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TYLER TECHNOLOGIES INC - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.(Edgar Glimpses Via Acquire Media NewsEdge) FORWARD-LOOKING STATEMENTS This document contains "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 that are not historical in nature and typically address future or anticipated events, trends, expectations or beliefs with respect to our financial condition, results of operations or business. Forward-looking statements often contain words such as "believes," "expects," "anticipates," "foresees," "forecasts," "estimates," "plans," "intends," "continues," "may," "will," "should," "projects," "might," "could" or other similar words or phrases. Similarly, statements that describe our business strategy, outlook, objectives, plans, intentions or goals also are forward-looking statements. We believe there is a reasonable basis for our forward-looking statements, but they are inherently subject to risks and uncertainties and actual results could differ materially from the expectations and beliefs reflected in the forward-looking statements. We presently consider the following to be among the important factors that could cause actual results to differ materially from our expectations and beliefs: (1) changes in the budgets or regulatory environments of our customers, primarily local and state governments, that could negatively impact information technology spending; (2) our ability to protect client information from security breaches and provide uninterrupted operations of data centers; (3) material portions of our business require the Internet infrastructure to be further developed or adequately maintained; (4) our ability to achieve our financial forecasts due to various factors, including project delays by our customers, reductions in transaction size, fewer transactions, delays in delivery of new products or releases or a decline in our renewal rates for service agreements; (5) economic, political and market conditions, including the global economic and financial crisis, and the general 21-------------------------------------------------------------------------------- Table of Contents tightening of access to debt or equity capital; (6) technological and market risks associated with the development of new products or services or of new versions of existing or acquired products or services; (7) our ability to successfully complete acquisitions and achieve growth or operational synergies through the integration of acquired businesses, while avoiding unanticipated costs and disruptions to existing operations; (8) competition in the industry in which we conduct business and the impact of competition on pricing, customer retention and pressure for new products or services; (9) the ability to attract and retain qualified personnel and dealing with the loss or retirement of key members of management or other key personnel; and (10) costs of compliance and any failure to comply with government and stock exchange regulations. A detailed discussion of these factors and other risks that affect our business are described in Item 1A, "Risk Factors." We expressly disclaim any obligation to publicly update or revise our forward-looking statements. OVERVIEW General We provide integrated information management solutions and services for the public sector, with a focus on local governments. We develop and market a broad line of software products and services to address the information technology ("IT") needs of cities, counties, schools and other local government entities. In addition, we provide professional IT services to our customers, including software and hardware installation, data conversion, training and for certain customers, product modifications, along with continuing maintenance and support for customers using our systems. We also provide subscription-based services such as software as a service ("SaaS"), which utilizes the Tyler private cloud, and electronic document filing solutions ("e-filing"). In 2010 we began providing e-filing for courts and law offices, which simplify the filing and management of court, related documents. Revenues for e-filing are derived from transaction fees and in some cases fixed fee arrangements. We also provide property appraisal outsourcing services for taxing jurisdictions. Our products generally automate three major functional areas: (1) financial management and education, (2) courts and justice and (3) property appraisal and tax and we report our results in two segments. The Enterprise Software Solutions ("ESS") segment provides municipal and county governments and schools with software systems and services to meet their information technology and automation needs for mission-critical "back-office" functions such as financial management and courts and justice processes. The Appraisal and Tax Software Solutions and Services ("ATSS") segment provides systems and software that automate the appraisal and assessment of real and personal property as well as property appraisal outsourcing services for local governments and taxing authorities. Property appraisal outsourcing services include: the physical inspection of commercial and residential properties; data collection and processing; computer analysis for property valuation; preparation of tax rolls; community education; and arbitration between taxpayers and the assessing jurisdiction. 22 -------------------------------------------------------------------------------- Table of Contents We monitor and analyze several key performance indicators in order to manage our business and evaluate our financial and operating performance. These indicators include the following: • Revenues - We derive our revenues from five primary sources: sale of software licenses and royalties; subscription-based arrangements; software services; maintenance and appraisal services. Subscriptions and maintenance are considered recurring revenue sources and comprised approximately 61% of our revenue in 2013. The number of new SaaS customers and the number of existing customers who convert from our traditional software arrangements to our SaaS model are a significant driver to our business, together with new software license sales and maintenance rate increases. In addition, we also monitor our customer base and churn as we historically have experienced very low customer turnover. During 2013, our customer turnover was approximately 2%. • Cost of Revenues and Gross Margins - Our primary cost component is personnel expenses in connection with providing software implementation, subscription-based services, maintenance and support, and appraisal services to our customers. We can improve gross margins by controlling headcount and related costs and by expanding our revenue base, especially from those products and services that produce incremental revenue with minimal incremental cost, such as software licenses and royalties, subscription-based services, and maintenance and support. Our appraisal projects are cyclical in nature, and we often employ appraisal personnel on a short-term basis to coincide with the life of a project. As of December 31, 2013, our total employee count increased to 2,573 from 2,388 at December 31, 2012. • Selling, General and Administrative ("SG&A") Expenses - The primary components of SG&A expenses are administrative and sales personnel salaries and commissions, share-based compensation expense, marketing expense, rent and professional fees. Sales commissions typically fluctuate with revenues and share-based compensation expense generally increases when the market price of our stock increases. Other administrative expenses tend to grow at a slower rate than revenues. • Liquidity and Cash Flows - The primary driver of our cash flows is net income. Uses of cash include acquisitions, capital investments in property and equipment and discretionary purchases of treasury stock. During 2013, we invested $26.9 million in property and equipment. Our investment in property and equipment included $20.3 million in connection with the construction of an office building in Plano, Texas. Our working capital needs are fairly stable throughout the year with the significant components of cash outflows being payment of personnel expenses offset by cash inflows representing collection of accounts receivable and cash receipts from customers in advance of revenue being earned. • Balance Sheet - Cash, accounts receivable and days sales outstanding and deferred revenue balances are important indicators of our business. Outlook We expect the trend of gradual improvements in the marketplace to continue in 2014. We have made significant investments in our business that we believe will enhance our market leadership and improve long-term revenue and margin growth. CRITICAL ACCOUNTING POLICIES AND ESTIMATES Our discussion and analysis of financial condition and results of operations is based upon our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States ("GAAP"). The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets and liabilities at the date of the financial statements, the reported amounts of revenues, cost of revenues and expenses during the reporting period, and related disclosure of contingencies. The Notes to the Financial Statements included as part of this Annual Report describe our significant accounting policies used in the preparation of the financial statements. Significant items subject to such estimates and assumptions include the application of the percentage-of-completion and proportional performance methods of revenue recognition, the carrying amount and estimated useful lives of intangible assets, determination of share-based compensation expense and valuation allowance for receivables. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies require significant judgments and estimates used in the preparation of our financial statements. Revenue Recognition. We recognize revenues in accordance with the provisions of Accounting Standards Codification ("ASC") 605, Revenue Recognition and ASC 985-605, Software Revenue Recognition. Our revenues are derived from sales of software licenses and royalties, subscription-based services, appraisal services, maintenance and support, and services that typically range from 23-------------------------------------------------------------------------------- Table of Contents installation, training and basic consulting to software modification and customization to meet specific customer needs. For multiple element software arrangements, which do not entail the performance of services that are considered essential to the functionality of the software, we generally record revenue when the delivered products or performed services result in a legally enforceable and non-refundable claim. We maintain allowances for doubtful accounts and sales adjustments, which are provided at the time the revenue is recognized. Because most of our customers are governmental entities, we rarely incur a loss resulting from the inability of a customer to make required payments. In a limited number of cases, we encounter a customer who is dissatisfied with some aspect of the software product or our service, and we may offer a "concession" to such customer. In those limited situations where we grant a concession, we rarely reduce the contract arrangement fee, but alternatively may perform additional services, such as additional training or creating additional custom reports. These amounts have historically been nominal. In connection with our customer contracts and the adequacy of related allowances and measures of progress towards contract completion, our project managers are charged with the responsibility to continually review the status of each customer on a specific contract basis. Also, we review, on at least a quarterly basis, significant past due accounts receivable and the adequacy of related reserves. Events or changes in circumstances that indicate that the carrying amount for the allowances for doubtful accounts and sales adjustments may require revision, include, but are not limited to, deterioration of a customer's financial condition, failure to manage our customer's expectations regarding the scope of the services to be delivered, and defects or errors in new versions or enhancements of our software products. We use contract accounting, primarily the percentage-of-completion method, as discussed in ASC 605-35, Construction - Type and Certain Production - Type Contracts, for those software arrangements that involve significant production, modification or customization of the software, or where our software services are otherwise considered essential to the functionality of the software. We measure progress-to-completion primarily using labor hours incurred, or value added. In addition, we recognize revenue using the proportional performance method of revenue recognition for our property appraisal projects, some of which can range up to five years. These methods rely on estimates of total expected contract revenue, billings and collections and expected contract costs, as well as measures of progress toward completion. We believe reasonably dependable estimates of revenue and costs and progress applicable to various stages of a contract can be made. At times, we perform additional and/or non-contractual services for little to no incremental fee to satisfy customer expectations. If changes occur in delivery, productivity or other factors used in developing our estimates of expected costs or revenues, we revise our cost and revenue estimates, and any revisions are charged to income in the period in which the facts that give rise to that revision first become known. In connection with these and certain other contracts, we may perform the work prior to when the services are billable and/or payable pursuant to the contract. The termination clauses in most of our contracts provide for the payment for the value of products delivered and services performed in the event of an early termination. For SaaS arrangements, we evaluate whether the customer has the contractual right to take possession of our software at any time during the hosting period without significant penalty and whether the customer can feasibly maintain the software on the customer's hardware or enter into another arrangement with a third party to host the software. If we determine that the customer has the contractual right to take possession of our software at any time during the hosting period without significant penalty and can feasibly maintain the software on the customer's hardware or enter into another arrangement with a third party to host the software, we recognize the license, professional services and hosting services revenues pursuant to ASC 985-605, Software Revenue Recognition. For SaaS arrangements that do not meet the criteria for recognition under ASC 985-605, we account for the elements under ASC 605-25, Multiple Element Arrangements using all applicable facts and circumstances, including whether (i) the element has stand-alone value, (ii) there is a general right of return and (iii) the revenue is contingent on delivery of other elements. We allocate the contract value to each element of the arrangement that qualifies for treatment as a separate element based on vendor-specific objective evidence of fair value ("VSOE"), and if VSOE is not available, third party evidence, and if third party evidence is unavailable, estimated selling price. For professional services associated with SaaS arrangements that we determine do not have stand-alone value to the customer or are contingent on delivery of other elements, we recognize the services revenue ratably over the remaining contractual period once hosting has gone live and we may begin billing for the hosting services. We record amounts that have been invoiced in accounts receivable and in deferred revenue or revenues, depending on whether the revenue recognition criteria have been met. In connection with certain of our contracts, we have recorded retentions receivable or unbilled receivables consisting of costs and estimated profit in excess of billings as of the balance sheet date. Many of the contracts which give rise to unbilled receivables at a given balance sheet date are subject to billings in the subsequent accounting period. We review unbilled receivables and related contract provisions to ensure we are justified in recognizing revenue prior to billing the customer and that we have objective evidence which allows us to recognize such revenue. In addition, we have a sizable amount of deferred revenue which represents billings in excess of revenue earned. The majority of this liability consists of maintenance billings for which payments are made in advance and the revenue is ratably earned over the maintenance period, generally one year. We also have deferred revenue for those contracts in which we receive a deposit and the conditions in which to record revenue for the service or product has not been met. On a periodic basis, we review by customer the detail components of our deferred revenue to ensure our accounting remains appropriate. 24 -------------------------------------------------------------------------------- Table of Contents Intangible Assets and Goodwill. Our business acquisitions typically result in the creation of goodwill and other intangible asset balances, and these balances affect the amount and timing of future period amortization expense, as well as expense we could possibly incur as a result of an impairment charge. The cost of acquired companies is allocated to identifiable tangible and intangible assets based on estimated fair value, with the excess allocated to goodwill. Accordingly, we have a significant balance of acquisition date intangible assets, including software, customer related intangibles, trade name and goodwill. These intangible assets (other than goodwill) are amortized over their estimated useful lives. We currently have no intangible assets with indefinite lives other than goodwill. When testing goodwill for impairment quantitatively, we first compare the fair value of each reporting unit with its carrying amount. If the carrying amount of a reporting unit exceeds its fair value, a second step is performed to measure the amount of potential impairment. In the second step, we compare the implied fair value of reporting unit goodwill with the carrying amount of the reporting unit's goodwill. If the carrying amount of reporting unit goodwill exceeds the implied fair value of that goodwill, an impairment loss is recognized. The fair values calculated in our impairment tests are determined using discounted cash flow models involving several assumptions. The assumptions that are used are based upon what we believe a hypothetical marketplace participant would use in estimating fair value. We base our fair value estimates on assumptions we believe to be reasonable but that are unpredictable and inherently uncertain. We evaluate the reasonableness of the fair value calculations of our reporting units by comparing the total of the fair value of all of our reporting units to our total market capitalization. Our annual goodwill impairment analysis, which we performed quantitatively during the second quarter of 2013, did not result in an impairment charge. During 2013, we did not identify any triggering events which would require an update to our annual impairment review. All intangible assets (other than goodwill) are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of other intangible assets is measured by comparison of the carrying amount to estimated undiscounted future cash flows. The assessment of recoverability or of the estimated useful life for amortization purposes will be affected if the timing or the amount of estimated future operating cash flows is not achieved. Such indicators may include, among others: a significant decline in expected future cash flows; a sustained, significant decline in stock price and market capitalization; a significant adverse change in legal factors or in the business climate; unanticipated competition; and reductions in growth rates. In addition, products, capabilities, or technologies developed by others may render our software products obsolete or non-competitive. Any adverse change in these factors could have a significant impact on the recoverability of goodwill or other intangible assets. Share-Based Compensation. We have a stock option plan that provides for the grant of stock options to key employees, directors and non-employee consultants. We estimate the fair value of share-based awards on the date of grant using the Black-Scholes option valuation model. Share-based compensation expense includes the estimated effects of forfeitures, which will be adjusted over the requisite service period to the extent actual forfeitures differ, or are expected to differ from such estimates. Changes in estimated forfeitures are recognized in the period of change and will also impact the amount of expense to be recognized in future periods. Forfeiture rate assumptions are derived from historical data. We estimate stock price volatility at the date of grant based on the historical volatility of our common stock. Estimated option life is determined using the weighted-average period the stock options are expected to be outstanding based primarily on the options' vesting terms, remaining contractual life and the employees' expected exercise based on historical patterns. Determining the appropriate fair-value model and calculating the fair value of share-based awards at the grant date requires considerable judgment, including estimating stock price volatility, expected option life and forfeiture rates. 25-------------------------------------------------------------------------------- Table of Contents ANALYSIS OF RESULTS OF OPERATIONS AND OTHER The following discussion compares the historical results of operations on a basis consistent with GAAP for the years ended December 31, 2013, 2012 and 2011. Percentage of Total Revenue Years ended December 31, 2013 2012 2011 Revenue: Software licenses and royalties 9.8 % 9.3 % 10.5 % Subscriptions 14.8 12.3 10.1 Software services 22.4 23.0 22.5 Maintenance 46.0 47.3 47.4 Appraisal services 5.0 6.2 7.5 Hardware and other 2.0 1.9 2.0 Total revenue 100.0 100.0 100.0 Operating Expenses: Cost of software licenses, royalties and acquired software 1.1 1.1 1.3 Cost of software services, maintenance and subscriptions 47.9 47.2 46.5 Cost of appraisal services 3.3 4.1 4.7 Cost of hardware and other 1.3 1.4 1.6 Selling, general and administrative expenses 23.6 23.9 24.5 Research and development expense 5.6 5.5 5.3 Amortization of customer base and trade name intangibles 1.1 1.2 1.1 Operating income 16.1 15.6 15.0 Other expense 0.3 0.8 0.7 Income before income taxes 15.8 14.8 14.3 Income tax provision 6.4 5.7 5.4 Net income 9.4 % 9.1 % 8.9 % 26 -------------------------------------------------------------------------------- Table of Contents 2013 Compared to 2012 Revenues Software licenses and royalties. The following table sets forth a comparison of our software licenses and royalties revenues for the years ended December 31: Change ($ in thousands) 2013 2012 $ % ESS $ 38,774 $ 32,060 $ 6,714 21 % ATSS 2,067 1,868 199 11 Total software licenses and royalties revenue $ 40,841 $ 33,928 $ 6,913 20 % Since March 2012, we have acquired two companies which provide financial and human capital management software solutions to the K-12 education market and one company that provides enterprise permitting, land management, licensing and regulatory software solutions to governmental agencies. The results of these acquisitions are included in our ESS segment from the dates of their acquisitions. Excluding the impact of acquisitions, total software licenses and royalties revenue increased 12% compared to 2012. Approximately half of the growth was due to an increase of $2.3 million in royalties on sales of Microsoft Dynamics AX by other Microsoft partners compared to the prior year. We record royalty revenue when the fees are fixed or determinable, which is known when we receive notice of the amounts earned pursuant to our royalty arrangements which are generally 30 to 60 days after each quarterly reporting period. Royalty revenue is dependent upon sales volume from Microsoft partners, as well as the timing of maintenance renewals, and can vary substantially from period to period. Excluding the impact of acquisitions, software licenses grew 5% mainly due to increased investments in product development over the past few years. However, software license growth was reduced somewhat because of a growing number of customers choosing our subscription-based options, rather than purchasing the software under a traditional perpetual software license arrangement. Subscription-based arrangements result in no software license revenues in the initial year as compared to traditional perpetual software license arrangements but generate higher overall subscription-based services revenue over the term of the contract. We had 100 new customers that entered into subscription-based arrangements in 2013 compared to 76 new customers in 2012. Subscriptions. The following table sets forth a comparison of our subscription revenues for the years ended December 31: Change ($ in thousands) 2013 2012 $ % ESS $ 59,070 $ 43,319 $ 15,751 36 % ATSS 2,794 1,299 1,495 115 Total subscriptions revenue $ 61,864 $ 44,618 $ 17,246 39 % Subscription-based services revenue primarily consists of revenues derived from our SaaS arrangements, which utilize the Tyler private cloud. As part of our subscription-based services, we also provide e-filing that simplify the filing and management of court related documents for courts and law offices. Revenues for e-filing are derived from transaction fees or in some cases fixed fee arrangements. The contract term for SaaS arrangements range from one to 10 years but are typically for a period of three to six years. Excluding the impact of acquisitions, subscription-based services revenue increased 37% compared to 2012. New SaaS customers as well as existing customers who converted to our SaaS model provided the majority of the subscription-based revenue increase. In 2013, we added 100 new customers and 63 existing customers elected to convert to our SaaS model. E-filing services also contributed approximately $5.0 million of the subscription revenue increase. E-filing revenue included $3.8 million related to a new contract with the Texas Office of Court Administration for our Odyssey File and Serve e-filing system for Texas courts ("e-File Texas.gov"), which was implemented in September 2013. This contract is a fixed fee arrangement and we expect it will provide a long-term recurring revenue stream of $17 million to $19 million annually when e-filing becomes mandatory in Texas in 2014. The remaining e-filing revenue increase is mainly the result of existing clients expanding mandatory e-filing for court documents. 27 -------------------------------------------------------------------------------- Table of Contents Software services. The following table sets forth a comparison of our software services revenues for the years ended December 31: Change ($ in thousands) 2013 2012 $ % ESS $ 85,459 $ 76,103 $ 9,356 12 % ATSS 7,808 7,305 503 7 Total software services revenue $ 93,267 $ 83,408 $ 9,859 12 % Software services revenues primarily consist of professional services billed in connection with the installation of our software, conversion of customer data, training customer personnel and consulting. New customers who purchase our proprietary software licenses generally also contract with us to provide for the related software services. Existing customers also periodically purchase additional training, consulting and minor programming services. Excluding the impact of acquisitions, software services increased 7% compared to 2012. The increase is partly due to growth in software license activity and due to contract arrangements that included more programming and other services. Maintenance. The following table sets forth a comparison of our maintenance revenues for the years ended December 31: Change ($ in thousands) 2013 2012 $ % ESS $ 175,180 $ 155,290 $ 19,890 13 % ATSS 16,540 16,561 (21 ) - Total maintenance revenue $ 191,720 $ 171,851 $ 19,869 12 % We provide maintenance and support services for our software products and certain third party software. Excluding the impact of acquisitions, maintenance revenue grew 9% from 2012. This increase was due to growth in our installed customer base from new software license sales and maintenance rate increases. Appraisal services. The following table sets forth a comparison of our appraisal services revenues for the years ended December 31: Change ($ in thousands) 2013 2012 $ % ESS $ - $ - $ - - % ATSS 20,825 22,543 (1,718 ) (8 ) Total appraisal services revenue $ 20,825 $ 22,543 $ (1,718 ) (8 )% Appraisal services revenue declined 8% in 2013 compared to 2012. The appraisal services business is somewhat cyclical and driven in part by statutory revaluation cycles in various states. The decline is mainly due to the completion in mid-2012 of a large contract in Pennsylvania. We expect appraisal revenues for 2014 will increase slightly compared to 2013. 28-------------------------------------------------------------------------------- Table of Contents Cost of Revenues and Gross Margins The following table sets forth a comparison of the key components of our cost of revenues for the years ended December 31: Change ($ in thousands) 2013 2012 $ % Software licenses and royalties $ 2,377 $ 1,983 $ 394 20 % Acquired software 2,078 1,888 190 10 Software services, maintenance and subscriptions 199,617 171,584 28,033 16 Appraisal services 13,809 14,889 (1,080 ) (7 ) Hardware and other 5,559 5,258 301 6 Total cost of revenues $ 223,440 $ 195,602 $ 27,838 14 % The following table sets forth a comparison of gross margin percentage by revenue type for the years ended December 31: Gross margin percentage 2013 2012 Change Software licenses, royalties and acquired software 89.1 % 88.6 % 0.5 % Software services, maintenance and subscriptions 42.4 42.8 (0.4 ) Appraisal services 33.7 34.0 (0.3 ) Hardware and other 31.6 24.4 7.2 Overall gross margin 46.4 % 46.2 % 0.2 % Software licenses, royalties and acquired software. Costs of software licenses, royalties and acquired software are primarily comprised of third party software costs and amortization expense for software acquired through acquisitions. We do not have any direct costs associated with royalties. In 2013, our software licenses, royalties and acquired software gross margin percentage increased compared to 2012 mainly due to higher revenues from royalties. The margin also benefited from a product mix that included slightly more proprietary software revenues, which have a higher gross margin than third party software. Software services, maintenance and subscription-based services. Cost of software services, maintenance and subscription-based services primarily consists of personnel costs related to installation of our software, conversion of customer data, training customer personnel and support activities and various other services such as SaaS arrangements and e-filing. Maintenance and various other services such as SaaS costs typically grow at a slower rate than related revenues due to leverage in the utilization of our support and maintenance staff and economies of scale. However, we accelerated hiring in 2013 to ensure that we were well-positioned to deliver our current backlog and anticipated new business. In late 2012, we signed a contract with the Texas Office of Court Administration for e-FileTexas.gov to manage e-filing of court documents. In early 2013 the state of Texas issued an order mandating e-filing in civil cases beginning in January 2014. Mandatory e-filing will be phased in over a two and a half year period, beginning with the largest counties in January 2014. We will be paid on a fixed fee basis but had very limited revenues in 2013 from e-FileTexas.gov. However, during 2013, we incurred expenses of approximately $3.3 million in connection with implementing the system in courts across the state. Excluding the limited revenues and cost incurred in connection with implementing e-FileTexas.gov in 2013, our software services, maintenance and subscription services gross margin would have been approximately 42.8%. Our implementation and support staff has increased by 202 employees since 2012. Most of these additions occurred mid-to late 2013. Appraisal services. Appraisal services revenues are approximately 5% of total revenues. The appraisal services gross margin declined slightly compared to 2012. A high proportion of the costs of appraisal services revenue are variable, as we often hire temporary employees to assist in appraisal projects, whose term of employment generally ends with the projects' completion. Our blended gross margin for 2013 increased 0.2% from 2012. The increase was due to higher royalty revenue and also benefited from a product mix that included slightly higher proprietary software revenues than third party software. Costs incurred related to our implementation of e-FileTexas.gov with minimal related revenues as well as increased hiring of implementation and support staff in order to expand our capacity to implement our contract backlog offset some of the positive impact of higher royalty and proprietary software revenue. 29-------------------------------------------------------------------------------- Table of Contents Selling, General and Administrative Expenses Selling, general and administrative ("SG&A") expenses consist primarily of salaries, employee benefits, travel, share-based compensation expense, commissions and related overhead costs for administrative and sales and marketing employees as well as, professional fees, trade show activities, advertising costs and other marketing related costs. The following table sets forth a comparison of our SG&A expenses for the following years ended December 31: Change ($ in thousands) 2013 2012 $ % Selling, general and administrative expenses $ 98,289 $ 86,706 $ 11,583 13 % SG&A as a percentage of revenues was 23.6% in 2013 compared to 23.9% in 2012. Excluding costs from acquisitions, almost half of the SG&A expense increase is due to increased stock compensation expense resulting from the substantial increase in our stock price over the last twelve months and higher payroll taxes associated with increased stock option exercise activity. Commission expense has also increased compared to the prior year periods due to higher sales. Research and Development Expense Research and development expense consists primarily of salaries, employee benefits and related overhead costs associated with product development. The following table sets forth a comparison of our research and development expense for the years ended December 31: Change ($ in thousands) 2013 2012 $ % Research and development expense $ 23,269 $ 20,140 $ 3,129 16 % Research and development expense consist mainly of costs associated with development of new products and new software platforms from which we do not currently generate revenue. These include the next version of Microsoft Dynamics AX project, as well as other new product development efforts. In 2007, we entered into a Software Development and License Agreement, which provides for a strategic alliance with Microsoft Corporation ("Microsoft") to jointly develop core public sector functionality for Microsoft Dynamics AX to address the accounting needs of public sector organizations worldwide. This agreement and subsequent amendments granted Microsoft intellectual property rights in the software code provided and developed by Tyler into Microsoft Dynamics AX products to be marketed and sold outside of the public sector in exchange for reimbursement payments to partially offset the research and development costs and royalties on direct and indirect public-sector sales worldwide of the solutions co-developed under this arrangement. In addition, Tyler has agreed to commit certain resources to the development of the next version of Dynamics AX and will receive software and maintenance royalties on direct and indirect public-sector sales worldwide of the solutions co-developed under this arrangement. Our research and development expense increased $3.1 million in 2013 compared to 2012. In 2013 we did not have any research and development expense offsets earned under the terms of our agreement with Microsoft compared to $1.0 million in research and development expense offsets in 2012. 30-------------------------------------------------------------------------------- Table of Contents Amortization of Customer and Trade Name Intangibles Acquisition intangibles are comprised of the excess of the purchase price over the fair value of net tangible assets acquired that is allocated to acquired software and customer and trade name intangibles. The remaining excess purchase price is allocated to goodwill that is not subject to amortization. Amortization expense related to acquired software is included with cost of revenues, while amortization expense of customer and trade name intangibles is recorded as operating expense. The estimated useful lives of both customer and trade name intangibles are five to 25 years. The following table sets forth a comparison of amortization of customer and trade name intangibles for the years ended December 31: Change ($ in thousands) 2013 2012 $ % Amortization of customer and trade name intangibles $ 4,517 $ 4,279 $ 238 6 % Estimated annual amortization expense relating to customer and trade name acquisition intangibles, excluding acquired software for which the amortization expense is recorded as cost of revenues, for the next five years is as follows (in thousands): 2014 $ 4,515 2015 4,515 2016 4,515 2017 4,515 2018 4,366 Other The following table sets forth a comparison of other expense, net for the years ended December 31: Change ($ in thousands) 2013 2012 $ % Other expense, net $ 1,309 $ 2,709 $ (1,400 ) (52 )% Other expense is primarily comprised of interest expense, non-usage and other fees associated with our revolving line of credit agreement. Interest expense was lower in 2013 than 2012 because we maintained higher debt levels in 2012 associated primarily with several acquisitions completed from October 2011 through November 2012. Income Tax Provision The following table sets forth a comparison of our income tax provision for the years ended December 31: Change ($ in thousands) 2013 2012 $ % Income tax provision $ 26,718 $ 20,874 $ 5,844 28 % Effective income tax rate 40.6 % 38.8 % The effective income tax rates were different from the statutory United States federal income tax rate of 35% due to state income taxes, non-deductible share-based compensation expense, the qualified manufacturing activities deduction, disqualifying incentive stock option dispositions and non-deductible meals and entertainment costs. We experienced significant stock option exercise activity in 2013 that generated $28.2 million excess tax benefits. Excess tax benefits reduce tax payments but do not significantly reduce the effective tax rate and can result in limitations on other deductions. In 2013, limitations resulting from excess tax benefits eliminated the qualified manufacturing activities deduction, which negatively impacted our effective tax rate. 31-------------------------------------------------------------------------------- Table of Contents 2012 Compared to 2011 Revenues Software licenses and royalties. The following table sets forth a comparison of our software licenses and royalties revenues for the years ended December 31: Change ($ in thousands) 2012 2011 $ % ESS $ 32,060 $ 30,194 $ 1,866 6 % ATSS 1,868 2,400 (532 ) (22 ) Total software licenses and royalties revenue $ 33,928 $ 32,594 $ 1,334 4 % Excluding the impact of acquisitions, total software licenses and royalties revenue declined by 3% compared to 2011. Most of the decline was due to fewer add-on sales to our existing customer base. In addition, software license growth was reduced somewhat because of a growing number of customers choosing our subscription-based options, rather than purchasing the software under a traditional perpetual software license arrangement. Subscription-based arrangements result in no software license revenues in the initial year as compared to traditional perpetual software license arrangements but generate higher overall subscription-based services revenue over the term of the contract. We had 76 new customers that entered into subscription-based arrangements in 2012 compared to 47 new customers in 2011. Subscriptions. The following table sets forth a comparison of our subscription revenues for the years ended December 31: Change ($ in thousands) 2012 2011 $ % ESS $ 43,319 $ 30,400 $ 12,919 42 % ATSS 1,299 760 539 71 Total subscriptions revenue $ 44,618 $ 31,160 $ 13,458 43 % Excluding the impact of acquisitions, subscription-based services revenue increased 40% compared to 2011. New SaaS customers as well as existing customers who converted to our SaaS model provided the majority of the subscription-based revenue increase. In 2012, we added 76 new customers and 68 existing customers elected to convert to our SaaS model. E-filing services also contributed approximately $2.3 million of the subscription revenue increase as a result of new clients implementing e-filing and several existing clients adopting or expanding mandatory e-filing for court documents in the last half of 2011 and 2012. Software services. The following table sets forth a comparison of our software services revenues for the years ended December 31: Change ($ in thousands) 2012 2011 $ % ESS $ 76,103 $ 60,840 $ 15,263 25 % ATSS 7,305 8,777 (1,472 ) (17 ) Total software services revenue $ 83,408 $ 69,617 $ 13,791 20 % Excluding the impact of acquisitions, software services increased 14% compared to 2011. The increase is due partly to contract arrangements that included more programming services as well as several state-wide arrangements that in addition to services, include more third party vendor services to build certain software interfaces. 32 -------------------------------------------------------------------------------- Table of Contents Maintenance. The following table sets forth a comparison of our maintenance revenues for the years ended December 31: Change ($ in thousands) 2012 2011 $ % ESS $ 155,290 $ 130,999 $ 24,291 19 % ATSS 16,561 15,499 1,062 7 Total maintenance revenue $ 171,851 $ 146,498 $ 25,353 17 % Excluding the impact of acquisitions, maintenance revenue grew 9% from 2011. This increase was due to growth in our installed customer base and maintenance rate increases on most of our product lines. Appraisal services. The following table sets forth a comparison of our appraisal services revenues for the years ended December 31: Change ($ in thousands) 2012 2011 $ % ESS $ - $ - $ - - % ATSS 22,543 23,228 (685 ) (3 ) Total appraisal services revenue $ 22,543 $ 23,228 $ (685 ) (3 )% Appraisal services revenue declined 3% in 2012 compared to 2011. The appraisal services business is somewhat cyclical and driven in part by statutory revaluation cycles in various states. The decline is mainly due to the completion in mid-2012, of a large contract in Pennsylvania offset slightly by the start-up of smaller projects, including several in Ohio. 33-------------------------------------------------------------------------------- Table of Contents Cost of Revenues and Gross Margins The following table sets forth a comparison of the key components of our cost of revenues for the years ended December 31: Change ($ in thousands) 2012 2011 $ % Software licenses and royalties $ 1,983 $ 3,034 $ (1,051 ) (35 )% Acquired software 1,888 1,125 763 68 Software services, maintenance and subscriptions 171,584 143,776 27,808 19 Appraisal services 14,889 14,550 339 2 Hardware and other 5,258 4,994 264 5 Total cost of revenues $ 195,602 $ 167,479 $ 28,123 17 % The following table sets forth a comparison of gross margin percentage by revenue type for the years ended December 31: Gross margin percentage 2012 2011 Change Software licenses, royalties and acquired software 88.6 % 87.2 % 1.4 % Software services, maintenance and subscriptions 42.8 41.9 0.9 Appraisal services 34.0 37.4 (3.4 ) Hardware and other 24.4 20.7 3.7 Overall gross margin 46.2 % 45.9 % 0.3 % Software licenses, royalties and acquired software. In 2012, our software license gross margin percentage increased compared to 2011 due to higher royalties and because our product mix included less third party software which offset higher amortization expense associated with acquisitions. Software services, maintenance and subscription-based services. In 2012, the software services, maintenance and subscriptions gross margin increased compared to the prior year partly because we improved our utilization of our support and maintenance staff and due to annual rate increases on certain services. Excluding 147 employees added with acquisitions, our implementation and support staff has increased by 103 employees since 2011. Most of these additions occurred mid-to late 2012. Appraisal services. Appraisal services revenues are approximately 6% of total revenues. The appraisal services gross margin declined compared to 2011. The appraisal services gross margin in 2011 was also favorably impacted by operational efficiencies associated with a large revaluation contract, which began in mid-2010 and was substantially complete by mid-2011. Our blended gross margin for 2012 increased 0.3% from 2011 mainly due to leverage in the utilization of our support, maintenance and subscription-based services staff and economies of scale and slightly higher rates on certain services. The gross margin also benefited from lower third party software costs and higher royalties. Selling, General and Administrative Expenses The following table sets forth a comparison of our SG&A expenses for the following years ended December 31: Change ($ in thousands) 2012 2011 $ % Selling, general and administrative expenses $ 86,706 $ 75,650 $ 11,056 15 % Excluding the impact of acquisitions, SG&A increased approximately 11% compared to 2011. SG&A as a percentage of revenues was 23.9% in 2012 compared to 24.5% in 2011. SG&A expenses increased due to higher commission expense in connection with increased sales; increased headcount in sales and related expenses to support geographic expansion; and increased incentive compensation costs due to improved results and higher stock compensation expense because our company stock price has increased substantially over the last few years. 34-------------------------------------------------------------------------------- Table of Contents Research and Development Expense The following table sets forth a comparison of our research and development expense for the years ended December 31: Change ($ in thousands) 2012 2011 $ % Research and development expense $ 20,140 $ 16,414 $ 3,726 23 % Our research and development expense increased $3.7 million in 2012 compared to 2011. The increase is mainly due to lower reimbursements from Microsoft in 2012. In 2012, we had $1.0 million in research and development expense offsets compared to $3.5 million in 2011, which were the amounts earned under the terms of our agreement with Microsoft. Under our amended agreement with Microsoft, the project included offsets to research and development expense, varying in amount from quarter to quarter from 2009 through 2012 for a total of approximately $6.2 million. As of September 30, 2012, we received the final $1.0 million under the agreement. Amortization of Customer and Trade Name Intangibles The following table sets forth a comparison of amortization of customer and trade name intangibles for the years ended December 31: Change ($ in thousands) 2012 2011 $ % Amortization of customer and trade name intangibles $ 4,279 $ 3,331 $ 948 28 % In 2012, we completed four acquisitions that increased amortizable customer and trade name intangibles by approximately $11.1 million. This amount is being amortized over a weighted average period of 11.8 years. Other The following table sets forth a comparison of other expense, net for the years ended December 31: Change ($ in thousands) 2012 2011 $ % Other expense, net $ 2,709 $ 2,404 $ 305 13 % Interest expense was higher in 2012 than 2011 due to higher debt levels associated with several acquisitions completed since October 2011 and stock repurchases in the last half of 2011. The effective interest rate in 2012 was 3.4% compared to 3.3% in 2011. Income Tax Provision The following table sets forth a comparison of our income tax provision for the years ended December 31: Change ($ in thousands) 2012 2011 $ % Income tax provision $ 20,874 $ 16,556 $ 4,318 26 % Effective income tax rate 38.8 % 37.5 % The effective income tax rates for both years were different from the statutory United States federal income tax rate of 35% due to state income taxes, non-deductible share-based compensation expense, the qualified manufacturing activities deduction, disqualifying incentive stock option dispositions and non-deductible meals and entertainment costs. The effective income tax rate in 2011 was also reduced by a research and development tax credit. The qualified manufacturing activities deduction declined in 2012 contributing to a higher effective tax rate. 35 -------------------------------------------------------------------------------- Table of Contents FINANCIAL CONDITION AND LIQUIDITY As of December 31, 2013, we had cash and cash equivalents of $78.9 million and investments available-for-sale of $1.3 million, compared to cash and cash equivalents of $6.4 million and investments available-for-sale of $2.0 million at December 31, 2012. As of December 31, 2013, we had no outstanding borrowings and an outstanding letter of credit totaling $2.0 million. Some of our customers require a letter of credit in connection with our contracts. The notional amount of performance guarantees outstanding secured by letter of credit as of December 31, 2013 was estimated to be approximately $29.0 million. We do not believe this letter of credit will be required to be drawn upon. We believe that cash from operating activities, cash on hand and access to the credit markets provides us with sufficient flexibility to meet our long-term financial needs. The following table sets forth a summary of cash flows for the years ended December 31: ($ in thousands) 2013 2012 2011 Cash flows provided (used) by: Operating activities $ 66,090 $ 58,668 $ 56,435 Investing activities (25,658 ) (34,736 ) (28,809 ) Financing activities 32,038 (18,852 ) (28,414 ) Net increase (decrease) in cash and cash equivalents $ 72,470 $ 5,080 $ (788 ) Net cash provided by operating activities continues to be our primary source of funds to finance operating needs and capital expenditures. Other potential capital resources include cash on hand, public and private issuances of debt or equity securities, and bank borrowings. It is possible that our ability to access the capital and credit markets in the future may be limited by economic conditions or other factors. We currently believe that cash provided by operating activities, cash on hand and access to the credit markets are sufficient to fund our working capital requirements, capital expenditures, income tax obligations, and share repurchases for at least the next twelve months. In 2013, operating activities provided net cash of $66.1 million, primarily generated from net income of $39.1 million, non-cash depreciation and amortization charges of $13.8 million and non-cash share-based compensation expense of $11.7 million. Cash from operations also benefited from timing of payments on wages and bonuses. In addition, deferred revenue balances were higher than 2012 due to an increase in annual software maintenance billings as a result of growth in our installed customer base and growth in subscription-based arrangements. These increases in liabilities were offset somewhat by higher accounts receivable balances from annual software maintenance billings, progress billings associated with large contracts and prepaid commissions on large contracts. In general, changes in the balance of deferred revenue are cyclical and primarily driven by the timing of our maintenance renewal billings. Our renewal dates occur throughout the year but our heaviest renewal cycles occur in the second and fourth quarters. At December 31, 2013, our days sales outstanding ("DSOs") were 87 days compared to DSOs of 95 days at December 31, 2012. DSOs are calculated based on accounts receivable (excluding long-term receivables, but including unbilled receivables) divided by the quotient of annualized quarterly revenues divided by 360 days. Accounts receivable at December 31, 2012 included several large billings for retentions associated with appraisal contracts. Investing activities used cash of $25.7 million in 2013 compared to $34.7 million in 2012. Investing activities in 2013 include $20.3 million paid in connection with the construction of an office building in Plano, Texas compared to $2.3 million in 2012. In 2012, we completed the acquisitions of Akanda Innovations, Inc., UniFund, L.L.C., Computer Software Associates, Inc. and EnerGov Solutions, L.L.C. The combined cash purchase prices paid in 2012, net of cash acquired was approximately $25.7 million. In May 2012, we purchased land and a building in Moraine, Ohio to support our appraisal and tax operations for a purchase price of $2.6 million, which was comprised of $1.7 million in cash and land and a building valued at $900,000. These expenditures were funded from cash generated from operations and borrowings under our revolving credit line. In 2011, we completed the acquisition of Windsor. The purchase price, net of cash acquired, was approximately $16.4 million. In March 2011, we paid $6.6 million for approximately 27 acres of land and a building in Plano, Texas. 36-------------------------------------------------------------------------------- Table of Contents Financing activities in 2013 provided cash of $32.0 million compared to cash used by financing activities of $18.9 million in 2012. Financing activities in 2013 were comprised of $18.0 million in net payments on our revolving line of credit offset by collections of $21.8 million from stock option exercises and employee stock purchase plan activity and $28.2 million excess tax benefit from exercises of share-based arrangements. Cash used in financing activities in 2012 was mainly comprised of $42.7 million in payments on our revolving line of credit offset by collections of $15.1 million from stock option exercises and contributions from the employee stock purchase plan and $8.8 million excess tax benefit from exercises of share-based arrangements. In 2011, cash used in financing activities was primarily comprised of purchases of treasury shares, net of proceeds from stock option exercises, borrowings and payments on our revolving credit line and contributions from our employee stock purchase plan. During 2011, we purchased 3.0 million shares of our common stock for an aggregate purchase price of $71.8 million. The share repurchase program, which was approved by our board of directors, was announced in October 2002, and was amended in April 2003, July 2003, October 2004, October 2005, May 2007, May 2008, October 2008, May 2009, July 2010, October 2010 and September 2011. As of December 31, 2013, we had remaining authorization to repurchase up to 1.7 million additional shares of our common stock. Our share repurchase program allows us to repurchase shares at our discretion and market conditions influence the timing of the buybacks and the number of shares repurchased, as well as the volume of employee stock option exercises. These share repurchases are funded using our existing cash balances and borrowings under our revolving credit agreement and may occur through open market purchases and transactions structured through investment banking institutions, privately negotiated transactions and/or other mechanisms. There is no expiration date specified for the authorization and we intend to repurchase stock under the plan from time to time. In 2013, we issued 1.4 million shares of common stock and received $18.3 million in aggregate proceeds upon exercise of stock options. In 2012 we issued 1.2 million shares of common stock and received $12.4 million in aggregate proceeds upon exercise of stock options. In 2011 we received $3.6 million from the exercise of options to purchase approximately 582,000 shares of our common stock under our employee stock option plan. In 2013, 2012 and 2011 we received $3.5 million, $2.6 million and $2.0 million, respectively, from contributions to the Tyler Technologies, Inc. Employee Stock Purchase Plan. We have a $150.0 million Credit Agreement (the "Credit Facility") and a related pledge and security agreement with a group of seven financial institutions, with Bank of America, N.A., as Administrative Agent. The Credit Facility provides for a revolving credit line of $150.0 million (which may be increased up to $200.0 million subject to our obtaining commitments for such increase), with a $25.0 million sublimit for letters of credit. The Credit Facility matures on August 11, 2014. Borrowings under the Credit Facility may be used for general corporate purposes, including working capital requirements, acquisitions and share repurchases. Borrowings under the Credit Facility bear interest at a rate of either (1) the Bank of America's prime rate plus a margin of 1.50% to 2.75% or (2) the 30, 60, 90 or 180-day LIBOR rate plus a margin of 2.50% to 3.75%, with the margin determined by our consolidated leverage ratio. The Credit Facility is secured by substantially all of our assets, excluding real property. The Credit Facility requires us to maintain certain financial ratios and other financial conditions and prohibits us from making certain investments, advances, cash dividends or loans, and limits incurrence of additional indebtedness and liens. As of December 31, 2013, we were in compliance with those covenants. As of December 31, 2013, we had no outstanding borrowings and unused available borrowing capacity of $148.0 million under the Credit Facility. In addition, as of December 31, 2013, our bank had issued an outstanding letter of credit totaling $2.0 million. This letter of credit reduces our available borrowing capacity and expires in 2014. We paid income taxes, net of refunds received, of $9.3 million in 2013, $13.1 million in 2012 and $13.4 million in 2011. We experienced significant stock option exercise activity in 2013 that generated $28.2 million excess tax benefits. Excess tax benefits reduce tax payments but do not significantly reduce the effective tax rate and can result in limitations on other deductions. The majority of this excess tax benefit was generated in the last half of 2013 and as a result we anticipate a tax refund in 2014 for approximately $9.7 million. In 2012 and 2011, excess tax benefits were $8.8 million and $3.6 million, respectively. Excluding acquisitions, we anticipate that 2014 capital spending will be between $12.0 million and $13.0 million. We expect the majority of this capital spending will consist of computer equipment and software for infrastructure replacements and expansion. We currently do not expect to capitalize significant amounts related to software development in 2014, but the actual amount and timing of those costs, and whether they are capitalized or expensed may result in additional capitalized software development. Capital spending is expected to be funded from existing cash balances and cash flows from operations. 37-------------------------------------------------------------------------------- Table of Contents From time to time we engage in discussions with potential acquisition candidates. In order to pursue such opportunities, which could require significant commitments of capital, we may be required to incur debt or to issue additional potentially dilutive securities in the future. No assurance can be given as to our future acquisition opportunities and how such opportunities will be financed. We lease office facilities, as well as transportation, computer and other equipment used in our operations under non-cancelable operating lease agreements expiring at various dates through 2021. Most leases contain renewal options and some contain purchase options. Summarized in the table below are our obligations to make future payments under our long-term revolving credit agreement and lease obligations at December 31, 2013 (in thousands): 2014 2015 2016 2017 2018 Thereafter Total Lease obligations $ 5,680 $ 4,677 $ 4,415 $ 3,880 $ 1,731 $ 2,339 $ 22,722 As of December 31, 2013, we do not have any off-balance sheet arrangements, guarantees to third parties or material purchase commitments, except for the operating lease commitments listed above. CAPITALIZATION At December 31, 2013, our capitalization consisted of no outstanding borrowings and $246.3 million of shareholders' equity. 38-------------------------------------------------------------------------------- Table of Contents |