Tyler Technologies Inc Q3 FY2024 Earnings Call

Hello, and welcome to today's Tyler Technologies Third 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. And as a reminder, this conference is being recorded today, October 24, 2024. I would like to turn the call over to Hala Elsherbini, Tyler's Senior Director of Investor Relations. Please go ahead.

Thank you, Rob, 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 those 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 carried our momentum from the first half of the year into the third quarter and delivered remarkably strong results. The quarter was highlighted by strong top and bottom line performance, even as we saw a more pronounced shift towards SaaS and our new software contract mix, particularly in public safety, where expected on-premise license deals shifted to SaaS contracts in the quarter resulting in license revenues that were below plan. SaaS and transaction revenues fueled our growth and both exceeded our expectations. Our non-GAAP operating margin expanded to 25.4%, benefiting from our cloud efficiency initiatives and improved professional services margins, and free cash flow reached a new quarterly high. As we've discussed in the past, our progress towards our 2025 and 2030 targets will not be linear. But our results through the first 9 months of this year bolster our confidence in achieving those top targets. We are beginning to see benefits from our cloud operations initiatives with efficiencies reflected in our results somewhat ahead of plan. Recurring revenues grew 12.1% and comprised 85% of our total revenues. Our SaaS revenues grew by 20.3%, representing our 15th consecutive quarter of SaaS revenue growth of 20% or more, consistent with our target of a 20% CAGR in SaaS revenues through 2025. The public sector market remains robust, supported by healthy budgets and an increased focus on modernizing aging mission-critical systems through cloud adoption. The strong market activity we've discussed for the past few quarters, along with excellent execution by our sales teams, is reflected in our new software bookings this quarter with our new SaaS contract value of approximately $105.6 million, up 78% over last year. Our leading market position, anchored by our deep domain expertise and large installed base forms the foundation of our long-term strategic focus on 4 key growth drivers: executing our cloud-first strategy, leveraging our unmatched installed base, expanding into new markets, and growing our payments business. Our cloud-first strategy is a pivotal driver of our success and continues to shape our future in our cloud living culture. We are leading with cloud across our product portfolio as the public sector market continues to embrace digital modernization and choose Tyler's next-generation cloud solutions. Additionally, we've made substantial progress with our cloud optimization efforts, driving efficiencies and scalability, while also making solid progress on version consolidation to further accelerate on-premise client migrations and enable clients to easily expand their mission-critical applications in the cloud. The pendulum is continuing to shift to the cloud with both new and existing clients, and we are seeing a growing trend of client-driven SaaS adoption. This is especially apparent in areas that have previously lagged the rest of our market in terms of cloud adoption, most notably, the public safety market, along with the state and federal market with our application platform. Overall, SaaS arrangements comprised 97% of our new software contract value in the third quarter. For the second consecutive quarter, 100% of our public safety new contract value was SaaS compared to only 28% a year ago. It was also a great quarter for flip signings as we signed a total of 108 flips of on-premises clients. The total contract value from flips was more than triple that of last year's third quarter, and the average ARR of flips rose by 37.2%. Our Courts & Justice business was very active in the third quarter. Our largest deal in the quarter was a contract with the Kentucky Court of Justice for the Enterprise Justice suite, including case manager, e-filing, and court analytics, in addition to payments. The initial 6-year term represents $35 million in total contract value, although only $10.6 million was recorded in bookings in backlog this quarter due to contract provisions. ARR starts at approximately $2.5 million and grows to $6.5 million in year 6, in addition to payments processing under a gross revenue model. Of note, the first 6 years of SaaS fees totaling $29 million were prepaid in October using ARPA funds. Other successful Tyler court clients and in particular, the North Carolina Administrative Office of the Courts served as strong references in this competitive sales process that spanned more than 12 years. Kentucky is our 17th statewide courts client and our third statewide enterprise justice solution deployed in the cloud. We also signed a 3-year $9.6 million SaaS contract for our Enterprise Justice suite with the Phoenix, Arizona Municipal Court. That agreement includes a cooperative master purchase agreement provision that enabled the Arizona Supreme Court to designate Tyler as a preferred software provider for all 170 courts in the state, including superior, justice, and municipal courts, with the alternative option being the state's aging legacy system. We're excited about the opportunity to expand our partnership across Arizona courts with significant potential ARR. Other notable third quarter SaaS deals included a $12 million 5-year contract with the city of St. Petersburg, Florida, the fifth largest in the state for enterprise permitting and licensing and enterprise ERP utility billing solutions along with payments. We signed 6 SaaS contracts for our enterprise public safety solution, including 2 of the fastest-growing cities in the U.S., the City of Frisco, Texas Police Department for $750,000 in ARR and the City of Round Rock, Texas police for $730,000 in ARR. Central to our growth is leveraging our unmatched installed base and expanding our addressable market through strategic cross-sell and upsell activity that unlocks significant expansion opportunities with both new and existing clients. A key cross-sell win this quarter was a multiyear strategic contract with the Texas Office of Court Administration for our Texas Connected Justice Data Cloud. This includes alliance exchange, enterprise data platform, open data platform, and our Digital Solutions division's engagement builder platform. This integrated solution captures real-time online data across every jurisdiction in the state. This multiyear engagement exemplifies our connected communities vision by creating a digital infrastructure for data sharing and decision-useful business intelligence and reporting. The contract adds $1.5 million in ARR and is the first of its kind in a large population state, paving the way for additional add-on opportunities. Another significant cross-sell win was a contract for the modernization of 18 different boards with the Illinois Department of Financial and Professional Regulation for our state regulatory application platform suite, which also brings in augmented field operations, formerly ARInspect. The 3-year contract leveraged our Illinois state enterprise agreement and represents $9.2 million in total contract value, with a 7-year option that adds $12.5 million in total contract value. We're pleased to see an increasing number of our clients modernizing their enterprise solutions using our application platform. Driving payments adoption of our differentiated payments business is another key element in our growth strategy. In the third quarter, we signed 268 new payment deals across Tyler software clients, representing approximately $8.6 million in projected ARR. Riverside County, an existing property and recording software client, is our first enterprise payments win in California. This collaborative effort expanded from initial property and recording payments contracts to processing payments for more than 10 agencies across the county, which is the fourth most populated county in California. In our enterprise portal business, we secured extensions for our digital government and payment processing services in 5 states, which includes winning competitive rebids for state enterprise portals in New Jersey and Indiana. We also expanded our scope with the state of Indiana to include resident engagement identity proofing for approximately $1 million in additional ARR. This builds on Tyler's chatbot front-end technology recently deployed representing the first AI project for Indiana and its residents. This solution was provided through a joint effort with our AI task force and our Indiana state enterprise team in collaboration with the Indiana Office of Technology. 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 $543.3 million, up 9.8% and organically grew 9.4%. Subscriptions revenue increased 17.6% and organically rose 17.3%. Within subscription, SaaS revenues grew 20.3% to $166.6 million and grew organically by 19.7% against a tough comparison with last year's third quarter. Keep in mind that there's often a lag from the signing of a new SaaS dealer flip to the start of revenue recognition; they 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 15.2% to $180.5 million, driven by higher transaction volumes from both new and existing clients, including the August go-live of the California Department of Parks and Recreation. SaaS deals comprised approximately 97% of our Q3 new software contract value compared to 80% last year. During the quarter, we added 181 new SaaS arrangements and converted 108 existing on-premises clients to SaaS, with a total contract value of approximately $141 million. In Q3 of last year, we added 161 new SaaS arrangements and had 79 flips with a total contract value of approximately $71 million. The average ARR from new SaaS contracts increased 38% over last year. The average ARR associated with our Q3 flips increased 37% over last year, as larger clients such as Cobb County, Georgia and Providence, Rhode Island flipped to the cloud. Our total annualized recurring revenue was approximately $1.85 billion, up 12.1% and organically grew 11.8%. We entered 2024 expecting operating margin expansion after experiencing the margin trough from our cloud transition in 2023. Our non-GAAP operating margin in the third quarter was 25.4%, up 60 basis points from last year. The margin expansion reflects the impact of our cloud efficiency initiatives, along with effective operating expense management and improved professional services margins. As we discussed on previous calls, merchant and interchange fees from our payment 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 $42 million in Q3 compared to $36 million last year. Because of strong earnings and effective working capital management, both cash flows from operations and free cash flow reached new quarterly highs at $263.7 million and $252.9 million, respectively, with free cash flow up 55.5%. Cash flow in the quarter was positively impacted by the deferral to the fourth quarter of approximately $14 million of federal tax payments. We ended the quarter with $600 million of convertible debt outstanding and cash and investments of approximately $548 million. Our net leverage at quarter end was approximately 0.1 times trailing 12-month pro forma EBITDA. In September, we replaced our existing $500 million unsecured revolving credit facility with a new facility that matures in 2029, increasing the size to $700 million in improving terms. This new revolver further improves our available liquidity and provides us with maximum flexibility to address potential financing needs. Our updated 2024 annual guidance is as follows: we expect total revenues will be between $2.125 billion and $2.145 billion. The midpoint of our guidance implies organic growth of approximately 9%. We expect that merchant fees will be up approximately 7% 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 $6.13 and $6.28 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 $9.47 and $9.62. We expect our free cash flow margin will be between 21% and 23%, including an estimated impact of approximately $54 million of incremental cash taxes related to Section 174. Other details of our guidance are included in our earnings release and in the Q3 earnings deck posted on our website. Now I'd like to turn the call back over to Lynn.

Thanks, Brian. As we close out another strong quarter, I want to highlight the consistently high level of execution and collaboration across our teams, which is even more critical to our ongoing success as we leverage a fully enabled cloud infrastructure to deliver continuous innovation and enhanced client experience. The strength of our One Tyler team is rooted in a shared commitment to excellence and to our mission, vision, and values, which drives our ability to execute at high levels. During the quarter, we were recognized by Newsweek as one of America's greenest companies, placing us among the top 500 greenest companies in the United States based on environmental sustainability. We were also named in Newsweek's America's greatest workplaces for parents and families 2024 list. We're gratified by this recognition of our commitment to fostering a strong inclusive culture with a healthy work-life balance and high-quality benefits. Now we'd like to open up the line for Q&A.

Your first question comes from Ken Wong from Oppenheimer. Please go ahead.

Lots of momentum this quarter on the cloud side. I wanted to maybe dive into that 3 times on the TCV of flips up to $36 million. Lynn or Brian, do you think this is a new run rate? Or is this just more of a one-off quarterly dynamic here?

As we said, these can be a little bit lumpy. This was a strong quarter with some larger flips, but that's a trend that we're seeing, more of our larger customers that have been slower to flip to the cloud, more complicated projects are now starting to move at a faster pace. The progress we've made with version consolidation over the last couple of years has also helped get us in a position to facilitate that as more of those customers are now on current versions of software and have gone through that upgrade process to put them in a position to move to the cloud. So I think as we've said in the past, we should expect to continue to see growth in the flip volume and the size of flips, and we sort of envision a bell curve-shaped trend of those over the next 3 or 4 years, and we're still kind of moving up the left-hand side of that bell curve. But it could be lumpy from quarter to quarter. But generally, we expect to continue to see the flips growth to achieve the targets we set out for 2030 of 80% to 85% of our on-prem base having moved to the cloud by then.

Yes. Just to amplify, Ken, Brian is right. It will tend to be lumpy. I don't think I would model this as our new run rate, which was your question. But we do expect to see this continued momentum.

Your next question comes from the line of Matt VanVliet from BTIG. Your line is open.

I'd be curious in terms of what you saw of sales linearity throughout the third quarter and maybe into October? And are you seeing at least lately any pressure of maybe decisions not being made until after the election? Or any impact there? But maybe just overall, what you're seeing in terms of demand linearity?

Yes. That's a good question. We're actually not seeing any slowdowns or hesitations due to the election. Generally speaking, when you look across all the business units at Tyler and particularly at our flagship products, most of our divisions are either at or exceeding their sales plans for the year. And so that's been good. The things that we've been talking about in the past couple of quarters have continued. And so we're not seeing any slowdown at this point or any pauses due to any macro factors or the election.

And really not any changes in linearity. We tend not to be super back-end loaded within quarters, and I don't think we've seen any change in that.

Our next question comes from the line from Alexei Gogolev from JPMorgan. Your line is open.

Lynn, I had a question about the incremental competition during the quarter. Are you seeing more pressure from players like ServiceNow and intelligence and analytics, in Workday in ERP? Or have those competitors subsided as demand in their core markets begins to recover?

I believe that the competitive landscape has remained fairly neutral this year. There hasn’t been a noticeable increase or decrease in competition. In specific areas like ERP, we do notice more competition from horizontal players like Workday, but this increase doesn’t seem significantly greater than what we've experienced in the past. With regards to ServiceNow, we see them competing with our platform, but our offerings differ from theirs. Their application platform is stronger in certain areas, making them a bigger player there. Overall, I think the competitive environment has stayed largely the same. Our win rates have remained consistent, and this trend continued in Q3, aligning with what we’ve seen over the past several quarters and probably the last couple of years.

And Brian, a quick question on 2025 guidance that you've provided last year. Directionally, would you be able to suggest that you think you could see top line growth acceleration next year versus this year? And how are you thinking about free cash flow margin that you provided considering the net working capital improvements that you've just reported?

Sure. Well, we're obviously not ready to give our '25 guidance yet, and we're in our planning process and kind of in the early stages of that. I think what we've talked about is that we're probably a little bit ahead of where we targeted 2025 along the path to our 2030 targets. But we said it's not linear. And being a little bit ahead doesn't necessarily mean where we finish up '25 or 2030 will be significantly ahead of those initial targets. So we're confident around those. I think specifically on the cash flow side, we're certainly well ahead of that. We're above where we targeted 2025 already. There are some things that have been affected this year that are a little bit more onetime. But I think generally, this would be a level we'd look to build off of for 2025. So I do expect that '25, our cash flow will be at least kind of consistent with where we are this year.

Our next question comes from the line of Michael Turrin from Wells Fargo Securities. Your line is open.

On the transaction business, ARR there are meaningful, we're used to seeing that maybe down sequentially in 3Q, and it was up this year. I know you had a comment on a go live, but anything else you'd point us towards and drivers of the transaction revenue base? And is the seasonality there at all changing?

I don't think there's really a change in the seasonality. And typically, the last half of the year is slower in terms of volumes. But that's been offset really by a couple of things. One is the revenues from new payments clients that we've added over the course of the last year, we've been disclosing those numbers. And consistently close to a couple of hundred this quarter, significantly above that in terms of the number of new payments customers that we're adding within our software client base. And we're also having better experience in getting those clients live faster and getting those revenues flowing faster from the time we sign them to the time that they're onboarded, and that's having a positive impact. And then within the transactions business in general, what we alluded to in terms of some new customers to the California State Parks contract that we signed late last year went live this quarter. That added about $3 million of revenue, although it wasn't a full quarter impact. Various things like in Florida with our payments contract the Florida turnpikes with SunPass went live during the quarter, and that added a couple of million dollars of new revenues. So it's really a combination of new business as well as increased volume. So we're seeing greater adoption through our client base, and we're working with our clients to help them get more of their citizens doing things online and running through our systems.

Yes, to expand on that a bit, Michael, Brian is correct. We are beginning to learn more effectively. The efficiencies in onboarding are leading to faster revenue recognition, which is fantastic. I want to highlight the go-live in California for a moment because it is significant. We signed this contract late last year and went live in less than three quarters. This is the largest contract in Tyler's history, and though we've mentioned this in previous calls, it often gets overlooked in the numbers. The real advantage of Tyler is our execution—be it in sales, implementations, support, or management. It requires substantial effort to achieve what we do. We have signed over 200 new deals and completed 100 flips each quarter, indicating considerable business activity driven by our teams, with execution that provides the referenceability to maintain momentum. Achieving a major go-live in California on schedule and within budget is a significant achievement for our teams and positions us well not only to execute on that contract but also to inspire others to replicate that success in different jurisdictions.

Just a small follow-on clarification, if I may, on the prior question. I think the primary question we're getting is just on the free cash flow performance. So Brian, just in summarizing some of what you said previously, it sounds like, is there anything you could do to help quantify anything that would fall into the more onetime basket? And it sounds like while you're not updating 2025 targets here, there's no reason to expect margin to go down next year relative to what you're delivering. You're just kind of working through plans. Is that the right takeaway for us at this point?

Yes, I think so. We're kind of at a little bit higher level than we had initially planned. I don't know that we would grow in terms of a margin significantly from where we are right now. But again, that's ahead of where we plan to be. The biggest onetime thing, which really will be reflected in the fourth quarter that's reflected in our full year guidance is what Lynn mentioned around the Kentucky courts contract where they are prepaying or prepaid in October, 6 years of SaaS payments. So there's a $29 million bump. That's not a typical situation that we see we're happy to accept that payment, but it's not typical. So that's the biggest onetime thing we're seeing that pull forward.

Our next question comes from the line of Terry Tillman from Truist. Your line is open.

It's great to hear the call out from my home state, Kentucky, multiple times. I have one question. It's a multiparter though. I think, Lynn, you've talked in your prepared remarks and it's in the press release around cross-selling success. What I'm curious is have you done things go-to-market kind of organized to kind of drive more of that pattern recognition? And what are some common plays you see for kind of the cross-selling? Like what product in particular seems to stand out? And then the second part of this question is the reality there's another milestone here for cross-selling success once you get these flips kind of stood up. And so maybe we could see a step-up even in more cross-selling once they're kind of stable on new cloud technology.

Yes, good questions, Terry. I'll begin with the second one. The answer is yes. Part of the strategy for doing flips is that it enhances our upselling opportunities. This presents another chance for us to engage with clients and offer additional products as they make new decisions. Regarding cross-selling, there are various factors involved. I believe the initiatives we've implemented internally over the past 12 to 18 months have significantly impacted this. I’ve mentioned in previous calls how we have adjusted our compensation structure for salespeople and different divisions. We have transitioned to a unified compensation model, ensuring that when multiple divisions contribute to a sale, there’s no competition over credit. The focus should be on Tyler's overall success. We've made internal changes that have helped reduce barriers and streamline processes. As for product suites, it’s interesting to note that some combinations work better than others. For example, we recently secured a major deal in Kenosha, Wisconsin, which included our full ERP suite along with enterprise, appraisal, tax, and municipal justice products, totaling about $1.6 million in annual recurring revenue. While certain products naturally complement each other, our cohesive Tyler narrative often leads to the successful bundling of products that may not initially seem related. We witnessed a similar situation in St. Petersburg, Florida, where we sold an enterprise permanent license alongside utility billing and payments, resulting in nearly a $2 million annual recurring revenue contract. We're observing progress largely due to our internal initiatives, and the success of our integrated Tyler story is clearly resonating in the market.

Your next question comes from the line of Joshua Reilly from Needham & Company. Your line is open.

So after being at the IACP event here, one of the topics that came up was where customers are at in terms of version consolidation. Just wanted to get an update on some of the key product areas where we are at with that. I believe Public Safety is at around 30%, which might get a bit behind some of the other larger products? And how do you think about the benefit to margins over the next several quarters as you get more up-to-date there?

No, good question, Josh. I mentioned in the last call that version consolidation is a major part of what we refer to as Phase 1 of our cloud transition. Each of our flagship products is advancing at varying speeds due to different starting points. As of the fall of 2024, I'm quite satisfied with our progress on version consolidation. We are ahead of where I anticipated we would be two or three years ago. For some of our products, it has been more challenging. However, if you look at our Courts & Justice, our Enterprise Justice solution, and our enterprise ERP solution, we now have a significant number of clients with just one or two versions, a considerable improvement from the previous five, six, or seven versions in the field. This progress is part of what has contributed to our strong performance this year. Our margin outperformance has partially come from cloud efficiencies. Our products are becoming more optimized to run on AWS, and we are also reaping the benefits from version consolidation. Maintaining and supporting fixed bugs on a single version or even two versions requires far fewer resources than handling six or seven versions. This consideration is crucial as we think about Phase 2 of our cloud strategy, which involves getting all our clients onto a single version with minimal disruption and higher client satisfaction through shorter release cycles. I believe we are making significant strides in this area. I expect this to continue positively impacting gross margins as we work towards our Tyler 2030 goals, which is where some of that margin improvement will originate. Overall, I am pleased with our current status on version consolidation.

Our next question comes from the line of Gabriela Borges from Goldman Sachs. Your line is open.

Lynn and Brian, I wanted to ask, given your experience in the space, we're clearly in a really healthy part of the budgeting cycle and the willingness to spend cycle across state and local governments. How should we be thinking about the sustainability of some of the healthy demand that you're seeing? And maybe just level set us on the ARPA funds, how much of a benefit do you think that you're seeing today versus how much could you see in 2025 and 2026 as the funds that are committed to actually get spent?

Yes, Gabriela, I believe that overall, budgets have been at a solid level for the past couple of years. I cannot predict what will happen in 3 or 5 years, and I can't even forecast what will happen in the next 2 weeks with the election. However, our current outlook and the leading sales indicators suggest that this level will remain stable for the foreseeable future. Our RFP counts, demo counts, and other leading sales indicators are strong and consistent with previous quarters and the last couple of years. These are the data points I focus on the most. I apologize for not addressing the second question.

ARPA funds.

ARPA funds have been an interesting topic over the last several years. There are certain deals that were clearly driven by ARPA funds. We talked about the Kentucky Enterprise Justice deal where they prepaid that all up front. We also had a significant deal, the Arizona Supreme Court deal that I mentioned in my prepared remarks, was also funded by ARPA funds. We don't always know, and we haven't always known when ARPA is the trigger, and what we've said over the past, sometimes, it's not the direct trigger, but it may have freed up other opportunities. There's been a hesitancy sometimes in our business to use ARPA funds given the recurring nature; they sometimes tend to have been used more on one-time things. We saw that sort of in our student transportation business, maybe for a large purchase of hardware, something like that. I think they've been helpful over the last few years. I don't think that's been a major tailwind to growth in sales. That's not what we're hearing from our sales folks.

But those will be available until the end of '26 to allocate those funds. Some of the uses for ARPA funds may not even have commenced yet. They could have been internally committed, but the purchasing process hasn't started. For instance, in the Kentucky deal, although they are using ARPA funds to cover six years of SaaS, that negotiation took 12 years to finalize from when we first began discussions. The deal didn't occur solely because of ARPA funds, but it influenced the timing. We wouldn't say that the deal happened exclusively due to ARPA funds; however, it certainly helped with the timing.

Our next question comes from the line of Saket Kalia from Barclays. Your line is open.

Lynn, maybe for you, just to hit on a little bit of a different topic. Tyler's services have always been really important for your government customers. But it's been interesting to see that business over time grow just a little bit slower than the rest of the software business. So maybe the question is, could you maybe speak to how the services intensity in the business is changing as Tyler becomes more of a SaaS company, and maybe relatedly, Brian, for you, maybe touch on how that impacts margins over time.

Yes, that’s a good question. To start, part of our strong performance this year has been due to our services gross margins, which we have focused on at the management level over the past couple of years, and you can see the results. This focus has been driven by the stabilization of the labor market. Increased stability means less turnover, and high turnover in our services areas creates inefficiencies, making onboarding take longer before new hires are billable. Additionally, we’ve implemented some internal initiatives that have significantly improved our professional services performance. Looking ahead over the next several years, I anticipate our services will remain relatively stable, though they may decline slightly next year. This is due to various factors, including our efficiencies and improvements in client onboarding. We have also taken steps regarding some of our larger implementations, like in Courts & Justice, and reduced the amount of customization work we undertake. Moving forward, we are shifting away from one-off custom applications as part of our cloud strategy. While this has been a key focus, you are correct that the percentage of revenues from our services has been decreasing, and I expect it to stay flat or decline in comparison to our other revenue growth areas.

Yes. So just as Lynn said, less services in the mix. Services are lowest margin and in fact, historically, have had a negative margin. So the combination of less services in the mix from all those factors that Lynn mentioned, combined with improving margins on the services we are doing, should continue to have a positive impact on our margins. And we pointed that out as one of the not the biggest, but one of the factors in driving towards our 2030 margin targets.

Our next question comes from the line of Charlie Strauzer from CJS Securities. Your line is open.

Lynn and Brian, when you talk to clients who are somewhat hesitant to flip, what are some of the reasons why they're so cautious? And ultimately, how do you convince them otherwise?

Some of the reasons for hesitation are historical in nature related to control. Employees who have been in their positions for a long time are accustomed to having control over their systems and everything else. Aging technology and infrastructure contribute to a growing openness to change. Additionally, the rise in cyberattacks has created a new demand for updates. It's important to note that every implementation we undertake is public; each county and city observes their neighbors and other jurisdictions to see what's happening. Any reluctance they felt five or seven years ago diminishes as they witness nearby jurisdictions making similar decisions and achieving success. Our ability to effectively support them in transitioning to a better environment plays a significant role in breaking down those barriers as we progress.

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

Lynn, I wanted to revisit the earlier question about the ARPA funds. With the deadline approaching to obligate these funds, I understand you have been cautious about directly linking them to specific deals. You mentioned the recent win in Kentucky, which is certainly encouraging in the Courts & Justice sector, but you pointed out that it took over ten years to secure. What is your sales team currently doing at the state and local levels to engage with customers about this commitment process and how Tyler products might fit into that? I realize that vendor decisions don't need to be finalized by the end of December, but I would like to ask in a different way, similar to Gabriela's previous question, about your confidence in seeing more deals that could contribute to the progress in 2025 and 2026, given the spending deadline.

Yes, Rob, I don't believe we're doing anything different from what we've done in the past couple of years. Our sales teams are equipped with information on ARPA funds and have the appropriate marketing materials. They generally understand the context and have their talking points. However, I want to emphasize that I can't make a direct connection between ARPA funds and Tyler's performance in a significant way over the last few years. While it has certainly been part of the overall landscape, the indicators we monitor for tracking demand and budgets remain consistent at this time. I’m not implying that ARPA hasn’t been beneficial; I just haven’t been able to establish a significant direct correlation, aside from some specific deals like the one in Kentucky. The notable aspect of that deal is that it underscores the lengthy nature of sales processes and our persistence, reflecting our long-term vision. Even 12 years later, we benefited from cash flow associated with ARPA funds, but we would have secured that deal regardless of whether ARPA funds were available.

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

Can you give us a little bit of sense around the AI opportunity? I think you referenced one large deal and how your customers are maybe thinking about leveraging AI over time and what that means from an upsell perspective?

Yes, Jonathan. We're starting to see some inquiries in RFPs about AI and the technology we're using. Currently, our approach hasn't changed much over the past few quarters. We're focusing on determining where to allocate our resources regarding AI, whether for internal or external solutions. I still believe there is significant potential for internal applications, especially in automating repetitive tasks that some employees handle. However, we have noticed an increase in interest. We made the acquisition of CSI last year, which incorporates AI as a core component and has seen success in the market. ARInspect also offers AI tools, and I previously mentioned its role in the Illinois deal. We're making progress in AI, and customers are beginning to engage more openly about it. Unlike a year ago, when clients were hesitant, there is now curiosity and interest emerging, although it’s not yet a key factor in deals. I expect we will discuss this further when we meet next year and probably even more the year after that.

Our next question comes from the line of Keith Housum from Northcoast Research. Your line is open.

In terms of like the acquisition front, you've got favorable debt terms, you're generating a good amount of cash. How are you guys thinking about acquisitions now? And then in terms of more specifically, is there specific end markets within your business that you're thinking that could benefit from acquisitions more than others? And perhaps what would they be?

Yes, Keith, we share a similar perspective. Over the past couple of years, our focus has been on reducing debt. Our cash reserves are nearing the amount of our convertible debt that is due in about 16 or 17 months. We are always on the lookout and review potential deals each quarter. Currently, we may be more selective than usual. However, as we approach 2025 and 2026, we will maintain our standards and valuation methods. You may notice that I will consider more opportunities that we might have previously decided against. At the moment, we don't have any specific deals in progress, but we are having internal discussions about where we can maximize our investments, and whether we should adopt a more proactive approach rather than a reactive one. Overall, our stance on capital remains consistent, but I anticipate some evolution in our strategy over the next 12 to 18 months.

Our next question comes from the line of Mark Schappel from Loop Capital. Your line is open.

John, a question for you. Building on the earlier question on version consolidation which has been somewhat of a gating item to get customers to migrate to the cloud. Could you just discuss some of the characteristics that you're using to encourage customers to move to the latest product release?

There are several factors at play, and each of our products is at different stages in this process. Some involve minor financial aspects, while others relate to new features that are only accessible in the cloud. Additionally, we are discontinuing support for certain older cloud versions. We haven't established firm boundaries yet, especially with our flagship products. Clients are beginning to recognize the advantages and necessity of upgrades. The challenge arises when clients have multiple products from us, each running on different versions, making it difficult for these products to communicate effectively. Support calls often reveal that clients with versions that are 4 or 5 years old are experiencing issues that were resolved in updates released several years ago, which they simply did not apply. This is part of our sales strategy and the various internal efforts we're making. It's a mix of different elements, not just one, and each is at a distinct phase. As mentioned earlier, we are managing multiple cloud transitions and consolidating versions simultaneously.

But with respect to version consolidation specifically, I guess you call it a stick is that we actually are sunsetting older versions and giving clients certainly ample notice. But letting clients know the version they're on, the oldest versions will no longer be supported after a certain date and working with them to move them to the current version for that date. And we've done that with multiple products. We've sunset multiple old versions of our enterprise ERP solution, our Enterprise Justice solution, and have made significant progress in moving those customers to current versions as we discontinue support of the older versions.

Our next question comes from the line of Clarke Jeffries from Piper Sandler. Your line is open.

A question for Brian on the sort of the pace of the SaaS revenue. I know you had quoted that the volatility of SaaS revenue, the timing of the go-lives from booked to a live system can be variable. But I just wanted to ask, we have 2 years now where the sequential growth in Q3 is the highest. I wanted to understand if that's purely circumstantial, if there's any emerging seasonality to those go-live, or is that just really reflective of typically high Q4 bookings activity?

Yes. It's probably more the latter. I don't think there's a certain characteristic or something that's causing that. It's probably around the timing, especially bigger customers, and it varies by market. For example, in the schools market, which is smaller for us, but they typically have a big push more in Q2 because they want to have new systems live before a new school year starts. Fiscal years don't really have as much to do with it. So I think it's more circumstantial.

Your next question comes from the line of Alex Zukin from Wolfe Research. Your line is open.

Congrats on another solid quarter. I'll ask maybe a longer-term question. I think it's been alluded to a little bit. But again, as we think about AI, both agentic, co-pilot or system, and you think about the customers that are starting to ask those questions. You think about the breadth of solutions that you're offering, both to your customers and across the portfolio of products. As we think about that monetization pathway, is that something we should think about maybe on top of the long-term guidance that you provided at the last Analyst Day through 2030, or is that embedded in there? I ask because it seems like the pace of the innovation wave has moved so fast since you guys fully were even able to contemplate that. So how do we think about those, the top line growth characteristics that could be associated there? And any incremental potential margin degradation or headwinds or thoughts about that? And then I have a quick follow-up.

Yes, absolutely, Alex. To put it simply, when we set our targets for 2030, we did not factor in efficiencies or internal improvements that AI might bring to our gross margins, nor did we include potential sales from newly developed or acquired products. While AI was already incorporated in some of our offerings, we had long-term sales plans in place. So, there may be some consideration for AI, but not in terms of increased research and development or mergers and acquisitions. It’s important to note that we are taking a careful approach to AI, and while we’re seeing more customers reference AI in their requests for proposals, it’s still not the majority. Our clients are likely to proceed cautiously. However, looking ahead 5 to 7 years, we see opportunities, and we won't wait until then to initiate projects. We will be proactive in this area. If any significant research and development project arises that might affect our expenses, we would certainly inform you. But regarding our long-term targets, we have not included any substantial benefits from AI in terms of margins or revenue.

And to what extent, maybe this is just a clarification. To what extent are you hearing or seeing in sales cycles that those types of questions are actually facilitating or we're amplifying flips or converts either the timeline around them or the momentum or enthusiasm? And then on free cash flow, Brian, again, I think the outperformance obviously both in the quarter and the guide for the full year, very notable. You noted that one Kentucky prepayment contract. How do we think about like when, where, and why those prepayments happen? And more so, as we look to '25 and beyond, is there any reason to assume that those would happen more frequently or less frequently and kind of changing the complexion of the free cash flow margins?

The prepayment was a unique situation related to the size, and it will reflect in the fourth quarter cash flow. This involved using ARPA funds to cover six years of SaaS payments, which I don't anticipate becoming a regular occurrence. More significantly, the transaction business characteristics are likely to impact free cash flow consistently. Transaction revenues, such as payments and e-filing, are generally received at the time of the transaction or shortly thereafter, which means we don’t hold large receivables. This aspect of the transaction business is very favorable for cash flow. As this sector grows, even slightly faster than the rest of our operations, it positively influences cash flow. We've also effectively managed our receivables, reducing our days sales outstanding and continuing to keep this under control. This is beneficial since those revenues are typically paid annually in advance, avoiding the need for large receivables. Thus, the transaction business is likely the main driver for enhanced margins and cash flow.

Yes. Regarding the follow-up question on AI and sales, clients are not seeking AI just for its own sake. However, with our CSI acquisition and the document redaction solution, there is a return on investment for the clients. This is a significant sales point. They can accomplish tasks with that system that used to require a lot of manual labor, thus alleviating the manual effort involved. Therefore, innovations like this are driving sales.

That concludes our question-and-answer session. I will now turn the call back over to President and CEO, Lynn Moore, for closing remarks.

All right. Thanks, Rob, 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.

This concludes today's conference call. Thank you for your participation. You may now disconnect.