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

Okay. Great. Thanks for joining day 2 of the Wells Fargo TMT Conference. I'm very pleased to have Brian Miller, EVP and CFO of Tyler. Do I have this right, where you've been since 1997?

I have been here since 1997.

It's amazing. So obviously, you'll have a lot of perspective to add to the conversation, but I'm sure you've noticed or maybe you haven't, but we've certainly noticed that over the past year in software, there's been this renewed interest and appreciation for vertical-focused software, right? We went through a period where horizontal software was very top of mind. And the idea was just -- the growth characteristics of those businesses captured a lot of attention. You've just been methodically doing what you're doing for a long time. And maybe we can just start by speaking to what Tyler does and what has kind of enabled that consistent profile that investors have come to appreciate again.

Yes, it's funny because in 1997, when I joined the company, and we sort of embarked on the strategy of providing software to local governments and now broader levels of government. We were a vertical software company, but that wasn't a term then. So there wasn't really a name for us. We were kind of a government software company. And so we're happy that at some point, it became a name for what we do. And we are a vertical software company focused exclusively on the public sector. We are very broad in terms of the products we offer to the public sector. We have, by far, the broadest product offering in the space and broad in terms of the levels of government we serve. We sort of grew up in the local government level, cities, counties, school districts; have significantly broadened our position with state governments, mostly through the acquisition of NIC 3 years ago. And they have a small presence with the federal government, about 5% of our revenues also came through an acquisition, both state and federal areas where we look to continue to grow. It's a big vertical market, obviously, the public sector. But it's interesting that it's such a fragmented market. It's historically served by lots of niche players, who usually focus on a narrow product area and often narrow geographically. So I could come either to just those court systems in California or tax systems in New York and New Jersey. So we're really unique in terms of the breadth of product offering, the size of our customer base. And there's really not a close #2 behind us. We have lots of competition and different competition in every product area. So not to say we have a monopoly or anything, but there's not another full vertical public sector software company that's anywhere near our size.

When we just think about the breadth, like how much of an advantage is that versus the fragmented players that are trying to do one thing? Is there an association with Tyler more broadly across public sector that helps? Or what has enabled our business model to succeed?

There's a number of factors around that. I think at one level, the products work together. So some of these areas are very adjacent. So if you think about our major product categories, ERP, financials, public admin, payroll, human resources; our biggest single product set, about 30% of our revenues. Within that suite of products, though, and what distinguishes us from the horizontal players like a Workday or an Infor is that we have dozens of applications integrated there that are government-specific licensing and permitting system, a utility billing system, parks and recreation, even cemetery management system. Those are things that the horizontal companies don't have, but the government still needs. And so the ability to have all of those in one integrated solution from one vendor is something that a lot of governments find value in. And then adjacent areas. So we do -- we're the leading provider of court systems, systems that manage all the aspects of a criminal or civil case, prosecutor, probation, jury, jails, all of those things. But then we also are a major player in the public safety area. So we do 911 systems, computer-aided dispatch, police record systems. Those are two completely different competitor sets in those two areas, even though they're very adjacent. So we're the only company that can offer an integrated solution where all of the information flows through all those things seamlessly. So we provide extra value from having the versus those individual point solutions from being able to integrate the solutions from having common foundational elements like one security and sign on, one payment engine, one workflow engine across all those and then a layer of data and analytics capabilities that sit on top of those that add value as well.

Can you just talk about the TAM and the penetration rates within the industry? Because I think sometimes investors think, "Well, gosh, Tyler has been around a long time. I wonder if they're starting to run into some level of penetration." But you're not, for [ what we've ] seen. Just maybe for those who don't have appreciation for how vast, like all these different categories end up being -- provide some...

Yes. As I said, it is very fragmented. Part of it because it's a really slow moving market, and it turns over very slowly. So we think that if you looked at all the systems that all the governments out there are using today that 60% or more of those are legacy systems. They're either homegrown systems, some of those 40 and 50 years old, Cobalt Systems, or systems from vendors who aren't competitive today, not necessarily out of the business, but at some point, didn't invest in the next generation of technology. So they have products that are widely installed and used, but [ nobody ] that would buy today. And so as those systems age and finally get to the point where a government says, this is at end of life, and for government, that's very different than the private sector, that's often 20 years of a cycle and sometimes longer; then it's not an opportunity for the existing vendor to replace it, but it's a new opportunity. So even in some of our big areas like ERP, where we have thousands of customers, we still have probably a mid-teens kind of a market share; our win rates are very different. Our win rates for our core products are typically north of 50%. So as these turn over slowly, we're winning kind of way more than our share because of our strong competitive position. Courts & Justice, is probably our biggest market share. We have about 55% of the U.S. court systems. But the ancillary products around that, like jails and jury and prosecutor, we have much smaller market shares because we're newer in those areas. So huge cross-sell opportunity and still plenty of runway ahead of us just in the U.S.

So can we bring cloud in the conversation and talk about the progress that you've made there? So Tyler has embarked on the cloud transformation. It seems like it's catching some good momentum. We've seen signs that the margins have troughed and are starting to build back. But maybe walk through the past couple of years, what the sort of impetus was for moving towards cloud? And just how you've seen receptivity, given you mentioned customers can be slow moving? So maybe it takes some time for that momentum to build. But what has the progress started to look like there?

Yes. Our cloud transition, like a lot of things in the government, has been slow and gradual. Government is typically not the first who want to embrace anything new, and cloud is not new anymore. But -- for many years, originally, we were, long ago, just a traditional license and maintenance model. Then for a long time, we offered a hybrid model that we either offered traditional license and maintenance on-prem deployments or a cloud deployment, which was really kind of a private cloud, a hosted solution, paid for with a subscription but hosted typically at 1 of 2 Tyler data centers. And so we offer this hybrid model and let customers decide which one they wanted, and we didn't really try to push them one way or another. And so very gradually for a long time, like 15 years, more and more of our business came in the cloud. 2019, that really kind of changed and we said we're not cloud-agnostic anymore, where we're cloud first. Clearly, this is where the future is. Not only it's better for Tyler, but it's better for our customers as well. 2019 was also the first year that 50% of our new business shows cloud. And so we changed our focus, changed things like sales commission structures, entered and increasingly started to move towards offering no longer offering products in a license model. Entered into an agreement with AWS so that we could get out of the data center business, which we couldn't scale, and move to the public cloud and just renewed that agreement this year after 5 years to start moving our clients out of our data centers and putting all of our new clients in AWS. And so that -- since 2019, the pace of the transition has really accelerated. Today -- last quarter, 97% of our new business is cloud. We're only selling a couple of products that still are offered licenses, and those are rapidly changing as well. We went through the margin and revenue pressures. So as those licenses went away and it took us time to build up the recurring stream, as you said, last year was kind of the trough of that and really a really important inflection point. So in '23, our SaaS revenues now exceed our license and maintenance revenues. It was the trough in terms of margins. And so now we're on a margin expansion trajectory. We had an Investor Day and talked about targets of going from a 23% operating margin, 23% to a 30%-plus margin in 2030, and we're well on that path. The midpoint of our guidance this year implies about 150 basis point improvement in operating margins, cash flow margins also seeing similar kinds of improvement. So really kind of on the other side of it, the market has gone from resisting to starting to be interested to really now embracing the cloud. And there's a lot of reasons for that, especially around the struggles that governments have with running their own infrastructure, with hiring and keeping and replacing retiring systems administrators and security people. Cybersecurity concerns, ransomware attacks also increasingly making them more comfortable with systems in an AWS environment than in their own networks.

We've talked about the sort of the slow-moving characteristics is one side of the customer profile, but the other side is they can't go out of business, they can't go anywhere. They have to find budget. Like these things have to happen at some point. So what are you able to say around visibility into where the market is going, where the opportunities are in the next 1, 2, 3 years out? And how that just informs whatever you're doing from a prioritization standpoint and spend as CFO?

Yes, we have a pretty highly visible model. We're now about 85% recurring revenues, either from maintenance or SaaS or from transaction-based revenues. Again, with these long sales cycles, our pipelines are highly visible as well. We've talked pretty consistently over the last several quarters about it being a very active market. RFPs, sales demos, all those metrics at very high levels from a historical perspective, with typical sales cycle of 12 to 18 months that points to better visibility over growth further down the road as things get executed and then get implemented and we start to recognize revenues. And even we're starting to see that impact in increased bookings and SaaS revenue growth north of 20% from that market over the last few quarters. So pretty good visibility about -- good confidence in the targets we've put out there. We've talked about accelerating revenue growth, although for us, there's never explosive growth. These things turn over slowly. So for us on the overall side, it's kind of high single, low double digits, transactions being a little bit faster growing. Right now, the SaaS revenue growth is significantly higher because as we transition our on-premise customers to the cloud, there's a pretty significant uplift in the revenues from the same customers.

And your customers kind of awareness of that [ TCO ] discussion and the discussion around reasons the cloud might come in more than the maintenance revenue stream, but you're enabling so much more. Is that something that you're finding most of the entities that you serve now just better...

Yes. Yes, they understand that. Even though they -- the change from maintenance to SaaS, it averages for us about 1.7, 1.8x uplift for a new customer. It's about a 2x uplift. But they understand that and we help them understand that, that their costs don't increase that, but it's generally cost neutral or sometimes cost beneficial to them to make that move because they have hardware they don't have to pay for and replace. They have maintenance. They have jobs, often jobs that they're having trouble filling, so they've got budget for, but can't find the people or afford to hire them or attract them to go to work for the county government. So that -- those costs go away. And so they understand that trade-offs and are open to it.

One question that we get from investors who are just coming up to speed on Tyler is just that is there any sort of macro-related exposure to think about? I think investors here, government and think, well, maybe there's something tied to election cycles or tied to something that might potentially impact the business. But you're broadly diversified, and I think you've sort of highlighted that. But in your assessment and amount of time as part of Tyler, have you noticed any macro sensitivities at all?

Well, not much. Yes. We're not inflated from everything, but from a lot of things. We're 98% domestic. So there's not [ geopolitical ] implications, tariffs -- talking about tariffs, don't affect us. We -- at the core, everything we provide is really essential to government. It's automating essential functions like public safety and courts and property taxes and licensing and payroll. So those aren't the kind of things that you would expect to see cut, even if there is a move towards government efficiency. We view that as something really positive for Tyler because generally the way governments are going to be more efficient is by implementing new technology to replace old systems that support manual -- highly manual, high labor-intensive processes. So at the core, the things we do -- or help our customers do are really all essential functions. We're -- and we've seen that in prior economic slowdowns really not much impact, maybe on the timing of new business, but the demand -- the drivers of the demand, the old system dying doesn't really change, and it's a pretty nondiscretionary decision to replace it. There is increasingly more of a push towards digital modernization. I think some of that has come post-COVID, where governments have said, "This system, it will work for maybe another 5 or 10 years, but it doesn't support hybrid work. It only works if the clerk can come to their desk, if it's a courthouse, and sit in front of a terminal." And now people want to have hybrid or remote work. And government hasn't been very good about adapting to that, providing citizen self-service so that people don't have to go down to the [ DMV ] to do something. Those kinds of things are becoming more and more important and maybe accelerating the pace of some of these replacements. But with respect to elections, I've been at Tyler for 27 years. I'm pretty sure that during that whole time, we have never mentioned elections on an earnings call or in an MD&A as a factor either positive or negative. It just doesn't really affect the business. One might think it would, but it doesn't.

Yes. I think that's helpful. Can we spend a little bit of time talking about the M&A strategy, how that -- I mean, you mentioned market is fragmented. I'm sure you pick up little points of opportunity just in your expertise within the public sector. So what informs the M&A strategy, prioritization efforts there?

Yes. Our CEO, Lynn Moore, likes to say M&A is in our DNA. We've done roughly 60 acquisitions over the time I've been at Tyler, which sounds like a lot of bit -- averages a couple of years. This year, there have been none. Last year, there were 4. A lot of these are smaller kind of tuck-in acquisitions that add a product, fill in a gap. Often it's around a core product in an existing suite of products. So for example, where we have this leading position in the court case management software space, we bought a SaaS company that just does probation software. We bought a SaaS company that just does jury software that had really great systems and expertise, but were very narrow and small companies that had trouble scaling, and then we can leverage -- our sales organization put more products in the same sales rep's bag, sell it back into our installed base and grow those things much faster than Tyler's core growth rate. We've done some acquisitions that filled in bigger gaps, that added a whole new sort of subverticals. So public safety several years ago was probably the biggest functional area of government that we didn't have an application in, and we acquired that through an acquisition of New World Systems. And then in 2021, the biggest acquisition we've ever done was NIC, which was a public company, focused on the state government level and really focused on payments and transactions, so that brought us the capabilities in the platform for payments and these broad state relationships to enable us to sell Tyler software products to state governments where we didn't have relationships or a sales organization. So we'll continue to do those tuck-in kinds of things. The tuck-ins maybe get a little bit bigger. There's still a lot of gaps around our products to things that we can fill in. Three of the acquisitions we did last year added AI capabilities, which were interesting. I'd say we've talked about -- our focus over the last couple of years has really been paying down the acquisition debt from the NIC acquisition, and we paid off all of our term debt earlier this year, 2 years ahead of the term of the debt. And so balance sheet is in a great place. We generate a lot of cash today. We've only debt on the balance sheet as a convert that's due in 2026, and it's at a quarter point of interest. It is in the money, but it's not terribly dilutive. We have about $700 million in cash. We've got a $700 million undrawn revolver, which Wells Fargo leads. And we did write a lot of cash. So we're in a good position in terms of bigger M&A. But in the short term, we have a lot of really important initiatives around the cloud transition, around the growth of our payments business, around cross-sell initiatives. So I'd say probably in the next year, we're not really looking for a multibillion dollar acquisition, but there will be those on the horizon.

Is that more of the reason that you said there have been zero over the past year or maybe for the year before? Is it more just digestion of prior acquisitions and the things that you're working on? Or was some of it at all tied to the interest rate environment?

Yes, more around the interest rate environment and paying down the debt this year and having accomplished that also, yes, is more around all these initiatives and management attention that we're pretty picky right now. And there are some things that we're always talking to a lot of people. And there also haven't been a lot of processes run from a lot of what we hear. There seem to be an outlook for more activity next year. I would say that we're more -- despite all the efforts of the investment bankers, we're more successful with acquisitions when we initiate a process. We find someone, it might be a partner of ours, rather than participating in that process, but we've done both.

Yes, that makes sense. How would you gauge progress with NIC thus far? And if there is an evolution of that progress, like the lessons learned, how you would view the synergies and cross-sell potential there currently versus what it looked like when you first made the acquisition?

Yes. So when we bought NIC, which was 2021, kind of in the middle of COVID, we start -- we approached them in mid-2020 about our thoughts that they'd make a good acquisition candidate for us; there were a couple of strategic opportunities we thought around it. One, it was a good business on its own in the public sector, but very complementary to Tyler, in that they were the back-end software mostly at the local level. They're mostly the digital front end to government, mostly at the state level. So a different revenue model really all funded by transactions, so kind of self-funding model where they build or provide interfaces to systems at the state level, a lot of which are not Tyler systems, big old mainframe systems for the DMV, for example, for your motor vehicle registration or hunting and fishing licenses. And so providing access to those, running the state website and facilitating transactions with citizens or businesses and then getting paid with convenience fees or service fees on top of that and processing all of those payment transactions. Tyler had a desire to expand its payments business because we have a lot of software products mostly used at the local level that facilitate payments that present bills, utility billing, traffic courts, licensing and permitting, property taxes, all those sorts of things. But we weren't a payment processor. And we had approached the market for a long time with partnerships, bringing in third-party payment partners that we might have had least integrations with, but got a revenue share from their payment processing revenues. So we wanted to keep more of that, be more involved and create a more integrated payment platform with our software products, and I see brought us the technology and the expertise around that. We also thought we had a great opportunity with a lot of Tyler products, that software products that had applicability at the state level, but we just didn't have a sales organization and didn't have those relationships. And we thought we could leverage these very deep relationships and these very broad contracts that NIC has with 28 different states to sell software into state governments. Both of those things have taken some time, but have proven to be true. We're increasingly seeing, both in terms of the pipeline and actual deals, a lot of successes in selling Tyler software into NIC states. And a lot of -- certainly beyond what we expected. We had a lot of use cases that we thought made sense, but a lot of things have emerged that weren't things we thought of before that have been opportunities. And in the payments, we're making a lot of progress there as well. We've reported the last few quarters, as we've integrated that NIC platform with our Tyler software products, starting to figure out our go-to-market motion and how we compensate everybody and how we drive those sales; last quarter, we sold 268 new deals for payments with Tyler software customers that add $8.5 million of new ARR. That was -- so that's been growing steadily. But we've just scratched the surface of it. We've got thousands of customers using Tyler software products that are payments opportunities.

Why wouldn't that be a no-brainer for those customers, given you mentioned you're already touching payments, and I think all of us have experienced places that we go, whether it's the DMV or somewhere else, where you're surprised there's not a better payments portal or something like that? Is it also just tied to the slower-moving nature of decision-making? Is it harder to go back and cross-sell something if a customer is already renewed? Or what are the things that...

Yes. It should be a no-brainer. I mean basically because our solution is a better solution than a generic horizontal payment solution. Because it's integrated with the software platform, it automates things like reconciliation. The same system that produced the bill, that produced the transaction is integrated with the payment platform. So it automates the manual process, it provides better reporting, better analytics. There's a whole lot of reasons why it's a better solution. And customers are willing to pay more for that, which is also good. So it's not a commoditized payment solution. And the good thing is often they can pay us more, but they can offset that by adding a $1 or $2 convenience fee to a utility bill or to your traffic ticket or to whatever you're paying for. So they can pay us more for a better solution, but not have a higher expense. It's really a matter of going back to our customers, often we're either replacing an existing solution, which we may have to wait until their contract's up; or in some cases, where we do enterprise-wide payments, we're replacing multiple payment providers, where Citi really doesn't have a strategy. They've got one payment provider for the Parks and Recreation Department, a different one for the court. It's a different one for the utilities. That's a little bit more complicated, but we've seen some good examples of that, one of them here in California last quarter. So it's a pretty compelling offering, we think. And so it's a matter of -- now pretty much all of our software deals when we're responding to RFP, they're not asking for payments. They still get a proposal for payments and an explanation of why it's better to do that through us. But yes, there's a huge runway, and we're just right at the beginning of it.

I'd be remiss if I didn't spend a little bit of time on the target. I think that the 2030 target model comes up often in investor conversations. Can you speak to the level of visibility you have that far into the future, given you do have long customer lifetimes? And what needs to happen for you to execute on both the growth and the margin side of those targets?

Yes. At our Investor Day last year, we put out 2025 and 2030 targets. We thought it was an appropriate time. We've never done that before, going out that far. But given the inflection point we were in the cloud transition, the opportunities ahead of the NIC acquisition a couple of years behind us, I thought it was important to make sure everybody was aligned with kind of where we thought things going and why. So we laid out revenue targets, cash flow targets, margin targets and kind of what the factors were, how we get there. I'd say 1 year, 1.5 years into it, we're increasingly confident of those targets. In some cases, we're ahead of plan. Not necessarily that means we change the ultimate target, that we're getting there a little faster. And we said all these things wouldn't be linear; but in terms of some of the underlying things like around the version of consolidation of our products, the flips of our on-prem customers, the adoption of the payments, all those things are tracking at least in line with where we expected or ahead of plan. So cash flow, certainly, we'll finish this year well ahead of where our 2025 targets were. So pretty good visibility over that stuff. I think we tried to be realistic, but -- especially around the transaction business because we were -- it was just at the beginning. I think the 10% to 13% growth targets we put out there, we're growing kind of high teens in the second half of this year. So those appear to be places where potentially there's an opportunity to outperform those over the longer term. But yes, there's a number of underlying factors. One of the biggest drivers of growth being just -- besides the transaction business, but the software growth being a couple of ticks above where it's historically been; is really around the cross-sell and upsell. So with this customer base we've accumulated over decades and the breadth of our product offerings, there's a huge cross-sell and upsell opportunity. And we've done a lot of work structurally and internally to remove barriers and create incentives and make sure that we're aligned to go after those opportunities the best way we can and starting to see more successes around that, not just between Tyler and the former NIC business, but really kind of all across Tyler. And that will continue to be one of our biggest assets to leverage as we try to drive higher growth.

Is there a trade-off that we should think about at all if payments is outpacing overall growth on the margin side?

Yes, there is because payments margins are not software margins. It's a great complementary business. It's a great cash flow. It doesn't take away from the software business. But they aren't the same margins, especially since most of our business is in a gross model, so we collect fees and then we pay out merchant fees and interchange fees; the margin is lower. We have said that we expect that our payments margins will continue to improve mostly because our focus is on these value-added higher-margin payments that are embedded with software as opposed to a sort of a more commoditized payment sort of agreement. NIC had some of those, historically, when they were just more of a payments company, with lower margins and more pressure on those contracts and really not the same opportunity because of the ties to the software. So we expect those margins to improve. But if payments growth significantly outpaces the software growth, it can put -- it can dilute our overall margins. We said built into those margin expansion targets were an expectation that payments would grow somewhat faster. If they grow a lot faster, then it would put more pressure on our overall margins, but certainly drive higher cash flow and bigger earnings.

Okay. I think time for just one more. So I'll leave it to you for closing thoughts. We've talked about this as a very consistent business. I don't know how much your planning cycle shifts from year to year. But as we're coming into year-end, if there are bigger areas of strategic focus, areas of investment, prioritization, anything else that you would kind of highlight in helping frame the next 1 or 3 years for investors?

Yes. Not a lot of changes. We got different focuses on investments. We're largely through a lot of the investment we've made around optimizing our products for the cloud, and we've released most of those cloud-efficient versions, which is having an impact on our margins positively. We have some AI investments. It's not like some of the big enterprise company...

Can you expand on that, just with the AI...

We've got some internal ones. So better uses of AI around things like implementations and professional services, data conversions around our support organization, none of these be terribly surprising kind of cases, and some in our DevOps. But in terms of our products, investments in features and functionality using AI, that mostly involves automating processes, governments do a lot of things that are routine processes, processing a license application. And also those have a lot of manual intervention in them. And so there's a lot of opportunity there. We've been -- without having unlimited budgets for all of that, we've been prioritizing and saying, where can we have the most impact for our customers? How can we monetize it the best? And how can we leverage some of those investments across multiple Tyler products? So we have some of those that'd be more of it in the next year or 2, but not like doubling our R&D budget. A lot of it is reallocating things that we've been doing that we're largely through with. And then there's investments around continuing to improve our client satisfaction. So we have very low turnover, return is 1% to 2%. As you pointed out, our clients don't get acquired and they don't go out of business. So we have a benefit there. But generally, we think our clients are pretty happy with us, and we innovate a lot and we bring them better software every year. But in order to sell them more things and to sell them payments, they need to be really, really happy. And so there are things that we're investing in around continuing to improve that client satisfaction, back-end systems that we might not have used the same system across the whole company for support, for example, so getting all of that on one system; investments in different aspects of creating a cost consistently good client experience across all of our products. And to help further that, we have a search underway right now for a new C-level position, Chief Client Officer, which is not a role that we've had company-wide in the past, that will be hopefully in place around the beginning of the year to oversee all of our support and professional services organization. So there'll continue to be investments around that.

It sounds like you've got plenty to keep busy with. Brian, I appreciate you making the trip to the West Coast. This is great.

You bet. Thank you.