Earnings Call Transcript - TYL Q2 2022

Operator, Operator

Hello, and welcome to today's Tyler Technologies Second Quarter 2022 Conference Call. Your host for today's call is Lynn Moore, President and CEO of Tyler Technologies. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. And as a reminder, this conference is being recorded today, July 28, 2022. I'd now like to turn the call over to Mr. Moore. Sir, please go ahead.

Lynn Moore, President and CEO

Thank you, Chris, and welcome to our call. With me today is Brian Miller, our Chief Financial Officer. First, I'd like for Brian to give the safe harbor statement. Next, I'll have some comments on our quarter, and then Brian will review the details of our results. I'll end with some additional comments, and then we'll take questions. Brian?

Brian Miller, Chief Financial Officer

Thanks, Lynn. During the course of 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. 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?

Lynn Moore, President and CEO

Thanks, Brian. We're pleased with our second quarter results as the public sector market environment remains strong and RFP and demo activities continue to trend positively. We leveraged successful multi-suite wins and cross-selling efforts to deliver a solid quarter, and our strong competitive position, coupled with an active public sector market, drove a 21% increase in bookings. Overall, we see the challenging broader macro environment as an opportunity to support our clients by replacing aging mission-critical systems and adding advanced digital services to serve the public more efficiently. Total revenues grew approximately 16% with organic growth of 6.2%. Services revenues were flat on an organic basis, exhibiting some softness due to labor market challenges affecting our hiring of implementation resources. Recurring revenues comprised 79.5% of our quarterly revenues and were led by 28% growth in subscription revenues. On an organic basis, excluding COVID-related revenues, subscription revenues grew 14%, reflecting both our accelerating shift to the cloud and growth in transaction-based revenues. We have now achieved greater than 20% subscription revenue growth in 58 of the last 66 quarters. We achieved solid revenue growth even as the shift in new software contract mix accelerates to SaaS from licenses. In Q2, 74% of our new software contract value was SaaS compared to 65% in Q2 last year. As expected, margins compressed, reflecting the increase in our SaaS new business mix and the associated decline in license revenues, as well as costs related to the cloud transition. Along with bookings performance, cash flow was a high point of the quarter as both cash flows from operations and free cash flow achieved new highs for a second quarter. April 21 marked the first anniversary of our NIC acquisition, and we continue to be excited about their performance and the growing pipeline of joint opportunities for both Tyler and NIC. NIC's core organic revenue growth was 8%. During the second quarter, we successfully extended our enterprise contracts in West Virginia, Vermont, Kansas, and Kentucky. NIC also signed our largest ARR contract for the quarter, a new four-year arrangement with the state of New Jersey for a digital motor vehicle titling solution, which we estimate will generate transaction-based revenues of approximately $5 million per year. In addition, NIC signed a new SaaS agreement for our cannabis solution with the states of Alabama and Illinois, which are both state enterprise clients. We continue to build momentum with our joint and cross-sell opportunities with NIC. Our active cross-sell pipeline doubled in value from Q1, and we closed three new deals with NIC clients, including the state of Utah for our Entellitrak Veterans Benefit System and the state of Kentucky for our VendEngine Resident Resources Solution. In other Tyler divisions, we signed four additional notable SaaS deals, each for different product suites and each with a total contract value greater than $3.8 million. Those include Maricopa County, Arizona, for our enterprise permitting and licensing solution; Lancaster, California for our enterprise ERP solution; Lima, Ohio for our enterprise justice and supervision solutions as well as our full suite of public safety applications; and Orange County, Florida for our enterprise assessment and tax solution. In addition, we signed six SaaS deals in the quarter with contract values between $2 million and $3 million each and 14 SaaS deals with contract values between $1 million and $2 million each. During the second quarter, we also amended our e-filing agreement with the state of Washington from a transaction-based volume arrangement to a fixed fee contract. The deal spans nine years for approximately $27 million. However, due to certain contract terms, the majority of this contract was not included in backlog or bookings this quarter. The deal adds approximately $2.8 million in ARR, expanding to over $3 million in ARR in the latter half of the agreement. Our largest new software contract in the quarter was a license deal with Montreal, Quebec for our enterprise assessment and tax solution valued at approximately $13 million. We also signed a second deal in Canada for the same solution with the Yukon territory worth approximately $2 million. In addition, we signed a significant license deal with Dallas County, Texas for our enterprise correction solution valued at approximately $4.5 million. Dallas County, which currently uses our enterprise case management solution, has the ninth largest jail system in the U.S., making it our largest jail client. Other significant license arrangements signed in the quarter, each with a total contract value of greater than $1 million include Charlotte County, Florida and Huntington Park, California for enterprise ERP solution; Fort Worth, Texas for our enforcement mobile solution; and Owasso, Oklahoma for our enterprise public safety, enforcement mobile, and data and insight solutions. Now I'd like for Brian to provide more detail on the results for the quarter and our annual guidance for 2022.

Brian Miller, Chief Financial Officer

Thank you, Lynn. Yesterday, Tyler Technologies announced its second-quarter results for the period ending June 30, 2022. In our earnings release, we included non-GAAP measures that we believe help clarify our results and allow for comparisons with other companies in the software sector. A reconciliation between GAAP and non-GAAP measures is available in our earnings release. Additionally, we have posted schedules containing supplemental information related to this call, including quarterly bookings, backlog, and recurring revenues, in the Investor Relations section of our website under the Financial Reports tab. For the quarter, both GAAP and non-GAAP revenues were $468.7 million, an increase of 16%, boosted by NIC and our other acquisitions in the past year. Organic revenue growth, excluding COVID-related revenues, was 6.2% on a GAAP basis and 5.8% on a non-GAAP basis. NIC's COVID-related revenues for the quarter surpassed our expectations, reaching $15.2 million. Revenues from the TourHealth initiatives concluded in the second quarter, and we expect to finalize the Virginia rent relief program in the third quarter, anticipating around $8 million in revenues for that period. As projected, license revenues dropped by 14.7% due to a continued shift in our software contract mix towards SaaS. Software and service revenues each increased by 18.3%, though service revenues remained essentially unchanged on an organic basis compared to last year, impacted by hiring delays in professional services staff amid the current labor market. We did hire a substantial group of implementers during the quarter, but the onboarding process takes several months before they become fully billable. We plan to expand our implementation team further in the second half of the year to manage our increasing backlog and pipeline, but we might continue to experience some pressure on service revenues in the short term. Subscription revenues rose by 28.2%, with strong organic growth of 14.1%. We added 167 new subscription-based arrangements and converted a record 96 existing on-premises clients, translating to about $115 million in total contract value. In the same quarter last year, we added 170 new subscription arrangements and converted 62 on-premises clients, equating to approximately $73 million in total contract value. Our software subscription bookings in the second quarter contributed $27.6 million in new annual recurring revenue (ARR). Subscription contract value made up roughly 74% of the total new software contract value signed this quarter, compared to 65% in the second quarter of last year. The value-weighted average term for new SaaS contracts this quarter was 3.7 years, down from 4.1 years last year. Transaction-based revenues, which include NIC portal, payment processing, and e-filing revenues and fall within subscriptions, totaled $154.4 million, an increase of 29.1%. Excluding NIC, Tyler's transaction-based revenues grew by 17.5%. E-filing revenues reached an all-time high of $18.5 million, representing a 14% increase. For the second quarter, our non-GAAP ARR was approximately $1.49 billion, reflecting a 16.3% rise. Non-GAAP ARR for SaaS software arrangements was around $405.6 million, up 24.9%. Transaction-based ARR was approximately $617.7 million, an increase of 29.1%, while non-GAAP maintenance ARR decreased by 2.3% to around $467.3 million due to the ongoing transition of on-premises clients to the cloud. Our backlog reached a record high of $1.85 billion at the end of the quarter, an increase of 13.9%. Bookings for the quarter were strong at about $562 million, up 21%, including transaction-based revenues. On an organic basis, bookings were also robust at around $423 million, up 16.3%. Over the trailing 12 months, total bookings amounted to approximately $2 billion, up 53.2%, with roughly $1.5 billion on an organic basis, up 21.1%. If the weighted average contract terms for new SaaS contracts had remained at last year’s level, organic bookings growth would have been 18.3%. As Lynn stated earlier, both cash flows from operations and free cash flow reached record highs for a second quarter. Cash flows from operations were $76.7 million, and free cash flow increased to $60 million, compared to negative $33.5 million last year. We are continuing to reinforce our already strong balance sheet. During the quarter, we paid down $60 million of our term debt. Since completing the NIC acquisition, we have reduced our term debt by $475 million. We also plan to pay down an additional $100 million in term debt by the end of this month. At the end of the quarter, our total outstanding debt was $1.275 billion, with cash and investments totaling $314 million. Notably, $600 million of our debt consists of convertible debt at an interest rate of 0.25%, while the remainder is in prepayable term debt due in 2024 and 2026. We additionally have an undrawn revolver of $500 million. Our net leverage as of June 30 was around 2.07 times the trailing 12 months pro forma EBITDA, and we expect our leverage to fall below 2 times by the end of July. The interest rate increases witnessed so far this year and those projected for the remainder of the year have led to significantly higher anticipated interest expenses than we initially expected. Moreover, we have debt discounts and issuance costs associated with our term debt that are being amortized as non-cash interest expenses. As we prepay term debt, we are required to speed up the amortization of these costs. Consequently, we have updated our earnings guidance for the full year to reflect the changes in our assumptions regarding interest. Our current expectation for total interest expense for the year is $30 million, which marks an increase of about $7 million or approximately $0.12 per share for both GAAP and non-GAAP earnings per share compared to our previous forecast. This increase includes around $4 million of cash interest on term debt and $3 million in additional non-cash amortization of debt discounts and issuance costs. Importantly, our revenue guidance remains unchanged, and our projections for operating margins align well with our earlier outlook.

Lynn Moore, President and CEO

Thanks, Brian. Against the backdrop of generally strong public sector budgets supplemented by federal stimulus funds, we're experiencing a very active market. With our leading competitive position and ongoing investments in strategic initiatives, we are well positioned to take advantage of the continued strength in our market. The acquisitions we've made over the last 18 months, including NIC, VendEngine, and US eDirect, are performing well and contributing to our strong competitive position, helping us create more cross-sell and upsell opportunities with both new and existing clients. In particular, our enthusiasm around the cross-sell opportunities through NIC continues to grow, with recent wins across multiple Tyler products and a rapidly growing pipeline of opportunities. We're also pleased with our progress around our combined payments business, as we begin to execute our go-to-market strategy to pursue a tremendous public sector payments TAM. We believe Tyler is uniquely qualified to deliver government-focused payment solutions, leveraging the strength of NIC's payment platform, analytics and reporting, and deep domain expertise together with Tyler's broad software portfolio and extensive client base, and we look forward to reporting our progress in the coming quarters. Even as we face an uncertain economic macro environment with rising inflation and interest rates, we have a great deal of confidence in our ability to continue to generate solid financial results and to grow cash flow. There are a number of factors that make Tyler's business resilient and relatively defensive compared to many software peers. The public sector market is more stable than many segments of the private sector. We provide solutions that power essential government services often replacing mission-critical systems that are end of life, and our clients don't go out of business or get acquired. Recurring revenues comprised approximately 80% and growing of our total revenues, generating highly reliable cash flow. In addition, the public sector is increasingly focused on moving into the cloud, which we support with our cloud-first model. Our experience during the recession more than a decade ago supports our confidence, and Tyler is clearly in a much stronger position today to succeed during an economic downturn. We also have the advantage of a very strong balance sheet and reliable cash flow, which enables us to continue to invest strategically in growth even if some competitors may be constrained. While we have term and convertible debt associated with the NIC acquisition and have been impacted by rising interest rates, we are modestly leveraged at approximately 2x adjusted EBITDA, and we expect to continue to delever. Accordingly, in the near term, we are prioritizing using our cash flow to reduce debt while retaining the flexibility to pursue strategic acquisitions and investments that provide long-term value. Finally, I'm happy to report that we remain on track with our major strategic initiatives, including projects related to optimizing our products for efficient deployment of the cloud, moving from our proprietary data centers to AWS, and ultimately accelerating the migration of our on-premise clients to the cloud and driving long-term margin expansion. With that, we'd like to open the line for Q&A.

Operator, Operator

Our first question is from Sami Badri with Credit Suisse. Your line is open.

Sami Badri, Analyst

First, I wanted to ask about the sales cycle related to the larger deals you announced this quarter. What was the sales cycle for these? Are the sales cycles tightening or elongating? Are they consistent with prior lengths? Any insights on this? Additionally, we are noticing a strengthening environment for state and local budget spending. A question we often receive from investors is how these revisions in state and local budgets connect with companies like yours. Could you provide some insight into what you observe in the field regarding the timeline from when budgets are announced to when they translate into actual bookings or revenues for you?

Lynn Moore, President and CEO

Yes, sure, Sami, it's Lynn. I'll start and I'll let Brian jump in. I think right now, our sales cycles are pretty normal. I think we've experienced times if you go back to the recession in '08, '09, that's where you started seeing things push out and get delayed. We saw a little bit of that during COVID. But I think the key is we continually talk about the fact that what we provide is essential functionality, and the software that we do provide are things that are needed and they're often replacing out-of-date systems. And so right now, the market looks good. The sales cycles are pretty typical for a normal healthy time, even with respect to those large deals. Sales cycles will vary a little bit across our different divisions. Some have longer than others. And sometimes the larger deals do take a little bit longer. But I think across the board, across our different product suites, I'd say sales cycles are pretty much on track. When you talk about the state and local government spending environment, what we're seeing right now really is it's pretty healthy. I agree their budgets are in good shape. I've made comments before that I think coming out of COVID, they were not hit nearly as hard as a lot of people anticipated some of the journal reports and other things that we've read. Also, with the infusion of some stimulus. And I know Brian's got some numbers and thoughts around ARPA. But I think right now, what we're seeing in our pipeline, all our leading indicators around RFPs and demos, things like that, you're seeing it a little bit in some of our bookings this quarter is that things are well right now in the state and local government.

Brian Miller, Chief Financial Officer

I would like to add a few points. Larger contracts typically involve longer sales cycles, and for some of these substantial deals, the duration can stretch to years from the initial discussions about a solution until a signed contract is reached, and this timing can be unpredictable. This was true for a couple of larger deals, namely the Montreal and Dallas deals, which both had lengthy cycles, but we remained steadfast. The timing for a deal to be recorded in the bookings can also differ significantly. In some jurisdictions, the process of acquiring a solution might begin before it is budgeted, as they recognize the solution’s critical importance and see the need for replacement as essential. Thus, they may initiate the sales or buying process early, allowing them to swiftly sign a contract once funding is in place. Conversely, others may include it in their budget and then either start or expedite the process. There are various ways this can unfold, so while new budgets are increasing, it doesn't necessarily lead to an immediate surge in pipeline activity, as these do not always align perfectly.

Matthew VanVliet, Analyst

You mentioned on the professional services side and overall implementation. You were a little bit limited both from a headcount perspective and the ability to hire new headcount to add to that. Just curious in terms of how that's progressing, both through July and what expectations, how those have changed through the end of the year? And then secondarily, has this increased your appetite to look to external partners to help with some of at least the more straightforward implementations or some of the more blocking tackling components of the deployments?

Lynn Moore, President and CEO

Sure, thanks, Matthew. I would say that we are facing labor market challenges that are affecting us like many others. We have been dealing with this for a while, which poses difficulties in hiring and recruiting. We are also noticing an increase in early retirements. The current impact is visible, and while we have significant business to pursue, our services revenues are slightly down. I anticipate this trend may continue throughout the year. Typically, we do tend to hire in large groups. For instance, our enterprise ERP group brought in a substantial number of new hires in February, and we plan to bring in another large group soon. However, it takes time for these new hires to acclimate and become fully billable on client projects, which can take four to six months, contributing to delays in our margins as they come on board. Regarding external partners, we've historically preferred to keep our services in-house. While this doesn't provide a significant margin advantage, it has proven beneficial in terms of professional relationships and client satisfaction for the past 25 years. Maintaining a direct connection from sales to implementation to support has been crucial for our market success. Therefore, at this moment, we are not looking to change that approach, as we believe this unique aspect of our business should remain in-house for now.

Matthew VanVliet, Analyst

Very, very helpful. And then, as you look at the state hunting license agreements that NIC has in place, how do you feel you're progressing in terms of getting through any demand associated with those customers, making your way into, I guess, sort of the local level that rolls up through those statewide purchasing agreements. You've captured a lot of the sort of low-hanging fruit that NIC just didn't have the product to sell through. Or are we still very early stages of the overall opportunity that those present for you?

Lynn Moore, President and CEO

Yes, Matthew. I believe I mentioned in the last call that we are likely just at the beginning of what we can accomplish with NIC, and perhaps only at the onset. They lacked some of the local relationships, so we are still getting to know each other. The fact that we've already completed a number of deals this early on, closing 15 deals so far, is noteworthy. Our active pipeline consists of around 100 deals totaling over $30 million, which is quite exciting in such a short timeframe while we continue our regular integrations with NIC. We have secured some important contracts, including VendEngine's contract with the Arkansas Department of Corrections, and another contract with Kentucky, as well as our Entellitrak Veterans Benefits contract with Utah. This progress is particularly impressive considering the collaboration between NIC and VendEngine, both of which we acquired in the last year in different business areas. It's encouraging to see that coordination and the ability to leverage NIC's strong state relationships and enterprise contracts.

Brian Miller, Chief Financial Officer

And I'd just add that specifically on hunting and fishing, we're still integrating US eDirect with the NIC outdoor recreation platform, but really a significant increase in our capabilities there. But I'd say we're in the very early stages of being able to drive that down more broadly, both within local government and at the state and federal levels. But that is one of the product areas that on a combined basis, we've got a lot of strength in and that we're looking for big things out of...

Lynn Moore, President and CEO

I apologize, Matthew, if you're asking about hunting, I heard state; we call those understanding.

Matthew VanVliet, Analyst

No, I was talking about the NIC deals, those agreements. But thanks for the extra color, Brian. Appreciated guys.

Operator, Operator

The next question is from Saket Kalia with Barclays. Your line is open.

Saket Kalia, Analyst

Lynn, can you share which product areas are most effective in converting maintenance customers to SaaS? I noticed there was a significant increase in total contract value converted this quarter compared to the same time last year. Where do you see the most success? Additionally, how do you anticipate the customer base transitioning to SaaS in the upcoming years?

Lynn Moore, President and CEO

Certainly, Saket. Thank you for your question. It's an excellent question. Currently, the main areas where we are experiencing the most flips are in our ERP segment. This includes both our enterprise ERP and ERP Pro solutions, which happen to have the largest customer base. For our enterprise ERP, we are already significantly ahead of our annual goal by about 35% in the first half of the year. In our ERP Pro solution, formerly known as Incode, we aim for approximately 180 conversions annually. While we see activity in other areas, these represent our highest volume. Moving forward, we expect to see growth not only in these areas but across all product lines. We are also conducting internal modeling for what we refer to as Tyler 2030, and a key element of our growth strategy involves transitioning our substantial customer base from on-premises to the SaaS model. At this moment, I cannot provide a specific projection for annual conversions and their growth, but I anticipate continued momentum and increased activity in this area over the next five to seven years.

Saket Kalia, Analyst

Got it. That makes sense. Brian, maybe for you as a follow-up. And maybe this is related to some of the hiring commentary that you folks had mentioned on services. But can you just talk a little bit about software and services bookings? It's been a couple of strong quarters of bookings, strong on bookings than done on revenue, frankly. So can you just talk about what's driving that strength? And just maybe anything different this year about the conversion to revenue here versus prior years?

Brian Miller, Chief Financial Officer

On the second part of your question, the conversion to revenue involves more SaaS, so there isn't an immediate revenue impact. Typically, the recognition of revenue occurs a quarter or two after the signing when the customer's environment is set up. Even with SaaS customers, there’s a delay. Additionally, we have a recurring revenue stream that begins to grow, starting in the third month of the quarter, leading to a month’s worth of revenue initially, followed by a full quarter's worth in the next quarter, and so on. The ongoing shift in our revenue mix has contributed to this, particularly with fewer licenses that are usually recognized mostly upfront. We also discussed some service pressure; our plan headcount is slightly below expectations, which affects the speed of new signings as we’re not ramping up our billable implementation teams as quickly as we could when fully staffed. This is a key aspect of the situation. Regarding higher bookings, we have mentioned that bookings tend to fluctuate from quarter to quarter, especially with large deals. In this quarter, a couple of significant deals with long sales cycles reached contract. Overall, it’s a combination of various factors, including a strong economic backdrop and budget situations for governments, enhanced by ARPA funds and federal stimulus support. As we noted in previous calls, sometimes it’s not entirely clear if a deal was funded by ARPA funds, but there are instances where it is, and sometimes these funds are allocated for other uses, which can still facilitate additional purchases. We are seeing robust performance in our inside sales teams selling more products to existing customers, likely driven by federal stimulus. However, this tailwind is expected to last until the end of 2024 for the commitment of those funds, extending to 2026 for spending. A study by Brookings indicated that as of the end of 2021, only about 40% of stimulus funds had been committed by local governments, suggesting continued support in the market. Our competitive position remains strong as we invest heavily and have expanded our product offerings through acquisitions and internal developments. Our average sales are larger now due to more bundled products, such as our data and insight solution and various public safety products, which enhance new sales. Multiple factors are contributing to this, but it’s important to note that there is usually a delay from bookings growth to revenue growth.

Operator, Operator

The next question is from Michael Turrin with Wells Fargo Securities. Your line is open.

Michael Turrin, Analyst

There were several comments throughout the prepared remarks around the strength and resilience of the demand environment. Just wondering if there's any more color you can add around what you're seeing from public sector customers currently and how the RFP volumes you're referencing compare to what you're used to generally seeing this time of the year?

Lynn Moore, President and CEO

Yes, absolutely, Michael. The last few years have been somewhat challenging due to COVID and other factors. However, we are currently observing a return to pre-COVID levels across the board. Our requests for proposals are increasing, our demonstrations are up, and overall the market appears quite robust. In certain segments of our business, the pipeline is even expanding beyond those pre-COVID levels, while in other areas it has merely returned to those earlier levels. At present, the market indicators indicate that budgets are strong and healthy, and there is significant demand.

Brian Miller, Chief Financial Officer

Yes, we recognize that our business is maybe a little bit more complicated given the transition from license to the cloud and the addition of NIC and their transaction-based revenue streams and our plans to grow what already is a pretty sizable payments business through NIC to grow that significantly. So we give a lot of metrics and we recognize you probably give too many metrics. But I'd say, if you're looking for kind of the North Star and what's really important as our model evolves, it would be those metrics around ARR and particularly, we do get the breakdown of those different components of ARR, but particularly software subscription ARR and transaction ARR. And we expect that maintenance will kind of flat right now, and will start to decline as more of those customers flip to the cloud. So really, the things that probably the most important metric would be around those recurring ARs from subscriptions and transactions.

Operator, Operator

The next question is from Joshua Reilly with Needham. Your line is open.

Joshua Reilly, Analyst

How should we think about the seasonality, if any, around the payments business now, including NIC, both from the portal revenues from core Tyler and NIC?

Brian Miller, Chief Financial Officer

Yes. Typically, the fourth quarter is lighter there, less activity through the portals, maybe slightly less in terms of payment volumes that are often associated with those portal transactions. So around the holidays and as people get to the end of the year, there's just a little bit lower activity there. The other thing that we talked about last quarter which is sort of new to us is in the Florida contract with the revenues around the payments for the Department of State and their corporate licensing activity, which is almost all in the first quarter, a little bit of it lags into the second quarter. And I think they were around $6 million of revenues associated with that that's seasonally towards the beginning of the year. But other than that, it's primarily a fourth quarter slowdown around the payments.

Joshua Reilly, Analyst

That's helpful.

Lynn Moore, President and CEO

I believe, Josh, that as we continue to grow our payments business, we are already expanding it within Tyler and extending it beyond just some of the NIC activities related to outdoor services. Looking ahead several years, I think you will notice that as the volume increases across a broader base and more products and constituents are involved, there will be a leveling off over time, although that will take a while to materialize.

Joshua Reilly, Analyst

Got it. And then just one other follow-up on the NIC business. What are you seeing in terms of the driver history record hold revenue that was from that segment? Is that recovering as you would have expected? And how much could that potentially positively impact revenue throughout the rest of the year?

Lynn Moore, President and CEO

Yes, I would say that the DHR is currently aligned with our internal plans for the year, which essentially indicates minimal growth. This is one of the areas in our business that we identify as being resistant to recession, yet we are noticing some impact on the DHR business. Historically, DHR was a significant part of the NIC businesses, but as we expand into new areas, I anticipate that DHR's contribution to our overall business will decrease somewhat. Currently, DHR accounts for around 17% of total revenues, possibly 19% if we exclude COVID impacts, and I expect this to trend down to about 15% as we enhance revenue from other government services, payments, and additional products.

Brian Miller, Chief Financial Officer

Yes. So typically, this quarter, they were down about 2%. So they're recovering a bit, but still softness there. And that's one also that we believe is affected indirectly by supply chain and some of that's tied to new vehicle sales. And those are a broader economy. There's no cars out there.

Operator, Operator

The next question is from Kirk Materne with Evercore ISI. Your line is open.

Kirk Materne, Analyst

Congrats on a really nice bookings quarter. Lynn, I was wondering could you just talk a little bit about what's your discussions like with customers today in terms of consolidating the number of vendors they're working with? I was just kind of curious you all obviously have a much more expansive product portfolio than you did 10 years ago. How much is the ability to sort of take wallet share a bigger part of the story today than it was say, 5, 10 years ago? And is that accelerating? Is that conversation accelerating? I'm just sort of wondering about thinking about you all more in sort of a net revenue retention basis, meaning the ability to expand sort of cross and upsell versus just be as reliant as you were on sort of net new, say, again, 5, 10 years ago?

Lynn Moore, President and CEO

Yes, Kirk, that's a good question. Our strategy has always focused on offering a comprehensive suite of products rather than single-point solutions. I believe this gives us a significant competitive edge. While some consultants suggest the opposite approach, I don't understand why, as dealing with multiple vendors and extra integrations seems more cumbersome than working with a single provider. Additionally, developing our offerings takes years, and leveraging cross-selling and upselling within our established customer base is a key strategic focus for us moving forward. Each quarter, our inside sales teams have consistently exceeded expectations, and as we make strategic acquisitions to expand our product lineup, I believe this trend will continue. I see this as one of our strengths in the market.

Kirk Materne, Analyst

And Brian, just on the ramp in sort of your services business and bringing out more billable or more headcount on that side. How should we think about that sort of impacting margins as we think a little bit ahead to 23%. I realize you guys are expecting margins maybe start picking up again in '24, not next year. But is there anything we should be aware of, meaning maybe a little bit heavier weight on the first half of the year next year as people get ramped up versus the back half? Any just color on that would be helpful.

Brian Miller, Chief Financial Officer

Yes. I think the margin impact is more of what we're seeing this year because you bring those people on, obviously, you're paying them their expenses, but it's maybe kind of a six months ramp-up to become fully billable. So initially, you get a margin hit from having the cost without the revenues associated with it. And then so from a negative impact, you will see that more this year. And then as they become billable and they're starting to generate revenues and help us deliver that backlog, then you see a positive impact. Services aren't a high-margin business for us as it is. But so I would expect that as you get into the early part of next year through the middle of next year, you'll start to see a positive impact from those employees being productive. And we hired, as Linda, a pretty big class or classes cumulatively, pretty large across Q2 and have pretty strong hiring plans in the second half of the year. So assuming we can execute on those and turnover seems to be settling down a bit. Then we'll have those resources billable in the first part of next year.

Operator, Operator

The next question is from Charles Strauzer with CJS Securities. Your line is open.

Charles Strauzer, Analyst

Just picking up on that last question about the labor hiring looking at the gross margin on a percentage basis in Q2, it was down pretty significantly year-over-year and down a touch sequentially while SG&A was lower. Was that kind of the main driver behind that?

Lynn Moore, President and CEO

Yes, the margin is influenced by a mix of professional services. As we mentioned earlier, we are observing a return of some cost savings from COVID, which are reflected in SG&A and cost of sales, especially in billable travel. Although we plan to maintain a significant amount of remote services similar to during COVID, billable travel is returning in certain segments of our business, affecting our margins, which we anticipated. Additionally, there are some transaction costs related to our cloud transition and the switch from our proprietary data centers to AWS. These factors align with our expectations. We also experienced a slight increase in revenue from COVID-related services at NIC, though these typically have a lower margin compared to Tyler's overall margin, resulting in a negative impact on margins due to over-performance in those revenues. We expect the last of those impacts to fade by the end of the third quarter, which should positively affect our margins.

Charles Strauzer, Analyst

That's helpful. And just staying on the AWS transition there, where do you think you are in terms of your expectations for that transition? Are you tracking ahead of schedule or behind, that kind of thing?

Lynn Moore, President and CEO

Yes. I think, Charlie, we're on track with our internal plans, both in terms of where we are with our product investments, what we've outlined for plans to exit our data centers. And when we talk about sort of getting the other side of the bubble costs. So right now, internally, I'm pleased with where we're sitting.

Operator, Operator

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

Rob Oliver, Analyst

There hasn't been a lot of commentary on public safety on the call. So then I thought I'd ask about that. It was a bit of a focus in Indianapolis. And over the last couple of years, you guys certainly have begun to see some nice success in cross-sell of public safety into your core. So just curious to know how you characterize that market right now? And when you look at the components of that RFP activity and pipeline, how does public safety fare in their win rates, and then how it sets up for that sort of all-important back half for the year in Q4?

Lynn Moore, President and CEO

Sure, Rob. Thank you for your comment. Currently, the public safety market has largely returned to a normal state. I feel good about our competitive position, though we have a few strong competitors that we've previously discussed. Some competitors in this space are burdened with significant debt, which could be affecting their performance with the change in interest rates. We've also heard reports about certain smaller competitors facing challenges, including layoffs. However, we're satisfied with our current standing. We invested heavily in mobility several years ago, and this investment continues to give us a notable advantage, along with our efforts to leverage our acquisitions in the Tyler Alliance narrative. In my opening remarks, I mentioned our contract with Lima County, Ohio, where we provided our Enterprise Courts & Justice product and solutions on the public safety side, which really appealed to the client. We're beginning to see positive developments there. Although the market still shows some resistance to the cloud, we're making progress with SaaS deals. We might have our first beta client in the AWS Cloud by late this year or early next year, which is an encouraging development in that market.

Brian Miller, Chief Financial Officer

Regarding capital expenditures, there isn't anything particularly significant to report. We are simply adjusting the timing of certain projects, especially in relation to some of our facilities. For instance, NIC is set to move to a new location in the Kansas City area, and the timing of these developments has shifted slightly. Overall, there are no major surprises in our capital expenditures at this point compared to our initial expectations at the beginning of the year. There are also some minor adjustments in how we capitalize our internal software development efforts, mainly related to optimizing our cloud products. Sometimes, there may be discrepancies between our original estimates and how accounting rules dictate what we capitalize versus what is classified as an expense.

Operator, Operator

The next question is from Alex Zukin with Wolfe Research. Your line is open.

Alex Zukin, Analyst

I have a few questions. It seems that bookings were very strong this quarter, and when you account for the duration of the contracts, the situation looks even better. Regarding the challenges you're facing with SaaS revenues, specifically due to the hiring difficulties in services that you mentioned, can you estimate where SaaS revenues might be if that challenge wasn't present? I have a few more questions as well.

Brian Miller, Chief Financial Officer

Yes, I'm not exactly sure how we would translate that. I think the lag in the start is pretty modest, but I think we would be seeing a little bit higher level, but I don't know that it's sort of a double-digit effect. I think it's pretty modest now. And like I said, we have pretty aggressive hiring plans for the rest of the year to get our teams up to full strength. And so I think it's a relatively short-term impact. We'll see how it plays out through the balance of the year. It could create some softness on that services side. But I think at this point, it's not a big impediment to growth in the subscription revenues, but certainly is some sort of a factor there.

Alex Zukin, Analyst

Got it. The other question is, with all the headlines about inflation and software companies increasing prices, can you remind us about the inflation adjustments or pricing strategies you have in place with customers? Specifically, I know that annual maintenance increases are part of that. As more customers transition to SaaS, how do you ensure you continue to capture those unit economics on the subscription contracts?

Lynn Moore, President and CEO

Yes, most of our maintenance contracts are annual agreements, with a few multiyear ones. A small percentage have built-in escalators, but generally, they allow for annual price adjustments. Some are tied to CPI, but that's not the majority. There's some flexibility in pricing, and we reviewed this in the spring. The majority of our maintenance contracts follow the June 30, July 1 cycle, which we discussed internally in March and April before reaching out. For SaaS contracts, similar principles apply. After the initial engagement, we can start implementing price increases. Many initial SaaS deals are multiyear terms, some with built-in escalators, but revenue recognition has historically been more flat-rate, leading to potential declining margin. We're making efforts to shorten the length of initial contracts and consider terms that allow for built-in escalators, which we price into our agreements. As these contracts renew annually, we'll have greater flexibility to adjust pricing. However, some existing contracts from a year or two ago have fixed pricing that we cannot change at this time.

Brian Miller, Chief Financial Officer

And in some of our products, we did implement sort of our above-normal maintenance increases this year. And we've also taken a look at our professional services billing rates and in some cases adjustments there to account for inflation.

Alex Zukin, Analyst

Perfect. Regarding cash flow, if you examine your model, you'll notice that every two years, your free cash flow seasonality in the first half fluctuates. It shifts from about 23% to 24% of the total year down to 10% to 12%. Firstly, could you help us understand this? It appears we are in one of those years that could be more like the 20-plus percent year. However, I would like to gain insight into the seasonality from a free cash flow standpoint as we consider the second half and the full year. Additionally, could you connect this to capital allocation? You mentioned intentions to pay down debt, which seems logical considering the rising interest expenses and the current environment. However, could you also discuss the possibility of an increased stock buyback given the current stock value and the fundamentals?

Brian Miller, Chief Financial Officer

I’ll address the first part of that. Typically, the third quarter is the strongest for cash flow each year, mainly due to maintenance billings. We generate nearly $470 million annually from maintenance, with a significant portion renewed by July 1. These billings are usually issued late in the second quarter and collected in the third. They are typically settled quickly, driving cash flow growth in the third quarter. Last year, there was an anomaly in the second quarter related to NIC because they were with us for only part of the quarter. There were unusual timing dynamics due to their acquisition, and they had a notable amount of customer cash from their transaction-based revenue, which was then paid out to customers post-acquisition, causing a discrepancy. This year, we expect a more standard full quarter with NIC, and their cash flow should be steadier throughout the year, considering the nature of most of their revenue. You will likely see a more even distribution moving forward, but I believe we will still generate over half, possibly around two-thirds, of our cash flow in the latter half of the year. However, last year’s situation was indeed unusual.

Lynn Moore, President and CEO

Yes. Regarding the question about cash usage, you are correct. Our main focus remains on paying down debt, but we are still open to acquisitions. We haven't closed the door or stopped engaging; we have been actively exploring opportunities and have taken part in a few processes this year. We made a purchase of USD Direct earlier this year, but we are looking for compelling opportunities at reasonable valuations. Recently, we've noticed that despite some turbulence in the broader markets, the expectations for several private companies have remained unchanged or even increased. It's puzzling when proposals come in at valuations higher than Tyler's. Currently, our blended debt rate is about 2%, which is largely due to our significant debt reduction efforts. When we first incurred this debt, our convertible debt made up about 34% of it. After this month's payment, it will be just over 50%. As we continue reducing our term debt, we will be less affected by interest rates moving forward, which is advantageous. Regarding share repurchases, I agree that looking five to seven years ahead, our stock could be appealing. However, unless there is a strong reason to make a significant move, I prefer focusing on debt reduction in the near term.

Operator, Operator

The next question is from Terry Tillman with Truist Securities. Your line is open.

Terry Tillman, Analyst

In Brian, I feel like I should follow the 10 because we're going past an hour, but I can't help myself since I have you here, so I'm going to ask a couple of questions. First, I want to address the Montreal deal for Bongor. My first question relates to the court system we discussed. They had a 25-year-old case management system. I know you've mentioned your high-end ERP business and your ERP Pro business, and then someone asked about public safety. How do current case management opportunities compare to some of these other cloud replacement opportunities? And then a quick follow-up.

Brian Miller, Chief Financial Officer

Case Management is one of our leading products in the marketplace, boasting a substantial market share. Our enterprise case management solution, previously known as Odyssey, is used by over 55% of courts in the U.S. and has been implemented in eight of the ten largest counties, along with approximately 17 statewide deployments. It remains a robust offering for us; however, it can be somewhat variable, especially with larger contracts. We often replace aging case management systems custom-built decades ago in certain counties. Currently, we see more activity in mid-range deals, but there are no significant statewide deals actively on the market at this moment. Nevertheless, our success rate on those opportunities is high. Our growth in the court sector is increasingly driven by additional products within our management suite. A notable example is our long-standing relationship with Dallas County, which has traditionally used our case management system and is now incorporating our jail solution. Through various acquisitions, we have expanded our portfolio to include probation, jury, prosecutor, and process service solutions, enhancing our offerings and growth potential in that area. Overall, we maintain a solid business with a strong competitive stance, though new opportunities may not be as prevalent right now. However, we are well-prepared for when they do arise.

Lynn Moore, President and CEO

Yes, and I want to highlight what Brian mentioned earlier. Our strong position continues to serve as a foundation and gateway for pursuing additional investments. For instance, we have made significant strides with projects like the Dallas County Jail deal. A few years ago, we acquired a company called CaseloadPRO, which was a key step in our enterprise supervision initiatives in L.A. County. This includes pre-trial supervision and extends to juvenile and adult services. We believe we will expand our offerings in L.A. County, which is the largest correctional justice department among counties in the United States.

Operator, Operator

Our final question is from Jonathan Ho with William Blair. Your line is open.

Jonathan Ho, Analyst

I'll keep it to one question. With the upcoming quarter, can you remind us of whether there are any large deals in terms of maybe some tougher bookings comparisons? SP1.

Brian Miller, Chief Financial Officer

A second. Yes. Last year, in Q3, we didn't really have any mega deals. Our biggest SaaS deal was about a $5 million contract value with Lawrence, Kansas, and we had a handful of license deals, the biggest of which was less than $3 million. So I think it's a pretty normal comp coming up.

Operator, Operator

The next question is from Keith Housum with Northcoast Research. Your line is open.

Keith Housum, Analyst

I'll keep mine to one question while I know we're running late here. Brian, maybe you just touch on the NIC acquisition, your ability to retain employees over the past year and how that affects the business going forward.

Brian Miller, Chief Financial Officer

Yes, it has been very solid, both at senior management and staff levels. We have experienced strong retention, largely because the acquisition made a lot of sense and opened up great growth opportunities for both NIC and Tyler. Their teams have recognized this. Looking back over the past year, the integration has been smooth for a deal of this magnitude, especially considering it was completed while we were largely remote during COVID. We have some individuals in new senior leadership roles at NIC, particularly Lizabeth as President and Thomas as COO, and they have done an excellent job managing their teams and the integration. We are very satisfied with the retention and the opportunities it has generated for both NIC and Tyler. For example, our Tyler Payments team has combined with the NIC Payments team, and they are now taking the lead in that area. So overall, we are very pleased with the retention there.

Lynn Moore, President and CEO

Yes, I think the excitement that we see in the cross opportunities and the things that we can do together, that just naturally flows up and down the organization, and I think that helps with retention.

Operator, Operator

At this time, there proves to be no more questions. Mr. Moore, I'll turn the call back over to you for closing remarks.

Lynn Moore, President and CEO

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

Operator, Operator

Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect.