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Tyler Technologies, Inc. (NYSE:TYL)

Q3 2008 Earnings Call

October 27, 2008 12:00 pm ET

Executives

John S. Marr, Jr. – President, Chief Executive Officer & Director

Brian K. Miller – Chief Financial Officer, Executive Vice President & Treasurer

Analysts

Charles Strauzer - CJS Securities

Kirk Materne - Bank of America Securities

Brian Kinstlinger - Sidoti & Company, LLC

David Yuschak - Sanders Morris Harris

[Dale Warmington - Dalwar Capital]

[Robert Moses - RGM Capital]

Operator

Welcome to today’s Tyler Technologies third quarter 2008 earnings conference call. Today’s call is being recorded. Your host for today’s call is John Marr, President and CEO of Tyler Technologies.

John S. Marr, Jr.

Welcome to our third quarter 2008 earnings call. With me on the call today is Brian Miller, our Chief Financial Officer. First I’d like for Brian to give the Safe Harbor statement and then I’ll have some preliminary comments and Brian will review the details of our operating results. Then I’ll have some final comments and then we’ll take your questions.

Brian K. Miller

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 projects. We refer you to our Form 10K and other SEC filings for more information on those risks.

John S. Marr, Jr.

The third quarter 2008 has proven to be very strong across the board at Tyler. We are pleased we posted our 30th consecutive profitable quarter. These results are a testament that our strategies and business model are sound and our products are competitive and that Tyler’s nearly 2,000 employees are executing at an exceptional level.

Our third quarter and year-to-date results exceeded our expectations by a substantial margin with nearly 25% revenue growth in the quarter and 22% year-to-date. As importantly, the revenue mix has been favorable with higher margin licenses, recurring maintenance and subscription services leading the way. All this delivered new quarterly highs and several key measures including total revenues, operating income, EBITDA and free cash flow excluding our real estate acquisition.

In fact, our free cash flow continues to be exceptional. In the quarter we saw an 81% increase in free cash flow excluding the real estate acquisition. Later on the call we’ll review our latest guidance but through September 30 our actual trailing 12 month results are revenues of $256 million, earnings per share of $0.60 before the legal settlement and $0.40 after the settlement and free cash flow of $50.3 million before real estate acquisitions.

Now, I’d like for Brian to provide more detail on the results of the quarter.

Brian K. Miller

This morning Tyler Technologies reported its results for the third quarter ended September 30, 2008. This was financially our best quarter ever by most measures with very strong earnings and even strong cash flow. You all have access to the press release and our Form 10Q has now been filed so I am going to limit my comments and focus on providing an analysis on the key factors contributing to our results this quarter and then move on to John’s comments on the current quarter and our outlook for the rest of the year as well as Q&A.

Revenues for the third quarter were $68.6 million, up 24.9% from the third quarter 2007. Our organic growth for the quarter was approximately 15% and about 10 percentage points of our growth was the result of acquisitions we’ve made over the past 12 months. We posted double digit revenue growth across all of our software related revenue lines. Software licenses were up 40% and topped $11 million for the second straight quarter.

Licenses from our Odyssey Courts & Justice solution was the biggest contributor to the license revenue increase and included some license revenues that had previously been deferred pending the achievements of certain milestones. Licenses from other products such as financial management and education systems and appraisals on tax systems also increased year-over-year.

Subscription revenues grew 38% over last year’s third quarter reflecting revenues from new customers as well as existing customers that have converted to our ASP model. During the quarter we signed two new ASP customers and converted eight existing customers. Growth in the base of customers subscribing to our disaster recovery services also contributed to the increase.

Maintenance revenue growth was 28% with acquisitions accounting for approximately 11% of the growth and the other 17% organic. Together recurring revenues from subscriptions and maintenance comprised over 45% of our total revenues for the third quarter in addition to a substantial amount of service revenues that are attributable to existing customers. Software services revenues grew 17% with increases across each of our major product categories.

Finally, appraisal services revenue increased 7% in the third quarter after showing year-over-year declines in the previous three quarters primarily due to the ramp up of the revaluation project in New Orleans. For the third quarter 2008 our blended gross margin increased 420 basis points to 43.6% compared to 39.4% in last year’s third quarter. The strong improvement is attributable to a more favorable revenue mix and particularly the high level of license revenues and operating leverage including improved staff utilization that contributed to higher margins across each revenue category.

Sequentially gross margins increased 50 basis points from 43.1% in the second quarter of 2008. SG&A expenses were 23.3% of revenue and 23.1% for the same period in 2007. The incremental SG&A expense related to acquisitions was primarily responsible for the slight increase in SG&A as a percentage of revenue. Net research and development expense was $1.4 million for the third quarter of 2008 compared to $639,000 for the same period last year.

The increase is primarily due to staffing increases associated with our joint development effort with Microsoft on the dynamic [AXERP] for the public sector. Research and development expense for the third quarter of 2008 includes $857,000 of cost reimbursement recognized under the amended research and development agreement with Microsoft. R&D in the third quarter of 2007 was offset by reimbursement by Microsoft of $883,000.

We have recently revised our agreement with Microsoft to define the scope of reimbursable developments through the balance of the project and we now expect to offset R&D expense by approximately $850,000 each quarter through the end of 2010. Operating income was $11.9 million and nearly 51% increase from the third quarter 2007. As we discussed last quarter we settled outstanding litigation related to SOX purchase warrants and recorded a non-cash charge of $9 million in the second quarter of this year.

This charge was not tax deductable and had the effect of significantly increasing our effective tax rate for the second quarter and each subsequent quarter in 2008 as we must allocate the tax impact respectively for the 2008 calendar year. In order to more clearly present our operating results on a comparable basis, in addition to GAAP income numbers we have also provided non-GAAP results that have excluded the effects of the non-cash [inaudible] settlement.

A reconciliation of earnings before the effect of the legal settlement to GAAP income is included in our earnings press release. For the third quarter of 2008, the impact of the legal settlement resulted in an effective tax rate of 48.4% and additional income tax of $1.5 million. Non-GAAP net income for the quarter excluding the income tax effects of the legal settlement was $7.8 million or $0.20 per diluted share, an increase of 52% compared to net income of $5.2 million or $0.12 per diluted share in the third quarter of 2007.

Including the impact of the legal settlement, GAAP net income for the quarter was $6.4 million or $0.16 per diluted share. As we have discussed before, our business model has very attractive cash flow characteristics that consistently produce annual cash flow well in excess of GAAP earnings. That certainly was the case in the third quarter when cash from operations was $27.5 million, an increase of 74.3% from $15.7 million for the same period in 2007.

The third quarter is historically our highest cash flow quarter of the year because we invoice a significant portion of our annual maintenance and support in June and collect much of that cash in the third quarter. We also collected cash on contracts containing milestone billing schedules and reduced our DSOs so total receivables grew at a much lower rate than deferred revenues. Before capital expenditures for real estate acquisitions, free cash flow for the quarter was $26.6 million compared to $14.7 million in 2007.

Our total capital expenditures during the third quarter were $13.9 million of which $13 million was associated with real estate for the company’s future office space requirements. So, free cash flow after all cap ex including real estate was $13.6 million for the quarter. Cap ex for the third quarter last year was $1 million. We also expect to complete the purchase of our office facility in [Fallis Lane] for approximately $10 million in cash during the fourth quarter of this year.

For the first nine months of this year, cash flow from operations was $45.4 million compared to $24.5 million for the same period in 2007. The year-to-date free cash flow for 2008 excluding the real estate acquisitions if $41.9 million versus $21.8 million for the first nine months of 2007. We did not capitalize any software development costs this quarter and amortization of post acquisition software development costs was $975,000 in the third quarter down from $1.1 million in last year’s third quarter.

Our backlog at September 30, 2008 was $235.6 million up approximately 4% compared to $225.8 million at September 30, 2007 and down slightly from $238 million at June 30, 2008. Backlog related to our software business which excludes backlog from appraisal services contracts was $209.8 million at September 30th, an increase of $11.7 million or 6% from September of last year.

Appraisal services backlog was $25.7 million at September 30, 2008 compared to $27.6 million at September 30, 2007 and $22.9 million at June 30, 2008. As we have built up our implementation capacity over the past few quarters we’ve been successful in bringing down the level of backlog for certain products including our Odyssey Court System to more closely align with clients’ desire to implementation time tables.

As we’ve discussed in the past we’ve had two primary uses of our free cash flow in addition to substantial ongoing investments in our products that are expensed either in cost of maintenance or as R&D expense. One of those uses of cash is our stock repurchase program. We’ve been a very consistent buyer of our own stock for several years. We have a long term outlook when considering the valuation of our stock and with the recent upheaval in the market we believe our stock is a particularly compelling value.

During the third quarter we repurchased 1,097,000 shares of common stock at a total cost of $16.9 million. For the first nine months of this year we’ve purchased a total of 2,194,000 shares at a cost of $31.3 million. Subsequent to the end of the third quarter we have purchased an additional 1.5 million shares for an aggregate purchase price of $20.6 million. We now have about 36.3 million basic shares outstanding. Last week our board of directors increased by 2 million shares our repurchase authorization so we may currently repurchase up to approximately 2,068,000 additional shares of our common stock.

It’s remarkable to look at the accretive impact of our stock repurchases since we began buying out stock back six years ago. Since the beginning of 2002 we have repurchased a total of 17.4 million shares of Tyler stock at an average cost of $7.86 per share. The second use of our cash flow has been for acquisitions. We completed one acquisition during the third quarter acquiring School Information Systems, Inc. for $9.9 million in cash and 70,492 shares of common stock.

SIS is based on St. Louis and provides financial and student information management systems for public school districts with 275 school districts and customers primarily located in Missouri and Illinois. We expect to expand the reach of SIS’ product suite in to additional states as part of the Tyler organization.

On the balance sheet we ended the third quarter of 2008 with $34.3 million in cash and investments and no debt. Days sales outstanding in accounts receivable at September 30, 2008 improved to 87 days compared to 93 days at September 30, 2007. This represents the lowest DSO level in six quarters. We also announced today that we’ve established a new revolving bank credit facility that provides for total borrowing of up to $25 million in addition to a $6 million facility for cash secured letters of credit.

Borrowings under this one year facility will bear interest at either LIBOR plus 1% or prime rate minus 1.5%. We established the line of credit to provide additional working capital availability to ensure we have the flexibility to take advantage of opportunities with respect to potential M&A activity as well as stock repurchases and capital expenditures. We also continue to consider leveraging our real estate assets once we complete those acquisitions.

Now, I’d like to turn the call back over to John for his comments on the quarter.

John S. Marr, Jr.

As you now know our results were strong. It is important to appreciate that this represents a broad based success. There really is no unusual or single event that is responsible but rather consistent execution across the entire business. Our balance sheet is evident of strong cash flow characteristics of our business. At September 30 we had $34 million in cash after investing over $68 million in cash year-to-date for acquisitions, stock repurchases and real estate.

So, the company has seen considerable growth in revenues with leverage and even better growth in earnings and free cash flow before the real estate. And, as importantly, we believe we are making investments that will in turn, turn those earnings and free cash flow in to shareholder value downstream.

We’re enjoying a very good 2008 but I appreciate in the current environment that most are interested in looking forward. I wish I could tell you exactly what the next year and beyond would look like, I can’t. But, I will offer some observations from our perspective. First, our company is built on strong fundamentals, nearly half of our revenues are recurring with less than 2% customer attrition and in these times customer loyalty will only strengthen.

We have a strong backlog, $235 million at September 30. There are other considerable revenues that we execute every year that are relatively certain but not represented in either of these numbers. In our view, with all this considered there’s a core level of reliable business that we can count on that will support reasonable results even in these extraordinary times.

Tyler also enjoys a strong balance sheet and excellent free cash flow resulting in very little exposure to the volatile credit markets. It is likely that all markets including local government will be affected by the economic conditions we are experiencing. To what extent and at what time is something that is hard to predict but as with our own business internal fundamentals, the fundamentals of the local government software market will be favorable over the long term.

For years now local government has been asked to do more with less and the current environment will only hasten this trend. Our products and services are not discretionary choices of local government but the tools they use to be more efficient and actually deliver more with less. There is a tremendous inventory of old systems out there nearing the point of unreliability; they need to be replaced.

Is there some discretion as to whether that occurs next year or further down the road? Yes. Is there any question that it needs to occur sometime in the reasonable future? No. So no, I can’t tell you exactly what things will look like a year from now but given our large customer base, our recurring revenue, strong backlog and excellent competitive position I believe we will continue to delivery decent results.

Think about it, our free cash flow and our EBITDA are greater than our total license revenue. I’m confident this will allow us to manage through these times. But more importantly, the fundamentals of our market are strong. Local government will make some adjustments and it could, could create some short term pressure. But, this will be a bigger marketplace three and five years from now.

These governments as group will be bigger, not smaller. Their need for our solutions will be strong and we will be in an increasingly strong position to serve those needs. This morning we also announced that we recently put a new bank revolving credit in place. This affords us the ability to pursue attractive acquisition opportunities, continue our repurchase program as well as invest aggressively in our products.

Our ability to obtain this line in these times with attractive terms is indicative of our strong financial position. Based on our strong performance year-to-date and our outlook for the remainder of the year, we have revised upward our guidance for the full year 2008. We current expect 2008 revenues to be in the range of $262 million to $265 million. We forecast 2008 diluted earnings per share to be approximately $0.57 to $0.60.

Before the non-cash settlement pertaining to the warrants, earnings of 34% to 37% including the settlement. Fully diluted shares for the year are expected to be approximately $39 million to $39.5 million. For the year estimated pre-tax expense related to stock options and the employee stock purchase plan is expected to be $3.5 million or approximately $0.07 per diluted share after taxes. We estimate an effective tax rate for 2008 of approximately 38% before the impact of the legal settlement and 49.9% including the settlement.

We expect free cash flow for the year to be within a range of $22 million to $26 million with total cap ex of approximately $30 million to $31 million for the year and total depreciation and amortization of approximately $12 million. Excluding real estate cap ex we expect free cash flow to be between $48 million and $53 million.

Now, we’ll take questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Charlie Strauzer – CJS Securities.

Charlie Strauzer – CJS Securities

A couple questions, they’re pretty straight forward, one is as you’re looking at Q4 how should we think about the segments and kind of the expected growth by segment there and any real big changes on the gross margin line by segments?

John S. Marr, Jr.

I think Q4 by segment would look very much like Q3 which would mean financial systems continuing to be a strong contributor and of course the justice area having come on line more meaningfully in the third quarter continuing generally at that level.

Charlie Strauzer – CJS Securities

Then if you look at the gross margins by reporting segment should we see much difference there too?

John S. Marr, Jr.

Not particularly. The biggest change is obviously that the gross margin on the license line varies pretty significantly depending on the revenues because the cost of licenses are relatively thick but otherwise there’s nothing that would point to anything other than the kind of changes in margins you get with volume changes.

Charlie Strauzer – CJS Securities

Then looking out especially on the Microsoft Agreement, Brian if you can highlight what has changed since the last amendment to the agreement? How is this new amendment different from the last one?

John S. Marr, Jr.

The last one has really the spirit of an arrangement in place which was that development we were doing for the public sector system that had value to their commercial or horizontal system that they would have an ability to contract with us to get IP rights to that and pay for it now and move it over there. So, that’s still the basis of our arrangement.

But, what really it didn’t address was looking over any reasonable period of time trying to quantify that and come up with an arrangement that was a little more consistent and had better visibility. So, since then we’ve looked at really the balance of the development projects through the first release to manufacturing and quantified that and quantified how much of that has value to them and they choose to include in their commercial system and come up with a much more predictable model so we will have relatively flat reimbursement through general release really through the end of 2010.

So that was the major change was trying to look out, quantify it and put in an arrangement in place where they knew what their cost was quarter-to-quarter and we knew what we could expect from a reimbursement standpoint. So, it’s only if we were to see a very material change in the product that that reimbursement would change and we don’t expect that to happen.

Charlie Strauzer - CJS Securities

When you talked to Microsoft and the people there, given all the turmoil of the last couple weeks and months, what are they saying to you in terms of their receptivity from the early client tests that they’ve done and the rollout dates and all those things related to that? What are they saying to you?

John S. Marr, Jr.

I’d say as you might expect. Both companies obviously are at very different levels but both companies are in a position to continue to support these longer term development efforts regardless of the current environment and again at very different levels. But both companies in the last week now have reported strong results and an outlook that is certainly reasonable enough to continue. We don’t expect this project to be affected by the current market.

As I indicated earlier, I don’t know how many projects that might have occurred next year might get pushed out a year or two but if they were on the table for next year, they’re going to occur sometime in the next two years. Really if you think of it that way, there could have been some business that would have occurred in the next year or two as we finish up this project that’ll be on the table when the product actually hits general release. I met with them last week. We have similar views of remaining committed to the project, getting it done, it’s on schedule, it’s generally on budget and we think there’ll be a good reception in the market place down the road.

Operator

Our next question comes from Kirk Materne - Bank of America Securities.

Kirk Materne - Bank of America Securities

Maybe taking a look at your guidance for the fourth quarter Brian. When you back into it, it seems that the seasonality from 3Q to 4Q this year versus last year’s a little flatter sequentially. Can you just go into that whether or not there are some deals that came in? I realize you guys don’t give quarter-by-quarter guidance so maybe my [inaudible] was just wrong to begin with, but can you just talk about the trends we should think about maybe from a seasonality perspective from 3Q to 4Q and any suggestions you maybe have for us going forward on that front?

Brian K. Miller

In the past the fourth quarter has typically been a fair amount stronger than any other quarter during the year. I think we’re seeing that starting to move out a little bit and there are less pronounced increases just from seasonality. As we’ve grown, our business is spread across more geographies and across more customers so we see a little bit less of that hockey stick effect in the fourth quarter. In this quarter there were some things that were timing so we increased our guidance for the second half of the year.

As you know we don’t give quarterly guidance. We leave that up to the analysts and you guys to put into your models, and some of that’s not actually predictable from quarter-to-quarter in terms of when deals sign and when licenses are recognized. But there was a little bit of timing in terms of things that we might have expected internally to have happened in the fourth quarter that happened in the third quarter that made this quarter a little bit stronger particularly on the license side. But I think over time we are seeing a little bit more of the smoothing of quarter-to-quarter.

Clearly a lot of our revenue’s maintenance and subscriptions, recurring revenue types of things just occur based on time passing rather than deals closing in the quarter.

Kirk Materne - Bank of America Securities

John must have a really great crystal ball into next year especially from a revenue standpoint, but there are some things you guys can control in terms of you do have a good view into maintenance revenue, subscription revenue and sort of your op ex. When you guys have had a nice lift in margins this year, can you just talk about it maybe qualitatively because I know you don’t want to get into guidance for next year but qualitatively about your ability to manage your margins as we head into next year and what our thoughts should be in terms of further margin expansion from these levels as we go into ’09?

While I recognize that revenue predictability is going to be very difficult, I’m just trying to get a sense on how closely you guys think you can manage the cost structure of revenue growth for it to trail down a little bit due to the macro factors?

John S. Marr, Jr.

Certainly we’re giving an awful lot of thought to that and we’re in the 2009 planning process and talking an awful lot with the divisional management teams regarding that. If you really look at what we see and touch in our own business as you see from the quarter and the guidance for the balance of the year and that certainly trickles into the beginning of next year, what we see directly is healthy. We don’t want to take off the table objectives we’ve had traditionally for growth and investments and products and these sorts of things if we don’t see those things.

On the other hand, obviously you have to be aware of what’s going on externally and you have to acknowledge that it could put some pressure on our space. I think we’re better insulated than most commercial businesses and even better insulated than most government segments but certainly we would appreciate there could be some guidance.

We’re really working hard to have a more dynamic plan that does try to achieve what’s available to us in the market place but rather than look at things as an annual plan with some measures along the way, we have an awful lot more in the way of consistently being perceptive as to what’s really happening in the state and have the variable expense increases only go into effect and occur, the hiring of the people and so forth when we can touch and feel those revenues. So it’ll be a much more dynamic plan and it’ll be more aggressively managed.

You’re getting right at what is our job and as we see it going forward. I certainly believe our company will have some growth next year. If you just look at the trajectory of maintenance revenues and subscription revenues and backlog of work, there’s growth built in our model as we leave one year and go into the next. But if it’s lower than it would have been, then we need to work hard to protect the margins we’ve achieved which might be the best you can do. And again if there is that final increment that we think we’d realize in ordinary times, then that’s an opportunity obviously for the margin to expand.

The net I would say is I think we will certainly see some growth even in a difficult market and I think we’ll have an opportunity to have margins generally in the range that we’re currently experiencing and yet we will have a plan that will look for opportunities for better growth and broadening those margins as well.

Kirk Materne - Bank of America Securities

John, I know the Federal government’s on a September year end. Can you just go into a little bit of the cadence about when the local government will start putting out RFPs? It might differ by region, but can you just give us some color on that?

John S. Marr, Jr.

There are really two things to consider there. The nice thing is as Tyler as grown geographically around the country, and that’s part of the answer to your earlier question where we’d seen more of a hockey stick and we see more of a leveling out of our revenues and earnings, part of it’s a result of that.

There really are three different fiscal cycles around the country. I think the most predominant is a June 30 fiscal year end. So I think that is the most commonly used mostly driven because of the educational side. Second to that would be the calendar year, and third to that would be the fiscal year September 30. I’m not aware of states that have the first quarter as their year end. It is spread out some and balanced a little bit.

The other thing though that has always gone on and is interesting is that different communities and different projects use that different ways. There seem to be a lot of governments that right now are preparing a budget and will put money in that budget. They’ll put $1 million or $2 million or whatever they think is appropriate to replace the system and then once that budget is approved, they’ll begin the process of going out and seeing what they really want and making a selection that’ll occur months later down the road.

Then there are others that go out and go through the process and decide exactly what it is they want and how much it’s going to cost, and then they go and get the approval. All of those things combined I think again are contributing to somewhat of a leveling of business as it occurs.

Operator

Our next question comes from Brian Kinstlinger - Sidoti & Company, LLC.

Brian Kinstlinger - Sidoti & Company, LLC

I appreciate the discussion of uncertainty for next year and I guess my question John for you is, first of all are you beginning to see any pushback yet from customers and how is it impacting pricing at all in the market place?

John S. Marr, Jr.

I haven’t seen a lot of pushback with customers. I think that again they’re understanding that they need to support the investments they have and align those systems, and the fact that they’re not discretionary that’ll remain pretty solid for the customer base.

On the new business side there’ll be projects that might happen this coming year and there’ll be incremental applications that might have been sold into our base that may not occur at the same rates. We expect to see some of that. We’ve seen some anecdotal evidence of certain projects being delayed or going off, and we’ve seen maybe some customers looking to purchase something from us, installed customers, but a lot of it’s cultural. It just didn’t feel right probably for that budget share at the current moment.

Again I think the fundamentals of our business and the market place are such that we’ll still make some progress during these times; maybe not at the same level. Pricing can really be a double-edged sword and one side of that is to our favor.

We’ve got very compelling offerings; we’re very cost effective on the higher mid-range and the lower Tier 1 type space; and I think some of the market that was less price sensitive in going with the Tier 1 vendors in some cases at much higher costs we have again seen some anecdotal evidence and heard some comments from some of that market place that the cost itself is going to be a bigger mix of the decision. And that will help us in that particular market place.

Brian Kinstlinger - Sidoti & Company, LLC

To that point, your software license exposure on pace doing a similar quarter at $43 million. Is there anything that is recurring? I know the maintenance and service is very recurring. So when you look to next year, how much of that is either in your backlog if you have to hit certain points in the program and how much has to be new business that you book through the year? Whatever that number is you do next year, how much comes from your backlog versus new business?

John S. Marr, Jr.

There isn’t anything recurring, but Brian do you have the license numbers?

Brian K. Miller

We don’t have the break out of the licenses separately but there is a portion of the licenses that’ll be coming out of backlog particularly on the court field and our property tax in appraisal systems or some of our larger financial systems that either have milestone based revenue recognition on licenses or more often percentage of completion accounting that those are recognized as services provided.

Brian Kinstlinger - Sidoti & Company, LLC

But most of them are new bookings?

Brian K. Miller

I don’t know. We can find out for you.

Brian Kinstlinger - Sidoti & Company, LLC

We’ll get that off line.

Brian K. Miller

It’s certainly a meaningful part comes out of backlog. Whether it’s more than half, I’d have to look.

Brian Kinstlinger - Sidoti & Company, LLC

In relation to the question that the previous gentleman asked, I guess I was confused and this is hypothetical, suppose in the second quarter you did start to feel it. Does that mean you’d be prepared to implement something to cut costs, you’re not sure? I’m’ just trying to understand how quickly you can manage costs while you’re increasing R&D somewhat and SG&A to something actually happening. Could that happen in three months, six months? I remember it was very quick back in the days of the tax and appraisal piece. I’m just curious in today’s market is that similar or not?

John S. Marr, Jr.

Tax and appraisal’s pretty different. We had very high project oriented revenues there and as those projects ran off, they weren’t replaced and we had a lot of resources that weren’t really funded.

As I said earlier, and it’s an environment where we want to be very careful about predictions, but the trajectory of our maintenance revenues and our subscription revenues and the size of the customer base that grows significantly year-to-year, all of that suggests that revenues would certainly be higher next year than they are this year.

I don’t see, based on what we’re currently seeing, a need for any kind of a reorganization or downsizing of resources. What I see is an environment where we certainly can’t take for granted the growth that we have. We need to watch very closely and if that growth doesn’t materialize and if some of that new license revenue doesn’t materialize that we manage our resources more aggressively and we hold the line more than a reduction.

Again I don’t see a situation where revenues would be lower next year than they are this year so it’s really about incremental costs and incremental revenues. That could mean redeploying certain resources from certain areas of our business to other areas of our business.

But even if we experienced, and I’m not suggesting we will, a reduction in new license revenue, that reduction would be offset by increases in maintenance and subscriptions and other types of services and we should be able to manage within that without any kind of a significant restructuring.

Brian Kinstlinger - Sidoti & Company, LLC

Related to Microsoft, we have the new agreement here and I’m curious how many guys you have on that development program, where that might go next year and given that they’re going to be reimbursing you $800,000, does that suggest that we won’t be up next year in R&D expense? Will be still be up? That’s the one thing that seems that you do have visibility to. Maybe you can give us a sense of that?

John S. Marr, Jr.

We’ll be up. We’re in the area of 70 FPs right now and that could grow as much as 50% next year. Some portion of that reimbursement will be nearly double next year than it was this year so some reasonable amount of that growth will be offset by higher reimbursement but our costs on the Microsoft project the way it’s currently contemplated will go up a little bit next year; $1.5 million, $2 million, something in that range.

Brian K. Miller

Our backlog at September 30, about 60% of it is licenses and software services with the balance being subscriptions, maintenance and appraisals. So about 60% of that backlog would be license and services. I don’t have the split between the two but it would be reasonable to assume that it wouldn’t be too far off from our overall revenue split, the relationship between licenses and services.

Brian Kinstlinger - Sidoti & Company, LLC

Did you revise the third quarter of last year because in your report you said $198.2 million in software? That would suggest a 5% increase but you said 11% in your prepared remarks.

Brian K. Miller

I don’t have a revision to that but let me go back and look. $226 total backlog and $198 million of non-appraisals.

Operator

Our next question comes from David Yuschak - Sanders Morris Harris.

David Yuschak - Sanders Morris Harris

Let me just ask you about real estate spending this year. When you take a look at your PP&E at the end of the year versus what it is now, obviously that’s a pretty significant commitment you’re making in real estate. Could you give us some sense as to what you envision with this kind of investment because it would certainly potentially demonstrate a lot of capacity to do a lot of things as you put that real estate into productive use?

John S. Marr, Jr.

You mean actually the use of the facilities?

David Yuschak - Sanders Morris Harris

Right.

John S. Marr, Jr.

We have talked about that on a previous call. All the real estate being acquired or built is in two different markets; the Lubbock, Texas market where the [Endco] division has grown and in the main market, [inaudible] where we have our munic area. We’re committed to all the different facilities. As I said we don’t see reorganizations or downsizings of any of those.

But as we manage the business going forward there are certain markets that are more productive for us than others and we will try to direct the growth and have directed the growth in those areas. These markets are kind of secondary markets I’d call them. We have a presence in the Dallas/Plano area. We have a presence in Seattle which has been very useful in the Microsoft projects. We have offices on 128 outside of Boston and in Research Triangle in the Carolinas.

We have some good talented contributors in those areas but as we grow a lot of resources, these secondary markets are very cost effective for us. We have good loyalty and longevity among the employees. They’re markets where we’ve been able to attract and retain long-term relationships with employees; we’re an employer of choice in those areas; we don’t experience people going across the street for marginally different pay or that sort of thing. We’ve made a conscious decision that those are good markets for us to grow in and those divisions have been very successful attracting and keeping those people.

Probably 100% of one of the buildings in Maine is and has been occupied by Tyler for years so it’s really just buying a building we’re already in and have a significant investment in. That’s where our ASP facility is and a lot of infrastructure is in place. The other building is currently leased out to the seller and as it becomes available, the projection of our growth here would be such that we would be filling that very consistently as it’s re-leased. If you don’t do something like that, you’ve got a lot of employees scattered over a lot of different buildings on a temporary basis and it’s just not as productive an environment.

In the Lubbock environment they’re in three different facilities right now; they’re spread out; they’re stuffed into those facilities; and we need to bring them together under one roof so to speak and give them a more productive environment. The reality is there simply doesn’t exist a space that size and that quality in the Lubbock market place so we made the decision to build it.

David Yuschak - Sanders Morris Harris

It does speak too though of the continued optimism you have for your financial product line as well.

John S. Marr, Jr.

That’s right.

David Yuschak - Sanders Morris Harris

As far as the court and justice, at your user conference you indicated there are several states now looking at the potential proposed with RFPs to implement a court and justice system. Could you give us some sense as to some timelines on those because I think there was upward of eight states kind of reviewing prospects for new systems? Could you give us an idea, because again it speaks to some optimism out there on the part of a city or county government to move ahead on some spending where there is a need? Could you give us a review of where those states may be on a timeline as to when they want to make a decision or at least some sense as to where they may be in thinking about moving ahead on that?

John S. Marr, Jr.

The quick answer is no. For years I think when Brian and I sat at hosting these calls, we kind of got specific opportunities out there and there was a lot of enthusiasm around Odyssey.

It’s very difficult to know exactly when a state or a county’s going to make a decision and obviously we don’t want to start getting those specifics out there and having to respond to them when we don’t control those things. But as you indicated, we’re tracking a number of states that we think have decisions in their future. I would think some of them certainly would be in the coming year and certainly some of them would be further out. There are other large counties that will be making those decisions as well. We see a good volume of business as we go forward.

As Brian indicated, we worked a little more backlog off because we’ve built up the delivery resources on the Odyssey side of the business and are obviously looking forward to replace that business with other deals. We see those deals. I’m not trying to avoid your question but I think it’s hard to predict exactly when they will occur. But given the volume I certainly expect some meaningful decisions in the coming year.

David Yuschak - Sanders Morris Harris

It certainly speaks to your customer base out there. At this point half a dozen look like from the pipeline but does not look like a lot of extraordinary caution if in fact there is a need to have that facility brought up to date so to speak.

John S. Marr, Jr.

That’s right.

David Yuschak - Sanders Morris Harris

On the ASPs you indicated I think Brian that you converted eight?

Brian K. Miller

Yes.

David Yuschak - Sanders Morris Harris

How many do you have now in total?

Brian K. Miller

The total ASP customers is 109.

David Yuschak - Sanders Morris Harris

That’s getting to be a very promising part of the long-term business model as well then?

John S. Marr, Jr.

Still relatively small in the overall company but it is fast growing both in terms of the number of customers and revenues albeit on a smaller base obviously. I think what you saw in the quarter was that more traction in the installed base than the new business market is good. We’ve certainly recognized that and will be certainly making the customer base aware of that and try to drive more of that. There isn’t the opportunity cost to licenses that you have with new clients so we’re pleased with the traction in the installed base and we’ll be pursuing that.

Operator

Our next question comes from [Dale Warmington - Dalwar Capital].

[Dale Warmington - Dalwar Capital]

Your tax rate. Could you explain why it’s so high?

Brian K. Miller

The tax rate is abnormally high this year because of the effect of the settlement we had last quarter with Bank of America regarding the dispute over the warrants. The way that was treated was that we issued warrants that had to run through the P&L and that’s a nondeductible expense that’s treated as an equity transaction or income taxes. So it’s a nondeductible non-cash expense that boosts our effective book tax rate. We’d be at about 38% excluding that one item.

[Dale Warmington - Dalwar Capital]

In terms of your revenue breakdown by geography, what percentage comes from say Canada, Puerto Rico and the UK?

John S. Marr, Jr.

It would be very small. It would be less than 5% of our revenues that would be from outside of the US and most of that would be Canada at this point.

Operator

Our next question comes from [Robert Moses - RGM Capital].

[Robert Moses - RGM Capital]

Two quick questions. One is really on just kind of framing the long-term revenue opportunity. I think John you’ve said in the past that a low to mid-double-digit growth is kind of where you’d hoped the company would be and I guess through nine months you’re definitely there this year. That would be kind of a market growth of 6% or 7%? Is that generally the long-term view?

John S. Marr, Jr.

Yes.

[Robert Moses - RGM Capital]

So if we go into next year, you’ll certainly do better than the market. The question is, is the market flat, is it up, kind of where it is. It doesn’t sound like you’re seeing a lot of indication that it’s anything other than normal but you’re just throwing up the caution flag just given everything that’s gone on at least the last couple months?

John S. Marr, Jr.

Yes. It’s more than a caution flag. We understand this market. A lot of us have been in it a long time and I have no question that somewhere tonight there’s a budget meeting and somebody’s going to challenge someone on the idea of buying a new system and whether it has to happen this coming year or could be held off for another period of time.

I expect that whatever the market would have been, it’ll be something a little less than that now. I don’t know if that’ll be enough that we can get the kind of growth that we’ve said we expect to have over the long run. I think we’ll be able to certainly get our market share out of that, but as I said I think even if that one system is deferred a year, if you look over the next three or four or five years, I think you’re going to see the same volume of business you otherwise would have seen regardless of the current environment. But exactly how it affects the timing of some of these systems is a hard thing to know.

Again the trajectory of our maintenance growth, subscription growth, our backlog, a lot of these things would suggest that we will have higher revenues this year than we have this year and we should be able to manage that. But whether they’re a little less growth than we’d see in most years will remain to be seen.

[Robert Moses - RGM Capital]

On the use of the balance sheet, the excess cash and the new credit facilities, certainly you have some things in the fourth quarter. I guess you’ve already bought back north of $20 million of stock and you’ve got the $10 million earmarked for [inaudible]. As we think about it though going forward with the cash you’re generating in the fourth quarter and beyond, just help me with how you think about buy-back versus acquisitions, because I know your stock’s come down a bit and it’s pretty intriguing yield, but how are you looking at other acquisitions? Are you seeing pricing coming down on those as well?

Brian K. Miller

We have thought that we have. We’ve seen some deals that our discipline was such that we weren’t interesting to them initially and they’ll come back around because there isn’t a market where they can just go get their price. So, we have seen some indications of that but, as you can see from the results, we actually haven’t closed an awful lot of acquisitions recently. We have seen indications, I do think there will be some attractive assets out there that will be more reasonable in terms of their valuation expectations and we hope to participate in that. But, we haven’t seen high volume real recently as you know.

There is no question that with our stock at the price it is at, if it were to remain in that range we feel good about our company and this asset and we will compare the valuation of Tyler to how we value other companies and when you buy your own company there aren’t integration issues, there aren’t new balance sheet items, there isn’t a level of uncertainty to so we feel very good about Tyler’s long term outlook. Obviously, if it’s more favorable than an acquisition that will weigh in to the decision process.

Analyst

Generally John I know there’s a lot of different metrics that go in to it but kind of free cash flow if you look at your own business and I guess it’s like $1.25, $1.30 per share on a cash flow basis, free cash flow. Is that the major metric you’d look at for your own business in terms of buying back your own stock?

John S. Marr, Jr.

It is the way I think a lot of you guys are looking at us and certainly the way we look at it. It can be a little lumpy. I did say that our trailing 12 months free cash flow is $50 million. At the end of the year it will be something like $50 million as well and obviously that’s a pretty compelling valuation metric assuming it’s sustainable.

I mean we had a very strong third quarter for free cash flow. It isn’t accounting, it’s free cash flow so timing can work in to that a little bit more and whether that’s a new level we just build on or whether we got a little bit ahead of itself we’ll have to see. But, we definitely look at that but we will look at a more conservative outlook than what this quarter brought to us in terms of the year and the trailing 12 months as we make those decisions.

Operator

Our next question comes from Brian Kinstlinger – Sidoti & Company, LLC.

Brian Kinstlinger – Sidoti & Company, LLC

A couple follow ups but first of all John and Brian, you guys normally discuss the RFP kind of situation. Are we seeing as many as we were in the quarters past, are we seeing a little bit less? Give me a sense where that is trending.

John S. Marr, Jr.

We are seeing a little bit less. We were seeing a little bit less even before the last month or two so we’re tracking that very closely. So, the volume of RFPs is actually off a little bit and again, it was off a little bit before the current markets got to the point that they’re at so I’m not sure that’s at all reflective of the most recent market changes here in the last month or so.

The average sales price, the average size of those is up a little bit so that offsets that a little bit and our competitive position or our market share has improved reasonably meaningfully so as a result you see that our license revenues was up and we continue to execute well within that. But, in terms of the absolute number of RFPs they are off a little bit.

Brian Kinstlinger – Sidoti & Company, LLC

In terms of appraisal services revenue, at what point is there one of these programs that will – when is the next big program that rolls off? Anything that’s meaningful high sort of $20 million of revenue?

John S. Marr, Jr.

Well, there are actually a number of states going in to cycles so we do see new business out there in the marketplace. We’re clearly the lead on the larger opportunities out there. There are a few companies in that marketplace these days and the ability to bond those and pursue those. There’s actually a number of states that are coming in to their cycle and we believe there’s a reasonable amount of business to come on line.

We really think the level we’re at is pretty stable bottom for appraisal services. We do have a large engagement in New Orleans which is going well and contributing to their success. What is that Brian 18 months left in that or there abouts?

Brian K. Miller

It was about a two year project and it’s really kind of kicked in the last six months.

John S. Marr, Jr.

We don’t have a lot running off. In those markets the cycles are actually going to turn in our favor. We’re at kind of a lower end of our range as you know so we don’t feel our exposure to the downside in those revenues.

Brian Kinstlinger – Sidoti & Company, LLC

My last question is related to real estate, any that you purchased. First of all, how long is [Nike] committed to leasing that space? Then, Brian can you go over the amortization roughly quarterly towards that building versus the lease income that you’ll be getting?

John S. Marr, Jr.

I can answer the lease while Brian gets the D&A information. There are three floors in the building that we purchased and two of the floors become available to us in three years and the third floor could become available to us in five years although there is actually a renewal option for the tenant there. So that’s the way that breaks down.

We currently have about 20,000 feet outside the primary building we [Fallis] that we’d be happy to relocate there tomorrow if it were available to us and just even conservative growth projections would mean that we would need the majority of those two floors by the time they become available. That was one of the things that was attractive to us is that we wouldn’t expect to have low utilization at any point in time on that particular property.

Brian K. Miller

The depreciation on that building should be on an annualized basis a little north of $300,000, about $318,000 a year.

Brian Kinstlinger – Sidoti & Company, LLC

Is that $300,000 from [inaudible] and lease income you’re getting? Is that right?

John S. Marr, Jr.

Yes, that sounds about right.

Brian Kinstlinger – Sidoti & Company, LLC

So the way you basically computed it was that versus the interest income to make it slightly above breakeven on your last call?

John S. Marr, Jr.

Slightly better on an earnings basis and more meaningfully better on EBITDA and free cash flow basis.

Operator

At this time there appear to be no more questions. Mr. Marr I’ll turn the call back over to you for closing remarks.

John S. Marr, Jr.

We appreciate everybody’s time on the call today. I think it’s one of our longer calls which is understandable in the time. If there are any further questions, feel free to call Brian or myself. Have a great day.

Operator

This does conclude today’s teleconference. You may now disconnect. Have a great day.

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Source: Tyler Technologies, Inc. Q3 2008 (Quarter End 9/30/08) Earnings Call Transcript
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