Tyler Technologies, Inc.

Hello, and welcome to today's Tyler Technologies fourth quarter 2022 conference call. Your host for today's call is Lynn Moore, President and CEO of Tyler Technologies. At this time, all participants are in a listen-only mode. Later, we will conduct a question and answer session, and instructions will follow at that time. As a reminder, this conference is being recorded today, February 16, 2023. I would like to turn the call over to Hala El-Shabini, Tyler's Senior Director of Investor Relations. Please go ahead.

Thank you, Emma, and welcome to our call. With me today is Lynn Moore, our President and Chief Executive Officer, and Brian Miller, our Chief Financial Officer. After I give the safe harbor statement, Lynn will have some initial comments on our quarter, and then Brian will review the details of our results and provide our annual guidance. Lynn will end with some additional comments and then we'll take your questions. During this call, management may make statements that provide information other than historical information and may include projections concerning the company's future prospects, revenues, expenses, and profits. Such statements are considered forward-looking statements under the safe harbor provision of the Private Securities Litigation Reform Act of 1995 and are subject to certain risks and uncertainties which could cause actual results to differ materially from these projections. We would refer you to our Form 10-K and other SEC filings for more information on those risks. Also in our earnings release, we have included non-GAAP measures that we believe facilitate understanding of our results and comparisons with peers in the software industry. A reconciliation of GAAP to non-GAAP measures is provided in our earnings release. We have also posted on the investor relations section of our website under the financials tab schedules with supplemental information provided on this call, including information about quarterly bookings, backlogs, and recurring revenues. On the Events and Presentations tab, we posted an earnings summary slide deck to supplement our prepared remarks. Please note that all growth comparisons we make on the call today will relate to the corresponding period of last year unless we specify otherwise. Len?

Thanks, Ella. Our fourth quarter results marked a solid finish to an eventful year as public sector demand remains strong and SAS adoption continues at an accelerated pace. Total revenues grew 4.3% with organic growth excluding COVID related revenues of approximately 6% and organic revenue growth for the full year was solid at approximately 8.2%. Recurring revenues comprised nearly 83% of our quarterly revenues. On an organic basis, subscription revenue grew 14.3%, reflecting both our accelerating shift to the cloud and growth in transaction-based revenues. Most importantly, SaaS revenues, included in subscriptions, grew 19.3%. We achieved solid revenue growth even as the shift in new software contract mix continued to accelerate to SaaS from licenses. In Q4, 86% of our new software contract value was SaaS, compared to 77% in Q4 last year. In our digital solutions division, which is formerly known as NIC, we continue to execute on cross-selling opportunities. And in Q4, we signed a significant new contract with the Kansas Department of Revenue to provide our data and insights assessment connect solution, which will work with our enterprise assessment solution used statewide in Kansas. We also signed sell-through deals for our recreation dynamic solution with the Utah Division of Outdoor Recreation and the Mississippi Department of Wildlife, Fisheries, and Parks. Our Digital Solutions Division also signed notable SAS software agreements with the State of Nevada and the Alabama Alcohol Beverage Control Board. We also signed a payments processing contract with the Wisconsin Department of Motor Vehicles, which is our first payments opportunity in Wisconsin. Finally, Our Digital Solutions Division won a competitive rebid for our Master Enterprise Contract with the State of Colorado's Statewide Internet Portal Authority Board, as well as an extension of our Master Enterprise Contract with the State of Oklahoma. In other Tyler Divisions, we signed seven additional significant SAS deals, each for different product suites, and each with a total contract value greater than $2 million. Those include contracts with the Cypress Fairbanks Independent School District in Texas, for our student transportation solution, the cities of Prosper, Texas and Glendora, California for our enterprise ERP and enterprise permitting and licensing solutions, the Placer County Water Agency in California and the city of Helena, Montana for our enterprise ERP solution, the city of Albuquerque, New Mexico for our enterprise permitting and licensing solution, and Lucas County, Ohio for our enterprise justice solution. In addition to those deals, We signed 12 SAS deals in the quarter with contract values between $1 and $2 million each. In the fourth quarter, we signed 153 new payments deals worth more than $4.7 million in estimated annual recurring revenue across Tyler divisions other than Digital Solutions. The largest of those was an agreement to provide payment processing for the city of Milwaukee, Wisconsin, with estimated annual revenues of more than $1.2 million. For the full year 2022, we signed 571 new payments deals worth more than $13 million in annual recurring revenue, many of which we were able to pursue because of the new capabilities that came to us with NIC. More than 80% of those were sold to existing Tyler Software clients. New payments-only agreements typically have a lag of three to six months between signing and revenue generation, while payments agreements that are embedded in a broader solution, such as a new ERP sale, may have a period of six to 18 months from signing to revenue generation. In our justice group, we signed two notable multi-suite license deals in the quarter for our enterprise public safety, enforcement mobile, and data and insight solutions with Stearns County, Minnesota and Richland County, Ohio. We also signed two significant license contracts for our enterprise justice solution with Midland County, Texas and Kankakee County, Illinois. which also include our enterprise supervision solution. Now I'd like for Brian to provide more detail on the results for the quarter and our annual guidance for 23.

Thank you, Lynn. Yesterday, Tyler Technologies reported its results for the fourth quarter ended December 31, 2022. Both GAAP and non-GAAP revenues for the quarter were $452.2 million, up 4.3% and 4.2%, respectively. Organic revenue growth, excluding COVID-related revenues, was 6% on a GAAP basis and 5.8% on a non-GAAP basis. COVID-related revenues for the quarter were $3.5 million, compared to $16.6 million in last year's fourth quarter. Revenues from all of our COVID-related initiatives have now officially ended. License revenue declined over 60% as our new software contract mix continued to shift to SaaS at an accelerated pace. Professional services revenue rose 2.8% and 8.5% organically, and we intend to continue to grow our implementation teams in 2023 to support delivery of our growing backlog and pipeline, but we'll likely continue to see some pressure on professional services revenue in the near term as these teams ramp up to become fully billable. Subscriptions revenues increased 11.9% and organically rose 14.3%. We added 140 new SaaS arrangements and converted 82 existing on-premises clients to SaaS, with a total contract value of approximately $99 million. In Q4 of last year, we added 135 new SaaS arrangements and had 71 on-premises conversions, with a total contract value of approximately $74 million. Our software subscription bookings in the fourth quarter added $21.4 million in new ARR. Subscription contract value comprised approximately 86% of the total new software contract value signed this quarter, compared to 77% in Q4 of last year. The value weighted average term of new SAS contracts this quarter was 3.9 years, consistent with last year. Transaction-based revenues, which includes state enterprise portal, payment processing, and e-filing revenues, and are included in subscriptions, were $146.5 million, up 6.9%. E-filing revenue reached a new high of $19.8 million, up 12.7%. Our non-GAAP ARR was approximately $1.50 billion, up 7.5%. Non-gap ARR for SAS software arrangements was $440.6 million, up 18.5%. Transaction-based ARR was $586.2 million, up 6.9%. And non-gap maintenance ARR was slightly down at $469.1 million due to the continued shift of new clients and migration of on-premises clients to the cloud. Operating margins in the quarter were pressured by the acceleration of the shift to the cloud in new business and the related decline in license revenues, as well as by an increase in R&D expense as certain development costs that we had expected to capitalize were expensed. Our backlog at the end of the quarter was a new high of $1.89 billion, up 5.2%. Bookings in the quarter were approximately $464 million, which was flat with last year. On an organic basis, bookings were approximately $354 million, up 2%. For the trailing 12 months, bookings were approximately $1.9 billion, up 9.5%, and on an organic basis were approximately $1.4 billion, up 1.6%. Capital expenditures for the year totaled $50.1 million, below our Q3 guidance of $58 to $62 million, primarily because of the reduction in capitalized software development that drove higher R&D expense. Cash flows from operations were 121.9 million, up 6%, and free cash flow was 114.7 million, up 20.6%. Both represented a new high for the fourth quarter. We continued to strengthen our already solid balance sheet throughout 2022. During the fourth quarter, we repaid $90 million of our term debt And since completing the NIC acquisition, we have paid down $755 million of debt. We ended the year with outstanding debt of $995 million and cash and investments of approximately $229 million. As a reminder, $600 million of our debt is in the form of convertible debt with a fixed interest rate of a quarter of a percent. The remaining $395 million is in prepayable term debt due in 2024 and 2026. with interest at floating rates based on LIBOR plus a margin of 125 or 150 basis points. Our exposure to floating rates is limited. Beginning in February 2023, SOFR has replaced LIBOR as our reference rate. We also have an undrawn $500 million revolver. Our net leverage at quarter end was approximately 1.64 times trailing 12-month profile EBITDA. We've also issued our initial guidance for 2023. Please keep in mind that our outlook for 2023 includes no COVID-related revenues as those initiatives were completed in the fourth quarter. For the year 2022, COVID-related revenues totaled $51 million with $10.8 million in subscriptions and $40.2 million in professional services. In addition, another revenue headwind that is factored into our guidance is the shift of two of our digital solution state enterprise agreements from the gross to the net model for payments, resulting in a $10.5 million reduction of revenues, although with a positive impact on margins. Our 2023 guidance is as follows. We expect both GAAP and non-GAAP total revenues will be between $1.935 billion and $1.970 billion. The midpoint of our guidance implies organic growth of approximately 8%. To add more color to our revenue expectations, we expect growth by revenue line to be in the following approximate ranges. Subscription revenues will grow in the mid-teens. Professional services revenues will decline in the high single digits, but excluding COVID revenues will grow in the high single digits. License and royalty revenues will decline approximately 30% or more. Maintenance will decline in the low single digits. Appraisal services will grow in the high single digits. And hardware and other revenue will be relatively flat. We expect GAAP diluted EPS will be between $4.10 and $4.25 and may vary significantly due to the impact of stock option activity on the GAAP effective tax rate. We expect non-GAAP diluted EPS will be between $7.50 and $7.65. While we don't give quarterly guidance, we do expect first quarter EPS to be in the range of Q4 2022 EPS with a significant sequential increase in Q2. Interest expense is expected to be approximately $26 million, including approximately $5 million of non-cash amortization of debt discounts and issuance costs. Other details of our guidance are included in our earnings release. Finally, while we don't give specifically guidance on free cash flow, we want to point out a change in taxes that we expect will have a significant impact on our cash taxes and therefore our free cash flow. The Tax Cut and Jobs Act required that starting in 2022, research and experimentation expenditures known as Section 174 costs are required to be capitalized and amortized over either five years for expenditures in the U.S. or 15 years for those incurred outside the U.S. for tax purposes. Since the enactment of the TCJA, businesses, including us, have been monitoring congressional actions around this rule, and there was a strong expectation that Section 174 would be repealed or delayed. However, Congress has not yet taken action. While the Section 174 change has a slight favorable impact on our tax rate, it significantly accelerates the timing and amount of our cash tax payments. Now I'd like to turn the call back over to Lynn.

Thanks, Brian. During 2022, we achieved notable milestones towards several key strategic initiatives. We made meaningful progress on our cloud journey through continued investment in cloud optimization, and moving to cloud-only deployment for many of our core solutions. Our intentional innovation is based on knowing our clients and anticipating their future needs. As you recall, in 2019 we launched a strategic shift from a cloud-agnostic model to a cloud-first model to deliver secure, scalable, dependable, and compliant digital infrastructure. We're pleased to see the accelerated pace of cloud adoption amongst our new clients. as well as a steady increasing pace of cloud migrations of on-premises clients. Additionally, we integrated our Tyler and NIC payments teams and launched a significant go-to-market strategy for payments with a growing and active pipeline. During the year, we added 571 new payments clients with the vast majority at the local level. We leveraged our strong relationships across state and local agencies, including the NIC state enterprise contracts, to expand our cross-sell opportunities with significant multi-solution deals that demonstrate the power of our one Tyler approach. We're still in the early stages of cross-sell, and it's exciting to see tremendous momentum and collaboration taking place. Since completing the acquisition of NIC, synergies between NIC and Tyler have delivered 19 cross-sell transactions worth $9.5 million in total contract value. Overall, the year was highlighted by significant wins, highly successful upsell efforts, and state renewals and expansions. Throughout the year, we also demonstrated a balanced yet opportunistic approach across our business and with respect to capital allocation. We maintain a strategic lens toward acquisitions and close three transactions that bring innovative and robust offerings to elevate our digital solutions payments business, broaden our integrated solutions, and add new technology. All three acquisitions, QuadThread, USC Direct, and Rapid Financial Solutions support a unified client experience and further our connected community's vision to support thriving communities through a common digital foundation for better data access, engagement, and transparency. As we move into 2023, I've never been more confident about Tyler's long-term prospects. This is an important year in our cloud transition, and we are tracking well with our cloud optimization product development efforts and the planned exit from our proprietary data centers in 2024 and 2025. We expect to reach an inflection point in our cloud transition in 2023, with a significant decline in license revenues that are being replaced by valuable long-term recurring SAS revenue. As a result of the short-term revenue headwinds from this shift, together with bubble costs related to the SAS transition, including duplicate costs of operating our proprietary data centers while moving our hosting to AWS, operating margins are expected to trough this year. The estimated impact of bubble costs on our 2023 non-GAAP operating margin is approximately 130 basis points. We are committed to returning to a trajectory of consistent operating margin expansion beginning in 2024. In fact, you'll see in our upcoming proxy statement that we have added operating margin expansion as a second metric for our long-term incentive plans for our senior leadership. Our move to cloud-first builds long-term value and supports multiple long-term growth drivers. In the mid-term, over the next five to seven years, we've talked about annual organic revenue growth in the 8% to 10% range with consistent long-term margin expansion of at least 50 to 100 basis points a year beginning in 2024, excluding the impact of merchant fees from payments expansion. We continue to refine our Tyler 2030 plan and look forward to sharing our longer term vision and clearly defined targets for revenue, margin, and payments growth during an investor day plan for mid-year. Look for more details on that soon. When we look at our operating margins, it's also important to consider the impact that growth in our payments business has on margins. We recognize revenues for payment processing under multiple revenue models. A gross model for agreements where we are responsible for merchant fees on the transactions, a net model, where the client assumes direct responsibility for merchant fees, and a revenue sharing model, similar to the net model, where we are effectively reselling a third party's processor services. The majority of NIC's payment processing is under the gross model, and in 2022, we paid total merchant fees of approximately $145 million, with a small margin earned on those fees. If those same contracts were on a net basis, our consolidated non-GAAP operating margin would have been approximately 200 basis points higher. Our operational and financial discipline, coupled with a strong balance sheet and ample liquidity, allow us to aggressively manage our debt profile and moderate the impact of rising interest rates. And delevering continues to be a priority for capital allocation. While the bar is high for acquisitions, we continue to have the flexibility to evaluate M&A prospects that present compelling strategic growth opportunities. To close, I'm proud of our Tyler team and what we continue to accomplish every day, even amid macroeconomic uncertainty. As you've seen in our press releases, we receive many industry and regional accolades, which is a testament to our work ethic, our culture, and our tireless efforts to support our clients' needs. We also received gratifying recognition for our environmental, social, and governance practices, being named to the Dow Jones Sustainability Index North America for the second consecutive year. The DJSI cited our notable gains in IT security, risk analysis, privacy protection, and human capital development. In addition, we were recently named to Newsweek's list of America's greatest workplaces for diversity. We're proud of these recognitions and remain committed to sustainable business practices. With that, we'd like to open up the line for Q&A.

We will now begin the question and answer session. To enter a question into the question queue, please press star 1 on your touch-tone phone. If you're using a speakerphone, please pick up your handset, then press the star key and the number 1. To withdraw your question, Press the star key, then the number one again. Please limit your question to one and one follow-up and then place yourself back in the queue for additional questions. We'll pause momentarily to assemble our roster. Your first question comes from the line of Sammy Badry with Credit Suisse. Your line is now open.

Hi, thank you very much. I had a question about the margin troughing in 23 and maybe you could just give us color on the ramp from the bottom of 23. What should we be thinking about where margins could go in 24? And I think the big thing here is maybe you could give us color on what are some reasons why the bounce off the trough could be faster versus slower? What are some things that could influence the speed of the margin movements?

Yeah, I think...

It's still a little early for us to give much color around sort of how we see that trajectory playing out in 2024 and over the mid-term, say, over the next five to seven years. As we mentioned in the prepared remarks, we expect to have an investor day around mid-year and provide more detail on that. But we're still refining those models. not really able to give a lot of color around that. As we've talked about, some of the factors that give us confidence that we do return to margin expansion in 2024, particularly around the wind down of some of the bubble costs as we exit our first data center. We think that this year actually We sort of reached that inflection point where the impact of declines in licenses are offset by the current stream of recurring revenues from subscriptions. I think in terms of the factors that could make that go faster or slower, Certainly one of those is the speed at which our payments business grows, and Lynn talked a little bit about the impact that has on our blended margins. But on the software side, I think that the trajectory around the speed of the flips from our on-premise customers will have an impact on that. Some of the other... efficiency gains and product optimizations, as we wrap those up, the ability to improve, lower our hosting costs, I think the speed at which those work their way into the model will also be a factor in how that trajectory, how fast that trajectory plays out.

Yeah, I think just to amplify on that, we've talked over the last couple years, we're about four years or so into this cloud transition. And we've talked about sort of the two pieces of it, the getting to the other side on the revenue side and then sort of getting the other side on the cost and expense side. And as Brian mentioned, on the revenue side, we're seeing that sort of inflection point that's going to take place probably later this year. And in the last couple of years, the lost licenses has been a significant impact. And our internal models are now showing that really the the new flips, the gains from flips, as well as the SaaS business over the last couple years, is going to, later this year, sort of pass that point of where we lost licenses. Remember, back in 2019, we did just over $100 million in licenses. So it's a significant change that we've been running through the financials. And then when you look on the cost side, each year as time goes by, we're getting better and better in visibility. We're We are making progress on optimizing our products. We're making more progress on our plans to exit our proprietary data centers. We're getting better data on how our products are actually operating within the public cloud. And so a lot of that stuff gives us that confidence that 2023 is that margin trough. If we look out farther, you know, there's other things that we're doing as well. We have a lot of internal initiatives around efficiencies. things like consolidating just some of our internal IT. We have other sort of satellite data centers that we're looking to collapse, as well as things like looking at real estate and stuff like that. So there's a lot of initiatives around that, which I think give us that confidence when we talk about 23 being sort of the margin trough.

Got it. Thank you for that color. I want to shift gears a little bit and just talk about your end market, your customers, the funding flywheel. We've clearly started to see some companies that are indexed to federal, state, and municipal budgets start to see the benefit of funds flowing in. They could be coming in from ARPA. Some of them are still coming in from the CARES Act. And just in general, state and local budgets are up or up a lot, I guess, in 2022, fiscal 2022, and look like they're going to be up low single digits in fiscal year 23, which means like the base level of state and local budgets are just much higher than what we've really seen before. Have you been able to identify some of those incremental lifts in those budget allocations or federal funds start to come into the business in the form of contracted revenue or bookings?

I think the answer is probably similar to what we've said in the past. I would say as I look at our clients' budgets, they're generally very healthy. As I've mentioned before, they were not as impacted by COVID as people thought. They are having access to federal funds. Some of it, Brian, the timetable is one of that. They still have a couple of years, I think, to spend that. So we're just generally seeing healthy budgets, healthy buying seasons, sort of just a really good robust market. In terms of identifying specific deals, there are occasions for that, but I think really what it does is it's more about just overall confidence in our clients being willing to spend money.

Got it. Thank you.

Your next question comes from the line of Rob Oliver with Baird. Your line is now open.

Great. Thanks, guys. Good morning. Lynn, one for you. You mentioned the milestones on the cloud side since 2019 when you pivoted to the cloud-first approach, and it certainly seems like those are paying off, particularly with new business around subscription, you know, definitely felt that among your customers in Indianapolis last year, talking to them about their readiness for cloud. But I wanted to ask a little bit about, you talked about new flips. How should we think about the pace of conversions? This is clearly going to be, you know, an important, you know, driver here. They're up, you know, modestly from last year, nothing to really write home about. So can you just help us understand how you're thinking about you know, maybe success relative to conversions and migrations of existing customers, you know, this year. Um, and then I had a quick followup for Brian. Thanks.

Yeah, sure. Robin. Um, you know, I think, uh, you're right. Our flips actually, I think they're up quite a bit year over year. Um, I think this year we did about 336 flips last year. We did about 239 flips, give or take. So, um, up roughly 40%. Um, I, I, I see flips being, uh, a significant driver of revenue growth over the next five to seven years. I see them continuing to grow at a healthy pace. I'm not in a position to tell you that we're going to grow another 15%, 20% each year, but we have a wide and deep customer base that has become a priority, and we're prioritizing our flips internally.

Great. Okay. Excellent. Thanks. And then, Brian, just one on the Q4 operating margin was a bit below our expectations, and that could be driven, indeed, by those flips or by NIC, but just wanted to get a little bit more color on that. Thanks.

Yeah, I'd say probably the two biggest factors there were one, that licenses declined pretty significantly, and we've talked about that expectation kind of going into 2023, but Q4 had a bit of a deeper decline from the mix of new business. So licenses were a relatively low number. And again, most of that is a shift in the mix as opposed to less new business. We did, as we typically have with our more license-heavy products in public safety and platform technologies. Some slippage out of the quarter in terms of timing, but that's pretty typical. So I'd say that the lower licenses were a big factor. And then probably the other factor is the higher R&D expense that we mentioned, where some expenses that we had expected to be capitalized were actually expensed because of the nature of the of the development efforts, and so that impacted our margins as well.

Got it. Okay. Thanks, guys. Appreciate it.

Your next question comes from the line of Matthew VanVleet with BTIG. Your line is now open.

Hey, good morning. Thanks for taking the question. I guess looking at the margin guide for 23, Brian, and just trying to reconcile kind of where we were previously to maybe some of the moving parts. I know you just mentioned the R&D coming in higher on the expense level than capitalized. I wonder if you could sort of quantify how much of that sort of changed versus what you were previously expecting. It looked like around maybe $6 million change. flip from capitalized to expense in the fourth quarter. Curious if you have a general sense of what that level will be in 23. And then secondarily, just how much of the compression on the operating margin side is from the declining license mix versus the bubble costs versus those R&D expenses? Thanks.

Yeah. So, yeah, for the full year, the difference in the capitalized versus expensed R&D versus our expectation was close to $9 million. We gave guidance for R&D for next year in the range of $108 to $110 million that's expensed. And our capitalized R&D in 2023 is expected to be in the high 30s, let's say around $37 million. Capitalization is a little bit higher, but R&D expense is higher in 2023. If you look at the midpoint of our guidance, it implies, I'd say, somewhere between 60 and 100 basis points of operating margin compression in total. And we mentioned that the bubble costs are estimated to be about 130 basis points of of impact on the 2023 margins. New bubble costs? New bubble costs. And that's higher than the impact was in 2022. We talked about those as being a little less than 100 basis points of impact. And that's to be expected because we continue to move more customers into the public cloud while we're still operating our two data centers. And so the the duplicate costs expand this year. And we've talked about an expectation in, I guess, the first half of 2024 that we'll be out of the first data centers and that'll start to mitigate.

Okay, very helpful. And then looking at just trying to square together some of the numbers with the commentary, it sounds like the subscription side and certainly SASP embedded within that continues to perform quite well. you're seeing not only new customers, but the flips sort of at elevated rates. But then when we look at the backlog numbers on the subscription side, there was a slight decline sort of quarter over quarter while maintenance continued to climb. So just curious if there were, I guess, any mix of some of the renewals that maybe were anticipated to flip that maybe didn't in the quarter or anything on that front that would sort of lead to the optics of the subscription backlog declining slightly while the sort of looking ahead version and the qualitative commentary around strong bookings would push more to the subscription side maybe in 23 than what we saw in Q4?

Yeah, I think one of the bigger factors around backlog, I think backlog is probably becomes maybe a little less meaningful or a little less of a full picture when you look at it, is really around how the accounting drives what goes into backlog and what doesn't. So transaction revenues don't sit in backlog, so as we add new payments or new portal revenues, those typically aren't under a fixed arrangement, even though they may be highly predictable and recurring. So there typically wouldn't be an addition to backlog for those. And then we've talked in the past as well about sometimes the terms of a contract agreement dictate how much goes into backlog. So, for example, a termination for convenience provision can significantly limit that. We saw that with a really large contract last quarter that was a $50-plus million contract that only $8 million went into backlog because of the termination for convenience provision. I think there are a lot of factors that start to make the backlog number maybe less of an important metric to look at how we expect to perform going forward.

Okay. Very helpful. Appreciate the answers. Thank you.

Your next question comes from the line of Pete Heckman with D.A. Davidson. Your line is now open.

Good morning. Thanks for taking the question. A few just clarifications there, and I may have missed some details, so forgive me if I'm repeating myself. But when we look at bookings, we typically see this quarter as a big public safety bookings quarter. Can you talk about how they are receiving the idea of converting to subscription? And then just clarifying, Were there any deals contained within bookings in the quarter that were greater than $5 million of TCV?

Yeah, sure, Pete. On the public safety side, it is typically a little bit larger quarter. We don't typically talk about deals that we've awarded but not signed. I will say that we had a couple of deals that were of significance that pushed for the quarter. We are continuing to see more and more acceptance on the public safety side to the SAS model and to subscriptions. And I think we're going to continue to see that going forward. It's part of our actual in our budget process. If you look generally across Tyler, I think for next year on an overall weighted value average, we're expecting north of 90%, 91% of deals next year to be in SAS with a significant increase on the public safety side. Still less than half on the public safety side, but it is something that we're doing some modeling and some things that we're trying to do to sort of push that model with our clients.

Yeah, in this quarter, we did not have any individual contracts that were more than $5 million in total contract values. We had a couple in the $4 million range. On the software side, we did. have a competitive rebid win with our state enterprise agreement in Colorado, which is one of our bigger states. And certainly the total value of that contract over the five-year term is well above $5 million. But on the software side, no individual deals more than $5 million. So it was more of a high-volume, sort of more mid-range deals this quarter.

Got it. And so to your point that bookings might become a slightly less useful metric given how you gross up the TCV related to variable revenue streams and contracts, I missed what you said on the 500 and some payments deals. What was the TCV related to that? And then can you give an approximation of how much that was included in full-year bookings? Would it have just been your estimate in the first year?

Yeah, and actually on the payment deal, there really wouldn't be anything that in the bookings number, only the actual revenues that they come through in a given quarter basically run through bookings and revenue at the same time. So for payments, we don't include, again, because they're not a fixed amount, we don't include those in bookings or in backlog. But those payments deals for the full year, we estimate that they'll add more than $13 million in annual recurring revenues. And there's a mixture of contracts there that are either gross or net processing through our platform and still some deals that are through our reseller arrangements where we have a revenue sharing platform. So the revenues are lower, but the margins are higher on those.

Right, right. Okay, that's helpful. I appreciate it.

Your next question comes from the line of Alex Sukin with Wolf Research. Your line is now open.

Hey, guys. So maybe just two for me. I guess the first one is kind of similar to one of the questions I think that's been asked, but maybe on a slightly different metric. Again, the subscription ARR, added in the quarter. This quarter seemed to be lower sequentially than the last two. So just maybe clarifying what drove that from a bookings perspective. And then more broadly, as we are much more geared towards subscription and SaaS, how should we think about, at least how are you guys thinking about kind of net new SaaS ARR, net new kind of subscription bookings growth for 23? And then we've got a quick follow-up on cash flow.

Well, we expect, clearly we expect that subscription booking and subscription ARR will accelerate from 2022 and 2023, both on the transaction side and the SaaS software side. Part of that, again, the change in the mix accelerating and a more significant decline in licenses this year with that being replaced by new subscription arrangements. I think the question about just the new subscription ARR, again, that number really just relates to new software deals. And as we said, there weren't any mega deals in this quarter, but a good volume of sort of mid-sized deals. I think more of that's just around the timing We've said that the pipeline continues to be very strong. The RFP activity remains generally stable at pretty elevated levels. So the market activity supports that expectation that we'll continue to see an accelerating rate of new software ARR.

Okay, perfect.

And then I guess, Brian, from a free cash flow perspective, When you think about the lag or the delta between operating margins and free cash flow for this year, it's obviously a little bit higher than in previous years given some of the items you mentioned around tax and expense or capitalization versus some R&D expenses. As we think about it for 23 and even more so for 24, what's the right expectation for free cash flow margins versus operating margins? Is that Delta specifically in these two years as we, you know, kind of trough margins and transition to SaaS?

Yeah, I think generally we would expect that, and we talked about what our capitalization, our CapEx, both software and non-software CapEx is for 2023. That's a bit higher, and some of that's related to software CapEx and some of that's related to facilities investments that we're making in a couple of particular locations. I'd expect that in 24 that that CapEx would decline. In general, I think our cash flow margin would grow in line with or faster than our operating margin would. once that CapEx starts to normalize. The impact of the Section 174, which is still a bit unclear, will be significant on cash flow in 2023 because if it stands, if it's not repealed, and we're not the first company or the first software company to talk about this. You're starting to see more of it. I know Microsoft talked about it. more than billion dollar impact on their taxes. But if it stands and isn't repealed or delayed, that our cash tax payments will be significantly higher this year because we'll have the impact of both sort of catching up the 2022 taxes under that assumption and making cash tax payments related to 2023. So it could be in the $100 million range of additional cash taxes this year, which would really, as I said, be two years' impact, roughly $50 million related to 2022 and $50 million related to 2023 in round numbers. So we'll see how that plays out, but that's sort of the current expectation. And given the way that tax change works, it will impact cash taxes for five years until it normalizes and you're putting on the same amount that you're amortizing.

Understood. So I guess, is it fair once we get through 23 and CapEx starts to trend down, would you expect it to kind of go back to that historical, you know, two to 300 point delta between margins and free cash flow margins, operating margins? I think that's fair.

Okay, perfect. Thank you.

Your next question comes from the line of Gabriella Borges with Goldman Sachs. Your line is now open.

Hi, good morning. Thank you. Lynn, I wanted to follow up on some of your comments on the demand environment. I think last quarter you talked about procurement cycles stretching out a little bit. Maybe just give us an update there. Are you seeing any issue, positive or negative, with stopping shortages, negative being the bottlenecking on procurement and positive being, hey, we don't have enough folks. We need to accelerate our adoption of technology at your customer base.

Yeah, thanks, Gabrielle. Right now, procurement cycles are pretty normal. They're going in line with our clients' budgets are healthy, and we're not really seeing delayed procurement cycles right now. Again, from our perspective, the market is relatively healthy, their budgets are healthy, and our competitive position remains strong. So we're seeing a pretty normal, really above normal market.

Okay. And my follow-up is on the competitive position. So as you think about the progress you've made with your cloud transition and really leaning into that, is there a scenario where you see a pace of share gain or a pace of displacement of incumbents Is that something you potentially are already seeing? Is that something that could be on the come? A little bit on how it advantages you competitively. Thank you.

I'll start on that, and Lynn can add to that. We do think that in our space that the shift to the cloud and our cloud strategy gives us a competitive advantage. As you know, we compete. across products with different competitors and generally in each of our product suites. And those range from some very large companies to a lot of smaller, more niche companies. And we think that where we are in the cloud transition is well in advance of where a lot of our competitors are. And that as that desire on our client base to move to the cloud accelerates, that gives us an advantage and an ability to increase our share because of where we are in our cloud transition. And then, as we've talked about in the past, our connected communities vision and the fact that we have this broad suite of products that work increasingly well together continues to provide us with a competitive advantage there in clients that are looking for a suite solution. And we think that's clearly one of our strengths.

Thank you.

Your next question comes from the line of Saki Kalia with Barclays. Your line is now open.

Okay, great. Hey, good morning, guys. Thanks for taking my questions here. Lynn, maybe to start with you, that was helpful detail in your prepared remarks just on the composition of NIC or digital payments when it comes to gross versus net. Maybe the question is, could you put a finer point just on how much of that digital payments business or the transaction revenue line is gross versus net? And then relatedly, how you maybe think about that mix going forward?

Yeah, I'll start, and Brian's probably got better numbers. At NIC, which is now our Digital Solutions Division, I would say the overwhelming majority of their payments business was on a gross basis. I would say on the Tyler side beforehand, more of it's been on the net basis. It's actually not a lever that we fully control. It's generally controlled by the customer and whether or not the customer wants to take the risk and on the interchange basis, fees or if not. There's a number of factors that go into there, but as of right now, a substantial part of Tyler's overall business is on the gross model because of NIC and where NIC was and how mature and vast that business was. We've got the number for merchant fees that we passed through last year was about, I think on the NIC side was about $142 million and maybe just you know, a handful of $3, $4, $5 million on the Tyler side. And looking at it next year, I think the NIC side is probably more around $145-ish million, again, with the same few million more on top from Tyler.

Yeah, I don't know that I have a lot to add to that. It clearly is the vast majority. We did mention that a couple of our state enterprise agreements at Digital Solutions are shifting in 2023. to net from gross and that's got about a $10.5 million impact. But as Lynn said, we don't really fully control that. So I would expect that still going forward that the majority of the business comes to us through the gross model where we're paying the merchant fees, which is why we wanted to sort of give you the apples to apples comparison of the the margin impact of a couple hundred basis points if all of those net ones were on the gross model and you took the merchant fees out of the revenue side. So I would say that as more Tyler customers that have traditionally been on a sort of a reseller with third party payment processors where we get a revenue share, which is a net accounting. As more of those over time migrate to our proprietary platform, we could have a shift from those customers that are currently on a net basis moving to a gross basis with Tyler. The net result is we keep more of the transactions, so we make more money. we'd have higher revenues, but it would have a negative impact on margins. And we'll attempt at our investor day to provide more color on how those work and how we see that playing out, because clearly significant growth in the payments business is an objective of ours and something that we're having a lot of success with and expect to continue to.

Got it. That's very helpful. Brian, maybe for my follow-up, and apologies, I think this question's been asked a couple different ways. I want to try one other way. The question is maybe how SaaS ARR did versus your own expectations this quarter? I think you said that maybe it was timing. We expect SaaS ARR to accelerate next year. I think it grew about 19% this quarter. I know the last quarter had some big deal activity. you know, that maybe makes it a tough sequential compare. But I'm just kind of curious how you think about sort of that, you know, that SAS ARR growth trajectory this year and if there's anything that we should keep in mind for how that, you know, for how that performed this quarter versus your expectations.

Yeah, I think it was generally in line with our expectation. I don't know that it was significantly varied from plan. I guess one other factor that, you know, that plays into that is the lag between when we sign a SAS deal and when we start to recognize revenues. And that can vary, but it can be typically the implementations are quicker, or the time from signing to starting to recognize revenues is quicker on a SAS deal than on a on-prem deal. But that can vary, and that can typically be, say, six months, but can be longer. And so I think when I talk about timing, it's more around the difference between when we sign something and when we're starting to recognize revenues.

I'd say there's two things there around timing. One is, just as Brian mentioned, yes, in the old days when you signed an on-prem license, you recognized the entire license up front. On a SaaS deal, particularly when we're doing multi-suite, multi-module deals, they're generally going to start paying those when those particular modules or pieces go live. So, you know, you've got a delay from the time you sign to where you get first parts of the customer up live. But as you continue that implementation and other pieces go live, then you'll get that buildup. I say the other side is when you look at flips, you know, there's things around flips that while long-term obviously provide really great long-term value in the short term, Sometimes we're providing some services, perhaps at discount or no charge. There also might be some concessions depending on how long the customer has had their license and where they sit. And so to sort of incentivize the flip, there's sometimes some sort of upfront concession, which can then create another lag factor before you get the full value of that flip.

Got it. Very helpful. Thanks, guys.

Your next question comes from the line of Jonathan Ho with William Blair. Your line is now open.

Hi. Good morning. Just wanted to, I guess, touch a little bit about cross-sell activity, which you spoke about quite a bit. Is there anything that we could expect to see either inflect or grow even more for 2023 as the NIC relationship has had a little bit more time to mature and with some of the new acquisitions?

Yeah, Jonathan, I mean, Look, cross-selling is one of our major, you know, mid- to long-term growth drivers. It's something we're talking about internally. As you look out over the next, you know, seven, eight years, talk about Tyler 2030 and things that can, quote, really move the needle. It's these things like flips. It's payments. It's cross-selling. It's also a lot of other things that we do really well. And, you know, we talk about areas of our business like supervision where the market's good or the TAM is good and where we're making really big gains there. But cross-selling is something that we're prioritizing across all of Tyler. We've actually started some new sort of strategic account management approach within NIC and bringing other resources, getting even further exposure to our sales channels, our sales leads. There's things that we will be working on in terms of internally around how we recognize revenues from cross-sells and how we incentivize things. and structurally, internally, things that we need to sort of clear out some of those barriers to sort of unleash that power even more. We're pretty excited about it. I mean, we had probably this past quarter probably one of the best stories we've had in a long time in terms of both cross-selling and sort of connected communities, which was the Kansas Department of Revenue story that I mentioned in my opening remarks. You know, this was a deal where This deal took place because of our DNI solution around assessments and the fact that we had such a broad footprint and presence within the state of Kansas from our enterprise assessment. But it also didn't happen without NIC and their contacts at the state and utilizing that state master contract. So that was three different pieces of our organization coming together to create a really great result and something that I think we can replicate across other states that deals $600,000 a year ARR deal, really a D&I deal, but really took the efforts of multiple divisions to do that. And I think that's sort of an example of what we're looking to do in the future.

Great. Thank you.

Your next question comes from the line of Kirk Mattern with Evercore. Your line is now open.

Yeah, hi, guys. This is actually Peter Berkeley on for Kirk. Appreciate you taking the question, sir. Um, so maybe Brian, just, just, just one for you. Um, you know, curious, are we at the point where, you know, there should sort of be more stability in terms of the impact of the subscription transition on revenue versus your guidance? You know, I mean, I think we all get at the moving target, but just curious if the level of dispersion is likely to go down from here on that in that sense.

Yeah, I think so. Um, you know, there's, we, we certainly expect a, uh, Bigger decline in license revenues this year. Licenses are always the least predictable of our revenue streams, at least in the short term. And so now with well into the 80s and the percentage of our revenues that are recurring, there's a much higher level of predictability. So I think we're definitely kind of around that corner and that there should be an increasingly higher level of confidence around our outlooks versus what we actually, where results come in.

Thanks, Brian.

Your next question comes from the line of Terry Tillman with Truist Securities. Your line is now open.

Hey, good morning. Thanks for fitting me in. Unfortunately for you all, I still have some of my questions, even though a bunch have been answered. Maybe, Lynn, the first question for you, it's kind of a two-fold first question, and then, Brian, I was going to ask you about payments. But, Lynn, in terms of those couple of larger public safety deals that slid into the first half, do you expect those to close in the first quarter? And then the second part of that first question for you is, you all had a great deal last quarter with the Department of State, and I know it's still small in terms of the federal sector for you all, But just anything you can share about optimism and more we could hear this year on that side. And then I wanted to ask you about payments, Brian.

Yeah, my expectation is that at least one of those larger deals is on track to close in Q1. As it relates to Tyler Federal, I think you're right. I mean, things that I'm seeing that's coming out of that division in terms of sales indicators, the pipeline, The volume of deals is up significantly year over year. We're also seeing, interestingly enough, more and more movement in the federal side to SAS, which is good to see. It's something that we've put an internal focus on in the last two years, and we're starting to see more of that receptiveness there. So I think there's positive things coming out of the federal space, and I like our position there right now.

That's great to hear. And then, Brian? You know, we've gotten a lot of data points on payments, and there's lots of puts and takes, though, particularly the gross to net or when there's a rep share. But could you just, like, really try to help boil it down in terms of, for 23, the payments revenue business? I mean, you know, would that grow at about a similar rate in 22? Or just anything you can share about the growth rate on the recognized revenue for payments? Thank you.

Yeah, I think the growth rate on payments is going to be – above Tyler's overall growth rate and it's going to be a positive contributor and I expect that in general that will be accelerating from 2022 both from adding new customers through the cross-sell motion which we talked about we've integrated our payments teams we've really got the go-to-market strategy down and now we're starting to execute on it whether it's using the expanded capabilities that NIC's platform brought us to drive that business down into the local level, continuing to have a focus on penetrating more of our customer base with payments either with our platform or partner platforms, driving more adoption into the customer base, and and then the addition of Rapid, so giving us capabilities on the disbursement side. And we've got some really interesting opportunities around that and think that's going to be a nice growth driver. So I'd say we generally expect the payments business to grow faster than sort of Tyler's top line revenues, at least in 2023.

Yes, we have our inside sales focusing on that existing customer base. When you look at areas like our enterprise side, whether it's enterprise ERP. We're including payments in all new deal responses. That doesn't mean they're getting in every new deal, but we are pushing payments in all of our new deals.

That's a great call. Thank you.

Your next question comes from the line of Joshua Riley with Needham. Your line is now open.

Thanks, guys, for squeezing me in. I'll just ask one question here since we're running over time. The software development costs were only $2 million in the quarter, which is obviously below what we were expecting. Can you just discuss the impact of the accounting changes to this figure and how guidance of $37 million for 2023 is the proper amount, implying an increase given the accounting changes that we have here?

Yeah, the guidance for 2023 changes of $37 million in capitalized software development encompasses how we expect those projects to be accounted for. So the impact of that change is reflected there, as well as other capitalized development projects that are either starting or ramping up during the year. So that's fully encompassed there. The change in expensing versus capitalizing for the full year of 2022 had about a $9 million impact versus what our initial guidance for capitalized software and R&D was.

And was that just reflected in that Q4 number? than the full $9 million impact? Or why was that only $2 million, I guess, in the quarter?

Well, it impacted the full year, but most of that impact was seen in the Q4 results. So that resulted in a much lower number in Q4 versus the rest of the year.

Got it. Thanks, guys.

Your next question comes from the line of David Unger with Wells Fargo. Your line is now open.

Thanks very much for squeezing me. I appreciate it. Just one for me, Brian. I heard in your comments and your prepared remarks, you're touching on growing the implementations team in 2023 to meet backlog. Can you just talk about the labor market trends you are seeing and where you stand currently in terms of hires, what we're seeing in terms of wage inflation, et cetera? Thank you.

Yeah, there continues to be challenges in the labor market, but it's definitely mitigating from what we saw last year. Obviously, it's been very common across multiple industries, but certainly in technology where you're seeing layoffs, hiring freezes, and so there's less pressure, I think, on us in terms of turnover, which is moderating. And there's less pressure than we saw last year on wage increases. So each of those are working in a positive manner for us.

Yeah, I'd say, David, if you go back 12 months ago, we were still experiencing really pretty high elevated turnover, still lower than industry, but higher than our norms, which As you know, all companies we're dealing with, as we progress throughout the year, things started, I think, I talk a lot about the pendulum, and the labor market pendulum is another one that I talk about, and it's definitely started to swing back. As we fell back into sort of November, December, I would say our turnover has actually come back down to sort of pre-COVID levels. Still early to see if that's where it stays, but I like that trend. as it relates to things like that Brian mentioned, you know, our services and implementation. That was an area that was hit particularly hard over the last couple years, and we've won a lot of business. We do have to do some hiring to ramp up to deliver on that business, and we're doing that. It also creates a little bit of margin pressure in the near term because, you know, when we hire large classes of implementers, it normally takes you know, four, five, six months before we get them out billable on the road.

Most of the growth in our headcount this year will be in revenue-generating positions.

That's excellent, Colin. Thanks very much. Appreciate it.

Your last question comes from the line of Keith Hewson with North Coast Research. Your line is now open.

Good morning, guys. Thanks for squeezing me in here. I'm just unpacking the payments just a little bit further. The 571 wins is obviously a phenomenal number for the year. Are these mostly agencies that are taking on payments for the first time, or are these actually competitive wins? And what do you see the trajectory, I guess, in 2023 for that same question?

I'd say the majority of that number, although not the majority of the dollars, but the majority of the number would be certainly new payments for for most of those customers so a lot of those are existing Tyler customers where we're adding payments to a utility billing system or a licensing and permitting system so we may be adding capabilities they may have only taken checks before and now we're providing online payment capabilities or credit card payments and a number of those are still under rev share agreements so The revenue generated on an individual payment opportunity may be relatively small, but at good margins. But some of the more significant wins are competitive wins, like we mentioned the City of Milwaukee. That's a full enterprise payment processing contract, and we're replacing another vendor there. I'd say the larger wins tend to be competitive wins. The smaller ones tend to be more first-time payments. Thank you.

This concludes our question and answer session for today. I turn the call back over to you, Lynn Moore.

Great. Thanks, everybody, for joining us today. If you have any further questions, please feel free to contact Brian Miller or myself. Have a great day, everybody.

This concludes today's conference. Thank you for attending. You may now disconnect.