Tyler Technologies Stock: Valuation Continues To Be A Concern (NYSE:TYL)

Summary

We think Tyler Technologies (NYSE:TYL) has been taking measured steps to control costs and enhance its free cash flow (or FCF) generation. We, however, view some of the attempts towards reducing the clutter on the balance sheet as a possible effort towards readying the company for a potential buyout. However, the valuation of the Tyler stock leaves little scope for a buyer to put a premium on top of the current valuation. Hence, we would not be a buyer of the stock.

Background and business

We had previously written on Tyler Technologies on Seeking Alpha: ‘Tyler Technologies: Risk Far Outweighs The Reward’

Key points

2024 management guidance from Q4 2023 results

• Revenue: $2.095 – $2.135 billion (8% growth at the mid-point)

• GAAP diluted EPS: $5.17 – $5.37
• Non – GAAP diluted EPS: $8.90 – $9.10
• FCF margin: 17% – 19% or $356 – $406 million (including a $50 million impact related to Section 174)

The Tyler management is focused on cost reduction both at the gross and the operating level.

• The company is trying to reduce costs at the gross level by moving to AWS and shutting down their own data centers, a move which will also help reduce capex.

• At the operating level, the growth in sales and marketing has been reduced. According to Tyler’s management, the company’s client relationship managers can take care of a lot of the new business and there are opportunities for synergies within the broader sales organization.

Paydown of debt

• Furthermore, Tyler continues to prioritize reducing its $600+ million debt, despite expecting to generate $381 million of FCF (mid-point of guidance).
• Tactical M&A continues to be an area where the company wants to keep an open mind.
• In 2023, Tyler generated $327 million of FCF and repaid debt of $345 million.

Our thesis

As early as in July 2022, the company had mentioned a Tyler 2030 plan.

As we model out and look forward, we’re starting to do some internal modeling around what we call Tyler 2030. And a big part of our growth strategy is converting that very high customer base from on-prem over into the SaaS world.

Source: Tyler Technologies Q2 2022 Earnings Call Transcript on Seeking Alpha

In June 2023, Tyler held its Analyst Day and disclosed the company’s 2030 plan.

Gross margin would contribute 6-8% over seven years, and operating expenses would contribute another 1-2%.

Despite the 6-7% in operating margin, FCF margins would improve by 8%+. The reason was reduction in capex to manage data centers.

Fast-forward to the management’s last 2024 guidance, FCF margin has already reached 17-19% or the 2025E view in the 2023 analyst day. On the one hand, the management is crystal ball gazing 7 years out and on the other hand, they end up achieving one of the stated near-term targets a year early. Did the Tyler management lowball expectations during their 2023 Analyst Day? We think so, and it was done to most likely demonstrate superior execution and to also make the business asset light.

Trimming the balance sheet

Often, companies want to capitalize expenses to prop up the earnings. When a company does the opposite as Tyler is doing, they are reducing the additions to their balance sheet.

The reduction in capex also lessens the asset side of the balance sheet.

Operating lease and PPE, both have been reducing. However, the one thing that was going up (software development costs) may also not increase much from here on.

There is a shift from some R&D that was previously being capitalized, especially around some of the cloud projects that will now be expensed. So a lot of it is the same people but now running through expense as opposed to being capitalized. And that’s – obviously, it doesn’t change our cash flow but it changes where it turns up on the income statement. So I think it’s important to note that we are expecting to drive margin expansion even as we have a movement away from capitalized software development and to more R&D expense.

Source: Tyler Technologies Q4 2024 Earnings Call Transcript on Seeking Alpha

In the Q4 2023 call, Tyler announced a change in how R&D will be treated. Instead of capitalizing the R&D costs, they would now be expensed.

To summarize, Tyler is increasing it spend on R&D but is choosing to reduce earnings rather than amortize the spend. This is a typical behavior buyers expect of sellers. In M&A, a buyer wants to see the true cash cost of the seller’s business. Hence, expensing gives the best view of the seller’s profitability to the buyer.

Tyler’s cash flow generation is strong and the company’s plan to accumulate capital to pay off the convertible notes in 2026 are aimed towards making it a 0-debt company.

We’re even though we will likely pay off the term debt sometime this spring, we still have that $600 million convert that’s due in a little more than two years. So my anticipation would be we will be building some cash reserves to be in a position to pay that off rather than renegotiate that at a high bank rate.

Source: Tyler Technologies Q4 2024 Earnings Call Transcript on Seeking Alpha

Should the management again pull forward its FCF margin targets for 2026 like they have done for 2025, the net debt could potentially reach zero within H1 2025 (assuming very limited leakage below the capex line). A 0-net debt company is more attractive as a target.

Valuation

• At an expected 2024 FCF of $380 million, Tyler trades at 2.2% FCF yield. This is much lower than the 3-month US treasury bonds, which currently yield 5%+.
• On an EV/EBITDA (forward) basis, Tyler trades at 30x which is also not inexpensive considering the sector average of 14x.

While a target FCF of $1 billion with a $3-4 billion in revenue (by 2030) sounds attractive, we think Tyler’s relationships and network is where the real value lies.

Using the graphic in the image above from an average number of products per user of ~3, the move to 8-10 implies a 3-3.5x uptick. Considering the operating leverage and cost-cutting measures, the 2030 targets look to incorporate this move up. Per the 7 year our plan, the valuations could look something like:

• 6% FCF yield based on the 2030 FCF of $1 billion
• 10x EV/EBITDA based on 3x the current EBITDA

The 2030 numbers are too far out and still do not look exciting. We find it hard to fathom the reason for Tyler’s valuation premium, other than the company is under consideration as a potential acquisition target.

Risks to our thesis

• While the market sentiment is not ideal from a timing standpoint, we think the higher for longer narrative can potentially allow Tyler to show execution muscle against its 2030 targets over the next few quarters, which can get the market even more excited.
• A shift in attention towards the presidential election post Q2 2024 could lead to some monetary easing and might give a fillip to Tyler’s valuations.

Conclusion

The 2030 plan was an unusually long one (7 years out) when typically, companies only talk about 3-to-5-year narratives. (So yes, some of Tyler’s customers are likely to be with the company for 7-8 years, but the government itself changes guard every four years.) Coming from a company which has the characteristics of a utility business, we feel more compelled to conclude that the Tyler management is virtue signaling potential buyers about the durability of the company’s cash flows, despite Tyler’s low gross margin (sub 50%) and relatively tepid growth for a software firm etc. Overall, we would continue to avoid the stock due to:

• Lack of valuation comfort on a standalone basis.
• Uncertainty around what premium could a potential buyer pay on top of the 30x EV/EBITDA.