. There's really a focus on data and having better data to make better decisions, having better analytics. Basically, the concept of business intelligence, which is not historically been something that government used to put a high priority on. But I think it's becoming increasingly important, both having internal data to making decisions and making data more available and transparent to the public. So I think those are some of the things around it that sort of layered on top of that sort of core demand driver, which is just a lot of old systems that are aging.

Got it. Okay. Is there any way of kind of contextualizing how far along we are in the digital transformation journey? It feels like it's kind of ongoing, and I know that you talked about how these gradual shifts that we're seeing take place.

Yes. I think governments in general are really early. I mean we think at a high level. If you look just at kind of the systems that they use today, that 60% to 2/3 of the systems that are being used by governments across the country today are either homegrown systems or systems from a vendor who's no longer competitive. And only 1/3 or so of the systems out there are -- came from a vendor who's competitive today. And so as those older systems age, I mean we're still not halfway through that. And as we get through that, then some of the ones that are competitive today become noncompetitive. And in terms of moving to the cloud, they've definitely in the early days of that, definitely lagging behind the private sector in that, and that's certainly a big part of our story. So the whole cloud shift and that part of the transformation is in the very early days for the government.

Well, great. And we're going to touch on cloud in just a minute here. But before we do, you talked about ARPA funds, you talked about steady stable environment. Any sense of how budgets might look next year for spending intentions? Do you think kind of similar to this year? Better or worse next year? Any sort of gauge?

Certainly they seem to be lining up with for this year. We like the environment, very similar. A lot of governments have junior in, maybe 60% or so of them. And so even still a little early for that, but getting early indications. But generally, it feels like the environment going into next year's budget is very similar to this year.

Okay. That's helpful. So maybe we can shift over to cloud now. You're in the midst of a transition to cloud. Can you remind everyone where you are in this transition? And specifically the pace relative to expectations and maybe what the shape of this would look like financially ultimately?

Yes. It's been a very long transition for Tyler. Historically, Tyler was a traditional license -- perpetual license and maintenance model. Really going back almost 20 years ago, we started to introduce a hosted model with the subscription. So we hosted those customers in our data centers -- proprietary data centers and made software available on a subscription basis and really had a hybrid model for a long time. And when customers choose the pace at which they want to move to the cloud. And that was a very slow pace. Like a lot of things in government, they're not the first adopters of almost anything. And so we had a very gradual kind of a transition for a number of years, which was actually really good for our business model. It was not a disruptive transition. And then we got to 2019. It's kind of an inflection point that, that was the first year that more than 50% of our new business chose the cloud and sort of hybrid choice environment. And it was also the year that we made the decision that we were all in on the cloud, and then we went -- we were no longer cloud neutral, that we were cloud first. We entered into a relationship with AWS to be our primary public cloud provider decided that we did not want to be in the data center business and to continue to scale that and launched a bunch of initiatives around that. Changing our sales processes to drive customers towards the cloud. We're launching a number of product development initiatives to optimize our products, which had originally been designed to be deployed on-prem to optimize those to be more efficient in the cloud. So all those things have been going on over the last 3 or 4 years. And now with a point where most of our products, we don't offer on anymore in the license model. There are a couple of exceptions, public safety being the one that's most notable that hasn't quite embraced the cloud as much. We have made significant progress in moving customers out of our data centers into the public cloud. We've released cloud efficient versions of most of our products this year and those that haven't gotten there yet or they're within a couple of quarters. And now we're at 85-plus percent of our new customers choosing the cloud. So we're very much there with new business with existing customers, we still have a big customer base that on-prem. $460 million, $470 million a year of maintenance. And roughly, only 15% to 20% of our on-prem customers have migrated to the cloud yet. So that process is ongoing. We've got a number of initiatives around that. We've said that by 2030, we expect that 75% to 80% of our customer base of our on-prem customer base will migrate to the cloud. And so there are a bunch of time lines around how we get that, but we're on track with that. That's a big revenue uplift opportunity typically as our customers move from on-prem to the cloud. It's an uplift of about 1.7x the maintenance revenue moving to a subscription. So -- there's a nice growth component in there and that kind of runs in parallel with our product -- product moves.

Okay. Great. And I think you've talked about kind of jumping in on that 2030 goal of the -- really the vast majority of the base moving to cloud. You've talked about it, I think, flips or migrations kind of accelerating in '25. Could you like unpack what's going to kind of govern the rate and pace of some of those flips and migrations?

Yes, there are a couple of governing items around the flips and just sort of back up from it, to get to that 85% -- 75% to 85% of our customer base in the cloud. We've got road maps for each product. Each product will be little bit different from where they're starting, how much of the customer is [ already ] moving. But there are a couple of governing items. The biggest one being was both an opportunity and a challenge for us around version consolidation or eliminating versions for all. So we have a lot of products. That's the strength of Tyler. It provides us with a lot of cross-sell opportunities that makes each of our products more competitive because of the breadth of products that we have and our ability to integrate those products and to create the Connected Communities vision that we've talked to our customers about. But within those products, in many cases, we support multiple versions of those products. And that becomes very expensive from a support standpoint and from a product development standpoint. Our vision in the cloud is that we have one version of every product in the cloud and the typical cloud model and that our customers all upgrade at the same time, they're all in one version. But in order to migrate our existing customer base to the cloud, those customers that aren't on the current version need to upgrade either before or when they make that flip to the cloud. And so we have an ongoing process, again, different for each product. But to sunset those older versions, move clients along to the new version, so they're in a position to be ready to flip to the cloud on a pace that supports our schedule. So -- we've been working through that. We've made progress with that, but continue to make progress over the next 2 or 3 years as we eliminate those older versions and get clients on the current version. What I talked about also around helping cloud efficient versions of our software is another item that was important to us around that transition. We, obviously, didn't want to move a lot of customers into the cloud on a product that's not -- that's expensive to host or that's not cloud optimized. So with that largely behind us, that sort of item is -- they're gaining out of those mostly kind of not as much a factor now, but we didn't really want to crank up the pace until we had the cloud optimized versions that lower our hosting costs. So I expect that pace of flips to increase next year, but I think we're probably still a year away from it being more rapidly increasing. I think it will be some sort of a bell curve over the next few years, and we're still definitely on the lower left side and working our way up that bell.

So just to reconfirm, you talked about like a [ 1.7 ] or so uplift relative to on-prem or their maintenance. And then I think at the end here, you were just kind of highlighting how the applications are really more efficient, right, to lower your hosting costs. So have you ever like kind of qualified what -- like how much more efficient? So it sounds like revenue upside and potentially cost?

Yes. Yes, both of those things. Yes. So eliminating the version. And I guess the third thing around that, that's sort of a part of that transition that also affects margins is what we kind of refer to as bubble costs. So moving from our data centers to AWS. As we work through that process, the costs are lower now hosting in AWS. But until we -- as we move those customers out, we start paying AWS as a host but we have a lot of fixed costs around our data centers that don't wait until we actually close the data center. So these bubble costs, which sort of get a little worse before they get better, but we talked about 130 basis point operating margin impact for this year. And we're -- our schedule to close the first data center on the middle of next year and the second one around the end of 2025. So over the next couple of years, 3 years, really, we'll see that lift from that. So we've talked broadly about margins in general. We talked about going from kind of the 23% operating margin place where we are now to 30%-plus by 2030. Most of that coming at the gross margin line and most of that around our cloud operations. So we've said 400 to 500 basis points of margin improvement. So collectively from the things we just talked about. And then there's some more margin improvement from improving our professional services margins from our OpEx and around our payments business as we continue to grow that, which I'm sure we'll talk about.

Absolutely.

Being able to provide more higher margin premium price payment services.

Okay. Awesome. Thanks for kind of quantifying it. That's helpful. One question I also wanted to touch on. Obviously, AWS is a really big partner of yours. What happens when customers would prefer a different cloud provider? Or if they're open or they have multiple clouds? Like have you guys talked about that expanding beyond just AWS? Are you happy just with AWS? How do you think about that?

Yes. It doesn't happen very often. We do have -- we're not exclusive to AWS. Clearly our primary partner, our products are, for the most part, as we've gone through these processes as we worked very closely with AWS. They're optimized to take advantage of services that AWS provides in their environment. Certainly, our pricing is based on volume and so the more capacity we have there, the better our pricing is. But our products will run in other clouds, and we have customers who have a Microsoft relationship that want to run in Azure and we can accommodate that. It's not very frequent. And most of our -- we may have some clients that want to have a multi-cloud environment, but it's not that common in government because, again, it's expensive and it's more complicated. So -- and obviously, AWS would like us to bring them more customers with Tyler software that they can expand those relationships around. We're in the 4th year of a 5-year agreement with AWS. I would say that we found them to be a great partner while over that course of that 4 years. And we talked about in the third quarter that our part of the reason our earnings have been a little bit better than planned this year. We've raised guidance a couple of times, and our margins are a little ahead of plan is mostly around our cloud operations and our hosting costs have been a bit lower than we had originally forecast. And we've talked about with AWS, I think internally, you're talking about -- we don't think we -- nobody can think of an example where we've asked them for something, and they've said no, which probably means we have asked for enough. But I would expect that, that will continue to be our focus there.

Okay. Great. That's helpful. So we talked about a big opportunity for transitioning to the cloud. Your portfolio is quite broad. So how do you kind of think about managing the transition amongst the entire portfolio? Like how does that kind of all come together?

Yes. Yes, because it's really a series of transitions. We talk about it as a transition, but it's really multiple transitions because each product is in a different place, and each customer base has a different -- different outlook, we have different versions for all issues. So I think the big thing is we have standards and targets across Tyler and then each product or operating unit has a plan to get there as that all kind of converge on what those long-term targets are. And we have milestones and measurements along the way to make sure that we're -- that everybody is moving towards achieving those targets that we've set out. So all trying to get to the same state. Newer products are closer to it. Products that we've acquired in recent years or built in recent years are almost all cloud native, really kind of already there. And then we also have parallel processes with clients and working with those and there's some differences between large clients and small clients and that affect kind of the pace of how that works.

Got it. Okay. And as we think about this portfolio, I think on average customers typically adopt maybe 2 to 3 products, but it seems like there's -- and I think you've discussed the potential for maybe adoption of upwards almost maybe 8 to 10 [indiscernible]. So seems like a considerable potential upsell cross-sell opportunity. What kind of drives that motion? How do you capitalize on it? How are you incenting the team to kind of head in that direction, all while doing the transition to the cloud?

Yes. And that's always -- cross-sell has always been a part of our growth story. That's one of the reasons why we have this unique product portfolio. No other company has the breadth of products that we have. Most of the companies we compete with, we compete in one of the sub-verticals. They have court systems, so they have public safety systems, they have tax systems, but they don't have all of those. We have a handful of competitors that might compete in 2 of those areas, but no one across the board. And we've done a lot to in recent years to create more value around that. We've got common foundational elements like across all of our products, we got have the same security and sign on. We have the common payment engines, service bus, workflow document management component. And then we have actually integrated products that make sense, like public safety and courts and justice, so those create one sort of integrated suite of products as opposed to where we compete with separate point solutions in those areas. So that's always sort of been the foundation of our cross-sell opportunity. But to some extent, it's been governed a little bit by what I talked about earlier in that customers just don't -- we have to wait until they're ready to replace that next system. And I think that's shifting a little bit. We have more products that we can sort of proactively sell to people. And especially around the cloud. We can create a story that you're moving your on-prem court case management system that you have from Tyler to the cloud. But you've got an on-prem probation system in an on-prem jury system from other vendors. You can move those all at the same time and integrate them in one Tyler solution and it's sort of a good inflection point for them to make that decision. So that's part of it. We talked a lot at our Investor Day in June about cross-sell and upsell opportunities. Through recent acquisitions and builds, we've got a lot more products now to cross-sell, most notably with the NIC acquisition 2.5 years ago, we have a big payment platform. And that opportunity to sell NIC payments using the NIC platform into our local government customer base is a big focus going forward. And we're really -- we've sort of laid the groundwork for that over the last couple of years. And now we're really just now starting to go to market in a big way with that. There's also an opportunity going the other way to sell Tyler software into state governments through the NIC relationships so do all those things. We've been kind of doing structurally the things we need to do in the background, creating compensation plans so that everybody gets paid and has the right incentives to do that. Just really developing the go-to sales -- go-to-market plans and how -- who approaches the customers and how we work together across divisions to do that while still continuing to pursue new logos in our normal business. So there's just a much bigger focus. And we've got things like our data and analytics platform that sits across products. That is another thing that we don't have to wait for an RFP to come out. That's something we can go sell to people. Payments, we don't have to wait for that. So there's sort of -- there's a number of different pillars to that, but it's a much bigger focus for us right now. Just to realize based on this customer base, we have 14,000 different jurisdictions, 40,000 -- almost 40,000 systems installed across them. But as you mentioned, the average customer has 2 to 3 systems from us and could have 8 to 10. So just -- and that customer base took decades to acquire in a market that moves slowly. I mean it's sort of an asset we have, and no one else has anything close to it. And you can't just go out and get it. So it's a big focus for us and something that I think you increasingly talk about progress there.

Yes, absolutely. What we -- I think we touched a little bit on payments there. We -- there's so much we can talk about here, but I want to get to some financial questions as well. So maybe I think what could be helpful for everyone is just to kind of touch on your SaaS revenue growth. It could be a little bit lumpu here and there. So I was wondering if you can just kind of remind us as to why some of the puts and takes here? And what the path towards linearity looks like towards your near and long-term goals that you set?

Yes. On the SaaS revenue growth, we've really talked about kind of low double-digit kind of 9% to 12% kind of growth in that over the next 7 years. It can be a little bit lumpy. There's both timing issues, there's big deals and how they affect it. And then there's the flip. So as we move that on-prem customers at $460 million, $470 million of maintenance to the cloud and get that 1.7x uplift, that creates additional growth from existing customers, but that also isn't a linear process. And so the pace of that will help govern where we are within that range. The new business, again, the timing of big deals, the timing of when those revenues hit. So there's also typically a lag from the time we sign a new SaaS contract or flip to when those revenues start to hit the income statement. It'd be a quarter, it may be 3 or 4 quarters depending on if they have to upgrade along the way. If they have the resources internally or their IT resources are ready to support them. Sometimes it happens in phases. A statewide court system might have groups of counties that come on in different times. So it takes -- it might take a couple of years to ramp up to the full run rate. And so that doesn't line up exactly with bookings. So sometimes [indiscernible]. New ARR added is higher, but SaaS revenue growth isn't as high and sometimes it's the other way around. So this last quarter, we had 26% SaaS revenue growth. But some of that was revenue where the contract was signed last year's third quarter. So there's a bunch of variables around it, but we're very comfortable with the sort of those long-term targets we've talked about and as those will drive margin expansion.

Got it. Okay. And we did hit on margin expansion and the 30% target. So maybe I'll shift over to free cash flow here. You reported results last month. And one of the highlights was free cash flow exceeding expectations. So I'm wondering if you could remind us again and unpack some of the dynamics you're seeing in that cash flow generated power?

Yes. As we move more and more to a recurring revenue, we're close to 85% recurring revenues, whether it's [ SaaS ] maintenance or transactions, and the transactions tend to be pretty predictable and recurring that the cash flow characteristics have improved. I mean maintenance and SaaS, we get paid in advance, and we have deferred revenue on the balance sheet. In transactions, we get paid at the time of the transaction. So there's not a receivable that's carried. So the cash flow characteristics in general have improved. Our collections and the pace of those, I think, have also improved. So most of that is just coming from operations, from better earnings and revenue growth. We've talked -- we have talked about this year, the impact of higher cash taxes. So we've had the Section 174 IRS changes have caused a fit to capitalize some R&D costs that we formally deducted in the current year. And so it's creating a -- and we've had a 2-year -- we had to make cash tax payments this year for both '22 and '23. So it's about $130 million cash tax impact this year. That will be closer to $40 million next year and then narrow over the next 4 or 5 years. But -- what we said it's over the next -- by 2025, we expect our free cash flow margin to be kind of in the high teens, 17% to 19%. And then ultimately, by 2030 to be in the high 20s and approaching 30% free cash flow margin. So pretty significant opportunities to continue to grow that. But cash flow is -- does grow at a pace ahead of our earnings growth.

Okay. Great. And thanks for reminding us of kind of the trajectory as we work towards the long-term goals. Okay. Maybe could you give us an update on your capital allocation strategy? How you're thinking about M&A in this environment? And kind of how that evolves as we kind of move further through the cloud transition?

Sure. We've historically used about 75% of our free cash flow for M&A. At times, we've used that. We did a big $2.3 billion acquisition of NIC for 2.5 years ago and incurred a pretty meaningful amount of debt. We have paid off most of -- a significant part of that over $1 billion of debt since then. Our term debt, which is floating rate, is down to a pretty small number. I think we'll be that completely repaid by, at least by, the middle of next year, if not sooner. So that's been the focus on is more recently. We've done some tuck-in acquisitions, and I think we'll continue to do those. They tend to be on the smaller side of things. We think we can grow faster than Tyler's core growth rate where we can leverage our customer base and our sales team to sell more of it. I think in terms of big M&A, again, we've got a lot of initiatives that we've just talked about on the flight. And even as we pay down the debt, I'd say in the very near term, that's probably not a big priority. The bar is really high for acquisitions right now. But that will evolve over the next couple of years. And -- but I think M&A is still kind of will be, as you look out over 2, 3, 4, 5 years, will be the biggest priority. We have -- the rest of our debt is a convert that's due in 2026 and is 0.25-point of interest. So that doesn't have to be dealt with for a while. And then we've been opportunistic about buybacks over the years. And again, as the debt is paid off and again, depending on valuations and where our stock trades, there could be opportunities there. We've tended to buy on big dips that we didn't think were reflective of long-term potential of the company. And so I think we'll be more open to that as -- again, as we get the debt paid and just balance that with M&A.

Very helpful. And unfortunately, we're out of time. Kind of flew by. So Brian, thank you so much. Great discussion, and thanks, everyone, for joining us.

You bet. Thank you.