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

Good morning, everybody. Thanks for joining for Day 2 of Baird's Global Consumer Technology and Services Conference. I'm Rob Oliver. I follow the SaaS and software sector here at Baird, and it's a pleasure to have Brian Miller, CFO of Tyler. Brian, good to see you.

Thanks. Great to be here.

Thanks. Hala Elsherbini from Investor Relations for Tyler is also in the room. If you're not familiar with the Tyler story, I hope you leave this session to becoming familiar with it because it's one of the great software companies we follow. Brian has a couple of slides to kind of level set the room to intro, and then we'll dive into Q&A. Please don't hesitate to be interactive here, [email protected]. We'll try to squeeze in as many questions as we can. Thanks, Brian.

Great. I will go through a couple of overview slides just real quickly. Again, for those of you that might not be as familiar with Tyler, and then we'll get into our conversation. So Tyler is a vertical software company focused exclusively on the public sector, narrow in terms of our focus on what is a very big vertical market but very broad in terms of both breadth of products we have for the public sector, the various levels of government we serve in the public sector. A little bit of long-term growth setup here. Since 2019, our recurring revenue growth has been at a 20% CAGR. So that has been accelerating as our cloud transition has progressed. SaaS revenue growth within the recurring revenues has grown a little faster than that at 25%. Last quarter was our 17th straight quarter of more than 20% SaaS growth. And even given the scale we've achieved and the growth we've had, we still are in a very, very fragmented market, so still sub-10% market share, although much higher win rates than that as customers turn over but still a really, really fragmented market. We are the largest company serving -- exclusively serving the public sector. From a software perspective, we're roughly 85% recurring revenues today, almost a 27% free cash flow margin last year and very, very sticky customers, 98% plus customer retention. Just across the bottom here, kind of the major product areas that we serve. ERP, public administration is our biggest sector, roughly 1/3 of our business; platform technologies, including payments and data and analytics, close to 30%; courts and justice, 15%; public safety, 911 systems, police fire and ambulance systems; k-12 schools, we do administrative side of schools, both ERP and student transportation, student information; property tax, which is a really important area for local governments because it's where they typically get most of their revenues is, we're the leader in that space as well; and then civic services would be things like licensing and permitting. Really kind of where we are today from 1998 when we entered this space through 2017, we really kind of built a broad portfolio of products, both through acquisitions and internal growth, kind of established the leadership position we have. Then between 2018 and 2022 was really focused on primarily accelerating our move to the cloud, entering the state and federal markets through acquisitions, focusing on enhancing our client experience and building a payments business around our software business. And so today, we're building on that basis. And having reached the sort of the inflection point in our cloud transition in 2023, we're now on a trajectory of both margin improvement and accelerated revenue growth as we move forward through the end of the decade. At our Investor Day a couple of years ago, we set out our vision for 2030 and our long-term targets around that time frame, both around growing our recurring revenues, improving our margins and free cash flow. So 4 primary growth pillars driving those objectives. One is leveraging our installed base, so continuing to build on that installed base of customers that's taken decades to accumulate. The average customer at Tyler has 2 to 3 products from us and could have 8 to 10 products. So we're very focused on cross-selling and upselling, flipping our on-prem customers to the cloud and selling them more products in association with that transition and continuing to expand our portfolio through acquisitions. Expanding our TAM, growing into the state and federal markets. Today, we're about only less than 5% federal revenues, 20% to 25% state and around 75% local, but look to continue to grow, particularly at the state, but where there are opportunities in the federal market. Our cloud transition is a driver of a number of initiatives around supporting our revenue growth. We're now very close to 100% of our new customers are coming to us in the cloud, and we have an ongoing transition of our big base of on-prem customers that are also moving to the cloud with a really nice revenue uplift. And lastly, growing our transaction business. So primarily through the acquisition of NIC in 2021, we now have a very robust payments platform that really gives us a differentiated payments offering where it's fully integrated with our software solutions. And we're in the very early days of leveraging our customer base to add payments on to those relationships. So our goals for 2030, we're talking about 10% to 12% CAGR in recurring revenue growth, all these organic targets that we certainly expect that there will continue to be M&A on top of this, which would get us in the $3.6 billion to $3.8 billion revenue range. Margin expansion. Our operating margin was 23% in 2023. Our target is for 30% plus by 2030 and free cash flow, free cash flow margin approaching that same 30% with a target of $1 billion of free cash flow by 2030. We have said that we are well on track, either on track or ahead of track for achieving all those goals as we've checked in here at kind of 2 years into it and continue to be very confident about achieving those.

Great.

I'll stop there.

Yes. Thanks, Brian. Appreciate it. Let's -- there's a few hot button issues I want to touch on, but let's start with the cloud transition. So first, you guys have recently sort of pivoted to talk about these in phases to sort of help us understand that and you guys have been very methodical about the model transition. And so far, it's been very effective. What phase are we in that now? I think we're now entering Phase 2, but can you help people to understand where we are and kind of what the next phase is?

Sure. Yes, we're kind of entering Phase 2, but Phase 1 and Phase 2 overlap. So there's not kind of a clear stop to one and start of the second. So Phase 1 was really around kind of a lot of things we've done around really shifting from a cloud neutral or cloud-agnostic approach to clearly a cloud-first approach, and that really started in 2019 where we really stopped selling for the most part, new software on-prem. We entered into a partnership with AWS to move to the public cloud from proprietary data centers that Tyler previously utilized. We launched -- we started projects around optimizing our products to be more efficiently deployed in the cloud. So a number of development efforts around that and started to accelerate the migration of our on-prem customer base to the cloud. So all those things are still ongoing. We made a lot of progress with all those. We've released cloud-optimized versions of most of our major products. We've made -- continue to make significant progress on the flips of on-prem customers, although we've said that, that will continue with a goal of having 85% of them converted to the cloud by 2030. We have exited our first proprietary data center last year. The second one will be out of at the end of this year and really all new clients have gone into AWS for some time. So a lot of it was around kind of getting clients to the cloud and that shift of how we position the client -- the company as a cloud-first company. Phase 2 is really more around kind of taking advantage of the cloud, not just where the clients are hosted or located, but really realizing the changes in our operating model and the benefits for both us and our customers of having our customers in the cloud. So changing -- one of the big advantages for our clients is that it is a better client experience when they're in the cloud. They -- it's a more seamless and easier process of and quicker process of getting new technology to them. So there's not this big, long cycle from the time we create a new release, they're typically big annual releases to getting it in the clients' hands and then having clients slowly adopt it that it can be 2 or 3 years from the time we build a feature to the time it's widely deployed. So in the cloud, when everyone is ultimately on one version of the software, it's both cheaper for us because we're not supporting multiple versions, but it's a better client experience for our clients because they're all on the same version and they all stay on our best product. So that sort of change of how our clients experience Tyler is a big part of Phase 2. And there's a lot of stuff behind that around creating a better, more consistent client experience as we strive to have more and more -- have customers have more and more products from Tyler, it complicates our relationship with them. And so we're doing a lot of work around improving that client experience and taking advantage of those customers being in the cloud to do that.

One of the things I think is often underappreciated by investors is just how siloed many of your different products were, both expensive for you to operate, whether in public safety or courts and justice, we would do checks and oftentimes, people wouldn't even know the other was Tyler and now what that then provides as an opportunity for you guys when you get to the cloud in terms of growth and cross-sell. So I wanted to touch on those. You mentioned leveraging your installed base. What sort of apples-to-apples compare are you seeing on that cloud conversion? And then you mentioned your average customer has 2 products. Like any early reads on how many additional products they're getting when they move to the cloud? Or is it still too early?

It's probably still kind of early for that. I think at least anecdotally, but we are seeing more upsell. And we're probably still in the pretty early days of being really intentional about that. We've also done both facilitating cross-sells within our existing customer base but also around the move to the cloud. We've done a lot of work around the company, particularly around sales compensation and how we structure our go-to-market to take away barriers or improve incentives to drive more cooperation across business units and to help accelerate that cross-sell. We do believe that when a client moves from on-prem to the cloud, it creates an opportunity for us to have a conversation with them not only about the Tyler product they're moving to the cloud, but other ancillary products from other vendors that they might have in that same area that we can use that as an opportunity to move to Tyler. So we're seeing some successes there. It's probably a little early to draw to like have numbers around a lot of it. What was the...

Just the uplift and kind of...

Yes. So when we move an on-prem customer to the cloud, it has pretty consistently been around a 1.7 or 1.8x uplift on a like-for-like basis in terms of revenue, so $100,000 of maintenance becomes $175,000 of SaaS. And then, of course, we pay some of that out to AWS for hosting. But it is better margin and over the life of the customer, significantly higher revenues. Today, if you look at our whole customer base, obviously, we have decades of on-prem customers that are still on-prem. We've got almost all of our new customers in the last few years going into the cloud, but the entire customer base on a revenue basis about -- is pretty much half and half, half still on-prem, half in the cloud. So we've got about $450 million of annual maintenance that will turn into $800-ish million of SaaS revenue before upsells over the next few years. We've said that we expect that by 2030 that 85% of -- at least 85% of the customer base will have migrated to the cloud, sort of in a bell-shaped curve trajectory. We're still on the left-hand uphill side of the bell curve and probably the peak of that is in '27, '28 kind of time frame. A lot of our bigger customers are still on-prem, but -- so still a lot of uplift opportunity there. But interesting, like our user conference was 3 weeks ago and conversations with all of our customers now -- government has been slow to move to the cloud, but it's really accelerated a lot in the last couple of years. And our customers almost unanimously understand that they will move to the cloud and they understand why and they understand why it's good for them. So it's just kind of a matter of when and what effort is required on their part to get there.

And you just touched on it, but one of the metrics on a quarterly basis that's always like a bit of a nail biter for investors close to the story is that flips number, which you guys give, which we appreciate. And so -- and recognizing that you guys have been very methodical about making sure you don't push public sector customers to the cloud before they're ready, which could really create a bad situation. Is it -- how should we think about the trajectory of that flip number...?

Yes. I mean I think both the number of flips and the average size of flips should generally trend upward through the '27, '28 time frame. It's not linear. So it's not every quarter. And even though we give the numbers every quarter, we encourage people not to focus too much on that -- on what happens in 1 quarter. There can be some lumpiness around it, especially around the larger ones moving. But we definitely are seeing that trend continue as we'd expect it would. And we've said that we're very much on track with our plans to get there. A couple of big drivers around clients' desire to move to the cloud. One of them is besides the fact that we have clearly articulated that our future is in the cloud and that's where our -- all of our products are going where all of our new customers are going. But governments, especially local governments really struggle a lot with their IT infrastructure and especially around people. They've got aging workforces. The silver tsunami of people retiring. They've got -- they really struggle to hire, especially IT people to compete with the private sector to pay market salaries to systems administrators and applications administrators to replace hardware. And so even if they want to stay on-prem, they're really struggling with that. The other thing is ransomware and cybersecurity that an incredibly large number of ransomware attacks on local governments that unfortunately are kind of easy targets around their networks often are vulnerable. And so we've seen a lot of customers either who have suffered a ransomware attack move to the cloud or that have seen their neighbors and peers suffer ransomware attacks and view the cloud and the AWS environment as much more secure than their own networks would be.

Got it. Got it. Great. I wanted to shift to the competitive landscape. You mentioned that it's still a very fragmented market. Just one observation I had was around the OpenGov deal, which for those that don't know OpenGov, venture-backed, a lot of buzz around this business. So very smart VCs involved in, something like 9 years later, they had like 1,900 customers and like sold the business to Cox Enterprises, and they looked exhausted. So my take. So I think this kind of speaks to how sticky your market is. But maybe help us understand who your competitors are and the 3 different core areas.

Yes. So we have different competitors in each of our software product areas. One of the strengths of Tyler is the breadth of our products, the way those products work together or integrated, especially in adjacent markets like courts and public safety, but really across all of our products where we have common foundational technologies. things like a common payment engine across all of those that create more value in each of our products. But we have different competition in each of those major product areas that were on that slide. So in the ERP space, we do compete with horizontal companies there like Oracle, SAP, Workday, Infor as well as a host of companies that just do public sector ERP that are mostly smaller private companies. OpenGov kind of falls in that category. The big horizontal companies we tend just to see kind of at the high end of the market. In public safety, we compete with Motorola MSI, with Hexagon, Axon is kind of dipping its toes into the software space. CentralSquare is a PE-owned company that competes both in private -- in public sector -- public admin and public safety. Courts and justice, a whole different set of competitors. We're the only company that has both courts and tax. Most of those companies are private companies that you wouldn't have heard of. Journal Technologies, which is part of Daily Journal, which is small public company is in that space. So different software competitors across all of those. Mostly a lot of these sort of legacy companies that were regionally focused often. And over time, a lot of those become less and less competitive. In the payment space, we compete with horizontal payment processors. But again, the advantage we have is that we're -- we have the deep integration to our software products that provide additional value to our customers from having that payment solution from the same provider.

Got it. Got it. Great. I've got some questions rolling in. So I appreciate it. We're going to try to get to all of them. I do want to address one of the big -- probably the biggest concern, and I think probably the reason why your stock is where it is right now at a valuation, which we view as compelling and that is concern on government spending and government dollars generally. So maybe we can start with, you laid out what exposure you have to Fed. But maybe talk, Brian, about what -- how you see the funding environment for your customers and how things like federal and/or federal-to-state, state-to-local dollars that trickle down could impact that...

Yes. The short answer is there's not a lot of impact that we're seeing. Very, very little impact. As I said, less than 5% of our business at the federal. At the state level, the 20% to 25% that we do there is almost all came from the NIC acquisition and mostly in a model that's kind of a self-funded model. So it's funded primarily through transaction fees or convenience fees. So in the state market, we, through the business that NIC built have 28 state enterprise relationships where we have these very broad contracts with the state governments. We manage their websites. We have built -- we basically provide the digital front end to their systems for citizens or businesses to interact with state governments. So for example, we might have built an interface to the DMV system so that you can renew your license plates each year. You would pay the state $70 and a $7 convenience fee goes to Tyler. So the state doesn't have a line item in their budget to pay Tyler for all this work that we do. It gets paid by convenience fees that they allow us to charge on these transactions. So it's certainly -- and all these are essential transactions we're processing, license -- CPA licenses, motor vehicle registrations, hunting and fishing licenses. So things that are -- they're not things that are discretionary. And at the local level, thousands of customers, so lots of different budget situations. But generally, we've said over the last couple of years, the budget backdrop has been pretty strong. It's certainly been supported by the federal stimulus from ARPA, but we don't really feel like that's been the major reason, it's been a strong backdrop. Local governments and the money they use to buy things from us are the biggest revenue sources, property taxes and those have been generally a pretty stable or pretty strong revenue stream, but sales taxes, licensing and permitting, utility bills, all those are the kinds of things that primarily fund us. There's very little federal funding that gets down to local governments that they would use for things they buy from us. But at the end of the day, kind of everything we provide is automating an essential function of government, public safety, property taxes, courts, none of those are optional. And mostly, the demand is driven by the replacement of an often 20- or 30-year-old legacy system that is at end of life and is a fairly nondiscretionary decision. So we've seen it through the Great Recession. We've seen it through COVID, very, very little impact on demand. Sometimes a little bit of timing bumps as people get distracted or evaluate kind of what's going on, but the underlying demand is just very, very consistent.

I think the timing is mostly what we hear about because even just ARPA -- and you guys were always hesitant to draw a direct line to ARPA deals, although you called a few out, but it was more kind of overall giving sort of more comfort in the spending environment perhaps. But we're going to anniversary the end of ARPA, assuming all the ARPA dollars still hang out there and they're not clawed back. And then I don't know, there was a sanctuary city list that came out last week, it then was taken back quickly. So the anniversary of ARPA plus additional pressures on local, even with that, it feels as if you guys are comfortable kind of with where you are.

Yes, definitely. We've talked about a little bit of softness in bookings in Q1. I think mostly just timing. Our business can be kind of lumpy, especially around large deals and last year was a really, really strong year. But we said our sales outlook for the year really hasn't changed from where it was as we entered the year. There was some stuff pulled into Q4 from Q1. We talked about that back in Q4 because of the ARPA sort of commitment deadline. But generally, we haven't changed our view of kind of what the year looks like from a sales perspective. And we've talked about really a very consistent level of new RFPs, sort of new business entering the pipeline is very kind of stable at an elevated level. We're not really seeing changes around that. The commentary at our user conference from a lot of clients that we've talked to as well as and some of that was reflected in some of the analyst notes after the user conference, but pretty unanimous comments around our customers really weren't seeing a change in -- or didn't see a change in what they thought they would be spending with Tyler or their funding environments. I would say that from this general discussion kind of starting with DOGE, but similar kinds of discussions at state levels and at local levels. So the focus on government efficiency is something we view as an opportunity because we think -- and I think even if you look at the Doge charter, it talks about we need better software, we need to update technology and we need better connectivity between agencies, which is exactly what we do. But that ultimately, to the extent governments get more efficient, technology is going to be the biggest driver of that. And so we believe that an increased focus on government efficiency at all levels ultimately will lead to potentially replacing systems sooner than when they absolutely have to because they're dying as governments more and more realized that, yes, if I go to this effort now, if I replace that 30-year-old system now, there are tangible cost savings, efficiency gains that make it worth it.

Got it. Two people to run DOGE, one didn't make the starting line, one's gone now. So we'll see if we're talking about it in a year from now. I did want to get one more question around AI. One thing I've noticed is over the years is you guys really are in a position to lead your customers because of the nature of what they do, and they're doing a lot. And so I've seen it with security. I've seen it with other features. And you guys have talked about having each of your products being -- sort of have an AI pathway throughout this year. And we're starting to see some government state of California, Washington, D.C., we saw at the ServiceNow event be interested in AI. So maybe talk -- leave us with a sort of where you are there relative to that.

Yes, governments usually aren't the first to adopt anything. They don't want to be the first, but there is a lot of interest around AI. I mean nobody -- you can't help but hear about AI all day long everywhere and governments aren't any exception to that. But a lot of interest, a lot of curiosity. But as you said, they're really, for the most part, looking to us to kind of -- as a partner they trust and someone that can help guide them through some of it. Middle America, we had a press release yesterday, Kenosha, Wisconsin, kind of a classic Tyler kind of client signed a contract to add several suites of systems from us, taxes, courts, licensing and permitting, ERP. They're not hiring Accenture to build a big AI strategy for them. But they're looking for us to show them how we can integrate AI into products that, that can benefit stuff they do every day. So there's 3 major areas that we're making investments around AI, some of which we already have. We've made some acquisitions that brought us some products. And we've said every product will have an AI road map this year. One is around service delivery or interactions with citizens, so the kinds of things you might expect around agents and chatbots to help citizens interact more easily with government. We went live late last year with -- or maybe it was earlier this year with the first AI project that the state of Indiana has done. So we created a resident engagement portal for them so that citizens can ask a question, and it will guide them to where they need to go. So they're not calling around and talking to people. So you can say, I want to start a beauty salon. What do I need to do? And it tells you, you need a business permit, you need to register with the Secretary of State, you need a cosmetology license, you need a tax -- file for taxes and it sends you links to all that. We -- one is around decision-making, so providing better data more easily to make good decisions. We have a priority-based budgeting solution that is really performing really well these days with some very large governments like Los Angeles County that uses AI to help them guide them through the budgeting process and identify areas where they can reduce spend to allocate to areas that are higher priority. And then around basically processing. So things like automating data entry and report writing. So for example, in our public safety system, our police records management system, we're investing in automating report writing. The average police officer spends more than 3 hours a day writing reports. And we can integrate AI into our system to help automate that. There's a very clear benefit to the police department to get 2 hours of productivity out of every police officer every day. So those are the kind of 3 broad areas that we're making investments in.

Great. Really helpful. Please join me in thanking Brian Miller from Tyler. Thanks, Brian.

Thanks.