泰勒科技 (TYL) 2018 Q4 法說會逐字稿

Hello, and welcome to today's Tyler Technologies Fourth Quarter 2018 Conference Call.

Your host for today's call is John Marr, Chairman of Tyler Technologies.

(Operator Instructions) And as a reminder, this conference is being recorded today, February 21, 2019.

I would like to turn the call over to Mr. Marr.

Please go ahead, sir.

Thank you, and welcome to our Fourth Quarter 2018 Earnings Call.

With me on the call today are Lynn Moore, our President and Chief Executive Officer; and Brian Miller, our Chief Financial Officer.

First I'd like for Brian to give the safe harbor statement.

Then Lynn will have some preliminary comments.

Then Brian will review the details of our fourth quarter results and provide our 2019 guidance.

Then I'll have some final comments and we'll take your questions.

Brian?

Thanks, John.

During the course of this conference call, management may make statements that provide information other than historical information that 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 refer you to our Form 10-K and other SEC filings for more information on those risks.

Effective January 1, 2018, we adopted the requirements of ASU No.

2014-09 Topic 606, Revenue from Contracts with Customers, utilizing the full retrospective method of transition.

Prior year amounts have been restated from previously reported amounts to reflect the impact of the full retrospective adoption of Topic 606.

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.

Lynn?

Thanks, Brian.

Our fourth quarter results provided a solid finish to 2018.

This was our 29th consecutive quarter of double-digit revenue growth as total GAAP revenues grew 11.2% and non-GAAP revenues grew 11.5%.

Organic growth improved from the third quarter to 7.4% on a GAAP basis and 7.3% on a non-GAAP basis.

Revenue came in at the low end of our guidance range primarily due to a higher level of software subscription contracts and the new business mix as well as the timing of several Public Safety deals that slipped out of the fourth quarter.

With regard to growth expectations, we focus internally more on total growth than on the distinction between the organic and inorganic components.

We've discussed before how our expectation that over time our organic likely slows somewhat.

Part of that is simply due to large numbers.

With revenues that will exceed $1 billion in 2019, achieving double-digit growth organically is increasingly difficult in a market that grows in the mid-single-digit range, especially when combined with the near-term revenue headwind that comes with the continuing shift towards software subscriptions and our new business mix.

In addition, maintenance from on-premises clients makes up about 40% of our revenues.

And although we have extremely low attrition and a history of consistent annual increases in rates, those factors generally result in 6% to 7% growth in maintenance revenues.

Also, while appraisal services makes up less than 3% of our total revenues, they are cyclical in nature, and in 2018 were down 12.7%.

That decline alone reduced organic revenue growth 60 basis points for the year.

Against that backdrop, we think it's especially important to note that our core software revenues, those revenues from licenses and subscriptions, are consistently growing organically in solid double digits.

In the fourth quarter, our core software license and subscription revenues grew 24% on a non-GAAP basis, with 15% organic growth, and for the year, they grew 23%, with 17% organic growth.

We also expect that we will continue to supplement our organic growth with strategic acquisitions.

We are patient and disciplined acquirers and look for acquisitions that strengthen our product offerings, leverage our existing client base and sales resources and expand our addressable market, all at fair valuations.

We believe that, as we have proven in the past, we will supplement our organic growth with these acquisitions and continue to achieve low double-digit total growth.

Software license and royalties revenues in the fourth quarter were very strong, up 15%, and exceeded $25 million for the first time.

GAAP subscription revenues grew 26% and non-GAAP subscription revenues grew 28%.

Total recurring revenues from maintenance and subscriptions grew 13% and comprised 65% of total revenue.

Our mix of new business was similar to the third quarter, with approximately 60% of the value of new software deals from on-premises license arrangements and 40% from subscription arrangements.

It was a particularly robust quarter for our ERP and Civic Services solutions, which had strong sales throughout the year.

The largest deals of the quarter were a SaaS arrangement for Munis with the city of Memphis, Tennessee, valued at approximately $4 million, and on-premises license arrangement for Munis with Jackson, Mississippi, valued at over $3 million and contracts with Cape Coral, Florida for both Munis and EnerGov valued at $4.4 million.

We also signed contracts valued at over $2 million each with Tucson, Arizona for EnerGov and York County, Pennsylvania for Munis.

For our Courts & Justice solutions, we expanded our presence with Odyssey case management in the key states of Texas and Illinois with an on-premises contract with Bell County, Texas and a SaaS contract with Lake County, Illinois, each valued at more than $2.5 million.

While it was an active quarter for new business in the public safety market, contract signings for several opportunities in which we were selected slipped out of the fourth quarter for a variety of reasons.

Significant new on-premises contracts signed in the quarter for our New World solution included Lake County, Ohio; Duluth, Minnesota; and West Waco, Texas, along with significant SaaS agreements with Kalmazoo, Michigan and Bethlehem, New York.

We continue to gain momentum with sales for our Socrata data insight solution, which we acquired on April 30.

We're particularly pleased with sales for the Socrata Connected Government Cloud, or SCGC, that we launched in May.

Our 2018 goal was to sign 6 new SCGC clients by year-end, and we far surpassed that with 18 SCGC sales across all levels of government in 2018.

Among the fourth quarter SCGC contracts were deals with the City of Austin, Texas; Fulton County, Georgia; the Idaho Supreme Court; and U.S. Department of Transportation.

Finally, we signed a significant contract for our Versatrans student transportation solutions with the First Student Inc.

organization, a leading provider of school bus transportation across North America.

We are particularly pleased with our cash flow performance for the fourth quarter as well as for the full year.

Free cash flow grew 39% in the fourth quarter and 46% for the full year.

With our strong cash flow and balance sheet, we continue to actively pursue strategic acquisitions that support our long-term growth objectives.

On October 1, we acquired MobileEyes, which we discussed on the third quarter conference call.

On December 7, we acquired SceneDoc, which provides mobile-first SaaS field reporting for local law enforcement agencies, enhancing our Public Safety offerings.

SceneDoc enables field capture of data, electronic notes and multimedia with secure storage and access to and from the cloud from smartphones, tablets, wearables and task-specific apps, which are quickly becoming first responders' primary tools for communicating in the field.

Subsequent to year-end, on February 1, we acquired MyCivic, a rapidly growing provider of citizen engagement applications.

MyCivic will elevate our current citizen-facing applications by enabling clients to provide a single app for citizens to interact with their local government in multiple ways.

This acquisition will benefit our entire client base as MyCivic has applicability across most of our solution areas.

Its unified design brings together many different user groups, such as citizens, parents, public safety agencies and businesses, and its mobile platform enables rapid development and deployment for clients.

Most recently, on February 1, we signed a definitive agreement to purchase MicroPact, Inc.

The transaction will be the second-largest in our history at approximately $185 million in cash and is expected to close in the first quarter.

MicroPact is a leading provider of specialized, vertically oriented case management and business process management applications for government.

This acquisition augments our product solutions, positions us in new practice area, such as health and human services, and provides a platform to expand our business across new and complementary markets, most notably with the opportunity to significantly expand our total addressable market through MicroPact's strong federal and state presence.

Now I'd like for Brian to provide more detail on the results for the quarter and provide our annual guidance for 2019.

Thanks, Lynn.

Yesterday, Tyler Technologies reported its results for the fourth quarter ended December 31, 2018.

I'm going to provide some additional data on the quarter's performance and provide our annual guidance for 2019, and then John will have some additional comments.

In our earnings release, we've included non-GAAP measures that we believe facilitate understanding of our results and comparisons with peers in the software industry.

These measures exclude write-downs of acquisition-related deferred revenue and acquired leases, share-based compensation expense, the employer portion of payroll taxes on employee stock transactions and amortization of acquired intangibles.

A reconciliation of GAAP to non-GAAP measures is provided in our earnings release.

We've also posted on the Investor Relations section of our website under the financial reports tab schedules with supplemental information provided on this call, including information about quarterly bookings, backlog and recurring revenues.

GAAP revenues for the quarter were $242 million, up 11.2%.

On a non-GAAP basis, revenues were $243 million, up 11.5%.

Subscription revenues for the quarter increased 26.1%.

We added 81 new subscription-based arrangements and converted 8 existing on-premises clients, representing approximately $33.2 million in total contract value.

In Q4 of last year, we added 83 new subscription-based arrangements and had 19 on-premises conversions, representing approximately $44.4 million in total contract value.

The total contract value for new subscription contracts this quarter was impacted by our intentional reduction in the standard initial term for those contracts.

Subscription clients represented approximately 44% of the number of new software contracts in the quarter compared to 42% last year, while subscription contract value comprised 40% of the total new software contract value signed this quarter compared to 33% in Q4 last year.

The value-weighted average term of new SaaS contracts this quarter was 4.1 years compared to 5.4 years in Q4 of last year.

Transaction-based revenues from e-filing and online payments, which are included in subscriptions, increased 6.1% to $17.3 million from $16.3 million last year.

That amount includes e-filing revenue of $13.1 million, up 4.5% over last year.

Annualized total non-GAAP recurring revenues for Q4 were approximately $636 million, up 13.7%.

Our backlog at the end of the quarter was $1.2 billion, up 1.7%.

Backlog included $365 million of maintenance compared to $348 million a year ago.

Subscription backlog was $480 million compared to $475 million last year and includes approximately $118 million related to fixed-fee e-filing contracts.

Our bookings for the quarter, which are calculated from the change in backlog plus non-GAAP revenues, were approximately $248 million, a decrease of 13.3% from Q4 of last year.

For the trailing 12 months, bookings were approximately $960 million, down 5.8%.

We had a difficult comparison to Q4 of last year, which included a $21 million contract with the State of Kansas judicial branch.

Also, as we noted earlier, the weighted average term of new software subscription agreements this quarter was 4.1 years compared to 5.4 years last year, as we continued to move to standardize on shorter initial subscription terms for most of our software offerings to provide greater pricing flexibility.

The change in the term of subscription rate agreements was responsible for 2.1 points of the decline in bookings.

Our software subscription bookings in the quarter added $7.9 million in new annual recurring revenue, up 11.2% from $7.1 million last year.

For comparison, if all of our new subscription contracts had been under license arrangements, we estimate that they would have represented additional license bookings of approximately $8 million.

We signed 46 new contracts in the quarter that included software licenses greater than $100,000, and those contracts had an average license of $371,000 compared to 48 new contracts with an average license value of $468,000 in the fourth quarter of 2017.

Cash flow from operations grew 32.7% to $70.9 million.

Free cash flow, which is calculated as cash from operations less CapEx, was $66.9 million, up 39.2%.

Our CapEx for the quarter was $4 million compared to $5.3 million last year.

We ended the quarter with $232 million in cash and investments and no outstanding debt.

Day sales outstanding and accounts receivable was 111 days at December 31, 2018, compared to 102 days at December 31, 2017.

Excluding current unbilled receivables, DSOs were 78 days at December 31, 2018, compared to 80 days at December 31, 2017.

Our guidance for the full year of 2019, which includes the estimated impact of the pending acquisition of MicroPact, is as follows: We expect 2019 GAAP revenues will be between $1.08 billion and $1.10 billion; and non-GAAP revenues will be between $1.09 billion and $1.11 billion.

We expect 2019 GAAP diluted EPS will be between $3.54 and $3.69 and may vary significantly due to the impact of stock option exercises on the GAAP-effective tax rate as well as the final valuation of acquired intangibles.

We expect 2019 non-GAAP diluted EPS will be between $5.20 and $5.35.

For the year, estimated pretax noncash share-based compensation expense is expected to be approximately $62 million.

We expect R&D expense for the year will be between $82 million and $84 million.

Fully diluted shares for the year are expected to be between 40 million and 41 million shares.

GAAP earnings per share assumes an estimated annual effective tax rate of 10% after discrete tax items and includes approximately $27 million of estimated discrete tax benefits primarily related to share-based compensation, which may vary significantly based on the timing and volume of stock option exercises.

Our estimated non-GAAP annual effective tax rate for 2019 is 24%.

We expect our total capital expenditures will be between $54 million and $56 million for the year, including approximately $16 million related to real estate and approximately $6 million as capitalized software at MicroPact.

Total depreciation and amortization is expected to be approximately $75 million, including approximately $47 million of amortization of acquired intangibles.

Now I'd like to turn the call back over to John for his further comments.

Thanks, Brian.

The fourth quarter continued the elevated level of investment we exhibited throughout the year.

The strength of our balance sheet and consistency of our cash flow gives us a great deal of flexibility to deploy capital and create long-term value.

At a high level, in 2018, we invested a total of $391 million in cash on acquisitions, R&D and stock repurchases.

The purchases of MobileEyes in October and SceneDoc in December brought us to a total of 5 acquisitions completed in 2018 for a total cash consideration of $178 million.

While these acquisitions further the objectives that Lynn mentioned earlier, expanding our TAM, strengthening our product offerings, providing cross-selling opportunities and advancing our connected community vision, we're also making incremental investments in those businesses.

Those investments include accelerated R&D, particularly at Socrata, as well as investments in operating expenses to strengthen the acquired organization's ability to drive future growth.

As a result, the 2018 acquisitions in the aggregate were dilutive to earnings in 2018 and will be dilutive in 2019.

We believe those investments, while putting pressure on short-term operating margins, will contribute to future revenue growth and margin expansion.

As we discussed at the beginning of the year, we also significantly increased our R&D spend organically.

Total R&D grew 34% in 2018 to $63 million with a wide range of product development projects across our product suites.

While R&D expense will grow organically at a slower rate in 2019, this year will still be a year of elevated investment in product development.

With R&D and acquired companies, including MicroPact, we expect total R&D to grow in the 30% range in 2019.

Finally, we were very active with our stock repurchase program in the fourth quarter as we bought back almost 781,000 shares of our stock for a total of $150 million.

That amount exceeded the total amount we spent on buybacks in the last 6 years combined, reflecting our confidence in the long-term outlook for Tyler.

Over the last 15 years, we have taken an opportunistic approach for our stock repurchases and have been particularly aggressive several times when the stock has pulled back 15% to 20% as it did in the fourth quarter, and hindsight has shown these strategies to be effective.

In addition, our board has added 1.5 million shares to our buyback authorization, which now stands at 2.7 million shares.

Although our current investment cycle will put pressure on margins, we are confident that our long-term model of low double-digit total revenue growth, consistent margin expansion and strong earnings and cash flow remains in place.

Now we'll take your questions.

(Operator Instructions) And your first question will come from Brent Bracelin of KeyBanc Capital Markets.

One for Lynn and one for Brian, if I could.

Lynn, I wanted to start out with a question about the business as it matures and scales to this $1 billion kind of level, you're addressing, I think, a $14 billion TAM.

My specific question is around the whitespace initiative.

As you get to this billion-dollar scale, how much room is there to continue to kind of grow faster than the 5%, 6% kind of growth rate of the market?

How competitive is the opportunity?

And as you think about 5 acquisitions in '18, do you think that's kind of the right pace to continue to sustain above market growth long-term in -- given the size of the business and scale?

Yes, sure, Brent.

Thanks for the question.

Yes, I think, as we look out over the near term, 3, 4, 5 years, internally, we believe that we can continue to grow faster than the overall rate.

Acquisitions have certainly played a part of that over the years, and really when we look at the acquisitions we did in 2018, on some level, I call those somewhat investment acquisitions.

These are things that we -- we're buying, we're going to bring them in, we're going to invest in them and really, the ultimate goal is to provide and prompt higher growth rates than perhaps other parts of our business.

You asked about the whitespace initiative.

The whitespace initiative is where we identify things like some of the acquisitions that we brought in.

It's also one of the reasons why we in 2019 made the decision to buy MicroPact, the company that obviously moves us into new markets, gives us the ability to grow into new addressable markets.

So that's something that we've looked at very carefully.

Helpful.

And then I guess, Brian, if I just look at the e-filing business, this quarter 6% growth, down from 16% prior quarter and 22% last year, I continue to think of about e-filing as an emerging market.

So a little surprised to see kind of that single-digit growth there.

Walk us through the dynamics around e-filing, the slowdown there you saw in Q4 and then the opportunity for growth over kind of -- in '19 and in '20.

Sure.

I think 2 things.

One, the sequential slowdown is really a seasonal impact.

There's simply in the fourth quarter, particularly in December around the holiday, there's less activity in the courts, less filings taking place and to the extent that a large portion of that business is transaction-based with the per-filing fee, that affects -- that's a normal impact we see in Q4.

You may say, you looked back at last year and you didn't see that.

It was sort of covered up last year by some new clients that came onboard that provided growth that offset the seasonal sequential drop.

This year, we didn't really have any new clients coming on in the last quarter, and we do believe that, that's a market that still has a lot of whitespace, a lot of runway there.

A large portion of the e-filing market -- or potential e-filing market in the U.S. is wide open, that they're not doing e-filing today.

So with our run rate in the low $50 million range in a market that we believe is close to $300 million a year, we think that less than half of that market is currently penetrated, and we expect that, over time, we'll continue to add new e-filing clients.

But again, it's somewhat lumpy.

We actually do have a reasonable pipeline of, I guess -- I say pipeline, a bit of a backlog of e-filing arrangements that will come online once an underlying court system goes live.

But as I said the timing of those is somewhat lumpy, and we just didn't have any new wins come on this quarter.

I realize you also asked about the pace of the acquisitions in 2018.

It was a year of significant activity.

I wouldn't say anything specifically drove that.

The whitespace initiative has always identified things.

We constantly evaluate potential acquisitions.

It's something we've done 20 years I've been at Tyler.

If you look out over the 20-year history, we've done probably 40-ish plus acquisitions.

It just happened to be a year where a lot of things lined up.

We saw a lot of good opportunities.

We were able to make good fair deals.

We've gone through a couple of years where it was very hard to make a fair deal.

We've talked before about a lot of money in the -- coming into our space from the private equity world and things like that.

Bringing those acquisitions in is a stress on the organization, and we've talked a little bit about in the last year about our elevated -- plus about our elevated investments, and you hear me talk about these as investment acquisitions.

We've got a lot going on, on our plate right now, and our focus right now is to really execute on all these investments that we're making.

The next question will come from Peter Heckmann of D.A. Davidson.

Can we dig in a little bit more on the bookings for the full year, acknowledging that there have been some large deals that occurred in prior year periods that may be exacerbating some of the optics of softer bookings?

Can you get into a little bit more detail on deal slippage, perhaps any change in the sales force or sales force comp that may be affecting bookings?

And then as well, any change in the competitive dynamics or demand drivers?

And just -- and again, part of it is optics, but clearly, bookings were softer in 2018.

And so I'm just trying to figure out what are the factors that factored into that.

And then what's your outlook for this year?

I mean, can we catch up on those deals and put up a relatively stronger bookings year in '19?

Well certainly, as you note, bookings, particularly with respect to large deals, can be somewhat lumpy.

And I'd say that's probably the biggest factor this year in the lower level of bookings.

We had several large deals, a couple more -- what we describe as more megadeals, like a statewide courts deal, the Illinois e-filing research deal that took place last year.

Those are typically multiyear deals.

So those revenues get recognized over many quarters and sometimes several years.

So they continue to -- we continue to work out of that backlog.

Even just in this quarter, if you look at, it was a really good quarter for sort of our bread-and-butter midsized deals.

But if you looked at the top 10 deals -- top 10 license deals plus the top 10 SaaS deals this quarter, those totaled $35 million.

Last year, the top 10 -- or top 20 deals totaled $70 million.

So it really shows the impact of the large deals in there.

And I don't think there's anything fundamentally that's changed either in our sales organization or sales compensation in the market dynamics, the competitive landscape.

Generally, it's pretty consistent with where it's been.

There's certainly been some activity in terms of acquisitions and consolidations amongst some of the other players in the space.

But don't believe those have negatively impacted us, and in some cases positively impacted us.

There were -- the timing of deals, particularly in the public safety space, continues to be less predictable.

And some of these are complex deals with multiple jurisdictions involved.

And because a lot of that business is concentrated in the fourth quarter, Public Safety, in general, we had a good quarter for awards, but we had a fairly large number of deals that certainly had the possibility of closing in the fourth quarter that have slipped out of the fourth quarter, and several of those have closed already early in the first quarter.

Variety of reasons around those.

No systemic cause that -- in a sense it just goes with our market.

We do expect that, based on our guidance, based on the activity in the space, that we would -- and again, coming off a year with not really strong bookings, that we'll see better growth in bookings next year.

And the last point there really is that we do have an increasing number of revenues that don't really come in, in terms of a single contract.

So more of the recurring revenues, things like Modria, our online dispute resolution solution, that are transaction-based.

And so there's not a big contract at the front that the revenues -- the bookings hit as the revenues hit.

And to the extent those are a greater part of our revenue base, you don't see them show up in upfront bookings.

And then we, of course, pointed out the impact of the shorter term on subscriptions that also negative -- doesn't affect the annual revenues at all but affects the optics for the booking number.

Got it, got it.

And then just as a follow-up.

Just looking at R&D and noncash stock compensation last 3 years, both about stripped revenue growth.

I think you've talked a little bit about the R&D.

Is the stock comp just a reflection of the current environment for hiring, the current employment environment?

Or are there higher skill sets you're trying to achieve?

It's really just the way that's accounted for.

So you account for the stock options on a black field, that's not better than the volatility.

And the elevated price of our stock raises the amount that you actually expensed.

We're very, I think, conservative in the way we award options and now restricted units as well.

The total units awarded has come down over the years as a percentage of outstanding fully diluted shares.

Total units is just fractionally above 1% now, and when you consider that on a net basis or after proceeds from stock options and the tax benefit, it's under 1%.

So this is not a case of us awarding additional options or restricted units.

The absolute number and the number as a percentage of outstanding shares is something we track very, very closely, and it's actually come down over the years.

It's just a function of the way the accounting is calculated.

The next question will come from Alex Zukin of Piper Jaffray.

So maybe just starting on the guidance.

I think -- is it possible, Brian, to get a sense for what the expectations are for MicroPact that are embedded in the guidance?

And can you speak to maybe how we should be thinking about the growth of MicroPact in '19?

And also maybe the implied organic growth guidance that you've provided?

And I've got a quick follow-up.

Sure.

And besides MicroPact, there are the tail of several other acquisitions, including Socrata for the first quarter of the year that were made in '18 that are included in the inorganic growth in that number.

We've said MicroPact's revenues for the last year were a little north of $70 million, somewhere between $70 million and $75 million.

It's been in the last year a low single-digit grower.

We do expect that growth to accelerate over time, but our expectation in the first year is that it will be pretty modest growth.

And the midpoint of our guidance would imply organic growth in total of, I'd say, in the 8.5% to 9% range.

And again, relatively modest growth on MicroPact in the first year.

We do believe MicroPact will be neutral-to-modestly accretive in terms of earnings.

So it's -- but the 2018 acquisitions in the aggregate are -- continue to be dilutive in 2019.

Got it.

And then maybe just a quick follow-up, a 2-part question.

If you think about the organic growth guidance for '19 and you think about the backdrop of the demand environment, the competitive environment, the increased acquisitions that you've done, can you maybe just give us a sense for the level of conservatism in that guide and what could drive outperformance there?

And then the follow-up would be for John.

As we think about returning to kind of an -- returning to an ability to actually -- to be margin-leveraged again, not in fiscal '19, is that presumably a fiscal '20 event or is it even great -- further in the future than that?

Yes, I'll start with the factors in the guidance.

I don't think our philosophy has changed.

We generally try to be realistic in our guidance relative to our plan and take into account that -- what is a reasonably likely range of expectations in terms of opportunities and risks that are embedded in there.

Again, as in the last couple of years, probably the biggest factor in where we fall in that range is the mix between license and subscription in the new business market.

And we see, as our revenues have grown, we've widened the range a bit in terms of our initial guidance and we typically narrow it as we go through the year.

But because so much of our revenue now is recognized upfront on a license deal and certainly over time on a subscription deal, it has a pretty significant impact, as you know, how that mix falls out.

So that being the biggest factor.

Certainly, timing of deals as well.

We have pretty consistent win rates.

But once we win a deal and are awarded it, sometimes there are a lot of factors, particularly as we get into more and more larger deals that make the timing of ultimately signing it and recognizing it a little less predictable, and we've seen that particularly in the fourth quarters in recent years.

And the second half of the question regarding our elevated spend on R&D and other investments is certainly a very good question.

As we mentioned in our prepared remarks, the cash flow characteristics of the company are both very good and very predictable with high visibility.

And we certainly spend a lot of our time on how we want to deploy that capital.

And we've talked a lot about acquisitions, which we were successful on executing on in '18 and already off to a pretty strong start here in '19.

We're active again in our repurchase program.

And then kind of the third leg of that stool is the organic investment in the company internally, which has been elevated as well.

Obviously, the difference in those spends are organic investments, for the most part.

Virtually all of that is expensed through the P&L and it's elevated.

So it's a drag on earnings, whereas the other 2 are just seen as investments.

These are important investments.

We've got the capital to deploy, investing in our products, widening the moat and protecting ourselves against the competitive threats out there are things we feel strongly and, in fact, I think, it's something we probably do better than the other 2. We compete with a lot of [PE] owned assets, a lot of financial owned assets that can't necessarily just invest in products and build new products.

That's what we do and we do it well.

We have pretty good certainty on the outcomes.

And so I think we have a strategic advantage and we'll continue to do that.

The last couple of years have certainly been elevated beyond what we would've expected.

I think that's a reflection of the opportunity we've seen in our products, and we think it's a good investment to make, although again, it's elevated relative to expectations we may have set.

My expectation would be that this would normalize, that we would grow into the current R&D spend.

I don't see the absolute dollars coming down.

I see us growing into it, and therefore the margins expanding.

But I'd be cautious to say that it will happen later in '19 or in 2020 because if those opportunities are there, we'll fund them, and we certainly don't want to restrict it ourselves.

But my expectation would be that, yes, later this year, into 2020, more than likely we'll start to see that normalize and see the margins accelerate again.

But again, if we see valid opportunities for further investment, then we'll certainly fund those.

Lynn used the phrase a couple times on the call, acquisition investments, which I think what we mean, we acquire companies and then we invest in them.

And the focus usually are on the acquisitions we did last year or the year before, Socrata or these deals, which are not yet real constructive in terms of their contribution within the company.

But if you look back a few more years and you look at names like ExecuTime or Brazos or Wiznet, which became our e-filing product, or Brazos, names that are kind of big.

They all have revenues that are multiples of what their revenues were when we acquired them and margins that are probably at least double what they were when we acquired them and that's kind of the model.

So we're in an investment cycle now.

We have a record of both the inorganic and organic investments paying off.

We are on a high investment cycle.

We expect to grow into that over the next 18 months or so.

But again, we're not shying away from investment opportunities.

We're actually looking for them and when they're valid and credible, we'll continue to fund them.

So I appreciate that, that's a little uncertain, but that's the way we look at things.

Next, we have a question from Scott Berg of Needham & Company.

This is Josh Reilly, for Scott Berg.

So just starting off here.

How are you thinking about going to market with MicroPact once the transaction closes?

How do you plan to cross-sell that product into your existing customer base?

And then can you talk about how the acquisition expands your TAM and what your thoughts are with the opportunity to expand into the federal market?

Josh, good questions.

MicroPact's got a pretty extensive sales force in their markets.

They also have been fairly successful with a partnership model.

They've been developing that for a number of years.

It's something that we have not historically done.

It's -- they're starting to see some traction with that and some success.

I expect them to continue to sell in their market the way they've historically sold, and expect that over the coming years, we'll learn some competencies from them.

In terms of cross-sell, I don't believe there's any necessarily immediate cross-sell opportunities.

We have products that will certainly play in the space that they play.

Good example is Socrata, they're already in the federal space, already in a lot of these agencies where they're at.

And I expect those opportunities to arise.

I'll let Brian talk a little bit about the TAM that we've seen with MicroPact.

Sure.

MicroPact focuses on the case management, which is their interpretation there, is much broader than our historical interpretation where we focus on court case management, but broadly case management and business process management.

That market, we believe, in total is about an $8 billion market in the U.S., of which about $2 billion is in the government sector.

So that's really the TAM expansion that we see immediately from MicroPact.

So that's not at all in our space.

And about roughly half of that, about $900 million of that government TAM, is in the federal space and about $1.1 billion is in the state and local space.

And that really is the expansion that we get immediately from the MicroPact acquisition.

And next, we have a question from Rob Oliver of Baird.

One for Lynn or John to start and then, Brian, a quick follow-up for you.

I just wanted to step back a little bit.

I know at the beginning of the response to Brendan's question, you guys talked about the whitespace initiative.

But I just wanted to understand a little bit better just the thought process and rationale about the expansion into federal.

Obviously, you guys really dominate local and municipal, federal is a much more competitive area with a lot of embedded players.

And I know MicroPact is a software solution, which it looks like can be leveraged across multiple areas and likely potentially on the HHS side into your core base as well eventually.

I'd like to hear about that.

But just, wanted to just step back and maybe get your thoughts on this move with Socrata and now MicroPact into federal?

Sure, Rob.

And I guess, I want to caution, while they do a significant amount of business in the federal space, they're not limited to the federal space.

They also play more at the state level, where we're not really active.

While we have some statewide engagements, we don't really play at the state agency level.

I would say that historically, over the years, we've looked at both the federal and the state market as something of interest to us.

It's adjacent to our market.

But frankly, we've never really found the right opportunity to make the move in that market.

And when we looked at the company like MicroPact -- and again, we've looked at a lot of companies over the years.

When we looked at a company like MicroPact, it looked a lot like Tyler.

It looked a lot like the kind of company going back 20 years ago when we would maybe go into a new space, whether it be moving into Appraisal & Tax or in the courts space or whatever.

We were looking for sort of a flagship company, good solid revenue base, good products, but most importantly, really good strong management team, a team with a culture that's very similar to Tyler.

We take moving into a new space very seriously and not something that we would certainly dip our toe in lightly, which is why we've really sort of waited for the right player.

MicroPact checked all those boxes.

We spent a lot of time with these people, really got to understand the market, understand the things they do well.

We believe it's a really good complementary fit.

I do believe long term there are some other opportunities, as you mentioned, Socrata as well.

But I think it's just a natural extension.

We're still focused on public sector.

That's what we've always done.

We believe they've done a great job in the federal space as well as the state space.

I think what's interesting about them as well is that they're -- when we looked at companies in the past, they have tended to be a more project-oriented as opposed to product-oriented, and that's certainly away from our business model.

The fact that they are a product-oriented company also really aligns with our underlying business model.

So we saw those synergies, and we think it's going to be good long term.

Great.

And then Brian, just a quick follow-up for you.

I know you've mentioned throughout the call just some of the impact or headwinds from the shorter durations, impact of bookings for shorter durations.

I just wanted to get a sense for, there's likely a positive at the other end of this with some more flexibility on price for you guys.

I just wanted to talk a little bit about what you're seeing on the pricing side and kind of what you expect to see play out there on the shorter durations.

Sure.

Yes, with our software subscription arrangements, typically, those contracts are -- very often they are a fixed annual fee for the initial term.

And so there's not -- even though in the economics, there may be embedded annual increases that are averaged out to get a level of annual payment, and therefore, level of annual revenue recognition, they're -- they effectively don't show growth during that initial term.

So we have a chunk of revenues with each of these contracts that doesn't grow until it gets to the end of the initial term.

And then we expect that, generally that we would have increases that are similar to the kinds of increases we get in maintenance, low to mid-single-digit annual increases that encompass an increasing level of features and functionalities that they get through the Evergreen model that we deliver our software under.

So it does a couple of things.

It shortens the period in which -- that we have that no growth revenues and gets us on a regular cadence of increases more rapidly and provides us with long-term flexibility that we're not locked into pricing for 5 years or 7 years and there could be uncertainty over our costs over that period.

So you're correct that as our older, longer-term subscription arrangements roll off and we get on a cadence of more regular increases in that base of revenues, it should go from a headwind to revenue growth to providing a benefit to our annual revenue growth.

The next question comes from Jonathan Ho of William Blair & Company.

I just wanted to maybe dig in a little bit in terms of how you see the opportunity to maybe accelerate the growth around Micro focus.

Is this a function of investing more in the product?

Are there other things that you can do?

And what do you ultimately see as sort of the ability to, I guess, invest in Micro focus just based on what you've seen today?

Yes.

Thanks, Jonathan.

As I mentioned, we will continue to invest in MicroPact.

They have been going through a little bit of a re-platforming of their product.

And I believe -- and it's showing well, it's already been sold, it's out in the market, it's doing really well.

I think if that product continues to become more robust and more configurable, it will help accelerate growth.

Like we said, they've been working on a partner network for a number of years that is starting to bear fruit.

They have some international opportunities that are coming out of that partner network.

So I think the market's good.

Their position in the market's good, both in the federal and the state, and we see it as a good growth driver down the road.

Got it.

And then just in terms of the follow-up.

I guess, when we look at sort of the duration impacts to bookings in 2018, do we expect there to be further, I guess, reduction in the duration in 2019?

Do we just sort of flat the current effects?

I mean, I just want to get a sense of how that will extend from the '18 to the '19 time frame?

I think, there's probably a little impact ongoing.

There's a mix of -- and we really kind of put the new standard terms in place in the first quarter, but you have proposals out there already of contracts in process and that takes a little while before you've sort of fully rolled it out.

We certainly have some contracts that are longer than that, longer than the standard 3-year initial term.

We have some that are shorter.

In some aspects, we have 1-year subscription arrangements.

So I think it will continue to, sort of, sort itself out.

I don't think it will be as dramatic.

We seem to be settling in closer to this 4-year average term.

But I think, because we didn't really start it with a hard start on January 1, there will be some continued impact until we settle in at the level that we'll ultimately be at.

The next question will come from Keith Howson of Northcoast Research.

This is Brendan, on for Keith.

Guys, I just want to ask a quick question about the New World product.

You've mentioned before, you're thinking about how to upgrade capability to target the Tier 1 space, and I'm just trying to get an update on how far along you guys are in those efforts?

And anything specifically that you had to do to upgrade the product?

Yes, Brendan.

We're continuing to invest in the New World products.

I guess, the short answer is that those investments are paying off.

We've seen significant product adoption in our sales this year, both across-the-board and records and our [patriot mobility].

We see increases in our pipeline right now that are up significantly year-over-year.

We talked earlier about some deal slippage.

That's kind of the good news, bad news about what we've been doing, is we've actually been expanding our market, we've been expanding the pipeline so there were a greater number of deals that we were trying to chase in Q4.

It's an evolving process, just like a lot of development efforts, but we're continuing to invest, we're continuing to make progress.

I don't think it's something that you say overnight, now we're there.

That's not sort of the way an R&D works.

We just -- we keep investing and we keep growing the TAM.

I think the key is back when we acquired New World as we went into 2017, so 2 years ago, we launched a couple of major development efforts that -- with respect to public safety.

And they're both adding features and functionality.

It's separating ourselves from the other competitors in our traditional mid-market space, but also adding that functionality that we needed to compete effectively at the upper end of the market.

And those projects are well along, and we've had releases along the way.

We've certainly seen impacts very positively on the win rates in our traditional mid-market space.

And I think we're just now getting to the point where we think that we have the ability now to actually check off the boxes in larger opportunities, and say, yes, we have -- we meet those requirements.

But having said that, the time line is long.

So if we respond to, say, an RFP in a larger opportunity early in 2019, that decision may not be made until late 2020 given the length of the sale cycles, and they are longer in larger deals.

So you could -- it could really be 2021 before you start to see real awards in revenues from those upper-tier customers, and literally 4 to 5 years after we launch the development projects.

So this is a space that requires patience that we have, and we see progress along the way that we're very pleased with but actually seeing it show up in financial statements is a long prospect.

Our next question comes from Kirk Materne of Evercore ISI.

John, I appreciate sort of your color and sort of -- around M&A and sort of the philosophy on that.

I was wondering though if you could just give us any color, or you and Lynn could give some color actually, on what you guys think about sort of, from a return perspective, on M&A.

Meaning as you stack these deals on top of each other, we don't necessarily get to see the kind of return New Word has had from a profitability perspective.

And given how fragmented your market is, I'd say there's almost a never ending opportunity for you all to do M&A.

So how do you think about getting the right return on prior deals before going into a new one?

I'm sure there's some thought process there, but if M&A is going to be a more regular part of the dialogue, it would just be helpful to have some color on that front.

Yes.

It varies based on the types of deals we're doing.

As we've said in recent years, we've really shifted largely away from consolidation plays, which really was more of an intrinsic valuation approach and return on the assets you're purchasing the way you might think.

So we're very disciplined in that case, multiples of EBITDA and sales and what they might do for us and discounting cash flows further on kind of a traditional approach to that.

There aren't a lot of significant consolidation plays out there doing very small -- there's a lot of $3 million, $5 million, $8 million companies with 60% of the revenues are recurring of the book you're buying.

And there just isn't a lot of that.

There's a lot of PE firms and even a couple of public firms that target those.

We have really moved away from those, which really employed more of the traditional return-on-investment approach that you're alluding to.

I won't say we're not disciplined.

I think we've always been disciplined and certainly moved out on some deals because of that discipline.

But we've certainly, I guess, loosened a little bit our model on strategic acquisitions, especially smaller strategic acquisitions.

So I mentioned ExecuTime earlier, probably a few of us even remember that acquisition from a number of years ago.

Very small, few million dollars in revenue.

We bought it at a reasonable price point.

But the reality is, when 5 years later, those revenues start to accelerate and the revenues are several times what they were acquired at and margins start to expand because of the scale, they've improved the competitive position of your other products in those areas, like Munis and Incode -- and you could say it almost doesn't matter too much how much you paid for them initially.

So it's a difficult thing to quantify on the strategic side, and I would say, Wiznet, we paid $10 million for that, and it's obviously our e-file products are worth hundreds and hundreds of millions, maybe you could argue $1 billion in our total segment of -- our total market cap.

So those were the deals we're looking for, and that's the way we look at it.

In 5 and 6 years out, when they hit scale, when they're growing at a good rate, when their margins are Tyler-like and then you back into what their proportionate valuation within Tyler's $8 billion market cap is, they're very, very compelling.

And those are the deals we're looking for, those -- that's why we invest in them in those early years after we acquire them, and we're looking for that kind of a return down the road.

Well, it makes a ton of sense.

I guess, the question is, is this just, in the next 3 or 5 years, getting the opportunity in front of you, the operating margin, certainly expansion story.

I think, longer term that seems to still make sense, but it seems like in the near term, maybe call it 3 to 5 years, if this is going to be more of an investment mode for you guys, operating margin is a little bit secondary to getting the right assets in the right portfolio put together.

Is that fair?

Maybe.

But you're going to have a hard time getting our management team to -- we really -- we work real hard to support these investments.

And I'll be honest with you right now, I appreciate the market likes investment.

You follow a lot of companies that aren't that focused on margins.

Some aren't even profitable and are highly valued.

We're really not culturally that kind of company.

So for us to support those investments, we really have to be convinced and have a high level of confidence that it's going to pay off.

We refer to this as a cycle.

I think we're in a high investment cycle right now.

There are a number of opportunities in our own core products as well as these acquisitions we've done and the incremental investments that should be made in order for them to realize the potential that we're supporting.

I think that cycle will cycle out, and we'll be in a period of time.

So right now, ideally, you have the right balance all the time, whatever it is, 80% or have reached some level of maturity that we've scaled, the margins are expanding, et cetera, et cetera, and you've got the right level of investment organically and inorganically.

Right now, we've got a higher percentage of that in the investment mode, and that's putting some pressure on margins.

I think that pendulum will swing back and forth and will return certainly to an expanding margin situation.

I took exception of one word in the script, it said consistent margin expansion.

Well that's not really what we have.

I think, over the long term, we have certain margin expansion but it is a little inconsistent.

That's really helpful.

And if I can sneak one in for Brian or for all of you.

Just on the buyback, obviously, the MicroPact acquisition will draw down some of your liquidity.

Would you all go into a sort of debt position to fund the buyback if the situation sort of unveiled itself?

I'm just kind of -- how, I guess, how bound are you by sort of your cash balance as it relates to a buyback?

I think Peter -- or Kirk, the answer is absolutely yes, we would, depending on the opportunity.

If you look at our history, we've done it before.

We did it 6, 7 years ago.

We took out a line of credit specifically to buy back stock and tapped that line to do so.

So the good news is we do experience good cash flow.

Our cash flow is fairly certain and predictable in the out year.

We take that into account when we look at all of our investments, including acquisitions and stock buybacks.

So we're certainly not -- we wouldn't be timid if the market opportunity was there.

So we -- like I said, we've done it in the past.

Yes.

You can look back to early '16, the last time we were really active in that first part of '16, and we had some debt on the balance sheet following the New World acquisition.

And we used more debt to buy stock back when we thought there was a more compelling opportunity in the short term.

I don't think we'd ever be, what you described as, heavily leveraged for buybacks.

But we're not opposed to using debt if we see the opportunity is compelling enough.

Just to add on to those though, Kirk.

What we've done in the past, as Brian and Lynn both indicated, we certainly would be comfortable.

We maintain the working capital line now so we have plenty of access to capital.

But we also know the kind of investors we attract, investing in quality companies, and part of that is a strong balance sheet.

So I think, as Brian said, we would never be over-levered.

And I think more than likely debt would incur to do an acquisition, a repurchase of stock or whatever investment we felt was compelling enough to support, would be pretty much on a temporary basis but a permanent debt situation is unlikely for us.

Our next question comes from Peter Lowry of JMP Securities.

Two quick questions.

First, of the several slipped Public Safety deals that have closed subsequent to Q4, is that a pace that is encouraging, discouraging or neutral at this point in the year?

And then second, can you remind us the mix of which revenue line items the MicroPact acquisition will show up in?

Yes, sure.

I think, it's probably neutral.

The timing of -- the deals we had been awarded going into the fourth quarter or were awarded in the fourth quarter, some of those get -- and that really happens every quarter.

We have deals that slip for a variety of reasons.

There are a lot of factors around doing business in the public sector, even down to when is that last council meeting, and did the city attorney get it on the agenda, are you able to round up all those signatures in time.

And sometimes the urgency isn't there on the client's part or -- and those deals slip.

We see that a lot of times, where in the fourth quarter though, where Public Safety has a bigger proportion of its business and has a bigger impact.

And -- but I don't think it particularly changes our plan this year.

We'll likely see the same scenario next year in the fourth quarter.

And so I'd say it's relatively neutral.

The MicroPact revenue mix, their business is -- actually their mix is fairly similar to the Tyler mix.

They're about -- I'd say, their plan for this year is somewhere around 17% of the revenues are licenses, about 30% services, a little bit heavier on services, 10% subscriptions, low to mid-40, 43%, say, maintenance.

So not too dissimilar from Tyler's current mix.

And Peter, on the Public Safety deals, I think when -- this happens all the time up and down our market, and we have lots of divisions where deals come in, deals go out.

For Public Safety, is -- I think is the volume of deals, is what we've been talking about last couple of years, as their win rates go up, the volumes going up, the number of deals in their pipeline, I think you'll just start to see some of that balance out to where when deals start slipping, they actually start getting sort of funneled back on the other side.

And I would expect that as you look out over time, you have less of this sort of discussion or focus on that.

The next question comes from Mark Schappel of Benchmark.

Brian, a question for you on the Public Safety business, kind of a follow-up to the prior question.

But this business has kind of had its ups and downs here, and I'm just wondering if you can just give us some ideas of some of the changes you're making in that business with respect to your go-to-market activities as well as maybe product development to try to get that business to perform a little better?

Well, I think, over the time since we've acquired New World, we've made some changes in their sales organization.

We have a different sales leadership there.

I think we've aligned some of the sales processes more closely with the way Tyler has historically done things.

But they're executing very well.

I mean, the win rates have basically doubled since the time we acquired them to where they are today.

I think that's a combination of the investments we've made in the company organizationally, the support organization, the sales organization.

Certainly, the investments we're making in the product are clearly having an impact on the market, that roadmap and those things that we've released along the way.

And I think the Tyler brand, the integration with other Tyler products, particularly our Courts & Justice, SoftCode, Brazos, all of those things have a positive impact on there.

So it is a market that is highly competitive.

It's a market that also is a little more seasonal in terms of the activity towards the latter part of the year.

But I think we're pleased with the progress we've made with the execution in that division, and I think some of this just sort of short-term inconsistency will play out, and this is going to be a business that, over the longer term, grows faster than Tyler's core business.

Right now, that's not the case.

But we, as we've talked about, some of these other investments where we make investments in acquired companies and it's a multiyear process to see those pay off.

As we look at the milestones that we've accomplished along the way, we feel very good about where the Public Safety business is today.

At this time, there appear to be no more questions.

Mr. Marr, I'll turn the call back over to you for closing remarks.

Okay, thank you.

And thank you all for joining us on the call today.

We appreciate your interest.

And if there are any further questions, feel free to contact Lynn Moore, Brian Miller or myself.

Thanks again, and have a great day.

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