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

Yes, it's positive. These are very sticky systems, just like pretty much everything we provide to government but they're also high margins. So compared to the more traditional margins in our transaction business around payments, these have software margins. So they will continue to drive our software -- our transaction margins higher over time as those layer in on top of the payments and other transaction-based business.

Let's talk a little bit more about cloud living. So you unveiled the next leg in your cloud journey, cloud living, which is expected to improve retention, help drive cross-sell, improve win rates and also help you expand margins. When you look at those 4 different levers, which benefit should become measurable first?

Probably the margin side. So there are a lot of benefits of our ongoing COP transition that have an impact on margins. Probably the biggest is version consolidation. So where historically, we have had a lot of products, and historically, we have supported multiple versions of products, whether on-prem or in the cloud. And that's really expensive from a development standpoint and a support standpoint. So a significant amount of our development resources and support resources are consumed by clients that are using older versions of our software. So as we move towards cloud living with one version of each product in the cloud optimized for the cloud, that has a significant margin impact. And we've seen some of that over the last couple of years as we have made progress with version consolidation and sunset older versions of software and gotten down, in some cases, from supporting 8 versions of a product to 2. But we still have another leg of that to go, but that's probably what we see the soonest. A more efficient release process, the ability to deploy software faster with fewer professional services, which are not profitable for us and the ability to reduce our support effort also will impact that margin. But I think margin is probably what you see first. And then as clients see the benefits and see an enhanced client experience we think that will contribute to improving our cross-sell and upsell opportunities and drive more on the revenue side.

Sort of to your point on the margin expansion, how much of Cloud Living's value over time do you think is going to come from lowering the cost to serve your customers versus that added revenue opportunity that you just talked about?

Well, both of those are important. I think a lot of the value comes from the cost side and really us operating more like a true SaaS business as opposed to sort of the hybrid we've had over years of moving from on-prem to the cloud. But the revenue opportunity is really important. We have -- we talked a lot about probably our most important asset is our client base. We have [indiscernible] installations of our products across 16,000 different jurisdictions, cities, counties, school district states. And that took decades to accumulate given the pace at which the market moves, that's unmatched in our space. But it's still a relatively small share of the overall market, and we talk about our average customer having 2 to 3 products from us and being able to go to 8 to 10 products and Cloud Living is one of those things that makes that easier for us and helps us accelerate that incremental growth with our existing customer base.

So -- let's talk about cloud conversions. You have said that you expect the peak of that conversion activity to be somewhere in the time frame of 2027 to 2029. And so as we sort of get closer to that what operational evidence are you seeing that would -- that tells you Tyler is ready to support that peak conversion activity?

Yes. So we've seen consistent growth in the number of migrations or flips as we call them, from on-prem to the cloud. For years, we were an on-prem software business, and we have decades of clients that were on-prem and then we moved to more of a hybrid model where we offered our products either in the cloud in a hosted model, originally in our data centers, now at AWS. And then really around 2019 or so shifted to a cloud-first model where we really only sell primarily new software in the cloud and started to be more active about moving our on-prem customers to the cloud. As with most things in the public sector, it's kind of a slow process. There's early adopters that are really eager here sort of the middle section, and then there are some that are laggards on the tail end. At this point, if you look at our overall customer base on a revenue basis, revenue equivalent basis about 55% of our revenue base is in the cloud today, and about 45% is still on-prem. We laid out at our Investor Day in 2023, we said if you took the on-prem customers at that point, we expected 75% to 80% of them to convert to the cloud by 2030. At our Investor Day in June, we updated that we expect 85% of them to move to the cloud. That's partially based on the progress we've made to date. But also as we're sort of moving into this next phase of using incentives and disincentives or carats and sticks, if you want to use that term, we're increasingly communicating to clients the new features and functionality will only be available in the cloud, even though their on-prem product will be -- continue to be supported and some of those are things like new AI features that we think will be very attractive and have a high return for them. And that's having an impact on the pace of those conversions. Cyber security is a big issue with clients and the vulnerability around their on-prem networks. That continues to be a big problem in the public sector and another motivating factor. And then just the general struggles they have increasingly with operating their in-house networks, particularly around people facing a big wave of retirements, especially on their technical staff and a lot of difficulty attracting paying market rates, retaining skilled people they need to run their networks. And so the cloud does become more attractive to them and they understand those benefits. I think the biggest change in the recent quarter is that we found a communication from our CEO to every on-prem client this last quarter, letting them know that we're going to be sitting down with them in the coming months and having the conversation to start to map out and formalize their path to move to the cloud, but it's not an indefinite open-ended opportunity to stay on-prem. And there are a number of factors that drive an individual client decision around when the timing is to move, but we want to have a clear understanding with each client of what that -- what those factors are and help them with what they need to start to execute the move to the cloud, whether it's support in analyzing the budget and what costs will go away when they move to the cloud that offsets the the higher cost to Tyler and a lot of planning that goes into it. But that's kind of actively underway now. So we're confident that the volume of flips will continue to increase in terms of revenue probably over the next 3 years, there's not going to be sort of a clear -- it's probably more of a continuous increase than a steep bell curve, but we're very confident about our ability to get to that 85% by 2030.

Great. So I have a few questions that I want to ask you on margins. So when we look at the entirety of your 2030 target model, you've got 3 to 4 points of expansion baked in from version consolidation 3 to 4 points from AI and 1 to 2 points from your transactions business. So when you look at those 3 levers, where is the greatest risk of overlap across cloud, AI and operating leverage components of your margin bridge?

Yes. I don't think there's a lot of overlap across those components that build up to that margin expansion framework. And we did -- again, the new targets that we laid out at our recent Investor Day were significantly higher than the targets we had previously laid out. We had previously talked about around a 30% operating margin by 2030. And and now our target is mid-30s. So the 3 to 4 points is really more than just version consolidation. It's really from the cloud transition overall. So version consolidation is certainly an important piece of that, but it also includes the scale and particularly the scale with AWS. So as we continue to move more clients into AWS and move our on-prem clients there, our unit costs go down as we continue to buy more capacity from them. So the economics around scaling are a significant part of it. And then the optimization of our products. So as we release newer cloud optimized versions of our solutions that run more efficiently in the cloud and particularly take advantage of features at AI at AWS, then that also continues to provide a positive margin impact. So yes, the biggest part comes from the cloud. We've talked about 3 to 4 points coming from AI, primarily our internal use of and then operating leverage across SG&A, some with R&D and AI has an impact on that as well in G&A, a lot of that just as we scale from a $2.5 billion company to a $3 billion and $4 billion company that there is a lot of scale and leverage in the Opex.

So you've said that the margin expansion will be consistent, but it might not be linear through 2030. What are some of the factors that might cause that to be a little bit more back-end weighted?

Yes, probably just how the cloud transition continues to play out and how we get those benefits of kind of the true cloud living operations that probably is a little bit more back-end loaded compared to some of the other impact -- their aspects of the margin expansion story.

Okay. So you talked about AI a little bit in the beginning, and I definitely want to talk about that a little bit more. You mentioned some of the ARR uplift that you're seeing from some of these early deals. So to that point, what have some of these early AI deals talk to you about the repeatability of willingness to pay for some of these products across your installed base?

Yes. I think what we're seeing is that our clients really recognize the benefits and are looking at it through an ROI lens and are confident that they're going to realize savings and efficiencies from implementing AI. I think, in general, when we talk about AI and our customer base, like with most things in the public sector, the adoption curve is going to be much slower than you see in the private sector. Similarly, we draw a lot of parallels to how we saw the cloud transition in the public sector market compared to the private sector. I'd say right now, our customers are sort of characterize it as cautiously curious about AI. In most cases, there are always a few sort of era adopters, but most of them want to learn a lot more about it, are very interested in how it can solve real problems they have particularly problems that stem from staffing shortages. And that's probably one of the biggest problems facing our challenges facing government at all levels, but particularly state and local government. They just don't have enough people to do the basic things they need to do. They lost a lot of workforce during COVID, a lot of that hasn't come back. They face a significant wave of retirements over the next 5 years. And it's not that they want to get rid of a lot of people, so they don't have enough people to get things done like reviewing a building permit application that might take you 6 months to get approved a lot of places or entering data into the court system. So there's a backlog of court cases because they're not caught up on getting cases into the system. So those are the kinds of things where we're focusing our initial development efforts in our initial product releases around AI. And our early returns have been really good with products like document automation, which automates data entry in the court system, where we're seeing clients pay, in some cases, the uplift is equal to what they're paying for the core software system that runs the court. So a client that's paying us $1 million of annual revenue for the court system is paying $1 million for the AI add-on to automate the data entry, but they're saving $2 million of labor expense by -- that they have budget for, but not people. So it's a really strong ROI for them. And we're actually seeing clients that are paying for that out of the labor budget rather than an IT budget. So it's not taking away from something else they would do on the IT side, but they're recognizing it. So we talk about it as enabling us to potentially access a whole new TAM that being the labor TAM as opposed to just the IT TAM.

So that's a really good point, especially as you mentioned, you start to shift from just being able to target IT budgets to being able to target a little bit more of the labor budget and you're seeing some of these things happen already. How does that change or potentially change your go-to-market motion when you think about selling some of these products?

Yes. I mean we're not going to have a separate AI sales force. I mean this will be sold by -- and is being sold by the product salespeople. So our clients clearly are telling us that they want AI that is embedded in or integrated with their core systems of record and not bolted onto it and they want it from someone they trust. So trust is a big factor in the public sector. References seeing it work somewhere else before they make the leap, whether it's buying a new ERP system or adding AI onto it. They want -- they're very concerned about their data. A lot of public data or public sector data is very sensitive, you're talking about criminal justice data or public safety data or tax data. So they're very concerned about how that data could be used and where it could go. They trust us with that. And conversely, we have a lot of data and access to a lot of data to build models with and to create very accurate AI products. So all of those things make us confident that our clients want AI from us around their core systems and where we're focusing our development efforts and the products that we're bringing to market over the next few months. And a lot of these are currently in what we call private preview, but kind of early pilot projects. Then as we -- as those early clients become references and can attest to the return and the efficiency gains, then we'll expect to see more broader go-to-market activities that will be kind of sold through our existing product teams, the inside sales organizations and certainly bundled with new software sales. And so we've talked about really kind of the second half of next year before we would expect those revenues to even start to be meaningful given sort of that progression that we need to go through to get to where clients are broadly comfortable we're starting to implement some of these solutions.

All right. So as we come up on time, I'd like to finish with a high-level question. So in your view, what is the hardest part of the Tyler investment case for you to explain to investors today?

Well, I think explaining it is okay, but having it resonate is probably the hardest part right now is the whole AI narrative. I mean it's very hard to sort of dispel this thesis that has been sort of broadly applied across a wide range of software companies other than through actually executing and proving that AI is an opportunity for Tyler. We draw a lot of parallels to the way we talked about the cloud transition. Years ago, there was a narrative that has cloud native software development took hold and that there would be a whole flood of new entrants that were cloud native companies that could develop software faster and we would have a whole new cohort of competitors that would take market share from us. But it sort of ignored the obvious that we could move to the cloud, which we did and develop software in the cloud, but that we had the strength of a really large customer base, a deep sales organization, the references and trust in the marketplace, which is super important. And again, the very deep domain expertise. So we were able to beat the company that takes our clients and takes the public sector to the cloud. Not that there weren't other competitors and some of those have been companies that we've acquired to fill in gaps in our product portfolio. So we see some parallels around that and the AI world. We think we're the company that will bring not every possible AI application to our clients, but around Tyler solutions that will be the company that AI will create an enhanced opportunity for us. But that's I think we just have to prove it out over time. Obviously, Tyler has a very, very long history of being -- executing at a very high level, consistent growth, consistent margin improvement and has built a very strong position in this space, and I think that provides us with an incredible platform to continue to build on.

Great. We are out of time. Brian, thank you so much for joining me today.

Thank you.