Tyler Technologies Inc Q2 FY2024 Earnings Call

Hello, and welcome to today's Tyler Technologies Second Quarter 2024 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, July 25, 2024. I would like to turn the call over to Hala Elsherbini, Tyler's Senior Director, Investor Relations. Please go ahead.

Thank you, Matt, 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 update our annual guidance for 2024. Lynn will end with some additional comments, and then we'll take your questions. During this conference 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, including information about quarterly recurring revenues and bookings. 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. Lynn?

Thanks, Hala. We built on the momentum from our strong first quarter performance to, again, deliver exceptional second quarter results marked by consistently high execution and a continuation of solid operating and financial performance. Each of our key metrics across revenues, earnings, operating margin, and cash flow exceeded our expectations. These results are especially meaningful given the significant shift towards SaaS in our new software contract mix, which pressured revenues and margins. Recurring revenues grew 8.4% and comprised 83% of our total revenues. SaaS revenues grew 23.2%, our 14th consecutive quarter of SaaS revenue growth of 20% or more above our target of a 20% CAGR in SaaS revenues through 2025. In addition, transaction revenues were ahead of plan driven by higher transaction volumes, including an increase in e-filing volumes and expanded payment services. Since committing to our cloud-first strategy in 2019, we've been intently focused on supporting our public sector clients' digital transformation and guiding their migration to Tyler's next-generation cloud applications. Last year, we reached an inflection point where valuable, long-term recurring SaaS revenues surpassed on-premises license and maintenance revenues. We're pleased to reach another milestone as we have now essentially completed the exit of our Dallas data center. This move is a significant achievement in our cloud migration roadmap as we continue to scale our deployments at AWS and drive more durable growth and margin benefits from our SaaS-based operating model. The public sector market remains healthy, characterized by high levels of RFP and sales demo activity. Our new business pipeline remains at elevated levels, reflecting the robust market environment, growing cross-sell opportunities, and continued strong execution by our sales organization. Our leading market position and competitive strengths, including our deep domain expertise continue to differentiate us in the marketplace. These strengths underpin our long-term strategic focus on four key growth drivers, leveraging our unmatched installed base, expanding into new markets, completing our cloud transition, and growing our payments business. Our large client base represents one of our most significant assets, and we're pleased to see strong go-to-market execution with significant cross-sell and upsell wins during the quarter, which included a joint effort with our Justice Group, leveraging our Digital Solution division's strong relationships in Florida for an agreement with the Florida Department of Corrections to manage all aspects of money transfer services for correctional facilities across the state. The contract brings together disbursement solutions from our Rapid Financial Solutions acquisition, inmate trust and accounting, and e-communications from the VendEngine acquisitions and payments through our Digital Solutions division. A single-sourced enterprise supervision and enterprise public safety contract with Cherokee Nation, Oklahoma, adding to its existing enterprise ERP solutions. The SaaS agreement was a joint collaborative sales effort resulting in a total Tyler client win. Additionally, we continue to innovate and elevate our clients' resident engagement experience by empowering citizens with direct connections to government through Tyler's MyCivic platform. In Mississippi, we expanded citizen access to mental health resources with the Mississippi State Department of Health, leveraging our state enterprise agreement. We continue to advance our cloud transition and make substantial progress with our product version consolidation efforts, which will accelerate our continued migration of on-premises clients to the cloud. We're also pleased with the numerous second quarter SaaS contract wins, which underscore the public sector market's recognition of cloud benefits, including enhanced security. One of the key themes that emerged during client interactions at our recent Connect 2024 user conference was a notable shift in client openness to embrace cloud technology and a growing expectation among on-premises clients that they will migrate to the cloud. This shift is especially apparent in the state and federal market with our application platform and in the public safety market, where 90% of second quarter public safety contract value was SaaS compared to 13% a year ago. Primarily as a result of this accelerated shift in public safety cloud adoption, SaaS arrangements comprised 97% of our new software contract value in the second quarter. Additionally, we signed 111 flips of on-premises clients, including a number of larger clients, with the average ARR flips growing 21.8%. We also had a very successful go-live in May with the SaaS migration of the Idaho State Court system. This is our first flip to the cloud of a statewide court system, and Idaho went live just four months after the project kicked off. This high-profile migration has been watched closely by other statewide and large county courts, and its successful execution is certainly a positive reference point as we engage with other large core clients about moving to the cloud. Key second quarter new SaaS deals and flips included a competitive win with the City of Topeka, Kansas for multiple integrated solutions, including enterprise ERP, enterprise permitting & licensing, and enterprise asset management for nearly $700,000 in ARR. And ERP Pro and Payments contract with Richland County, Wisconsin, funded via ARPA funds. That was executed on an accelerated 90-day sales cycle, leveraging our enhanced sales enablement and competitive intel teams. The Idaho State Police signed a SaaS contract for our integrated enterprise public safety suite including CAD, records management, and e-citations. This Tier 1 competitive win demonstrates our growing momentum with state public safety agencies and represents the sixth state police agency to adopt our enterprise public safety solutions. The United County, New York Department of Emergency Services also chose our integrated Public Safety Suite for 64 agency client-driven SaaS deployment. Hunt County, Texas, upgraded to Enterprise Public Safety from our Public Safety Pro solution, and Spotsylvania County, Virginia, signed a contract for our enforcement Mobile Solutions, joining eight of the 14 largest Virginia agencies using Tyler Public Safety applications. We signed an enterprise justice SaaS flip with Fulton County, Georgia, which includes Atlanta. The contract with ARR of $1.9 million follows Fulton County's Enterprise appraisal and tax SaaS flip signed in the first quarter and includes integrated justice solutions such as prosecutor and jail as well as additional client management services under our unified One Tyler approach. We also signed an enterprise supervision expansion with the Arizona Supreme Court that builds on the success of adult probation to add juvenile probation for all 15 counties across the state. We leveraged the state relationship, which led to a five-year enterprise justice agreement with the Phoenix Municipal Court, representing in excess of $2.25 million in ARR. This strategic and highly competitive win includes five one-year extension options and paves the way for expansion and new court software opportunities in a large population state. Another theme coming out of Connect '24 was pronounced interest in AI and our expanded AI capabilities that were added through our 2023 acquisitions. High interest is turning into multiple new deals and cross-sell wins for our application platform, leveraging our augmented field operation solutions, formerly ARInspect with four inspection SaaS arrangements in the quarter across state, environmental, health, and regulatory agencies. These included the California State Board of Pharmacy to configure and automate five regulatory inspection types, the Kentucky Department of Environmental Protection, the New York Department of Health, and the Arkansas Department of Labor and Licensing, which was a cross-sell win leveraging our Digital Solutions division's state enterprise relationship. Another key to our growth strategy is expanding our differentiated payments business. And similar to our first-quarter results, higher transaction volumes contributed to better-than-expected transaction revenues. In the second quarter, we signed 195 new payments deals across Tyler Software clients, representing approximately $8 million in projected ARR. In our state enterprise portal business, we secured extensions for our digital government and payment processing services under four state enterprise contracts, including Hawaii, New Jersey, Kansas, and Kentucky, and also won a sole-source award with the state of Rhode Island as no extensions remained under the previous contract. We also signed a two-year renewal with the state of Illinois for our Outdoor and Enterprise Licensing Solutions. Now I'd like Brian to provide more detail on the results for the quarter and our updated annual guidance for 2024.

Thanks, Lynn. Total revenues for the quarter were $541 million, up 7.3% and organically grew 6.5%. Subscriptions revenue increased 12.1% and organically rose 11.8%. Within subscriptions, our SaaS revenues grew 23.2% to $156 million and grew organically 22.5%. Keep in mind that there's often a lag from the signing of a new SaaS flip or SaaS deal or flip to the start of revenue recognition that can vary from one to several quarters. Because of this, as well as the timing of SaaS renewals and related price increases, SaaS revenue growth both year-over-year and sequentially may fluctuate from quarter to quarter. Transaction revenues grew 3.8% to $177.7 million. Transaction revenues exceeded our plan, primarily due to higher transaction volumes from new and existing clients, including recreational licenses such as hunting and fishing, which begin their peak season during Q2. In addition, e-filing revenues grew 11.2%. The year-over-year comparison for transaction revenues continued to be impacted by the change in mid-2023 from the gross model to the net model for payments under one of our state enterprise agreements. This will no longer be a factor in year-over-year growth comparisons in the second half of the year, and our expectation is for mid- to high teens growth in transaction revenues in the second half of 2024. SaaS deals comprised approximately 97% of our Q2 new software contract value compared to 82% last year. During the quarter, we added 203 new SaaS arrangements and converted 111 existing on-premises clients to SaaS with a total contract value of approximately $127 million. In Q2 of last year, we added 170 new SaaS arrangements and had 94 on-premises conversions with total contract value of approximately $93 million. More importantly, the average ARR associated with our Q2 flips increased 21.8% over last year as larger clients such as Fulton and Clayton Counties in Metropolitan Atlanta, Georgia; the cities of Tucson, Arizona and Birmingham, Alabama; and the Columbus, Ohio City schools flipped to the cloud, including transaction revenues, expansions with existing clients and professional services, total bookings increased 7.3% on an organic basis. Our total annualized recurring revenue was approximately $1.8 billion, up 8.4% and organically grew 7.8%. In previous quarters, we discussed our expectation that 2023 would be the operating margin trough from our cloud transition and that 2024 would mark a return to operating margin expansion. Our non-GAAP operating margin in the second quarter was 24.5%, up 150 basis points from last year. The margin expansion reflects improved margins from our cloud operations, along with effective operating expense management and improving professional services margins. As we discussed on previous calls, merchant and interchange fees from our payments business under the gross revenue model have a meaningful impact on our overall margins as they are passed through to clients and are included in both revenues and cost of revenues. We incurred merchant fees of approximately $45 million in Q2. Because of strong earnings and effective working capital management, both cash flows from operations and free cash flow were above expectations for the quarter at $64.3 million and $48.6 million, respectively. Cash flow in the quarter was impacted by approximately $29 million of incremental cash taxes due to Section 174. We ended the quarter with $600 million of convertible debt outstanding and cash and investments of approximately $262 million. Our net leverage at quarter end was approximately 0.65x trailing 12-month pro forma EBITDA. Our updated 2024 annual guidance is as follows: We expect total revenues will be between $2.120 billion and $2.150 billion. The midpoint of our guidance implies organic growth of approximately 9%. We expect that merchant fees will be up approximately 6% over last year, and that implied organic growth, excluding merchant fees, would be approximately 20 basis points higher. We expect GAAP diluted EPS will be between $5.76 and $5.96 and may vary significantly due to the impact of discrete tax items on the GAAP effective tax rate. We expect non-GAAP diluted EPS will be between $9.25 and $9.45. We expect our free cash flow margin will be between 18% and 20%, including an estimated impact of approximately $60 million of incremental cash taxes related to Section 174. Other details of our guidance are included in our earnings release and in the Q2 earnings deck posted on our website. Now I'd like to turn the call back over to Lynn.

Thanks, Brian. Our exceptional performance in the first half of 2024 positions us well for a strong second half. We're pleased with our progress across all fronts as we remain on track with key initiatives around our four-pronged growth strategy while demonstrating our competitive strength and model durability. Our cloud transition is beginning to generate the expected benefits of margin improvement and enhanced client experience. As you know, in 2019, we launched a multiyear cloud strategy to shift our solutions and operations to a cloud-first business model, leading our clients to a future in the cloud. As we enter the next phase of our cloud journey, and as more new and existing clients embrace our cloud strategy, we see increasing opportunities to prove areas critical to our clients that ultimately affect client satisfaction, including product release cycles, product consistency, performance reliability, and cost-effectiveness. To effectively address these areas and lead this change, I'm pleased to share that Russell Gainford has been promoted to Chief Cloud Officer, effective immediately. Over the past three years, Russell has proven his ability to own the overall vision for Tyler's cloud-first strategy. And in his new capacity, he will continue to drive our cloud initiatives across our organization, including developing our cloud technology and operation standards, controls and business processes, overseeing our strategic business partner and vendor relationships as well as architecting the organizational design and staffing plans in collaboration with operational leaders. Shifting to capital allocation, our disciplined approach bolsters our strong balance sheet as we've repaid our term debt during this period of higher interest rates. This coupled with our ability to consistently generate strong free cash flow provides tremendous flexibility to take advantage of opportunities to make investments that drive shareholder value, including product development, M&A and potentially stock buybacks. And while the bar is currently high for acquisitions, we continue to evaluate strategic tuck-in acquisitions while building liquidity to be in a position to address our convertible debt maturity in March of '26. I'm also pleased to highlight that Tyler recently was recognized by two leading publications as we were included on Times list of America's best midsized companies and Forbes' Best Employers for Women's list. Before I close, I'd like to welcome our two new board members, Margot Carter and Andy Teed, who were elected at our May 9th Annual Meeting. Margot brings a wealth of experience in cloud software and SaaS transformations, AI and payments. She currently serves as President of Living Mountain Capital, where she invests in and advises companies and private equity firms on digital transformation and innovative strategies. She has an extensive background in finance M&A and corporate governance and has served on several public company boards. Andy is a seasoned technology executive with significant public sector experience. He currently serves as the CEO of Eco Parking Technologies, an integrated lighting and parking guidance company. Prior to that, Andy spent nearly 20 years at Tyler in various senior leadership roles. His extensive public sector experience and familiarity with our products and clients along with his knowledge of cloud technologies, make Andy a valuable addition to our Board. I also want to thank our two outgoing Board Directors, Dusty Womble and Mary Landro for their years of service and contributions to Tyler's success. Finally, I'd like to express my appreciation to our entire Tyler team for their hard work and continued commitment to driving growth while leading our clients on their digital modernization journeys. Our leadership is aligned with a unified focus on cloud living, and I've never been more confident in our prospects and Tyler's future. Now, we'd like to open the line for Q&A.

The first question is from Alexei Gogolev with JPMorgan. Your line is now open.

Thank you, Brian. Congratulations on great results. Brian, I was wondering about the components of higher CapEx, what were they? If you could elaborate on that? And why are we seeing some decline in R&D? And does this have anything to do with your plans to reallocate certain R&D components? Remember, you were saying you were planning to do that for COGS going into OpEx?

Those two are related, but they are not connected to any reclassification of R&D. They are interrelated in terms of our various R&D projects. Some of these projects require capitalization, while others are expensed. Occasionally, there is a shift between these two categories. Therefore, a higher portion of our development costs is being capitalized, and a smaller portion is being expensed to R&D. This is simply a shift between capitalization and expense based on the nature of the projects.

Understood. And then the second one about your AWS contract renewal. Could you elaborate on the potential benefits to gross margin and whether you think there will be a one-off benefit or do you expect to unlock more discounts as you progress through the contract?

Yes, Alex. I believe there are a few factors at play. We recently signed a long-term extension, and as we continue to guide more of our clients to AWS and increase their spending each year, we receive additional discounts. I expect these discounts to keep coming. Additionally, we're seeing operational efficiencies from product optimization as we optimize and consolidate our operations on AWS, which we've previously discussed. There are multiple factors involved, but I do anticipate that our gross margins will improve in the future. While I can't say this will happen in the next 12 months, I expect that over the next six to seven years, in line with our Tyler 2030 vision, several of our gross margin lines will enhance. We're making progress on all these fronts.

Next question is from the line of Matt VanVliet with BTIG. Your line is now open.

Continuing to have more success at the state level, curious how much of that's being driven by the integration more holistically on the sales team with the NIC team and sort of some of those hunting licenses versus the product maturation and the acceptance of cloud at that level. And as you look on a go-forward basis, how much of these deals are having sort of multiproduct together to where the more, I guess, combined sales effort is paying off here?

Yes, Matt, you raise a valid point. We are definitely experiencing increased momentum, especially in cross-selling within that sector. This reflects the longstanding relationships our DSD division has built and our intensified effort in capitalizing on them over the last few years. We've made several changes, such as adjustments in compensation and sales commissions, as well as executive leadership pay, aimed at breaking down barriers and enhancing cross-selling opportunities. We are witnessing a growing number of multiproduct deals, which I mentioned in my earlier notes. This aligns with my ongoing vision of operating as a cohesive company, eliminating any internal barriers that may have previously impeded cross-selling and upselling. We are beginning to see the benefits of this strategy as relationships continue to strengthen and become more productive.

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

Great. Lynn, my question is for you. Just a rapid and somewhat stunning, I guess, I would say, having followed you guys a long time increase in public safety customers' willingness to adopt the cloud. And you guys clearly are right there to address that opportunity. I was just wondering this is one of the areas within core Tyler that has been historically the most competitive. And I think somewhat of a modest concern for investors. I was hoping you could address the extent to which this cloud move is really underscoring competitive advantages for you guys, perhaps the relationship with AWS as you take a sector of your market that historically was somewhat more reticent to move to the cloud, how that is helping you? And then as you look at that public safety pipeline where you see sort of current Tyler customers and where that cross-sell advantage might be?

Yes, you're right, Rob. Public safety has had surprising results this year. At the end of last year and into this year, we decided to lead our clients to the cloud, similar to our approach across all of Tyler. The momentum is evident, and as you know, our clients communicate about this, which gives us a competitive advantage. We can offer all our core public safety products in a SaaS environment, unlike many of our competitors. While the market is still very competitive, I am pleased with our current position and some significant wins against major Tier 1 competitors, such as the Idaho State police deal. It’s an interesting dynamic. I previously mentioned that momentum is building, and it’s exciting to witness. We are also beginning to see the effects of heightened cybersecurity concerns across our clients, leading to several changes. For instance, we had six transitions in public safety in Q2, some prompted by ransomware incidents. The ability to adapt and quickly support these clients, even if not with full functionality at first, has demonstrated significant benefits and is helping to instill confidence in our clients and their communities regarding the cloud.

Next question is from the line of Michael Turrin with Wells Fargo. Your line is now open.

Great, looks like a strong Q2 for SaaS, fairly even split between new deals and conversions and the metrics. So, I was just hoping you could maybe speak to the drivers there. How you'd expect that mix between new deals and conversions likely trends. And if anything, seasonal in terms of Q2 and what we're looking at, we should be mindful of there?

Yes, I don't believe there is anything particularly seasonal regarding the timing of new deals and flips, which can be a bit inconsistent. We anticipate that, over the mid- to long-term, both the number and size of flips will continue to increase. One significant aspect this quarter was that the average recurring revenue from flips was nearly 20% higher. We pointed out some of the larger flips occurring as well. Generally, we are seeing a high adoption rate of SaaS, with 97% of new business coming from it. Public safety is likely to have some licensing deals in the latter half of the year, which may cause a slight decline. However, the trend towards greater acceptance of SaaS in public safety is clearly ongoing. Therefore, we expect to see an upward trend in flips, although there may be some fluctuations from quarter to quarter, and the majority of our new deals will continue to be in SaaS.

Yes. I think, Michael, too, I think when you look at the numbers and compare quarter-over-quarter from last year, we've talked about the public sector market and how budgets are healthy and sales pipeline is strong. I think you're seeing that. We had I think if you look at our total new software deals, it's up about 11% year-over-year. Our flips are actually up about 18%, and our new SaaS deals were up about 20%. Licenses, as Brian mentioned, are continuing to decline. I think licenses in Q2 were a little less than 1% of total revenues. And for the year, maybe a little less than 1.5% is what we're looking for the rest of the year. You're seeing the results of a good healthy market, and you're seeing the results of that market continuing to embrace SaaS and the cloud.

Next question is from the line of Charles Strauzer with CJS Securities. Your line is now open.

Just looking at guidance for the back half of the year, is there anything abnormal that we should think about when modeling the cadence of the back half? Just anything into our thinking here.

I don't think there's a whole lot at a very high level, I think you'll continue to see revenue step up a bit from where they were in the second quarter, particularly around professional services, we'll continue to see grow a bit. SaaS will continue to see growth sequentially. I think the biggest growth in the second half will be, as you'd expect, SaaS revenues continue to step up quarter-to-quarter as more new customers come online and as we execute more flips and we get the impact of those revenues. The other revenue lines, I think generally, you'll see be fairly consistent with where they were in the second quarter across the third and fourth quarters. And dropping down to the bottom line, I think you'll see earnings generally in the same range that we see in the second quarter in the third and fourth quarters. And cash flow, certainly, the third quarter historically is by far our strongest cash flow quarter because of timing of maintenance collections and that will be the case as well.

Next question is from the line of Alex Zukin with Wolfe Research. Your line is now open.

I want to connect a few ideas and put forward a thought. It appears that the changes are occurring more swiftly and are more significant. You are appointing someone to lead the cloud division full-time right away. My question is whether it seems like the worth of the maintenance portfolio and the value of these changes, considering the attachment rate and the broader range of other services you are promoting and the transactional revenues, is increasing. Is the value of that pipeline significantly greater than what you had expected before? How should we consider its impact on the profit and loss statement over the next year or two?

Yes, Alex, I would say that in the last several quarters, we're seeing a bit more growth than we had anticipated. When we take a step back and consider our long-term goals for 2030, what's been happening recently really reinforces our plans and commitments. In terms of timing, we've always mentioned that our trajectory towards 2030 won't be a straight line. However, with each passing quarter, as I notice these positive developments, I become increasingly confident in our direction and objectives.

Next question is from the line of Saket Kalia with Barclays. Your line is now open.

Okay, great to hear about the positive results this quarter. Brian, I have a question for you regarding the payments business. I believe you mentioned mid- to high teens revenue growth for the second half, but please correct me if I’m mistaken. Do you view the payments business as an equation involving same-store sales growth and market share gains? Alternatively, how do you perceive the relationship between net revenue retention in that area and new customer acquisition? I’m interested in your thoughts on this equation in relation to the expected mid- to high teens growth rate for the second half.

Yes. The shift from low single-digit growth in the first half to mid- to high teens in the second half is largely due to the effects of us overcoming the gross to net change from one of our state contracts last year. If we analyze the high teens growth, the same-store growth or customer growth is usually in the high single digits, possibly nearing 10%. This is particularly the case with our Digital Solutions division's state contracts, where we experience either increased transaction volumes or add services that generate more revenue from the same customer. The portion that contributes to the mid- to high teens growth is primarily our new customer growth, which is driven by integrating the payments platform into our local government customers and linking it to both new and existing software customers. We've mentioned that these engagements tend to have higher margins and premium pricing. For instance, this quarter we gained $8 million of new Annual Recurring Revenue from new payment customers linked to our software customers. That’s how we perceive the breakdown of that growth.

Yes. When we look ahead to 2030, we are projecting long-term compound annual growth rates of low double-digit growth in transaction growth. Additionally, we've improved our client onboarding process, resulting in greater efficiencies and allowing us to recognize revenue more quickly. Furthermore, increasing same-store sales through further adoption within our client base is a major contributor.

Next question is from the line of Terrell Tillman with Truist. Your line is now open.

I have one question, and it'd almost be in two parts. So just bear with me. First, in terms of Idaho, congrats, Lynn, on the successful go-live. It sounded like four months, that's pretty strong. I'm curious though, you said this is an important milestone, I know you have some really large, on-prem or kind of private cloud customers in courts, but also maybe some that are more ready to move. How are you thinking about some of these other potential large, court flip opportunities, whether they're actionable this year or into next year? And then, Brian, just the second part of this question is, with CSI, ResourceX, ARInspect. I was intrigued last quarter because there were some big deals there. I think you said it was about a $4 million kind of quarterly run rate on those AI-based kind of solutions. Does that still hold? Or is it picking up from there?

Yes, that's a great question, Terry. Regarding the Idaho SaaS flip, there are limited state court implementations available. Achieving our first timely and live implementation that serves as a reference was a remarkable accomplishment by our team. I want to highlight, as we have in previous discussions, the impressive amount of work our teams do behind the scenes. We often discuss the numbers, but significant effort goes into making our clients operational, whether it involves a SaaS flip or a new implementation, and our teams performed exceptionally well. This business relies heavily on references, and many state courts have shown interest in the SaaS flip, keeping a close watch on Idaho. I do anticipate this will lead to other major statewide SaaS flips or large court SaaS flips. While I won't claim they'll occur in September, I believe we will see increasing momentum in that market over the upcoming quarters.

Yes. With respect to the three acquisitions from last year that have strong AI capabilities, they continue to perform really well in terms of the new business market, and they are continuing to grow. We highlighted last quarter a couple of large deals, and I think we mentioned a few of those this time as well. I think we've been really pleased with the speed at which those have started to contribute, and we're able to leverage cross-sells. Of course, that's part of the thesis behind all of those acquisitions that we can leverage our existing sales organizations in our existing customer base and new deal opportunities to sell more of those newly acquired products. And I think we've been really pleased with the speed at which we've been able to execute on those and particularly CSI adding that to some of our large court deals. ResourceX already had some large client engagements, and we're continuing to see those come on board as well in ARInspect. We called out several state deals there this quarter. So those are all performing really well and contributing nicely kind of out of the box.

Yes, there's a lot of buzz for these out in the marketplace, Terry. And as Brian said, it's kind of twofold. On the one hand, it's a great playbook that we've run for many years, a tuck-in acquisition that we can get in the hands of our sales teams and get out to our installed base but also in areas like ResourceX, for example, I mean, it's a differentiator for us in our new enterprise ERP sales. So, it's both a competitive advantage in new sales but also a huge opportunity to deploy through our installed base.

Next question is from the line of Josh Reilly with Needham & Company. Your line is now open.

Just on the Dallas data center closure, can you just remind us in the income statement where the expenses for that data center lie? And what's the implication for our second half modeling with that shutting down? And then just secondarily, along the margin front, can you just give us some color on what drove the margin improvement in services?

I'll take the first part of it. Most of the costs for the data center are reflected in the subscription expenses, which are impacting the gross margin. Additionally, there are costs related to depreciation, operating expenses, and personnel. The first data center that closed in Dallas is a colo facility, so it doesn't affect real estate costs. These expenses will be included in our margin profile for the second half of the year. However, keep in mind that as we approach the closure of the second data center, which we anticipate will happen by the end of next year, we will incur additional costs related to running that center as well as costs from AWS during the transition of customers out. Those costs will rise until we complete the migration of more customers and approach the closure. The effects of closing the first data center will be somewhat balanced by the ongoing expenses from the second data center, but we expect to see a greater improvement after that data center closes in 2025. Overall, I believe our operating margins will remain fairly consistent in the second half of the year compared to Q2.

I would say that one of the things that is gratifying to me is that we outlined this vision of closing the data centers a couple of years ago, and we are basically on track to achieve it. This effort involves a lot of work from many people, and it continues to validate what we outlined a couple of years ago as we began our cloud transformation. It’s reassuring to see this progress. Another benefit of moving out of the Dallas data center and eventually the other data center is the significant future capital expenditure savings. We would have spent a considerable amount of money over the next five to seven years if we hadn't made this decision. Regarding your question about pro services gross margins, there are a couple of factors at play. First, there has been a heightened focus from the management team over the past year to analyze and boost those gross margins and utilization. Additionally, we are starting to observe more stability in our workforce, which has been the case for several quarters. Turnover rates have decreased substantially. In the Pro Services division, high turnover can be challenging, especially as we experienced post-COVID when employees were moving around. It takes time to train new employees and bring them up to speed so they can be productive. The current labor market dynamics contribute to this, but the return to more stable turnover levels is certainly beneficial. Plus, the management team's focus has been instrumental in driving improvements.

I think the ongoing move to the cloud helps us there as well because in a general sense, we're able to deploy software more efficiently in the cloud. And version consolidation helps us as well to some extent there on both services and support.

And to that point, Brian, I guess, remote delivery of services, it's something we really started around COVID and clients continue to have more and more acceptance of that delivery model.

Next question is from the line of Peter Heckmann with D.A. Davidson. Your line is now open.

Most of my questions have been answered. I wanted to follow up on the NIC transaction and see if you're noticing any changes regarding those self-funded, state-level IT portal deals. Are the states looking for something different or more? Also, it seems like you had good renewal activity in the first half. What is your perception of other states transitioning to that self-funded portal model in the future? Or do you think it's more likely that you will approach it on an agency-by-agency basis at the state level?

It's a combination of both, Peter. The state-funded model is what the former NIC, now DSD, was built upon. I believe there will continue to be demand for that model, especially with tight budgets. We discussed last quarter the significant deal we secured with California State Parks, which is the largest contract in Tyler's history, and that deal was only possible because of the self-funded model. Moving forward, we will likely see an increasing focus on agency-specific opportunities as part of our strategy to introduce more products on a targeted agency basis, which aligns more closely with Tyler's traditional model. Over the past couple of quarters, particularly in the last year, we have internally realigned our Platform Solutions division with our Digital Solutions division to leverage both of those opportunities. This alignment allows us to coordinate our sales teams, reduce overlap, and drive sales for both models as we progress.

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

Can you give us a little bit of additional color about your thoughts around cybersecurity and what this could potentially mean in terms of either upsell opportunities or accelerated transition to the cloud? Just want to get a sense for how much this is sort of impacting the industry as a whole.

Yes, Jonathan. It's a reality we face, and we often say it's not a question of if but when a cybersecurity event occurs. Such events have certainly affected our clients and other public sector agencies as well. This presents a natural opportunity to accelerate discussions about moving to the cloud. We've seen several cases of this already. I mentioned a few related to public safety last quarter, and while I prefer not to emphasize them too much, they are indicative of the current market situation. We've been getting better at transitioning clients to the cloud for various reasons, particularly because of cybersecurity concerns, which allows us to modernize their systems and introduce additional products. We’re all navigating these challenges, and our main goal is to respond effectively to our clients. We’ve improved our ability to quickly set up clients, even if it's not with all the functionalities they would have in an on-premise system right away. This provides us with an opportunity to reassess their needs and possibly upsell further solutions. So yes, these issues are present and we're addressing them.

Next question is from the line of Kirk Materne with Evercore. Your line is now open.

Yes. Congrats on the quarter. Lynn, I was wondering, on the public safety side, when customers are now flipping in a bigger way towards cloud, how does that change the competitive environment for you? Meaning, I'd imagine there are a lot of smaller competitors that don't necessarily either have the scale on the cloud side or potentially or as advanced as you all. Is that leading to better, I guess, win rates in that particular segment of your business as well?

Yes, I think it's a competitive differentiator right now. We've seen this historically across different business lines where competitors make a move, and then we follow suit. Currently, I feel confident about our position in public safety. We offer the most comprehensive solutions, especially those that can be deployed in the cloud. While some smaller companies have cloud-native solutions, they often lack the depth of functionality and may struggle with larger deals and execution capabilities. Over the past 12 to 18 months, the execution of our strategy in public safety has been impressive. It required a change in mindset for both the sales team and all operational teams, and this messaging is resonating in the market, which is exciting to witness. A few years ago, I mentioned that it could take several years, maybe five or six, before we reached 50% SaaS levels in public safety. This highlights the changing dynamics in the market. Fortunately, due to our previous efforts, we are well-positioned to not only benefit from these changes but also lead them.

Next question is from the line of Gabriela Borges with Goldman Sachs. Your line is now open.

This is Kelly Galanis on for Gabriela. Congrats on the quarter as well. Given that a lot of your customers are now kind of on a new fiscal year, can you share some early observations on what customer budgets are looking like this year relative to last year? And then, how much of this stronger demand that you're seeing is tied to these healthy budgets versus kind of just demand for cloud and these other factors you're talking about?

Yes, many of our clients operate on a June 30 fiscal year. However, we don't have extensive insight into their budgets. Overall, they appear steady and healthy. Most of our sales procurement cycles are lengthy, although not all span multiple years. I believe the budgets are currently in good shape, and our win rates are strong. One noteworthy observation this year is that across our product lines, all indicators remain robust. Almost all of our divisions are meeting or exceeding their sales projections at the midyear mark. This positions us favorably as we look ahead to the next several quarters. Currently, we are not observing any negative shifts in public sector budgets.

Yes. Additionally, there is a growing need for digital modernization, which reflects how governments are adapting to achieve more with fewer resources. Many public sector employees left their jobs during COVID, and overall, government workforce levels have not been restored. As a result, they are working to deliver essential services under staffing limitations and are increasingly turning to technology for support. This situation goes beyond simply replacing outdated systems; it involves a more strategic approach where new technology enables them to manage their essential tasks despite budget and personnel challenges.

Next question is from the line of Mark Schappel with Loop Capital Markets. Your line is now open.

Nice job on the quarter. John, question for you in your prepared remarks, you noted continued progress you're making around your product version consolidation efforts. Just wondering if you could elaborate on the progress you made during the quarter on that front and also what we can expect maybe in the coming quarters here.

Certainly, Mark. Version consolidation has been a significant aspect of what I've described as the first phase of our cloud transformation. This phase involves selecting AWS, optimizing products, and consolidating versions as we exit the data centers. Version consolidation is essential for several reasons. Firstly, we need to streamline to a single product and achieve a cloud release, ensuring our clients are updated with the latest versions. Without this, they won't effectively transition to the cloud, which is a foundational aspect of our strategy. While you may not observe consistent quarter-to-quarter progress, there are specific goals being met. For instance, in our enterprise ERP division, formerly known as our munis product, we have approximately 95% of our clients on a single version now, compared to a few years ago when many versions were in use, affecting hundreds of clients. This marks a notable advancement, and it remains a priority across all our divisions and operating units, where similar progress is being achieved.

Thank you for your question. There are no additional questions waiting at this time. So, I'll pass the call back to Lynn Moore for any closing remarks.

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

That concludes the conference call. Thank you for your participation. You may now disconnect your lines.