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

Okay. We'll get started. Thanks, everyone, for joining us this afternoon. Trevor Walsh, Senior Analyst here at Citizens JMP. And I'm glad to be joined by Brian Miller, EVP and CFO of Tyler Technologies, to do a fireside chat. And then we'll open it up to questions from the audience towards the tail end. So Brian, welcome.

Yes. Thank you. Thanks for having me.

So finished out 2023 in a strong way. So congrats on that piece. What makes you just kind of looking forward to the next 12 months? What's getting you excited about the business? Kind of what opportunities are you seeing in the year ahead?

Yes, we did have a good finish to 2023. Really for the full year, we finished a little bit ahead of our plans for the year. And we raised our guidance through the year. And at the end, we came in really right at the high end of our earnings guidance and pretty much achieved what we wanted for the year. We talked about 2023 being really a pivotal year, especially around our cloud transition. During the year, we crossed over to where now SaaS revenues are greater than our license and maintenance revenues. We had talked for some time about 2023 being the trough year in margins with the margin pressure and compression that we got from that cloud transition and really kind of getting around that curve. And so in the fourth quarter, we saw margin expansion. And our expectation for 2024 is to be back on that long-term trajectory. And our plan and our guidance includes pretty good margin expansion, maybe a little bit ahead of where we would have previously expected for 2024. So a lot of excitement around those initiatives, mainly around our cloud transition that will happen in 2024. We're moving from proprietary data centers to AWS and expect to exit our first data center midyear, which is in line with the timetable we've talked about before. And that is one of the margin drivers, really starting to move a little faster with flipping or migrating our on-prem customers to the cloud and look to see good progress on that this year as well.

Great. Appreciate the good -- the overview. Let's maybe go dig a little into the flips. Obviously, a lot of questions around that on the last earnings call. Do you -- and understand, I think, about 20%, if I am correct, as far as customers on the cloud currently and then the 2030 vision, 75%, 80% is kind of the target.

Yes, relative to our current on-prem customer. So if you look at our customer base today sort of on a revenue equivalent basis, if you translate the current maintenance revenues into SaaS revenues, where about 40% of our customers or our revenue base is in the cloud today, and about 60% is still on-prem. Of that 60% that's on-prem or what was on-prem midyear last year when we did our Investor Day, only about 15% have been migrated to the cloud and 20% or so at the end of the year. We expect that to be in the 80%, 85% range by 2030. So...

Great. Okay. Are we -- do we get a little bit maybe too fixated just on the flips in and of themselves? Because I mean it seems like there's upsell opportunity that comes with that, so maybe we kind of lose the force of the trees a little bit. Can you comment on that?

Yes. I mean I think there's a lot of interest around the absolute number of flips. We give that every quarter, and we give the dollar value or the contract value associated with those. And the fourth quarter was 92 flips. And it's not super precise number. We've talked -- we're talking about through 2030, this migration. We have a plan and a road map for every product. Every product is sort of starting out in a different place with where that customer base is in terms of acceptance of the cloud. So some areas like public safety has been the slowest to embrace the cloud. And in a lot of places, especially rural places, they're not yet comfortable putting a 911 system in the cloud. But that's changing actually kind of rapidly. Other areas like ERP, we've been migrating customers for 15 years to the cloud. So each product has a road map and a time line that converges on getting us to that 80%, 85% by 2023. But there's a lot of variables around how you get there. We're very confident in getting there. But from quarter-to-quarter, it's not a number we precisely predict at the beginning of the quarter. Although the number of flips in Q4 was relatively consistent with the year before, the dollar value -- contract value was up 39%. So we're seeing more bigger customers start to move. And I'd say in general, there's still a lot of our bigger customers who are still on-prem. It's a little bit more complicated process for them, although they have a lot of motivation to do that.

Sure. That's great color. Maybe we'll step back and just look more 2025, 2030 targets, just kind of more broadly, whether it's top line, margin expansion, et cetera. Where do you think the pace could accelerate? Or where do you kind of see upside kind of and what you're thinking kind of based on, again, finishing out '23 and looking, going forward?

Yes. So at our Investor Day last June -- and it was the first time we did an Investor Day since 2019. So a lot of things have changed in the company since then including a really big acquisition and growth in the transaction or payments business. So we set targets and expectations midterm for 2025 and long term for 2030. So a few months into that, at the end of the year, the progress we made in 2023 was right in line with what we expected or maybe slightly ahead of that. On the revenue side, I think we're tracking the way we need to with the cloud initiatives that get us there and with the payments cross-sell. Free cash flow is actually a little bit ahead. So our guidance for 2024, we talked about a 17% to 19% free cash flow margin. And that's the range we gave for 2025. So we're a little bit ahead on the cash flow side but really, really on track with the initiatives that are going to drive us towards those 2025 and 2030 targets. I think where there's potentially upside maybe is, especially in the longer-term one, is around that transaction business. One of our -- the 4 growth pillars we talked about is growing that transaction business. And to a large extent, that takes place through cross-selling payments, whether it's acquiring payments, inbound payments or disbursements, but selling those solutions to our software customers. With the NIC acquisition in 2023, we gained a really robust payments platform, a lot of experience processing high-volume payments for state governments. And now we're looking to drive that down into our local government customer base by integrating that payment platform into our software solutions, things like utility billing, traffic court, municipal court systems, parks and recreation, licensing, permitting, property taxes, all those things where we provide the back-end systems and now being able to layer payments under that. So it's a tremendous opportunity. I mean a multibillion-dollar opportunity just in our customer base. But we're just at the very beginning of that. So we've talked about a 10% to 13% CAGR in our transaction revenues between now and 2030. But there's certainly upside to that if we're very successful as we move forward. But again, we're just at the beginning. So it's a little soon to change those targets, but we feel pretty good about the opportunity and how we're positioned to take advantage of it.

Great. The California Department of the State direct deal was super interesting. How -- but there are some puts and takes around kind of the self-funded version versus just buying software. And can you maybe just what -- in your ideal mind as a CFO, do you want more of those types of deals? Or do you want -- how do you see that playing out? Or what's the ideal state is?

Yes. I think it showed that we can take all the strengths that Tyler has and create a sort of a creative model that works for the customer. So this is a deal we did in the fourth quarter. It's actually the largest by estimated volume because -- by value because it's a transaction-based deal but the largest deal in the company's history, estimated value of about $175 million over 8 years. So this is a deal with the California State Parks to provide software solution as well as some services and payment processing. So all bundled together. Previously, they had multiple vendors for that. Conduent was sort of the overall prime contractor. We had a little piece of software, less than $3 million a year in revenues from a piece of their outdoor recreation software. And then Elavon was doing their payment process. So as California went out to look at new providers, we were able to win the contract for the whole bundle of business. So -- and that's being funded in a sort of a self-funded model. So rather than us getting paid SaaS fees or SaaS revenues for the software, it's bundled into a stream of revenues that will come from transaction. It's basically funded by users. So the users of the parks, people paying for park admission, for campground reservations, to take a tour of the Hearst Castle, all those things, there'll be convenience fees added to those that then come to Tyler and fund the whole solution. So it all show up in transaction revenues rather than part of it being in SaaS revenues. It will be a little bit seasonal because the usage varies from season to season. But the margins are at least as good as they would have been in separate pieces. The margins on payment processing are lower than SaaS margins, obviously, but the blended margins are at least as good as they would have been. But California has budget issues, and so they preferred not to have to put a line item in their budget to fund the software. And because there are users paying fees that this can be funded through, it -- and because we have a lot of experience with that kind of a model through NIC, it gave us an opportunity to offer a solution that works for their funding, works for us. I don't see a lot of deals like this happening. We've done a couple in parks. We actually did one with the Wyoming State Parks as well on a much smaller scale. But I think generally, not every application has a set of users that are paying fees that can fund this sort of a software deal. But it's a great combination because we have such a strength in payment processing as well as industry-leading outdoor recreation software that we're able to bundle that and bring that whole thing into Tyler at $20-plus million a year in revenues.

Great. Why don't we maybe go from the more long-term view to the more narrow or more shorter-term view of '24? You put out guidance for '24. At least from the top line, that was ahead of where our expectations were, which is great. But -- and I know you don't guide to necessarily quarterly type of numbers, but can you help us just understand or walk us through progression for both the revenue and earnings or profitability metrics, kind of how that looks throughout the next -- especially give us some the dynamics that you've got.

Yes. Sure. Happy to do that because it's not linear through the years -- through the year. We have a few things that affect that and want investors to understand kind of how that progression looks. So on the revenue side, the second half is a little bit stronger than the first half. It's not super seasonal. The software continues to grow through the year. Transactions are -- and we've talked about this quite a bit since we've added the NIC business. Transaction revenues are typically lighter in the second half of the year, especially in the fourth quarter. Fewer business days, holidays affect people making payments or conducting business with governments. So -- and there are a lot of sort of statutory deadlines and tax filings earlier in the year that drive those volumes up. So on a total revenue basis, I think it's probably like 49% in the first half, 51% in the second half. So a little bit more heavily weighted to the second half of the year. But within the revenues, SaaS revenues, you should expect to see those grow sequentially each quarter through the year. So up in Q1 from Q4 of '23 and then growing sequentially, maybe call it, $10 million a quarter. On the transaction revenues, they'll grow sequentially in Q1 and Q2, flattish in Q3. And then they declined in Q4, which is a normal seasonal pattern. And that's kind of sequential growth compared to last year, so year-over-year growth, transaction revenues are going to be flat to down slightly in the first half of the year. And that's really a reflection of one of our state enterprise contracts. We've talked about this quite a bit last year as well, changed from a gross to net model on their payments. So same business, but rather than us being responsible for merchant fees and including those both in revenues and cost of revenues, those have moved to a net model. And that happened midyear next -- last year. So that impacts the first half of this year until we lap that. And so you kind of see flat to down on transaction revenues in the first half of the year because of the change in merchant fees. And then roughly low double-digit growth for the second half of the year, probably high single and then low double digit in the last 2 quarters. So that's the revenue side. And then on the EPS side, our guidance is $8.90 to $9.10. It's more heavily weighted towards the second half of the year. So on the total EPS, it's probably 45%, 46% in the first half and 54%, 55% in the second half of the year. From a sequential basis, I think EPS grows modestly in Q1 compared to Q4. It steps up more in Q2, and then it steps up again in Q3 and is relatively even in Q3 and Q4. Really, that second half step-up is more focused around the margin improvement we get from cloud, especially as we exit our first data center midyear. So we'll start to see those fixed costs around that data center go away in the second half. And also, we see more impact of the timing of flips from on-prem customers over the last few quarters now starting to kick in, and to some extent, the California contract kicking in. So a little bit of back-end weighted towards the year. But overall, I think the midpoint of our guidance implies 70-ish basis points of margin improvement, which is on track with what we've talked about in the past.

Awesome. Thanks for that additional kind of perspective leading us through the year. Is there -- just by the way, is the AWS partnership impacting at all any of that kind of EPS?

I mean that's one of the reasons that our margins are maybe a little bit ahead of where we would have thought going into the year. AWS is our primary public cloud provider. We entered into our first agreement with them back in 2019 when we really sort of accelerated the shift from being a cloud-neutral or a cloud-agnostic business selling both licenses and SaaS to really focusing on SaaS. And we've gone from 2019, half of our new business was SaaS and half was licensed to today it's about 90% SaaS. And so we've been migrating customers out of our data centers, which we used to host our SaaS customers in proprietary data centers. We're moving those to AWS to get out of the data center business. Been putting all of our new customers in AWS, and now, our first 5-year agreement is coming up for renewal or came up for renewal. We renewed it effective at the beginning of the year. And now that we scaled quite a bit there, have a lot more -- 5 years of experience in how that's working, we have worked with help from AWS to optimize our products to run more efficiently in the cloud and particularly in AWS. And I've been really pleased with the efficiencies we're getting there. Our unit costs continue to come down pretty meaningfully, and we were able to further lower those through this new agreement. And we'll start to see the impact of those in the beginning of the year, and that will continue to expand as we scale up more in their environment.

Great. Awesome. Just maybe one final piece on that note around just the data center exits. Can you just give us a sense of the magnitude of kind of the CapEx, savings, but as you exit, kind of what's that look like on just a nominal basis of the -- and then does that -- do those dollars shift somewhere else into the business to go towards...

Yes. I mean we saw a lot of that in 2023. So we made the decision back in 2019 that we were going to move towards exiting the data center. We had thousands of customers that were hosted in our data centers. So it's been a road map and a complicated one to get there. The first one, we've consistently said mid-2024, and we're right on track to do that. So as we've moved forward with that plan, we have been able to reduce the CapEx around those data centers. Obviously, we're trying not to put more equipment into those. So in 2022, we spent about $5 million in data center CapEx. Prior to that, it was closer to $20 million a year. And it's just -- '23 and '24, it's around $1 million a year. And then that goes away that -- so CapEx generally have been coming down. Our CapEx in 2024 should be $3 million or $4 million, less than it was in 2023. Some of that around -- we've wrapped up some projects around some facilities. And then going forward, CapEx should -- it's just sort of a normal maintenance CapEx, our facilities and our people, and it should grow in line or lower than revenue growth.

Got it. Okay. Perfect. Maybe just one last final shot for me, and then I'll open it up to the audience. How do you guys think about as the broader leadership team kind of balancing product innovation with making sure, obviously, the fit with customer base but not necessarily getting too complex in any particular feature or capability and pricing it well, et cetera? How do you guys think about that going forward?

Yes. Because we exclusively serve the public sector, it's a little bit different market and a different approach to things than you'll see with private sector. Typically, our customer base is not sort of looking to be on the leading edge of new technology. You can kind of see that in the slowness they've had to embrace the cloud. You've seen it a lot -- across a lot of areas. Government is very risk averse. They don't like change in general. They want to be more efficient. They want to provide better services to citizens, but they don't really have to because they're not -- they don't have competition. So it kind of carries over into their appetite for new technology. So we're usually bringing things to them before they're asking for them from us. And so we're ahead of anticipating what kind of needs they'll have and how we can make their operations more efficient and make lives better for the citizens. But then -- but we're making those investments early based on how we think we can get the most impact for our customers. So things like AI, there's a mixed bag around how governments are looking at it. You see some that are more progressive, that are anxious to incorporate AI into their operations. And you see some that flat out banned AI in the government or in their applications. So there, we've got task force that are looking at how we can prioritize within Tyler, where we make those investments into our products, where it can provide the most impact for our customers. Customers and governments do a lot of things that would seem to lend themselves well, sort of routine tasks like processing and application for a business license or a building permit. You see a lot of places where there's massive backups in processing building permits. We sell licensing and permitting systems, but there's still a lot of manual processing done through those, and that's one of those areas where we think AI could do a lot of that task. One of the advantages Tyler has is because we have such a big customer base with close to 40,000 installations of our products across the country and so many governments using our systems, we have a tremendous amount of data that's flowing through those systems that can help shape that machine learning. So we're being very thoughtful about it and prioritizing it. We don't have unlimited R&D budgets, but we think we can, like we have been historically, be at the forefront of sort of leading our customers through that.

Great. Thanks for that perspective. I'll hold to my promise and see if there are any questions from the audience.

Regarding the merchant fees, there is a 90 basis point impact embedded into the 2024 guide. Could you just talk about what factors give you the confidence that, that is the impact? And is there anything that could cause that to grow or shift over time?

Yes. So in our payment processing business, most of our customers are on a gross model, so we pass through merchant fees. So we charge customers a percentage of the transaction, and then we pay out a significant part of that to the credit card networks in merchant fees. So it's both in revenues and cost of revenues. If you -- and it's about $154 million in our 2024 plan, and it's relatively flat because of this one customer that changed from gross to net. So that piece of the revenues is not growing this year. So if you took that out of revenues, so the rest of our revenues, excluding those pass-through merchant fees, are growing much faster. So that impact sort of lowers our growth rate at the midpoint of our guidance by about 90 basis points. It's not a frequent occurrence. This was -- we don't see a lot of customers -- an indication that a lot of customers are looking to make that change. Most customers like the -- to have a fixed rate with us. So we don't really see much risk around that or change around that. Merchant fees in general, if you take them out of both our revenues and our cost of sales, they also negatively impact our margin. So our margin would be almost -- our overall operating margin would be almost 200 basis points higher, excluding the impact of merchant fees. So it's significant both to margins and revenue but just kind of passes through there.

Great. I think that's all. We're out of time. Thank you, sir. Appreciate it.

Thank you.