Description

TYL develops, sells and supports software that state and local governments (mainly local) use to conduct mission critical functions such as budgeting, payroll, filing court documents, sending out tax bills and routing school busses.  Over the last eight years, TYL's revenue has grown organically at a 13.6% annual rate, and it now sports a 19.0% ROTC.  TYL is currently trading at a P / FCF of 16.7x based on my conservative 2010 FCF estimate.  I believe this is modest given the quality of the business, the likelihood of near term financial improvement, and TYL's long term opportunity.

Background

State and local governments are very different from private enterprises, and this begets unique software needs.  The primary difference is that governments don't have "high powered incentives" such as the opportunity to earn a profit or the risk of going out of business, so government officials are primarily concerned with avoiding major mistakes that might cost them a re-election.  This makes state and local governments a particularly slow moving and risk averse customer base that desires modern software, but doesn't need cutting edge solutions, especially given the higher risk associated with new technology.  In addition, municipalities prefer gradual software updates instead of the more frequent and larger upgrades that occur among private enterprises.  A final characteristic of state and local governments is that they usually lack sophisticated internal IT staffs which means that they need software that is easy to use and comes with good customer support.  This lack of internal resources also creates bias towards integrated solutions which is likely to increase over time as governments struggle to replace their baby boomer IT staff with a younger generation of workers that is less willing to work for the government.

Most enterprise software companies like Oracle and SAP are organized around the needs of commercial customers who are proactively looking for ways to leverage technology to improve competitiveness or profitability and who can attract the talent required to manage their IT infrastructure.  In addition, these companies' products are designed for the kinds of workflows and accounting processes that you'd find at a manufacturer or a service provider and adapting them to local governments requires considerable customization.  These factors make traditional software vendors poorly suited to serve local governments.  In addition, these software vendors usually rely on third party integrators like Accenture which creates two additional problems.  The first is that it places a greater distance between the software developer and the installer which reduces the degree to which those parties can leverage each other's expertise.  The second problem is that like the Tier 1 software vendors, the integrators are also focused on business customers, and they lack the domain expertise required to serve local governments.  All of these factors collectively increase the risk and cost associated with implementing and running commercial software at the local government level.  Georgia, for example, spent $10MM's attempting to use a customized SAP product for education applications, but choose to abort the project after twice failing to implement it effectively.  Another example is King County Washington which spent $70MM attempting to implement a PeopleSoft solution.  A final example is the State of Indiana which hired Computer Associates to build a courts and justice system.  After two years of effort, Indiana jettisoned the project, sued Computer Associates in an attempt to recoup their costs, and bought a commercial-off-the-shelf solution from TYL for 11MM.  (To put these amounts in perspective, a very large contract for TYL would be around 10MM.)

Everything about TYL, by contrast, is geared to address the unique needs of local governments.  TYL is vertically integrated, so they install their own software and don't rely on third party integrators.  In addition, TYL's solutions are built specifically for local governments and thus require relatively little customization.   Consequently, TYL's implementations are much cheaper and more predictable because its staff are very experienced at installing their products, and those solutions are already tailored to the peculiarities of local governments.  Once installed, TYL's products are upgraded gradually which is much easier for customers to digest, and also happens to be much more efficient for TYL to support.

In addition to Tier 1 ERP vendors, TYL also competes with small regional firms who are focused on local governments.  These competitors can match TYL's domain expertise, but they usually lack the critical mass required to invest in their products on an ongoing basis.  This is viable in the medium-term because municipalities seldom replace their software until absolutely necessary, and they often become two to three generations behind technologically.  One example of this inertia is Dallas County which in 2004 purchased a TYL solution to replace the county's 1970's mainframe / Cobalt-based system.  Such inertia allows incumbent regional players to milk their maintenance streams without investing much in their products, but the legacy systems eventually have to be replaced, and by that point, the regional player's products will have become uncompetitive.

TYL is the only company that is both focused on local governments and has the scale required to keep its products technologically current.  This differentiation has allowed it to make initial inroads among large municipalities who have historically favored Tier 1 vendors like Oracle, as well as take share from smaller players whose products are becoming obsolete.  Over the last eight years, TYL has grown at a 13.6% organic rate, which is much faster than Gartner's estimate of 7-9% industry growth.

TYL's History

Up until 1997, TYL was a conglomerate with roots in steel pipe manufacturing and auto parts retailing, among other things.  In 1997, recognizing the fragmentation of the local government software industry (and probably also the mediocrity of their existing businesses), the company embarked on a consolidation strategy with the goal of building a national player.  From 1998 to 2000, TYL acquired 10 IT companies, and it sold the last of its legacy businesses in 1999.  This provided TYL with critical mass in the space, and management began the long process of organizing TYL's divisions into a cohesive whole.  Since 2000, TYL has made a handful of other acquisitions, but only one of those was significant in size.

While some of TYL's acquisitions have focused on adding adjacent products, especially in the very beginning, many of its acquisitions have been focused on geographic expansion.  In those cases, TYL's strategy has generally been to purchase small, geographically constrained players whose products are later in their lifecycle.  When the acquiree's products sunset, TYL offers its core products as the replacements, which allows TYL to begin establishing a beachhead of referenceable accounts in that geography. 

Referencable accounts are absolutely critical for growing in the government marketplace, whether it be in a new geography or with a new product.  One example of this was TYL's launch of its Odyssey product earlier in the decade.  Odyssey was far superior to its competition technologically, and TYL announced Odyssey's first two contracts with great fanfare in 2H02.  (One of the contracts was for a statewide deployment in Minnesota which was a major award for a firm that had historically served small and medium sized governments.)  Despite this initial success, however, municipalities are ultimately very risk averse, and all of the other prospective customers stood on the sideline for the next three years as Odyssey established a successful track record at it's original installations.  After that, the product received a flurry of orders in late 2005 and began to build momentum. 

Over the last decade, rationalizing products and integrating operations have also been part of TYL's acquisition strategy.  For example, as TYL has migrated customers away from acquired products to its core products, it has been able to leverage the maintenance and support costs of its core products across an increasing number of customers and eventually discontinue the support costs of the acquired products.  In addition, TYL reorganized the various divisions' salesforces into a national salesforce. 

TYL has also aggressively invested in the competitiveness of its core products, with R&D spending increasing sevenfold since 2003.  One indication of TYL's industry leadership is its relationship with MSFT.  Around 2006, MSFT approached TYL about developing a government version of MSFT's Dynamics product, and the two companies announced a co-development agreement in early 2007. 

Risks & Recent Results

Property taxes are a major source of funding for municipal governments, and the largest risk for TYL has been that the housing downturn and the recession will reduce government budgets and curtail TYL's orders.  (This risk has been on investors' minds for at least two years now.)  While falling home values are a concern, and management has monitored the situation closely, a number of factors appear to have insulated TYL to date.

The first is that when the housing market peaked in mid-2006, there was a wide gap between the market prices at which homes were sold and the appraised values upon which property taxes are based.  One of the most extreme examples of this was in California where appraised values are set by the most recent purchase price of the home, which could have been many, many years ago.  Another factor is that even if market values fall below appraised values, municipalities always have the option of increasing the tax rates to hold property taxes constant.  The final, and seemingly most significant factor benefiting TYL, however, appears to municipalities' tendency to run legacy software until it absolutely has to be replaced.  This has left local governments unable to defer upgrades since their mission critical IT systems are already cantankerous, raising the specter of failure.  This is a very different situation from discretionary social programs or deferrable public works projects, both of which are getting cut in the current environment.

While TYL's orders were decent in 2008, they slowed somewhat in 1H09.  Management said that both 1Q09 and 2Q09's RFP activity was level with the prior year, but that customers were awarding orders more slowly than last year, causing TYL's "active deal pipeline" to swell.  Most of these projects were put into governments' long-term plans three to five years ago and more recently moved into the budget and RFP stages.  In normal times, such projects would be funded without many questions, but the current environment has triggered requests for additional demo's and similar justifications.  Earlier in the year, management said that these dynamics could add 6-9 months to the order process, and this appears to be playing out as expected.  On the 2Q09 call, they said that a number of delayed deals appear to be moving closer to approval since TYL is seeing activities that usually foreshadow an award, like negotiating contracts.  If these orders come through as expected, orders should pick up in 2H09, and management even indicated that they might have some large orders to discuss. 

TYL began getting a toehold in the high-end six years ago and today has a small, but successful group of large referenceable accounts.  Today's budget pressures appear to be playing to TYL's advantage in this area since its solutions are much cheaper than those of the Tier 1 vendors.  Gaining traction in this part of the market would be excellent since those deals are much larger than the ones that TYL has won in the past.

While software is a lumpy business from quarter to quarter, TYL's management team has a history of transparency and credibility, and their allusions to improvement in 2H09 will probably be realized.  Back in 2004 and 2005, TYL had a string of disappointing earnings results, and the team was very forthcoming about their challenges.  1Q07 was another time that the company reported disappointing results, and at that time, management claimed that the weakness was temporary; this proved true and results soon recovered.  Lastly, I keep detailed records of the long-term expectations that management has outlined over the last several years, and they have delivered on most of these objectives.

Long-Term Financial Model

TYL enjoys the high recurring revenue and operating leverage that is characteristic of many software companies.  48% of it's revenue comes from maintenance or subscriptions (a.k.a. software as a service), and the firm has a history of steadily improving its operating margins as it has leveraged COGS and operating expenses. 

Revenue growth and operating leverage are both expected to continue.  TYL only has 2% market share, and I expect them to continue growing in the high single digits as the industry grows and as they take share.  This could prove conservative since TYL has grown organically in the low-to-mid teens in recent years, and because they will probably eventually get traction in the high-end of the market. 

Gross margin was 41.4% in 2008, and management has said that they should be able to increase it to around 50% over the next several years.  They have also indicated that OM's should be able to increase to over 20%, up from the 14.0% reported in 2008.  "Over 20%" probably understates the opportunity since TYL's most profitable division has OM's in the mid-to-high 20%'s, and this is the target for its less mature divisions.  Sticking with conservative estimates, however, still implies FCF growth in the low-to-mid teens over the next several years. 

Past Results and Future Projections

I'm currently expecting FCF of $1.08 in 2010, implying that TYL is trading for 16.7x FCF.  I've also modeled for TYL to realize low-to-mid teens FCF growth over the next several years, but I'd emphasize that these estimates are "reasonable, with plenty of opportunity for upside" for the reasons that I mentioned previously.

Financial highlights are shown below: 

Catalyst

Improved results in 2H09 that with risk to the upside.  Additional evidence that municipal budget woes will not derail TYL's market opportunity.  Possible large orders in 2H09.  Modest valuation for a high quality software company.