UNITED STATESSECURITIES AND EXCHANGE COMMISSION
FORM 10-K
þ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OFTHE SECURITIES AND EXCHANGE ACT OF 1934
Commission File Number 1-10485
TYLER TECHNOLOGIES, INC.
Registrant’s telephone number, including area code: (972) 713-3700
Securities registered pursuant to Section 12(b) of the Act:
Securities registered pursuant to Section 12(g) of the Act:NONE
INDICATE BY CHECK MARK WHETHER THE REGISTRANT (1) HAS FILED ALL REPORTS REQUIRED TO BE FILED BY SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 DURING THE PRECEDING 12 MONTHS (OR FOR SUCH SHORTER PERIOD THAT THE REGISTRANT WAS REQUIRED TO FILE SUCH REPORTS), AND (2) HAS BEEN SUBJECT TO SUCH FILING REQUIREMENTS FOR THE PAST 90 DAYS. YES þ NO o
INDICATE BY CHECK MARK IF DISCLOSURE OF DELINQUENT FILERS PURSUANT TO ITEM 405 OF REGULATION S-K IS NOT CONTAINED HEREIN, AND WILL NOT BE CONTAINED, TO THE BEST OF REGISTRANT’S KNOWLEDGE, IN DEFINITIVE PROXY OR INFORMATION STATEMENTS INCORPORATED BY REFERENCE IN PART III OF THE FORM 10-K OR ANY AMENDMENT TO THIS FORM 10-K. YES þ NO o
INDICATE BY CHECK MARK WHETHER THE REGISTRANT IS AN ACCELERATED FILER (AS DEFINED IN RULE 12b-2 OF THE ACT). YES þ NO o
THE AGGREGATE MARKET VALUE OF THE VOTING STOCK HELD BY NON-AFFILIATES OF THE REGISTRANT WAS $363,087,000 BASED ON THE REPORTED LAST SALE PRICE OF COMMON STOCK ON JUNE 30, 2004, WHICH IS THE LAST BUSINESS DAY OF THE REGISTRANT’S MOST RECENTLY COMPLETED SECOND FISCAL QUARTER.
THE NUMBER OF SHARES OF COMMON STOCK OF THE REGISTRANT OUTSTANDING ON FEBRUARY 28, 2005 WAS 39,879,219.
DOCUMENTS INCORPORATED BY REFERENCE
CERTAIN INFORMATION REQUIRED BY PART III OF THIS ANNUAL REPORT IS INCORPORATED BY REFERENCE FROM THE REGISTRANT’S DEFINITIVE PROXY STATEMENT FOR ITS ANNUAL MEETING OF STOCKHOLDERS TO BE HELD ON MAY 19, 2005.
TYLER TECHNOLOGIES, INC.FORM 10-KTABLE OF CONTENTS
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PART I
ITEM 1. BUSINESS.
DESCRIPTION OF BUSINESS
Tyler Technologies, Inc. (“Tyler”) is a major provider of integrated information management solutions and services for local governments. We partner with clients to make local government more accessible to the public, more responsive to the needs of citizens and more efficient in its operations. We have a broad line of software products and services to address the information technology (“IT”) needs of virtually every major area of operation for cities, counties, schools and other local government entities. Most of our customers have our software installed in-house. For customers who prefer not to physically acquire the software and hardware, we provide outsourced hosting for some of our applications at one of our data centers through an applications service provider (“ASP”) arrangement. We provide professional IT services to our customers, including software and hardware installation, data conversion, training and, at times, product modifications. In addition, we are the nation’s largest provider of outsourced property appraisal services for taxing jurisdictions. We also provide continuing customer support services to ensure proper product performance and reliability, which provides us with long-term customer relationships and a significant base of recurring maintenance revenue.
Tyler was founded in 1966. Prior to early 1998, we operated as a diversified industrial conglomerate, with operations in various industrial, retail and distribution businesses, all of which have been sold or otherwise disposed. In 1997, we embarked on a multi-phase growth plan focused on serving the specialized information management needs of local governments nationwide. In 1998 and 1999, we made a series of strategic acquisitions of companies in the local government IT market.
In addition to our continuing operations in the software and services business described above, we also operated from 1998 through 2000 a business segment focused on providing outsourced property records management for local governments and reselling related data. In late 2000, we decided to dispose of the information and property records services segment in order to strengthen our balance sheet and allow us to focus our resources on the segment of business that we believe offers the greatest growth and profit opportunities. We expect to continue to capitalize on these opportunities by leveraging our large national client base, our long-term relationships with local government customers, and our deep domain expertise in local government operations through the development of state-of-the-art technologies and new nationally branded applications solutions. We have and are continuing to develop a new generation of software products, some of which are based on n-tier architecture, SQL-compliant databases, browser compatibility and component-based technology.
MARKET OVERVIEW
The state and local government market is one of the largest and most decentralized IT markets in the country, consisting of all 50 states, approximately 3,100 counties, 36,000 cities and towns and 14,500 school districts. This market is also comprised of approximately 35,000 special districts and other agencies, each with specialized delegated responsibilities and unique information management requirements.
Traditionally, local government bodies and agencies performed state-mandated duties, including property assessment, record keeping, road maintenance, law enforcement, administration of election and judicial functions, and the provision of welfare assistance. Today, a host of emerging and urgent issues are confronting local governments, each of which demands a service response. These areas include criminal justice and corrections, administration and finance, public safety, health and human services, and public works. Transfers of responsibility from the federal and state governments to county and municipal governments and agencies in these and other areas also place additional service and financial requirements on these local government units. In addition, constituents of local governments are increasingly demanding improved service and better access to information from public entities. As a result, local governments recognize the increasing value of information management systems and services to, among other things, improve revenue collection, provide increased access to information, and streamline delivery of services to their constituents. Local government bodies are now recognizing that “e-government” is an additional responsibility for community development. From integrated tax systems to integrated civil and criminal justice information systems, many counties and cities have benefited significantly from the implementation of jurisdiction-wide systems that allow different agencies or government offices to share data and provide a more comprehensive approach to information management. Many city and county governmental agencies also have unique individual information management requirements, which must be tailored to the specific functions of each particular office.
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Many local governments also have difficulties attracting and retaining the staff necessary to support their IT functions. As a result, they seek to establish long-term relationships with reliable providers of high quality IT products and services such as Tyler.
Although local governments generally face budgetary constraints in their operations, their primary revenue sources are usually property taxes, and to a lesser extent, utility fees, which tend to be relatively stable. In addition, the acquisition of new technology typically enables local governments to operate more efficiently, and often provides a measurable return on investment that justifies the purchase of software and related services.
Gartner Dataquest estimates that state and local government spending for IT products and services will grow from $42.3 billion in 2004 to $50.8 billion in 2007, with local government accounting for $21.1 billion of IT spending in 2004 and $24.9 billion in 2007. The external services and software segments of the market, where our business is primarily focused, are expected to be the most rapidly growing areas of the local government IT market, expanding from $9.4 billion in 2004 to $12.5 billion in 2007.
PRODUCTS AND SERVICES
We provide a comprehensive and flexible suite of products and services that address the information technology needs of cities, counties, schools and other local government entities. We derive our revenues from four primary sources:
We design, develop and market a broad range of software products to serve mission-critical “back-office” functions of local governments. Our software applications are designed primarily for use on hardware supporting UNIX/NT operating systems. Many of our software applications include Internet-accessible solutions that allow for real-time public access to a variety of information or that allow the public to transact business with local governments via the Internet. Our software products and services are generally grouped in four major product areas:
Each of our core software systems consists of several fully integrated application modules. For customers who acquire the software for use in-house, we generally license our systems under standard license agreements that provide the customer with a fully paid, nonexclusive, nontransferable right to use the software. In some of the product areas, such as financials and property appraisal, we offer multiple solutions designed to meet the needs of different sized governments.
We also offer certain software products on an outsourced basis for customers who do not wish to maintain, update and operate these systems or to make large up-front capital expenditures to implement these advanced technologies. For these customers, we either host the applications and data at one of our data centers, or maintain the hardware and software at the client’s site. Customers typically pay monthly fees under multi-year contracts for these services.
Historically, we have had a higher concentration of revenues in the second half of our fiscal year due to governmental budget and spending cycles.
A description of our suite of products and services follows:
Software Licensing
Financial and City Solutions
Our Financial and City Solutions products are ERP (Enterprise Resource Planning) systems for local governments, which integrate information across all facets of a client organization. Our financial products include modular fund accounting systems that can be
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tailored to meet the needs of virtually any government agency or not-for-profit entity. Our financial systems include modules for general ledger, budget preparation, fixed assets, requisitions, purchase orders, bid management, accounts payable, contract management, accounts receivable, investment management, inventory control, project and grant accounting, work orders, job costing, GASB 34 reporting, payroll and human resources. All of our financial systems are intended to conform to government auditing and financial reporting requirements and generally accepted accounting principles.
We sell utility billing systems that support the billing and collection of metered and non-metered services, along with multiple billing cycles. Our Web-enabled utility billing solutions allow customers to access information online such as average consumption and transaction history. In addition, our systems can accept secured Internet payments via credit cards and checks.
We also offer specialized products that automate numerous city functions, including municipal courts, parking tickets, equipment and project costing, animal licenses, business licenses, permits and inspections, code enforcement, citizen complaint tracking, ambulance billing, fleet maintenance, and cemetery records management.
Tyler’s Financial and City Solutions products include Web components that enhance local governments’ service capabilities by facilitating online access to information for both employees and citizens and enabling online transactions.
Courts & Justice
We offer a complete, integrated suite of products designed to automate, track and manage the law enforcement and judicial process, from the initiation of incidents in computer-aided dispatch/emergency 911 systems through the process of arrest, court appearances and final disposition to probation. These applications may be installed on a stand-alone basis or integrated with our other products to eliminate duplicate entries and improve efficiency.
Our Web-enabled court systems are designed to automate the tracking and management of information involved in criminal and civil court cases, including municipal, family and probate courts. These applications track the status of criminal and civil cases, process fines and fees and generate the specialized judgment and sentencing documents, citations, notices and forms required in court proceedings. Additional judicial applications automate the management of court calendars, coordinate judge’s schedules, generate court dockets, manage justice of the peace processes and automate district attorney and prosecutor functions. Related products include jury selection, “hot” check processing, and adult and juvenile probation management applications. Our courtroom technologies allow judges to review cases, calendars, and to scan documents and mug shots using a Web browser. Additionally, document-imaging options include the ability to scan, store, retrieve and archive a variety of criminal and civil case-related documents.
Our law enforcement systems automate police and sheriff functions from dispatch and records management through booking and jail management. Searching, reporting and tracking features are integrated, allowing reliable, up-to-date access to current arrest and incarceration data. The systems also provide warrant checks for visitors or book-ins, inmate classification and risk assessment, commissary, property and medical processing, and automation of statistics and state and federal reporting. Our computer-aided dispatch/emergency 911 system tracks calls and the availability of emergency response vehicles, interfaces with local and state searches, and generally assists dispatchers in processing emergency situations. The law enforcement and jail management systems are fully integrated with the suite of court products that manages the judicial process.
Our court and law enforcement systems allow the public to access, via the Internet, a variety of information, including criminal and civil court records, jail booking and release information, bond and bondsmen information, and court calendars and dockets. In addition, our systems allow cities and counties to accept payments for traffic and parking tickets over the Internet, with a seamless and automatic interface to back-office justice and financial systems.
In 2002 we introduced Odyssey, an all-new unified court case management system, that became available for general release in the third quarter of 2003. Odyssey uses enhanced Web-browser concepts to render a unique user interface. It incorporates current technology – XML, n-tier architecture, component-based design, and an ultra-thin client footprint – to maximize the value of a court’s investment in new software. We believe that some of Odyssey’s design concepts, including embedded imaging functionality, COM+ objects to enable local customization, and an architecture that enables multiple deployment options, are unique in the court automation marketplace. Odyssey was the first of our new generation of n-tier, browser-based products and our initial marketing efforts for the new court case management system have been focused on states, large cities and counties.
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Property Appraisal and Tax
We provide systems and software that automate the appraisal and assessment of real and personal property, including record keeping, mass appraisal, inquiry and protest tracking, appraisal and tax roll generation, tax statement processing, and electronic state-level reporting. These systems are image- and video-enabled to facilitate the storage of and access to the many property-related documents and for the online storage of digital photographs of properties for use in defending values in protest situations. Other related tax applications are available for agencies that bill and collect taxes, including cities, counties, school tax offices, and special taxing and collection agencies. These systems support billing, collections, lock box operations, mortgage company electronic payments, and various reporting requirements.
We have also developed a new appraisal system, Orion, based on the same technology platform that we used for Odyssey. Orion will replace several UNIX based products and became available for general release during 2004. Orion provides an intuitive, browser-based interface, integration for Geographic Information System applications, valuation, assessment administration and tax billing and collection.
Document Management
We offer a number of specialized applications designed to help county governments enhance and automate courthouse operations. These systems record and index information for the many documents maintained at the courthouse, such as deeds, mortgages, liens, UCC financing statements and vital records (birth, death and marriage certificates).
Software Services
We provide a variety of professional IT services to customers who utilize our software products. Virtually all of our customers contract with us for installation, training, and data conversion services in connection with their purchase of Tyler’s software products. The complete implementation process for a typical system includes planning, design, data conversion, set-up and testing. At the culmination of the implementation process, an installation team travels to the customer’s facility to ensure the smooth transfer of data to the new system. Installation fees are charged separately to customers on either a fixed-fee or hourly charge basis, depending on the contract, with full pass-through to customers of travel and other out-of-pocket expenses.
Both in connection with the installation of new systems and on an ongoing basis, we provide extensive training services and programs related to our products and services. Training can be provided in our training centers, onsite at customers’ locations, or at meetings and conferences, and can be customized to meet customers’ requirements. The vast majority of our customers contract with us for training services, both to improve their employees’ proficiency and productivity and to fully utilize the functionality of our systems. Training services are generally billed on an hourly basis, along with travel and other expenses.
Maintenance and Support
Following the implementation of our software systems, we provide ongoing software support services to assist our customers in operating the systems and to periodically update the software. Support is provided over the phone to customers through help desks staffed by our customer support representatives. For more complicated issues, our staff, with the customer’s permission, can log on to customers’ systems remotely. We maintain our customers’ software largely through releases that contain improvements and incremental additions, along with updates necessary because of legislative or regulatory changes.
Virtually all of our software customers contract for maintenance and support from us, which provides a significant source of recurring revenue. We generally provide maintenance and support under annual contracts, with a typical fee based on a percentage of the software product’s license fee. These fees can be increased annually and may also increase as new license fees increase. Maintenance and support fees are generally paid in advance for the entire maintenance contract period. Most maintenance contracts automatically renew unless the customer or we give notice of termination prior to expiration. Similar support is provided to our ASP customers, and is included in their overall monthly fees.
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Appraisal Services
We are the nation’s largest provider of real property appraisal outsourcing services for local government taxing authorities. These services include:
Local government taxing entities normally reappraise real properties from time to time to update values for tax assessment purposes and to maintain equity in the taxing process. In some jurisdictions, reassessment cycles are mandated by law; in others, they are discretionary. While some taxing jurisdictions perform reappraisals in-house, many local governments outsource this function because of its cyclical nature and because of the specialized knowledge and expertise requirements associated with it. Our business unit that provides appraisal outsourcing services to local governments has been in this business since 1938.
In some instances, we also sell property tax and/or appraisal software products in connection with appraisal outsourcing projects, while other customers may only engage us to provide appraisal services. Appraisal outsourcing services are somewhat seasonal in nature to the extent that winter weather conditions reduce the productivity of data collection activities in connection with those projects.
STRATEGY
Our objective is to grow our revenue and earnings internally, supplemented by focused strategic acquisitions. The key components of our business strategy are to:
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When considering acquisition opportunities, we generally focus on companies with strong management teams and employee bases and excellent customer relationships. In December 2003, we acquired Eden Systems, Inc. (“Eden”), a provider of financial, personnel and citizen services systems for local governments. Eden had 2003 revenues of approximately $11.8 million. In December 2003, we also acquired certain assets of a business that provides forms software to users of some of our software products. Prior to these acquisitions, our most recent acquisition included in our continuing operations was completed in November 1999.
SALES, MARKETING, AND CUSTOMERS
We market our products and services through direct sales and marketing personnel located throughout the United States. Other in-house marketing staff focuses on add-on sales, professional services and support.
Sales of new systems are typically generated from referrals from other governmental offices or departments within a county or municipality, referrals from other local governments, relationships established between sales representatives and county or local officials, contacts at trade shows, direct mailings, and direct contact from prospects already familiar with us. We are active in numerous national, state, county, and local government associations, and participate in annual meetings, trade shows, and educational events.
Customers consist primarily of county and municipal agencies, school districts and other local government offices. In counties, customers include the auditor, treasurer, tax assessor/collector, county clerk, district clerk, county and district court judges, probation officers, sheriff, and county appraiser. At municipal government sites, customers include directors from various departments, including administration, finance, utilities, public works, code enforcement, personnel, purchasing, taxation, municipal court, and
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police. Contracts for software products and services are generally implemented over periods of three months to one year, with annually renewing maintenance and support update agreements thereafter. Although either the customer or we can terminate these agreements, historically almost all support and maintenance agreements are automatically renewed annually. Contracts for appraisal outsourcing services are generally one to three years in duration. During 2004, approximately 34% of our revenue was attributable to ongoing support and maintenance agreements.
COMPETITION
We compete with numerous local, regional, and national firms that provide or offer some or many of the same products and services that we provide. Most of these competitors are smaller companies that may be able to offer less expensive solutions than ours. Many of these firms operate within a specific geographic area and/or in a narrow product or service niche. We also compete with national firms, some of which have greater financial and technical resources than us, including Oracle Corporation, Lawson Software, Inc., SAP AG, MAXIMUS, Inc., Affiliated Computer Services, Inc., SunGard Data Systems, Inc. and Manatron, Inc. In addition, we sometimes compete with consulting and systems integration firms, such as BearingPoint, Inc. and Accenture Ltd., which develop custom systems, primarily for larger governments. We also occasionally compete with central internal information service departments of local governments, which require us to persuade the end-user department to discontinue service by its own personnel and outsource the service to us. We compete on a variety of factors, including price, service, name recognition, reputation, technological capabilities, and the ability to modify existing products and services to accommodate the individual requirements of the customer. Our ability to offer an integrated system of applications for several offices or departments is often a competitive strength. Local governmental units often are required to seek competitive proposals through a request for proposal process.
SUPPLIERS
All computers, peripherals, printers, scanners, operating system software, office automation software, and other equipment necessary for the implementation and provision of our software systems and services are presently available from several third-party sources. Hardware is purchased on original equipment manufacturer or distributor terms at discounts from retail. We have not experienced any significant supply problems.
BACKLOG
At December 31, 2004, we estimated our sales backlog was approximately $142.2 million, compared to $139.3 million at December 31, 2003. The backlog represents contracts that have been signed but the products have not been delivered or the services performed as of year-end. Approximately $97.8 million of the backlog is expected to be installed or services are expected to be performed during 2005.
INTELLECTUAL PROPERTY, PROPRIETARY RIGHTS, AND LICENSES
We regard certain features of our internal operations, software, and documentation as confidential and proprietary and rely on a combination of contractual restrictions, trade secret laws and other measures to protect our proprietary intellectual property. We generally do not rely on patents. We believe that, due to the rapid rate of technological change in the computer software industry, trade secrets and copyright protection are less significant than factors such as knowledge, ability and experience of our employees, frequent product enhancements, and timeliness and quality of support services. We typically license our software products under exclusive license agreements which are generally non-transferable and have a perpetual term.
EMPLOYEES
At December 31, 2004, we had approximately 1,400 employees. Appraisal outsourcing projects are periodic in nature and can be widely dispersed geographically. We often hire temporary employees to assist in these projects whose term of employment generally ends with the project’s completion. None of our employees are represented by a labor union or are subject to collective bargaining agreements. We consider our relations with our employees to be positive.
INTERNET WEBSITE AND AVAILABILITY OF PUBLIC FILINGS
We file annual, quarterly, current and other reports, proxy statements and other information with the Securities and Exchange Commission, or SEC, pursuant to the Securities Exchange Act. You may read and copy any materials we file with the SEC at the SEC’s Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an Internet site that contains reports,
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proxy and other information statements, and other information regarding issuers, including us, that file electronically with the SEC. The address of site ishttp://www.sec.gov.
We also maintain an Internet site, the address of which is www.tylerworks.com. We make available free of charge through this site our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Forms 4 and 5, Current Reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC. In addition we also make available free of charge through this site our Code of Business Conduct and Ethics, Corporate Governance Guidelines, Audit Committee Charter, Charter for the Compensation Committee and Charter for the Nominating and Governance Committee. We intend to satisfy the disclosure requirements regarding amendments to, or waiver from, a provision of our Code of Business Conduct and Ethics by posting such information on our Web site.
ITEM 2. PROPERTIES.
We occupy a total of approximately 290,000 square feet of office and warehouse space, 30,000 of which we own. We lease our principal executive office located in Dallas, Texas, as well as other offices, facilities and project offices for our operating companies in California, Colorado, Connecticut, Florida, Georgia, Idaho, Iowa, Maine, Massachusetts, Michigan, New York, North Carolina, Ohio, South Dakota, Texas, Washington, and Wisconsin.
ITEM 3. LEGAL PROCEEDINGS.
Other than ordinary course, routine litigation incidental to our business and except as described in this Annual Report, there are no material legal proceedings pending to which we or our subsidiaries are parties or to which any of our properties are subject.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
Not applicable.
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PART II
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.
Our common stock is traded on the New York Stock Exchange under the symbol “TYL.” At December 31, 2004, we had approximately 2,400 stockholders of record. A number of our stockholders hold their shares in street name; therefore, there are substantially more than 2,400 beneficial owners of our common stock.
The following table sets forth for the calendar periods indicated the high and low sales price per share of our common stock as reported on the New York Stock Exchange.
We did not pay any cash dividends in 2004 or 2003. Our bank credit agreement contains restrictions on the payment of cash dividends. Also, we intend to retain earnings for use in the operation and expansion of our business, and, therefore, we do not anticipate declaring a cash dividend in the foreseeable future.
The following table summarizes certain information related to our stock option plan and our Employee Stock Purchase Plan (“ESPP”). There are no warrants or rights related to our equity compensation plans as of December 31, 2004.
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During 2004, we purchased approximately 1.5 million shares of our common stock for an aggregate cash purchase price of $12.5 million. A summary of the repurchase activity during 2004 is as follows:
The repurchase program, which was approved by our board of directors, was announced in October 2002, and was amended in April and July 2003 and October 2004. On October 27, 2004, our board of directors authorized the repurchase of an additional 2.0 million shares for a total authorization to repurchase 3.1 million shares of our common stock. As of December 31, 2004, we had authorization to repurchase up to 2.5 million additional shares of our common stock. There is no expiration date specified for the authorization and we intend to repurchase stock under the plan from time to time in the future.
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ITEM 6. SELECTED FINANCIAL DATA.(In thousands, except per share data)
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FORWARD LOOKING STATEMENTS
In addition to historical information, this Annual Report on Form 10-K contains forward-looking statements. The forward-looking statements are made in reliance upon safe harbor provisions of the Private Securities Litigation Reform Act of 1995. The forward looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those reflected in the forward-looking statements. Factors that might cause such a difference include, but are not limited to, those discussed in the section of Management’s Discussion and Analysis of Financial Condition and Results of Operations entitled “Factors That May Affect Our Future Results and Market Price of Our Stock.” Readers are cautioned not to place undue reliance on these forward-looking statements, which reflect management’s opinions only as of the date hereof. We undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements. Readers should carefully review the risk factors described in this Annual Report and other documents we file from time to time with the SEC.
When used in this Annual Report, the words “believes,” “plans,” “estimates,” “expects,” “anticipates,” “intends,” “continue,” “may,” “will,” “should,” “projects,” “forecasts,” “might,” “could” or the negative of such terms and similar expressions are intended to identify forward-looking statements.
OVERVIEW
We provide integrated information management solutions and services for 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 property appraisal outsourcing services for taxing jurisdictions.
Our products are generally grouped into four major areas:
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:
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When considering acquisition opportunities, we generally focus on companies with strong management teams and employee groups and excellent customer relationships. In December 2003 we acquired Eden Systems, Inc. (“Eden”), a provider of financial, personnel and citizen services systems for local governments. In December 2003, we also acquired certain assets of a business that provides forms software to users of some of our software products. Prior to these acquisitions, our most recent acquisition was completed in November 1999.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Our discussion and analysis of financial condition and results of operations is based upon our consolidated 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 and expenses during the reporting period, and related disclosure of contingent assets and liabilities. The Notes to the Consolidated Financial Statements included as part of this Annual Report describe our significant accounting policies used in the preparation of the consolidated financial statements. On an on-going basis, we evaluate our estimates, including, but not limited to, those related to intangible assets, bad debts and our service contracts. 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 affect significant judgments and estimates used in the preparation of our consolidated financial statements.
Revenue Recognition. We recognize revenues in accordance with the provisions of the American Institute of Certified Public Accountants Statement of Position (“SOP”) 97-2, “Software Revenue Recognition,” as amended by SOP 98-4 and SOP 98-9, as well as Technical Practice Aids issued from time to time by the American Institute of Certified Public Accountants, and in accordance with the SEC Staff Accounting Bulletin No. 104 “Revenue Recognition.” Our revenues are derived from sale of software licenses, appraisal services, maintenance and support ,and services that typically range from 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, sales adjustments and estimated cost of product warranties, 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. Occasionally, customers may become dissatisfied with the functionality of the software products and/or the quality of the services and request a reduction of the total contract price or similar concession. While we engage in extensive product and service quality assurance programs and processes, our allowances for these contract price reductions may need to be revised in the future. 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, management at our corporate offices as well as at our operating companies 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, sales adjustments and estimated cost of product warranties 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.
For those software arrangements that include customization of the software, which is considered essential to its functionality, and for substantially all of our real estate appraisal outsourcing projects, we recognize revenue and profit as the work progresses using the
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percentage-of-completion method and the proportionate performance method of revenue recognition. 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.
We use contract accounting, primarily the percentage-of-completion method, for those software arrangements that include customization or modification of the software, or where our software services are otherwise considered essential to the functionality of the software. In addition, we recognize revenue using the proportionate performance method of revenue recognition for our real estate appraisal projects, some of which can range up to three years. 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 fair value of products delivered and services performed in the event of an early termination. 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. Management reviews 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. This liability primarily consists of maintenance billings in 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.
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. In addition, we capitalize software development costs incurred subsequent to the establishment of technological feasibility. Certain of these intangible assets are amortized over their estimated useful lives. All intangible assets with definite and indefinite lives are reviewed for impairment annually or whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of goodwill is generally measured by a comparison of the carrying amount of an asset to its fair value, generally determined by estimated future net cash flows expected to be generated by the asset. Recoverability of other intangible assets is generally 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. Events or changes in circumstances that indicate the carrying amount may not be recoverable include, but are not limited to, a significant decrease in the market value of the business or asset acquired, a significant adverse change in the extent or manner in which the business or asset acquired is used, or a significant adverse change in the business climate. In addition, products, capabilities, or technologies developed by others may render our software products obsolete or non-competitive.
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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, 2004, 2003 and 2002. These results include the results of operations of Eden from the date of its acquisition on December 2, 2003. See Note 2 in the Notes to the Consolidated Financial Statements.
2004 Compared to 2003
Revenues
The following table sets forth a comparison of the key components of our revenues for the following years ended December 31:
Software licenses. For the year ended December 31, 2004, software license revenues included $3.5 million related to Eden Systems, compared to $100,000 for the same prior year period. Excluding the software license revenue related to Eden, the increase in software license revenues from 2003 to 2004 was approximately $900,000 or 3%. The change was the result of the following factors:
We have recently introduced a variety of new software products which have replaced certain legacy products. The acceptance of these new products in the marketplace is on-going. The following software products have been released in the last two years:
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Software services. Software services revenues increased $4.9 million, or 13%, compared to the prior year period after excluding the increase in software services revenues generated by Eden of $7.7 million. Higher software services revenues were attributable to the following factors:
Maintenance. We provide maintenance and support services for our software products and third party software. Maintenance revenues for the year ended December 31, 2004 included $4.1 million from Eden, compared to $300,000 for the same prior year period. Excluding the impact of Eden, maintenance revenues during the year ended December 31, 2004 increased approximately 15% compared to 2003 due to growth in our installed customer base and slightly higher maintenance rates on certain product lines.
Appraisal services. The decrease in appraisal services revenues is due to the completion of certain significant appraisal contracts, particularly the completion of our contract with Lake County, Indiana in the fourth quarter of 2003. These larger projects are often relatively discretionary in nature, and the projects we recently completed have not been replaced by similar projects.
Cost of Revenues and Gross Margins
The following table sets forth a comparison of the key components of our cost of revenues and associated gross margins, and those components stated as a percentage of related revenues for the following years ended December 31:
Cost of software license revenues. The increase is related to the general release of several software development products and the commencement of the related amortization expense. Once a product is released, we begin to amortize the costs associated with its development over the estimated useful life of the product. Amortization expense is determined on a product-by-product basis at an annual rate not less than straight-line basis over the product’s estimated life (generally 3-5 years). Development costs consist mainly of personnel costs, such as salary and benefits paid to our developers, and rent for related office space. Current year product releases include the Orion appraisal and tax products and an enhancement to one of our financial and city solutions products. Amortization expense for 2004 also includes a full year of expense related to Odyssey Courts versus only four months in 2003.
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Cost of software services and maintenance revenues. Cost of software services and maintenance revenues primarily consists of expenses, such as personnel costs related to installation of our software licenses, conversion of customer data, training customer personnel, support activities and various other services such as ASP and disaster recovery. During the year ended December 31, 2004, Eden contributed cost of software services and maintenance revenues of $7.9 million, compared to $500,000 in the prior year. Excluding Eden, cost of software services and maintenance revenues increased $8.3 million, or 15%, during 2004. Additional staff has been added to provide faster implementation of our existing backlog. Excluding Eden, software services and maintenance revenues increased 14% for the year ended December 31, 2004 compared to 2003. Cost of software services and maintenance revenues increased more than the associated revenues due to the time required to train and orient additional personnel hired during 2004 before they can effectively perform revenue-generating tasks, such as training and implementations. In addition, expenses increased as the costs related to certain employees who previously worked on new software development products ceased to be capitalized as those projects were completed and these employees moved into implementation and support functions.
Cost of appraisal services revenues. The decline in the cost of appraisal services revenues is consistent with lower appraisal services revenues. In 2004, appraisal revenues declined at a faster rate than cost of appraisal revenues due to the use of subcontractors to supplement our appraisal staff on some of our larger contracts during 2004, resulting in lower margins. The nature and timing of these contracts required us to retain staff on either short notice or with specific qualifications, thus increasing the associated costs as a percentage of appraisal revenues.
Gross margin. Excluding the results of Eden, our gross margin for 2004 was 37% compared to 39% in the prior year. The decline in gross margin from the prior year period was due to the following factors:
Selling, General and Administrative Expenses
The following table sets forth a comparison of our selling, general and administrative expenses (SG&A) for the following years ended December 31:
SG&A associated with Eden amounted to $4.4 million in 2004 compared to $350,000 in 2003. Excluding Eden, SG&A increased 8% year-over-year. The increase in SG&A is a result of the following factors:
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Amortization of Acquisition Intangibles
The following table sets forth a comparison of amortization of acquisition intangibles for the following years ended December 31:
Amortization expense has declined compared to the prior year due to certain intangible assets recorded for previous acquisitions that became fully amortized beginning mid 2003 and throughout 2004. This decline was offset somewhat by the amortization expense for acquisition intangibles recorded for the acquisition of Eden in December 2003. Acquisition intangibles are composed of the excess of the purchase price over the fair value of net tangible assets acquired that is allocated to acquired and amortizable software, customer related intangibles and trade name with the remainder allocated to goodwill that is not subject to amortization. The estimated useful lives of acquired software, customer related intangibles and trade name are 3 to 5 years, 20 to 25 years and 5 to 25 years, respectively. Estimated annual amortization expense relating to acquisition intangibles for the next five years is as follows (in thousands):
Realized Gain on Sale of Investment in H.T.E., Inc.
On March 25, 2003, we received cash proceeds of $39.3 million in connection with a transaction to sell all of our 5.6 million shares of H.T.E., Inc. (“HTE”) common stock to SunGard Data Systems Inc. for $7.00 cash per share. Our original cost basis in the HTE shares was $15.8 million. After transaction and other costs, we recorded a gross realized gain of $23.2 million ($16.2 million or $0.36 per diluted share after income taxes of $7.0 million) for the year ended December 31, 2003.
Income Tax Provision
The following table sets forth a comparison of our income tax provision for the following years ended December 31:
The effective income tax rates for the periods presented were different from the statutory United States federal income tax rate of 35% primarily due to the utilization of the capital loss carryforward in 2003, increased state income taxes and non-deductible meals and entertainment costs.
The income tax provision for the year ended December 31, 2003 includes income tax expense of $7.0 million relating to the realized gain from the sale of our investment in HTE (after reduction in valuation allowance related to the utilization of a capital loss carryforward amounting to $1.1 million on a tax-effected basis). For 2003, we had an effective income tax rate of 38% (excluding the effect of the HTE gain) compared to 42% in 2004. The majority of the increase was due to higher state income taxes because in 2004 we had more sales and profitability in highly taxed states than in the prior year.
Discontinued Operations
One of our non-operating subsidiaries, Swan Transportation Company (“Swan”), had been involved in various claims raised by former employees of a foundry that was owned by an affiliate of Swan and Tyler prior to December 1995. These claims were for alleged work-related injuries and physical conditions resulting from alleged exposure to silica, asbestos, and/or related industrial dusts. After a series of bankruptcy court filings involving Swan, on December 23, 2003, Tyler in accordance with the terms of the plan of reorganization, transferred the stock of Swan to the Swan Asbestos and Silica Trust (“Trust”), an unaffiliated entity that will oversee
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the processing and payment of all present and future claims related to the foundry. On December 23, 2003, we paid $1.48 million to the Trust in full and final release from all liability for claims associated with the once-owned foundry (the “Swan Matter”). As a result of the release, any claimant is barred from asserting any such claim, either now or in the future, against Tyler or its affected affiliates. During the year ended December 31, 2003, the gain on disposal of discontinued operations of $424,000 primarily resulted because we fully settled the Swan Matter at an amount less than initially recorded and certain aspects of the settlement were conducted in a beneficial tax manner. Accordingly, we recognized for the first time certain tax benefits associated with payments on behalf of the Swan Matter.
Net Income
The following table sets forth a comparison of our net income, earnings per diluted share, income from continuing operations per diluted share and diluted weighted average shares outstanding for the following years ended December 31:
Net income for the twelve months ended December 31, 2003 included a $16.2 million realized gain after income taxes relating to the sale of our investment in HTE, which had a diluted earnings per share effect of $0.36 per diluted share.
2003 Compared to 2002
Software licenses. Software license revenues for 2003 benefited from the successful first phase installation of Odyssey Courts in the State of Minnesota and Lee County, Florida. Software license revenues from these two contracts totaled $3.4 million for the year ended December 31, 2003 compared to none in the prior year. In addition, we increased revenues from our financial and city solutions software products by approximately $200,000 primarily by increasing sales and implementation staff and releasing a new version of one of our county tax products for our customers in the Midwest. However, sales of third-party software licenses relating to our financial and city solutions products declined by approximately $700,000 due to the sales of a one-time upgrade of the graphical user interface on some of our proprietary products in 2002 and decreased emphasis on sales of third-party licenses in 2003. In late 2003, we opened a new financial and city solutions sales office in California in an effort to further penetrate the west coast market.
We also experienced a decline in our property appraisal and tax software license revenues of approximately $750,000. Most of this decline related to one large property appraisal and tax software installation in the third quarter of 2002.
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Software services. Higher software services revenues were attributable to the following factors:
Maintenance. The maintenance revenue increase was due to growth in our installed customer base and slightly higher rates on certain product lines.
Appraisal services. The decrease is related to the completion and progression of several major appraisal contracts. During 2003, we signed a new six-year contract to provide Nassau County, New York Board of Assessors (“Nassau County Extension”) with updated property assessments and additional property appraisal and tax software. The following table contains the appraisal services revenues for significant contracts for the years presented:
The following table sets forth a comparison of the key components of our cost of revenues and gross margins, and those components stated as a percentage of associated revenues for the years ended December 31:
Cost of software license revenues. In September 2003, we began amortizing the software development costs of our Odyssey Courts product, as it was complete and ready for general release to the public. The amortization for Odyssey Courts is calculated using the straight-line method of amortization over an estimated five-year useful life. In 2003, we recorded amortization expense of approximately $559,000 related to Odyssey Courts for the period September 1, 2003 (general release date) through December 31, 2003. In addition, during 2002, we had several smaller products in the development stage released in late 2002 and early 2003 that contributed to the increase in amortization expense.
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Cost of software services and maintenance revenues. The increase in costs is consistent with higher software services and maintenance revenues for the same periods, although software services and maintenance revenues grew at a more rapid rate than the cost of those revenues, which is reflective of more efficient utilization of our support and maintenance staff and economies of scale.
Cost of appraisal services revenues. The decrease in the cost of appraisal services revenues is consistent with the decrease in appraisal services revenues. We often hire temporary employees to assist in appraisal projects whose term of employment generally ends with the projects’ completion. However, key appraisal personnel and management were retained in anticipation of new appraisal contracts, which contributed to a 3% decline in appraisal gross margins compared to 2002.
Gross margin. Our overall gross margin improved over the prior year due to higher software services and maintenance revenues without a corresponding increase in related personnel costs reflecting a more efficient utilization of our support and maintenance staff and economies of scale. Improvements in software services and maintenance gross margin were slightly offset by declines in software license gross margin due to amortization of new product releases and declines in the appraisal services gross margin.
The following table sets forth a comparison of our SG&A for the following years ended December 31:
The increase in selling, general and administrative expenses in 2003 compared to 2002 is a result of the following factors:
The decrease in amortization from 2002 is related to certain of our acquisition intangibles becoming fully amortized during 2003.
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Other Income (Expense), Net
The following table sets forth a comparison of the key components of other income (expense), net for the following years ended December 31:
During the year ended December 31, 2002, we incurred approximately $704,000 of legal and other costs associated with legal matters concerning various tort claims HTE alleged against us and HTE’s attempted redemption of our 5.6 million shares for $1.30 per share. In September 2002, HTE released us from all tort claims and a court declared HTE’s reported redemption of our shares was invalid. In March 2003, we sold for cash our entire investment in HTE for $7.00 per share.
The increase in interest income is related to higher invested cash balances, including $39.3 million in cash received upon the sale of our investment in HTE in late March 2003, proceeds from the exercise of stock options, as well as cash generated from operations. The cash received from the sale of HTE was offset by payments totaling $24.1 million for repurchase of a total of approximately 6.0 million shares of our common stock in a modified Dutch Auction tender offer in May 2003 and on the open market throughout 2003. In addition, we made a cash payment of approximately $12.1 million, net of cash acquired, for two acquisitions made in December 2003, the most significant of which is Eden.
The 2003 income tax provision includes income tax expense of approximately $7.0 million relating to the realized gain from the sale of our investment in HTE (after reduction in valuation allowance related to the utilization of a capital loss carryforward amounting to $1.1 million on a tax-effected basis). For the year ended December 31, 2003, we had an effective income tax rate of 38% (excluding the effect of the HTE gain). The effective income tax rates for 2003 compared to 2002 were different from the statutory United States federal income tax rate of 35% primarily due to the utilization of the capital loss carryforward in 2003, state income taxes and non-deductible meals and entertainment costs.
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The following table sets forth a comparison of our net income, earnings per diluted share, income from continuing operations per diluted share and diluted weighted average shares outstanding for the years ended December 31:
During 2003, we repurchased approximately 6.0 million shares of our common stock through our modified Dutch Auction tender offer and purchases on the open market. Had we not executed those repurchases, our net income per share including the gain on the sale of our investment in HTE, for the year ended December 31, 2003 would have been reduced by $0.07 per diluted share.
NEW ACCOUNTING PRONOUNCEMENTS
In December 2004, the Financial Accounting Standards Board (“FASB”) recently enacted Statement of Financial Accounting Standards No. 123R (“SFAS No. 123R”), “Share-Based Payment” which replaces Statement of Financial Accounting Standards No. 123 (“SFAS No. 123”), “Accounting for Stock-Based Compensation” and supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees.” SFAS No. 123R requires the measurement of all employee share-based payments to employees, including grants of employee stock options, using a fair-value-based method and the recording of such expense in our consolidated statements of operations. The accounting provisions of SFAS No. 123R are effective for reporting periods beginning after June 15, 2005.
We are required to adopt SFAS No. 123R in the third quarter of 2005. The pro forma disclosures previously permitted under SFAS No. 123 no longer will be an alternative to financial statement recognition. See Note 1 in our Notes to Consolidated Financial Statements for the estimated impact on net income and net income per diluted share amounts for the third and fourth quarter of 2005, of recording share-based payments in our consolidated statement of operations using a fair-value-based method similar to the methods required under SFAS No. 123R to measure compensation expense for employee stock incentive awards.
FINANCIAL CONDITION AND LIQUIDITY
Historically, we have funded our operations and cash expenditures primarily with cash generated from operating activities. As of December 31, 2004, our balance in cash and cash equivalents was $12.6 million and we had short-term investments of $13.8 million, compared to cash and cash equivalents of $10.3 million and short-term investments of $11.7 million at December 31, 2003. Cash provided by operating activities was $22.2 million compared to cash provided by operations of $22.5 million in 2003 and $19.8 million in 2002. Cash and short-term investments increased primarily due to continued strong operating performance and collections of receivables.
At December 31, 2004, our days sales outstanding (“DSOs”) were 92 days compared to DSOs of 98 days at December 31, 2003. The decrease in DSOs is due primarily to continued strong cash collections during 2004. DSOs are determined based on accounts receivable divided by the quotient of annualized quarterly revenues divided by 360 days.
Investing activities used cash of $9.9 million in 2004 compared to $590,000 in 2003 and $8.0 million in 2002. The cash used in investing activities in 2004 was comprised of investments in software development costs and property and equipment, short-term bond funds and additional purchase price payments related to the Eden acquisition. Investing activities in 2003 included $39.3 million of gross proceeds on the sale of our investment in H.T.E., Inc. which was offset by the investment of such proceeds in short-term bond funds, software development costs, property and equipment and the acquisition of Eden.
On February 11, 2005, we entered into a new revolving bank credit agreement (the “2005 Credit Facility”). The 2005 Credit Facility matures February 11, 2008 and provides for total borrowings of up to $30.0 million and a $10.0 million Letter of Credit facility under which the banks will issue cash collateralized letters of credit. As of February 28, 2005, our effective interest rate was 4.2% under the
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2005 Credit Facility. As of December 31, 2004 we had no debt and outstanding letters of credit totaling $4.8 million under a previous debt agreement to secure surety bonds required by some of our customer contracts. As of February 28, 2005, we had no outstanding borrowings under the 2005 Credit Facility.
During 2004, we made capital expenditures of $6.8 million, including $4.6 million for software development costs. The other expenditures related to computer equipment, furniture and fixtures and expansions related to internal growth. Capital expenditures were funded from cash generated from operations.
Proceeds from sales of short-term investments were $10.1 million during 2004. During 2004, we invested $8.9 million in auction rate municipal bonds. The bonds pay interest at various fixed rates.
Pursuant to our purchase agreement with Eden, two of the shareholders of Eden were granted the right to “put” their remaining shares to Tyler and we were also granted the right to “call” the remaining shares. In January 2004, we purchased 500 shares for $145,000 in cash. We purchased the remaining 2,000 shares for a cash purchase price of $580,000 in July 2004.
Financing activities used cash of $9.9 million in 2004 compared to $25.4 million in 2003 and $3.4 million in 2002. The cash used in financing activities in 2004 was primarily comprised of purchases of treasury shares net of proceeds from stock option exercises. Financing activities in 2003 included the purchase of approximately 6.0 million shares of our common stock through our modified Dutch Auction tender offer and purchases on the open market for $24.1 million.
During 2004, we purchased approximately 1.5 million shares of our common stock for an aggregate cash purchase price of $12.5 million.
In 2004, we received $1.9 million from the exercise of options to purchase approximately 680,000 shares of our common stock under our employee stock option plan. During 2003 we issued 554,000 shares of common stock and received $1.7 million in aggregate proceeds, upon exercise of stock options and during 2002 we issued 491,000 shares of common stock and received $1.6 million in aggregate proceeds upon exercise of stock options.
During 2004, we received $673,000 for contributions to the Tyler Technologies, Inc. Employee Stock Purchase Plan (“the ESPP”), which was adopted by our shareholders in May 2004. In October 2004, we issued 44,000 shares of common stock for contributions made to the ESPP during the three months ended September 30, 2004. In January 2005, we issued 48,000 shares of common stock for contributions made to the ESPP during the three months ended December 31, 2004.
In March 2003 we retired an outstanding $2.5 million, 10% promissory note payable. The note was originally due in January 2005 and required quarterly interest payments.
Subsequent to December 31, 2004 and through March 1, 2005 we have purchased approximately 915,000 shares of our common stock for an aggregate cash purchase price of $6.3 million.
Excluding acquisitions, we anticipate that 2005 capital spending will be approximately $6.2 million, $3.9 million of which will be related to software development. Capital spending in 2005 is expected to be funded from existing cash balances and cash flows from operations.
From time to time we will 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. In the absence of future acquisitions of other businesses, we believe our current cash balances and expected future cash flows from operations will be sufficient to meet our anticipated cash needs for working capital, capital expenditures and other activities through the next twelve months. If operating cash flows are not sufficient to meet our needs, we may borrow under our credit agreement.
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We primarily lease offices, as well as transportation, computer and other equipment used in our operations under non-cancelable operating lease agreements expiring at various dates through 2013. Most leases contain renewal options and some contain purchase options. Following are the future obligations under non-cancelable leases at December 31, 2004 (in thousands):
It is not our usual business practice to enter into off-balance sheet arrangements. Moreover, it is not our normal policy to issue guarantees to third parties. As of December 31, 2004, we have no material purchase commitments, except for the operating lease commitments listed above.
CAPITALIZATION
At December 31, 2004, our capitalization consisted of $118.4 million of shareholders’ equity.
FACTORS THAT MAY AFFECT FUTURE RESULTS AND MARKET PRICE OF OUR STOCK
An investment in our common stock involves a high degree of risk. Investors evaluating our company should carefully consider the factors described below and all other information contained in this Annual Report. Any of the following factors could materially harm our business, operating results, and financial condition. Additional factors and uncertainties not currently known to us or that we currently consider immaterial could also harm our business, operating results, and financial condition. This section should be read in conjunction with the Consolidated Financial Statements and related Notes and Management’s Discussion and Analysis of Financial Condition and Results of Operations included in this Annual Report. We may make forward-looking statements from time to time, both written and oral. We undertake no obligation to revise or publicly release the results of any revisions to these forward-looking statements. Our actual results may differ materially from those projected in any such forward-looking statements due to a number of factors, including those set forth below and elsewhere in this Annual Report.
A decline in information technology spending may result in a decrease in our revenues or lower our growth rate.
A decline in the demand for information technology among our current and prospective customers may result in decreased revenues or a lower growth rate for us because our sales depend, in part, on our customers’ level of funding for new or additional information technology systems and services. Moreover, demand for our solutions may be reduced by a decline in overall demand for computer software and services. Accordingly, we cannot assure you that we will be able to increase or maintain our revenues.
We may experience fluctuations in quarterly revenue that could adversely impact our stock price and our operating results.
Our actual revenues in a quarter could fall below expectations, which could lead to a decline in our stock price. Our revenues and operating results are difficult to predict and may fluctuate substantially from quarter to quarter. Revenues from license fees in any quarter depend substantially upon our contracting activity and our ability to recognize revenues in that quarter in accordance with our revenue recognition policies. Our quarterly revenue may fluctuate and may be difficult to forecast for a variety of reasons, including the following:
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Fluctuation in our quarterly revenues may adversely affect our operating results. In each fiscal quarter our expense levels, operating costs, and hiring plans are based on projections of future revenues and are relatively fixed. If our actual revenues fall below expectations, we could experience a reduction in operating results.
As with other software vendors, we may be required to delay revenue recognition into future periods, which could adversely impact our operating results.
We have in the past had to, and in the future may have to, defer revenue recognition for license fees due to several factors, including whether:
Because of the factors listed above and other specific requirements under generally accepted accounting principles in the United States for software revenue recognition, we must have very precise terms in our license agreements in order to recognize revenue when we initially deliver and install software or perform services. Negotiation of mutually acceptable terms and conditions can extend the sales cycle, and sometimes we do not obtain terms and conditions that permit revenue recognition at the time of delivery or even as work on the project is completed.
Compliance with changing regulation of corporate governance and public disclosure may result in additional expenses.
Changing laws, regulations, and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act of 2002, new Securities and Exchange Commission regulations and New York Stock Exchange rules, are creating uncertainty for companies such as ours. The costs required to comply with such evolving laws are difficult to predict. To maintain high standards of corporate governance and public disclosure, we intend to invest all reasonably necessary resources to comply with evolving standards. This investment may result in an unforeseen increase in general and administrative expenses and a diversion of management time and attention from revenue-generating activities, which may harm our business, financial condition, or results of operations.
Increases in service revenue as a percentage of total revenues could decrease overall margins and adversely affect our operating results.
We realize lower margins on software and appraisal service revenues than on license revenue. The majority of our contracts include both software licenses and the provision of professional services. Therefore, an increase in the percentage of software service and appraisal service revenue compared to license revenue could have a detrimental impact on our overall gross margins and could adversely affect operating results.
Selling products and services into the public sector poses unique challenges.
We derive substantially all of our revenues from sales of software and services to state, county and city governments, other municipal agencies, and other public entities. We expect that sales to public sector customers will continue to account for substantially all of our revenues in the future. We face many risks and challenges associated with contracting with governmental entities, including:
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Each of these risks is outside our control. If we fail to adequately adapt to these risks and uncertainties, our financial performance could be adversely affected.
The open bidding process for governmental contracts creates uncertainty in predicting future contract awards.
Many governmental agencies purchase products and services through an open bidding process. Generally, a governmental entity will publish an established list of requirements requesting potential vendors to propose solutions for the established requirements. To respond successfully to these requests for proposals, we must accurately estimate our cost structure for servicing a proposed contract, the time required to establish operations for the proposed client, and the likely terms of any other third party proposals submitted. We cannot guarantee that we will win any bids in the future through the request for proposal process, or that any winning bids will ultimately result in contracts on favorable terms. Our failure to secure contracts through the open bidding process, or to secure such contracts on favorable terms, may adversely affect our business, financial condition, and results of operations.
Fixed price contracts may affect our profits.
Some of our present contracts are on a fixed-priced basis, which can lead to various risks, including:
If we do not adequately assess these and other risks, we may be subject to cost overruns and penalties, which may harm our business, financial condition, or results of operations.
We face significant competition from other vendors and potential new entrants into our markets.
We believe we are a leading provider of integrated solutions for the public sector. However, we face competition from a variety of software vendors that offer products and services similar to those offered by us, as well as from companies offering to develop custom software. We compete on the basis of a number of factors, including:
We believe the market is highly fragmented with a large number of competitors that vary in size, primary computer platforms, and overall product scope. Our competitors include the consulting divisions of national and regional accounting firms, publicly held companies that focus on selected segments of the public sector market, and a significant number of smaller, privately held companies. Certain competitors have greater technical, marketing, and financial resources than us. We cannot assure you that such competitors will not develop products or offer services that are superior to our products or services or that achieve greater market acceptance.
We also compete with internal, centralized information service departments of governmental entities, which requires us to persuade the end-user to stop the internal service and outsource to us. In addition, our customers may elect in the future to provide information management services internally through new or existing departments, which will reduce the market for our services.
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We could face additional competition as other established and emerging companies enter the public sector software application market and new products and technologies are introduced. Increased competition could result in price reductions, fewer customer orders, reduced gross margins, and loss of market share. In addition, current and potential competitors may make strategic acquisitions or establish cooperative relationships among themselves or with third-parties, thereby increasing the ability of their products to address the needs of our prospective customers. It is possible that new competitors or alliances among current and new competitors may emerge and rapidly gain significant market share. Further, competitive pressures could require us to reduce the price of our software licenses and related services. We cannot assure you that we will be able to compete successfully against current and future competitors, and the failure to do so would have material adverse effect upon our business, operating results, and financial condition.
We must respond to rapid technological changes to be competitive.
The market for our products is characterized by rapid technological change, evolving industry standards in computer hardware and software technology, changes in customer requirements, and frequent new product introductions and enhancements. The introduction of products embodying new technologies and the emergence of new industry standards can render existing products obsolete and unmarketable. As a result, our future success will depend, in part, upon our ability to continue to enhance existing products and develop and introduce in a timely manner or acquire new products that keep pace with technological developments, satisfy increasingly sophisticated customer requirements, and achieve market acceptance. We cannot assure you that we will successfully identify new product opportunities and develop and bring new products to market in a timely and cost-effective manner. Further, we cannot assure you that the products, capabilities, or technologies developed by others will not render our products or technologies obsolete or noncompetitive. If we are unable to develop or acquire on a timely and cost-effective basis new software products or enhancements to existing products, or if such new products or enhancements do not achieve market acceptance, our business, operating results, and financial condition may be materially adversely affected.
Our failure to properly manage growth could adversely affect our business.
We have expanded our operations rapidly since February 1998, when we entered the business of providing software solutions and services to the public sector. We intend to continue expansion in the foreseeable future to pursue existing and potential market opportunities. This rapid growth places a significant demand on management and operational resources. In order to manage growth effectively, we must implement and improve our operational systems, procedures, and controls on a timely basis. We must also identify, hire, train, and manage key managerial and technical personnel. If we fail to implement these systems or employ and retain such qualified personnel, our business, financial condition, and results of operations may be materially and adversely affected.
In addition, a significant portion of our growth has resulted from strategic acquisitions in new product and geographic markets. Although our future focus will be on internal growth, we will continue to identify and pursue strategic acquisitions and alliances with suitable candidates. Our future success will depend, in part, on our ability to successfully integrate future acquisitions and other strategic alliances into our operations. Acquisitions may involve a number of special risks, including diversion of management’s attention, failure to retain key acquired personnel, unanticipated events or circumstances, legal liabilities, and amortization of certain acquired intangible assets. Some or all of these risks could have a material adverse effect on our business, financial condition, and results of operations. Although we conduct due diligence reviews of potential acquisition candidates, we may not identify all material liabilities or risks related to acquisition candidates. There can be no assurance that any such strategic acquisitions or alliances will be accomplished on favorable terms or will result in profitable operations.
We may be unable to hire, integrate, and retain qualified personnel.
Our continued success will depend upon the availability and performance of our key management, sales, marketing, customer support, and product development personnel. The loss of key management or technical personnel could adversely affect us. We believe that our continued success will depend in large part upon our ability to attract, integrate, and retain such personnel. We have at times experienced and continue to experience difficulty in recruiting qualified personnel. Competition for qualified software development, sales, and other personnel is intense, and we cannot assure you that we will be successful in attracting and retaining such personnel.
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We may experience difficulties in executing our acquisition strategy.
We occasionally expand our business through the acquisition of complementary companies. We cannot, however, make any assurances that we will be able to identify any potential acquisition candidates or complete any additional acquisitions on terms that are acceptable to us. In addition, we cannot assure you that any future acquisitions will be successfully integrated or will be advantageous to us.
We may be unable to protect our proprietary rights.
Many of our product and service offerings incorporate proprietary information, trade secrets, know-how, and other intellectual property rights. We rely on a combination of contracts, copyrights, and trade secret laws to establish and protect our proprietary rights in our technology. We cannot be certain that we have taken all appropriate steps to deter misappropriation of our intellectual property. In addition, there has been significant litigation in the United States in recent years involving intellectual property rights. We are not currently involved in any material intellectual property litigation. We may, however, be a party to intellectual property litigation in the future to protect our proprietary information, trade secrets, know-how, and other intellectual property rights. Further, we cannot assure you that third parties will not assert infringement or misappropriation claims against us in the future with respect to current or future products. Any claims or litigation, with or without merit, could be time-consuming and result in costly litigation and diversion of management’s attention. Further, any claims and litigation could cause product shipment delays or require us to enter into royalty or licensing arrangements. Such royalty or licensing arrangements, if required, may not be available on terms acceptable to us, if at all. Thus, litigation to defend and enforce our intellectual property rights could have a material adverse effect on our business, financial condition, and results of operations, regardless of the final outcome of such litigation.
Our products are complex and, as such, we run the risk of errors or defects with new product introductions or enhancements.
Software products as complex as those developed by us may contain errors or defects, especially when first introduced or when new versions or enhancements are released. Although we have not experienced material adverse effects resulting from any such defects or errors to date, we cannot assure you that material defects and errors will not be found after commencement of product shipments. Any such defects could result in loss of revenues or delay market acceptance.
Our license agreements with our customers typically contain provisions designed to limit our exposure to potential liability claims. It is possible, however, that we may not always be able to negotiate such provisions in our contracts with customers or that the limitation of liability provisions contained in our license agreements may not be effective as a result of existing or future federal, state or local laws, ordinances, or judicial decisions. Although we maintain errors and omissions and general liability insurance, and we try to structure our contracts to include limitations on liability, we cannot assure you that a successful claim could not be made or would not have a material adverse effect on our business, financial condition, and results of operations.
Our Application Service Provider strategy has yet to gain widespread acceptance.
Some businesses choose to access enterprise software applications through application service providers, or ASPs, which are businesses that host applications and provide access to software on a subscription basis. The public sector market for ASP solutions is new and unproven. Acceptance of our ASP model depends upon the ability and willingness of different governmental entities to accept and implement ASP solutions. Some prospective clients have expressed security and privacy concerns with the ASP model, including a concern regarding the confidential nature of the information and transactions available from and conducted with governments and concerns regarding off-site storage of such information. We have limited experience selling our solutions through ASPs and may not be successful in generating revenue from this distribution channel.
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Changes in the insurance markets may affect our ability to win some contract awards and may lead to increased expenses.
Some of our customers, primarily those for our property appraisal services, require that we secure performance bonds before they will select us as their vendor. The number of qualified, high-rated insurance companies that offer performance bonds has decreased in recent years, while the costs associated with securing these bonds has increased dramatically. In addition, we are generally required to issue a letter of credit as security for the issuance of a performance bond. Each letter of credit we issue without corresponding cash collateral reduces our borrowing capacity under our senior secured credit agreement. We cannot guarantee that we will be able to secure such performance bonds in the future on terms that are favorable to us, if at all. Our inability to obtain performance bonds on favorable terms or at all could impact our future ability to win some contract awards, particularly large property appraisal services contracts, which could have a material adverse effect on our business, financial condition, and results of operations.
Recent volatility in the stock markets, increasing shareholder litigation, the adoption of expansive legislation that redefines corporate controls (in particular, legislation adopted to prevent future corporate and accounting scandals), as well as other factors have recently led to significant increases in premiums for directors’ and officers’ liability insurance. The number of insurers offering directors and officers insurance at competitive rates has also decreased in recent years. We cannot predict when the insurance market for such coverage will stabilize, if at all. The continued volatility of the insurance market may result in future increases in our general and administrative expenses, which may adversely affect future operating results.
Our stock price may be volatile.
The market price of our common stock may be volatile and may be significantly affected by many different factors. Some examples of factors that can have a significant impact on our stock price include:
In addition, the stock market has from time to time experienced significant price and volume fluctuations that have particularly affected the market prices for the common stock of technology companies. These broad market fluctuations may adversely affect the market price of our common stock. In the past, following periods of volatility in the market price of a particular company’s securities, securities class action litigation has often been brought against that company. We cannot assure you that similar litigation will not occur in the future with respect to us. Such litigation could result in substantial costs and a diversion of management’s attention and resources, which could have a material adverse effect upon our business, operating results, and financial condition.
Historically, we have not paid dividends on our common stock.
We have not declared or paid a cash dividend since we entered the business of providing software solutions and services to the public sector in February 1998. Our credit agreement restricts our ability to pay cash dividends. We intend to retain earnings for use in the operation and expansion of our business. We do not anticipate paying any cash dividends on our common stock in the foreseeable future.
Provisions in our certificate of incorporation, bylaws, and Delaware law could deter takeover attempts.
Our board of directors may issue up to 1,000,000 shares of preferred stock and may determine the price, rights, preferences, privileges, and restrictions, including voting and conversion rights, of these shares of preferred stock. These determinations may be made without any further vote or action by our stockholders. The rights of the holders of our common stock will be subject to, and may be adversely affected by, the rights of the holders of any preferred stock that may be issued in the future. The issuance of preferred stock may make it more difficult for a third party to acquire a majority of our outstanding voting stock. In addition, some provisions of our Certificate of Incorporation, Bylaws, and of the Delaware General Corporation Law could also delay, prevent, or make more difficult a merger, tender offer, or proxy contest involving us.
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Financial Outlook
From time to time in press releases and otherwise, we may publish forecasts or other forward-looking statements regarding our results, including estimated revenues or net earnings. Any forecast of our future performance reflects various assumptions. These assumptions are subject to significant uncertainties, and as a matter of course, any number of them may prove to be incorrect. Further, the achievement of any forecast depends on numerous risks and other factors (including those described in this discussion), many of which are beyond our control. As a result, we cannot be certain that our performance will be consistent with any management forecasts or that the variation from such forecasts will not be material and adverse. Current and potential stockholders are cautioned not to base their entire analysis of our business and prospects upon isolated predictions, but instead are encouraged to utilize our entire publicly available mix of historical and forward-looking information, as well as other available information regarding us, our products and services, and the software industry when evaluating our prospective results of operations.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
Market risk represents the risk of loss that may affect us due to adverse changes in financial market prices and interest rates. As of December 31, 2004, we had funds invested in a state and municipal bond mutual fund and auction rate municipal and corporate bonds, all of which we accounted for in accordance with SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” These investments were treated as available-for-sale under SFAS No. 115. The carrying value of these investments approximates fair market value. We are not exposed to any market risk related to the municipal bond mutual fund as we liquidated it in February 2005. Due to the nature of the auction rate municipal and corporate bonds, we are not subject to significant market rate risk.
We have no outstanding debt at December 31, 2004, and we therefore are not subject to any interest rate risk.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
The reports of our independent registered public accounting firm and our consolidated financial statements, related notes, and supplementary data are included as part of this Annual Report beginning on page F-1.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
None.
ITEM 9A. CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures — Our chief executive officer and our chief financial officer have evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Securities Exchange Act Rules 13a-15(e)) as of December 31, 2004. Based on such evaluation, our chief executive officer and chief financial officer have concluded that as of December 31, 2004 such disclosure controls and procedures were effective and designed to ensure that information required to be disclosed by us in the reports we file or submit under the Securities Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms, and include controls and procedures designed to ensure that information required to be disclosed by us in such reports is accumulated and communicated to our management, including the chief executive officer and chief financial officer, as appropriate to allow timely decisions regarding required disclosure.
Internal Control Over Financial Reporting — During the quarter ended December 31, 2004, there were no changes in our internal controls over financial reporting, as defined in Securities Exchange Act Rule 13a-15(f) and 15d-15(f), that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
Management’s Report on Internal Control Over Financial Reporting — Tyler’s management is responsible for establishing and maintaining effective internal control over financial reporting as defined in Securities Exchange Act Rule 13a-15(f). Tyler’s internal control over financial reporting is designed to provide reasonable assurance to Tyler’s management and board of directors regarding the preparation and fair presentation of published financial statements.
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Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation.
Management assessed the effectiveness of Tyler’s internal control over financial reporting as of December 31, 2004. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control - Integrated Framework. Based on our assessment, we believe that, as of December 31, 2004, Tyler’s internal control over financial reporting is effective based on those criteria.
Management’s assessment of the effectiveness of internal control over financial reporting as of December 31, 2004 has been audited by Ernst & Young, LLP, the independent registered public accounting firm who also audited Tyler’s consolidated financial statements. Ernst & Young’s attestation report on management’s assessment of Tyler’s internal control over financial reporting appears on page F-2 hereof.
ITEM 9B. OTHER INFORMATION
PART III
See the information under the following captions in Tyler’s definitive Proxy Statement, which is incorporated herein by reference. Only those sections of the Proxy Statement that specifically address the items set forth herein are incorporated by reference. Such incorporation by reference does not include the Compensation Committee Report, the Audit Committee Report or the Stock Performance Graphs, which are included in the Proxy Statement.
The information required under this item may be found under the section captioned “Proposals For Consideration — Proposal Two — Ratification of Ernst & Young LLP as Our Independent Auditors for Fiscal Year 2005” in our Proxy Statement and is incorporated herein by reference.
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PART IV
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULE.
The following documents are filed as part of this Annual Report:
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and ShareholdersTyler Technologies, Inc.
We have audited the accompanying consolidated balance sheets of Tyler Technologies, Inc. and subsidiaries as of December 31, 2004 and 2003, and the related consolidated statements of operations, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2004. Our audits also included the financial statement schedule listed in the Index at Item 15(a). These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Tyler Technologies, Inc. and subsidiaries at December 31, 2004 and 2003, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2004, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Tyler Technologies, Inc.’s internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 3, 2005 expressed an unqualified opinion thereon.
ERNST & YOUNG LLP
Dallas, TexasMarch 3, 2005
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We have audited management’s assessment, included in the accompanying Management’s Report on Internal Controls over Financial Reporting, that Tyler Technologies, Inc. maintained effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Tyler Technologies, Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, management’s assessment that Tyler Technologies, Inc. maintained effective internal control over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, Tyler Technologies, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Tyler Technologies, Inc. as of December 31, 2004 and 2003, and the related consolidated statements of operations, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2004 and our report dated March 3, 2005 expressed an unqualified opinion thereon.
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Tyler Technologies, Inc.
See accompanying notes.
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December 31, 2004 and 2003
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
We provide integrated software systems and related services for 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 property appraisal outsourcing services for taxing jurisdictions.
Tyler’s business is subject to risks and uncertainties including dependence on information technology spending by customers, fluctuations of quarterly results, a lengthy and variable sales cycle, dependence on key personnel, dependence on principal products and third-party technology and rapid technological change.
PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include our parent company and our subsidiaries, all of which are wholly-owned as of December 31, 2004 (see Note 2). All significant intercompany balances and transactions have been eliminated in consolidation. In 2005 we merged all of our subsidiaries into the parent company.
CASH, CASH EQUIVALENTS, SHORT-TERM INVESTMENTS AND OTHER
Cash equivalents include items almost as liquid as cash, such as money market investments with insignificant interest rate risk and original maturities of three months or less at the time of purchase. For purposes of the statements of cash flows, we consider all investments with original maturities of three months or less to be cash equivalents.
In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” we determine the appropriate classification of debt and equity securities at the time of purchase and re-evaluate the classification as of each balance sheet date. At December 31, 2004 and 2003, we classified our short-term investments as available-for-sale securities pursuant to SFAS No. 115. Investments which are classified as available-for-sale are recorded at fair value as determined by quoted market price and unrealized holding gains and losses, net of the related tax effect, if any, are not reflected in earnings but are reported as a separate component of other comprehensive income until realized. Interest and dividends earned on these securities are reinvested in the securities. The cost basis of securities sold is determined using the average cost method. Following is a summary of short-term investments:
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Included in other assets is a $7.5 million restricted certificate of deposit with a maturity in excess of one year which collateralizes letters of credit required under our surety bond program. These letters of credit expire during 2005 and early 2006.
REVENUE RECOGNITION
We earn revenue from software licenses, postcontract customer support (“PCS” or “maintenance”), hardware, software related services and appraisal services. PCS includes telephone support, bug fixes, and rights to upgrades on a when-and-if available basis. We provide services that range from installation, training, and basic consulting to software modification and customization to meet specific customer needs. In software arrangements that include rights to multiple software products, specified upgrades, PCS, and/or other services, we allocate the total arrangement fee among each deliverable based on the relative fair value of each. Fair values are estimated using vendor specific objective evidence.
We recognize revenue from software transactions in accordance with Statement of Position (“SOP”) 97-2, “Software Revenue Recognition,” as amended by SOP 98-4 and SOP 98-9 and, in accordance with the Securities and Exchange Commission Staff, Accounting Bulletin No. 104, “Revenue Recognition” as follows:
Software Licenses:
We recognize the revenue allocable to software licenses and specified upgrades upon delivery of the software product or upgrade to the customer, unless the fee is not fixed or determinable or collectibility is not probable. If the fee is not fixed or determinable, including new customers whose payment terms are three months or more from shipment, revenue is generally recognized as payments become due from the customer. If collectibility is not considered probable, revenue is recognized when the fee is collected. Arrangements that include software services, such as training or installation, are evaluated to determine whether those services are essential to the product’s functionality.
A majority of our software arrangements involve “off-the-shelf” software. We consider software to be off-the-shelf software if it can be added to an arrangement with minor changes in the underlying code and it can be used by the customer for the customer’s purpose upon installation. For off-the-shelf software arrangements, we recognize the software license fee as revenue after delivery has occurred, customer acceptance is reasonably assured, that portion of the fee represents a non-refundable enforceable claim and is probable of collection, and the remaining services such as training are not considered essential to the product’s functionality.
For arrangements that include customization or modification of the software, or where software services are otherwise considered essential, we recognize revenue using contract accounting. We use the percentage-of-completion method to recognize revenue from these arrangements. We measure progress-to-completion primarily using labor hours incurred, or value added. The percentage-of-completion methodology generally results in the recognition of reasonably consistent profit margins over the life of a contract since we have the ability to produce reasonably dependable estimates of contract billings and contract costs. We use the level of profit margin that is most likely to occur on a contract. If the most likely profit margin cannot be precisely determined, the lowest probable level of profit in the range of estimates is used until the results can be estimated more precisely. These arrangements are often implemented over an extended time period and occasionally require us to revise total cost estimates. Amounts recognized in revenue are calculated using the progress-to-completion measurement after giving effect to any changes in our cost estimates. Changes to total estimated contract costs, if any, are recorded in the period they are determined. Estimated losses on uncompleted contracts are recorded in the period in which we first determine that a loss is apparent.
Software Services:
Some of our software arrangements include services considered essential for the customer to use the software for the customer’s purposes. For these software arrangements, both the software license revenue and the services revenue are recognized as the services are performed using the percentage-of-completion contract accounting method. When software services are not considered essential, the fee allocable to the service element is recognized as revenue as we perform the services.
Appraisal Services:
For our real estate appraisal projects, we recognize revenue using the proportionate performance method of revenue recognition since many of these projects are often implemented over a one to three year period and consist of various unique activities. Under this method of revenue recognition, we identify each activity for the appraisal project with a typical project generally calling for bonding, office set up, training, routing of map information, data entry, data collection, data verification, informal hearings, appeals and project management. Each activity or act is specifically identified and assigned an estimated cost. Costs which are considered to be associated with indirect activities, such as bonding costs and office set up, are expensed as incurred. These costs are typically billed as incurred and are recognized as revenue equal to cost. Direct contract fulfillment activities and related supervisory costs such as data
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collection, data entry and verification are expensed as incurred. The direct costs for these activities are determined and the total contract value is then allocated to each activity based on a consistent profit margin. Each activity is assigned a consistent unit of measure to determine progress towards completion and revenue is recognized for each activity based upon the percentage complete as applied to the estimated revenue for that activity. Progress for the fulfillment activities is typically based on labor hours or an output measure such as the number of parcel counts completed for that activity. Estimated losses on uncompleted contracts are recorded in the period in which we first determine that a loss is apparent.
Computer Hardware Equipment:
Revenue allocable to computer hardware equipment, which is based on vendor specific objective evidence of fair value, is recognized when we deliver the equipment and collection is probable.
Postcontract Customer Support:
Our customers generally enter into PCS agreements when they purchase our software licenses. Our PCS agreements are generally renewable every year. Revenue allocated to PCS is recognized on a straight-line basis over the period the PCS is provided. All significant costs and expenses associated with PCS are expensed as incurred. Fair value for the maintenance and support obligations for software licenses is based upon the specific sale renewals to customers or upon renewal rates quoted in the contracts.
Deferred revenue consists primarily of payments received in advance of revenue being earned under software licensing, software services, hardware installation and support and maintenance contracts. Unbilled revenue is not billable at the balance sheet date but is recoverable over the remaining life of the contract through billings made in accordance with contractual agreements.
Prepaid expenses and other current assets include direct and incremental costs, consisting primarily of third party sub-contractor payments and commissions associated with arrangements for which revenue recognition has been deferred. Such costs are expensed at the time the related revenue is recognized.
USE OF ESTIMATES
The preparation of our consolidated financial statements in conformity with accounting principles generally accepted in the United States (“GAAP”) requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Significant items subject to such estimates and assumptions include the application of the percentage-of-completion and proportionate performance methods of revenue recognition, the carrying amount and estimated useful lives of intangible assets and valuation allowance for receivables. Actual results could differ from those estimates.
PROPERTY AND EQUIPMENT, NET
Property, equipment and purchased software are recorded at original cost and increased by the cost of any significant improvements after purchase. We expense maintenance and repairs when incurred. Depreciation and amortization is calculated using the straight-line method over the shorter of the asset’s estimated useful life or the term of the lease in the case of leasehold improvements. For income tax purposes, we use accelerated depreciation methods as allowed by tax laws.
INTEREST COST
We capitalize interest cost as a component of capitalized software development costs. We capitalized interest costs of $63,000 during 2003 and $269,000 during 2002. We did not capitalize any interest costs during 2004.
RESEARCH AND DEVELOPMENT COSTS
Research and development costs are included with selling, general and administrative expenses and are expensed when incurred. We expensed research and development costs of $2.5 million during 2004, $1.1 million during 2003, and $611,000 during 2002.
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OTHER INCOME (EXPENSE), NET
Components of other income (expense), net are as follows:
INCOME TAXES
Income taxes are accounted for under the asset and liability method. Deferred taxes arise because of different treatment between financial statement accounting and tax accounting, known as “temporary differences.” We record the tax effect of these temporary differences as “deferred tax assets” (generally items that can be used as a tax deduction or credit in the future periods) and “deferred tax liabilities” (generally items that we received a tax deduction for, which have not yet been recorded in the income statement). The deferred tax assets and liabilities are measured using enacted tax rules and laws that are expected to be in effect when the temporary differences are expected to be recovered or settled. A valuation allowance would be established to reduce deferred tax assets if it is likely that a deferred tax asset will not be realized.
STOCK COMPENSATION
In accordance with SFAS No. 123, “Accounting for Stock-Based Compensation,” we elected to account for our stock-based compensation under Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” as amended, and related interpretations, including Financial Accounting Standards Board (“FASB”) Interpretation No. 44, “Accounting for Certain Transactions involving Stock Compensation,” an interpretation of APB No. 25, issued in March 2000. Under APB No. 25’s intrinsic value method, compensation expense is determined on the measurement date; that is, the first date on which both the number of shares the option holder is entitled to receive, and the exercise price, if any, are known. Compensation expense, if any, is measured based on the award’s intrinsic value – the excess of the market price of the stock over the exercise price on the measurement date. The exercise price of all of our stock options granted equals the market price on the measurement date. Therefore, we have not recorded any compensation expense related to grants of stock options.
The weighted-average fair value per stock option granted was $6.03 for 2004, $3.41 for 2003, and $3.61 for 2002. We estimated the fair values using the Black-Scholes option pricing model and the following assumptions for the periods presented:
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Pro forma information regarding net income and earnings per share is required by SFAS No. 123 for awards granted after December 31, 1994, as if we had accounted for our stock-based awards to employees under the fair value method of SFAS No. 123. The pro forma impact of applying SFAS No. 123 in 2004, 2003 and 2002 will not necessarily be representative of the pro forma impact in future years. Our pro forma information is as follows:
In December 2004, the FASB issued SFAS No. 123R, “Share-Based Payment”. SFAS No. 123R is a revision of SFAS No. 123 “Accounting for Stock-Based Compensation,” and supersedes APB No. 25. Among other items, SFAS No. 123R eliminates the use of APB No. 25 and the intrinsic value method of accounting, and requires the cost of employee services received in exchange for awards of equity instruments, based on the grant date fair value of those awards, to be recorded in the financial statements. The effective date of SFAS No. 123R is the first reporting period beginning after June 15, 2005, which is the third quarter of 2005 for calendar year companies, although early adoption is allowed. SFAS No. 123R permits companies to adopt its requirements using either a “modified prospective” method, or a “modified retrospective” method. Under the “modified prospective” method, compensation cost is recognized in the financial statements beginning with the effective date, based on the requirements of SFAS No. 123R for all share-based payments granted after that date, and based on the requirements of SFAS No. 123 for all unvested awards granted prior to the effective date of SFAS No. 123R. Under the “modified retrospective” method, the requirements are the same as under the “modified prospective” method, but also permits entities to restate financial statements of previous periods based on proforma disclosures made in accordance with SFAS No. 123.
We currently utilize a standard option pricing model (Black-Scholes) to measure the fair value of stock options granted to employees. While SFAS No. 123R permits entities to continue to use such a model, the standard also permits the use of a “lattice” model. We have not yet determined which model we will use to measure the fair value of employee stock options upon the adoption of SFAS No. 123R.
SFAS No. 123R also requires that the benefits associated with the tax deductions in excess of recognized compensation cost be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after the effective date. These future amounts cannot be estimated, because they depend on, among other things, when employees exercise stock options. However, the amount of operating cash flows recognized in prior periods for such excess tax deductions, as shown in our Consolidated Statement of Cash Flows, were $582,000 during 2004, $292,000 during 2003, and $198,000 during 2002.
We currently expect to adopt SFAS No. 123R effective July 1, 2005; however, we have not yet determined which of the adoption methods we will use. Subject to a complete review of the requirements of SFAS No. 123R, based on stock options granted to employees through December 31, 2004, we expect that the adoption of SFAS No. 123R on July 1, 2005, would reduce both third quarter 2005 and fourth quarter 2005 net earnings by approximately $200,000 ($0.00 per share, diluted) each quarter.
SFAS No. 123R also requires employee stock purchase plans (ESPP) with purchase price discounts greater than 5% to be compensatory. Our ESPP has a 15% purchase price discount with “look back” features, but the plan can be modified at any time. Based on our current intention to modify certain portions of our plan, we expect the related compensatory charge would reduce both third quarter 2005 and fourth quarter 2005 net earnings by approximately $50,000 ($0.00 per share, diluted) each. See Note 12 for further information on our stock-based compensation plans.
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COMPREHENSIVE INCOME
Changes in accumulated other comprehensive income are as follows:
SEGMENT AND RELATED INFORMATION
Although we have a number of operating subsidiaries, separate segment data has not been presented as they meet the criteria for aggregation as permitted by SFAS No. 131, “Disclosures About Segments of an Enterprise and Related Information.”
GOODWILL AND OTHER INTANGIBLE ASSETS
We have used the purchase method of accounting for all of our business combinations. Our business acquisitions result in the allocation of the purchase price to goodwill and other intangible assets. We allocate the cost of acquired companies first to identifiable assets based on estimated fair values. The excess of the purchase price over the fair value of identifiable assets acquired, net of liabilities assumed, is recorded as goodwill.
Under SFAS No. 142 “Goodwill and Other Intangible Assets,” we will evaluate goodwill for impairment annually as of April 1st, or more frequently if impairment indicators arise. An impairment loss is recognized to the extent that the carrying amount exceeds the asset’s fair value. In the implementation of SFAS No. 142, we identified two reporting units for impairment testing. The appraisal services and appraisal software stand-alone business unit qualified as a reporting unit since it is one level below an operating segment, discrete financial information exists for the business unit and the executive management group directly reviews this business unit. The other software business units were aggregated into the other single reporting unit. The appraisal services and appraisal software stand-alone business unit is organized in such a manner that both of its revenue sources are tightly integrated with each other and discrete financial information at the operating profit level does not exist for this business unit’s respective revenue sources.
IMPAIRMENT OF LONG-LIVED ASSETS
We periodically evaluate whether current facts or circumstances indicate that the carrying value of our property and equipment or other long-lived assets to be held and used may not be recoverable. If such circumstances are determined to exist, we measure the recoverability of assets to be held and used by a comparison of the carrying amount of the asset or appropriate grouping of assets and the estimated undiscounted future cash flows expected to be generated by the assets. If the carrying amount of the assets exceeds their estimated future cash flows, an impairment charge is recognized by the amount by which the carrying amount of the assets exceeds the fair value of the assets. Assets to be disposed of would be separately presented in the balance sheet and reported at the lower of the carrying amount or fair value less costs to sell, and are no longer depreciated. The assets and liabilities of a disposed group classified as held for sale would be presented separately in the appropriate asset and liability sections of the balance sheet.
COSTS OF COMPUTER SOFTWARE
Software development costs have been accounted for in accordance with SFAS No. 86, “Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed.” Under SFAS No. 86, capitalization of software development costs begins upon the establishment of technological feasibility and prior to the availability of the product for general release to customers. We capitalized software development costs of approximately $4.6 million during 2004, $6.8 million during 2003 and $7.2 million during 2002. Software development costs primarily consist of personnel costs, rent for related office space and capitalized interest cost. We begin to amortize capitalized costs when a product is available for general release to customers. Amortization expense is determined on a product-by-product basis at a rate not less than straight-line basis over the product’s remaining estimated economic life.
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Amortization of software development costs was approximately $6.1 million in 2004, $4.1 million during 2003, and $2.8 million during 2002 and is included in cost of software license revenue in the accompanying consolidated statements of operations.
FAIR VALUE OF FINANCIAL INSTRUMENTS
We use the following methods and assumptions to estimate the fair value of each class of financial instruments at the balance sheet date:
CONCENTRATIONS OF CREDIT RISK AND UNBILLED RECEIVABLES
Concentrations of credit risk with respect to receivables are limited due to the large number of customers to which our products and services are provided, as well as their dispersion across many different geographic areas. Historically, our credit losses have not been significant. As a result, we do not believe we have any significant concentrations of credit risk as of December 31, 2004.
We maintain allowances for doubtful accounts, sales adjustments and estimated cost of product warranties, which are provided at the time the revenue is recognized. Since most of our customers are governmental entities, we rarely incur a loss resulting from the inability of a customer to make required payments. Events or changes in circumstances that indicate that the carrying amount for the allowances for doubtful accounts, sales adjustments and estimated cost of product warranties 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.
Our property appraisal outsourcing service contracts can range up to three years and, in one case, as long as six years in duration. In connection with these contracts as well as certain software service 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 fair value of products delivered and services performed in the event of an early termination. We have recorded retentions and unbilled receivables (costs and estimated profit in excess of billings) of $11.7 million and $7.6 million at December 31, 2004 and 2003, respectively, in connection with such contracts. Retentions are included in accounts receivable and amounted to $1.7 million at December 31, 2004, of which $536,000 is expected to be collected in excess of one year.
One customer accounted for approximately 10% of our total consolidated revenues during 2002.
INDEMNIFICATION
In November 2002, the FASB issued Interpretation No. 45 (“FIN 45”), “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” FIN 45 requires that a guarantor recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee or indemnification. FIN 45 also requires additional disclosure by a guarantor in its interim and annual consolidated financial statements about its obligations under certain guarantees and indemnifications. The following summarizes the agreements we have determined are within the scope of FIN 45:
Most of our software license agreements indemnify our customers in the event that the software sold infringes upon the intellectual property rights of a third party. These agreements typically provide that in such event we will either modify or replace the software so that it becomes non-infringing or procure for the customer the right to use the software. We have recorded no liability associated with this indemnification, as we are not aware of any pending or threatened infringement actions that are possible losses. We believe the estimated fair value of these intellectual property indemnification clauses is minimal.
We have also agreed to indemnify our officers and board members if they are named or threatened to be named as a party to any proceeding by reason of the fact that they acted in such capacity. A form of the indemnification agreement is filed as Exhibit 10.1 to our Form 10-K for the year ended December 31, 2002 and incorporated by reference herein. We maintain directors’ and officers’ insurance coverage to protect against any such losses. We have recorded no liability associated with these indemnifications as we are
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not aware of any pending or threatened actions or claims against any officer or board member. As a result of the insurance policy coverage, we believe the estimated fair value of these indemnification agreements is minimal.
RECLASSIFICATIONS
Certain amounts for previous years have been reclassified to conform to the current year presentation.
(2) ACQUISITIONS
During December 2003, we acquired one company, Eden Systems, Inc. (“Eden”), and certain assets of another business that provides forms software to users of some of our software products. The results of these acquisitions have been included in our consolidated financial statements since their respective dates of acquisition. We acquired 95% of the outstanding common stock of Eden on December 2, 2003 and purchased the remaining 5% of the outstanding stock at various dates in 2004. Eden provides financial, personnel and citizen services applications software for local governments. We believe Eden’s products and expertise will complement our business model and give us additional opportunities to provide our customers with solutions tailored specifically for local governments. In particular, the addition of Eden considerably increases our presence in the western part of the United States.
Following is a summary of our 2003 acquisitions:
Cash paid for acquisitions excludes acquired cash balances of approximately $2.1 million and includes payments in cash of $946,000 paid during the year ended December 31, 2004 in connection with the purchase of remaining minority interest and other settlement matters. The value of the Tyler common stock was determined based on the average market price of Tyler’s common shares over the ten-day period before the terms of the acquisition were agreed to and announced. Approximately $2.0 million of goodwill is expected to be deductible for tax purposes. The software, trade name and customer related intangibles have useful lives of 3-5 years, 5-25 years and 25 years, respectively.
Pursuant to the agreement with Eden, two of the shareholders of Eden were granted the right to “put” their remaining shares to Tyler and Tyler was also granted the right to “call” the remaining shares. In January 2004, Tyler purchased 500 shares for $145,000 in cash. We purchased the remaining 2,000 shares for a cash purchase price of $580,000 in July 2004, which increased our ownership of the outstanding common stock of Eden from 96% to 100%.
The following unaudited pro forma information presents the consolidated results of operations as if our acquisition of Eden occurred as of the beginning of 2002, after giving effect to certain adjustments, including amortization of intangibles, interest and income tax effects. Pro forma information does not include acquisitions that are not considered material to our results of operations. The pro forma information does not purport to represent what our results of operations actually would have been had such transaction or event occurred on the dates specified, or to project our results of operations for any future period.
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The following table summarizes the estimated fair values of the assets acquired and liabilities assumed at the date of acquisition for Eden, excluding the impact of minority interest. Following is the allocation of purchase price to assets acquired and liabilities assumed:
(3) DISCONTINUED OPERATIONS
Background of Disposed Businesses
Discontinued operations include our former information and property records services segment for which our board of directors approved a formal plan of disposal in December 2000, two non-operating subsidiaries related to a formerly owned subsidiary that we sold in December 1995 and an automotive parts subsidiary sold in March 1999.
The business units within the discontinued information and property records services segment were sold in 2000 and 2001. In May 2001, we sold all of the common stock of one of the businesses in the discontinued information and property records services segment. In connection with the sale, we received cash proceeds of $575,000, approximately 60,000 shares of Tyler common stock, a promissory note of $750,000 and other contingent consideration. In June 2002, we renegotiated the proceeds from the May 2001 sale transaction and received cash of approximately $846,000 (including interest of $46,000) and a renegotiated promissory note. In August 2003, we received $127,000 to fully settle this promissory note. In June 2002, we also sold the building of a business unit included in this segment. Net proceeds from the sale totaled $961,000.
One of our non-operating subsidiaries, Swan Transportation Company (“Swan”), had been involved in various claims raised by former employees of a foundry that was owned by an affiliate of Swan and Tyler prior to December 1995. These claims were for alleged work related injuries and physical conditions resulting from alleged exposure to silica, asbestos, and/or related industrial dusts. After a series of bankruptcy court filings involving Swan, on December 23, 2003, Tyler in accordance with the terms of the plan of reorganization, transferred the stock of Swan to the Swan Asbestos and Silica Trust (“Trust”), an unaffiliated entity that will oversee the processing and payment of all present and future claims related to the foundry. On December 23, 2003, we paid $1.48 million to the Trust in full and final release from all liability for claims associated with the once-owned foundry (the “Swan Matter”). As a result of the release, any claimant is barred from asserting any such claim, either now or in the future, against Tyler or its affected affiliates.
Composition of Gains on Disposals
During the years ended December 31, 2003 and 2002, we recorded gains on disposal of discontinued operations, after income taxes, of $424,000 and $1.8 million, respectively.
During the year ended December 31, 2003, the gain on disposal of discontinued operations of $424,000 primarily resulted because we fully settled the Swan Matter at an amount less than initially recorded and certain aspects of the settlement were conducted in a beneficial tax manner. Accordingly, we recognized for the first time certain tax benefits associated with payments on behalf of the Swan Matter.
During the year ended December 31, 2002, the Internal Revenue Service issued temporary regulations that in effect allowed us to deduct for tax purposes losses attributable to the March 1999 sale of our automotive parts subsidiary that were previously not allowed. The tax benefit of allowing the deduction of this loss amounted to approximately $970,000. In addition, we renegotiated a note receivable and certain contingent consideration in connection with a subsidiary sold in 2001 and received proceeds of $846,000 (including interest of $46,000) in 2002. We initially assigned no value for accounting purposes to the note receivable and contingent
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consideration when the loss on the disposal of the discontinued operation was first established in 2000 and when the note was first received in 2001. In addition, we entered into an agreement in the fourth quarter of 2002 to settle the Swan Matter for an amount that was approximately $200,000 less than the liability initially established for this matter. The aggregate effects of these events, net of the related tax effects, and other minor adjustments to the reserve for discontinued operations resulted in a credit to discontinued operations of $1.8 million in 2002.
(4) RELATED PARTY TRANSACTIONS
We have two office building lease agreements with a shareholder and non-corporate officers. Total rental expense related to such leases was $1.4 million during 2004, $1.5 million in 2003, and $1.1 million during 2002.
Total future minimum rental under noncancelable related party operating leases as of December 31, 2004, are as follows:
As disclosed in Note 11 – Shareholders’ Equity, we purchased 1.5 million shares of our common stock from a former director for cash of $4.0 million in 2002.
(5) PROPERTY AND EQUIPMENT, NET
Property and equipment, net consists of the following at December 31:
Depreciation expense was $2.5 million during 2004, $2.4 million during 2003, and $2.4 million during 2002.
(6) INVESTMENT SECURITY AVAILABLE-FOR-SALE
On March 25, 2003, we received cash proceeds of $39.3 million in connection with a transaction to sell all of our 5.6 million shares of H.T.E., Inc. (“HTE”) common stock to SunGard Data Systems Inc. for $7.00 cash per share, pursuant to a Tender and Voting Agreement dated February 4, 2003. Our original cost basis in the HTE shares was $15.8 million. After transaction and other costs, we recorded a realized gross gain of $23.2 million ($16.2 million after income taxes of $7.0 million, including the utilization for tax purposes and reduction in valuation allowance for accounting purposes related to a capital loss carryforward amounting to $1.1 million on a tax effected basis).
Our 5.6 million shares of HTE represented an ownership interest of approximately 35%. Under GAAP, a 20% or more investment in the voting stock of another company creates the presumption that the investor has significant influence over the operating and financial policies of that company, unless there is evidence to the contrary. Tyler’s management previously concluded that no such influence existed. Thus, we accounted for our investment in HTE pursuant to the provisions of SFAS No. 115 and our investment in HTE was previously classified as an available-for-sale security. As of December 31, 2002, we had an unrealized holding gain of $11.4 million ($7.4 million after income tax of $4.0 million), which was included as a component of other comprehensive income.
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We originally acquired the 5.6 million shares of HTE common stock in 1999 in exchange for approximately 2.8 million shares of our common stock. On October 29, 2001, HTE, pursuant to the Florida “control share” statute, attempted to redeem all 5.6 million shares of HTE common stock owned by us for a cash price of $1.30 per share. A series of legal actions were then filed by both parties concerning the legality of the redemption. On September 24, 2002, we entered into a settlement agreement with HTE in which HTE agreed that it would not attempt any other redemption of our shares. In addition, HTE agreed to dismiss and release us from the tort claims it alleged against us. During 2002, we incurred approximately $704,000 of legal and other related costs associated with these matters, which are classified as other non-operating expenses in the accompanying statements of operations.
(7) GOODWILL AND OTHER INTANGIBLE ASSETS
Goodwill, other intangible assets and related accumulated amortization consists of the following at December 31:
Total amortization expense was $8.8 million during 2004, $7.0 million during 2003, and $6.1 million during 2002.
The allocation of acquisition intangible assets is summarized in the following table:
The changes in the carrying amount of goodwill for the two years ended December 31, 2004 are as follows:
Estimated annual amortization expense relating to acquisition intangibles is as follows:
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(8) ACCRUED LIABILITIES
Accrued liabilities consist of the following at December 31:
(9) LONG-TERM OBLIGATIONS
In 2002, we entered into a revolving bank credit agreement which originally matured on January 1, 2005 but was extended to February 14, 2005 (“2002 Credit Facility”). The 2002 Credit Facility provided for total availability of up to $10.0 million. Borrowings bore interest at either prime rate or at the London Interbank Offered Rate (LIBOR) plus a margin of 3% and were limited to 80% of eligible accounts receivable. The 2002 Credit Facility was secured by substantially all of our personal property, by a pledge of the common stock of our operating subsidiaries, and was also guaranteed by our operating subsidiaries. The 2002 Credit Facility required us to maintain certain financial ratios and other financial conditions and prohibited us from making certain investments, advances, cash dividends or loans. As of December 31, 2004, we were in compliance with those covenants.
At December 31, 2004, our bank had issued outstanding letters of credit totaling $4.8 million under our 2002 Credit Facility to secure surety bonds required by some of our customer contracts. These letters of credit have been collateralized by restricted cash balances invested in a certificate of deposit. Our borrowing base under the 2002 Credit Facility was limited by the amount of eligible receivables. At December 31, 2004, we had no outstanding bank borrowings under the credit agreement and had an available borrowing base of $8.0 million.
We paid interest of $105,000 in 2004, $238,000 in 2003, and $377,000 in 2002, which includes non-usage and other fees associated with the credit agreement.
On February 11, 2005, we entered into a new revolving bank credit agreement (the “2005 Credit Facility”). The 2005 Credit Facility matures February 11, 2008 and provides for total borrowings of up to $30.0 million. Borrowings bear interest at either prime rate or at LIBOR plus a margin of 1.5%. The 2005 Credit Facility is secured by substantially all of our personal property. The 2005 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. The new credit agreement also includes a $10.0 million Letter of Credit facility under which the banks will issue cash collateralized letters of credit.
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(10) INCOME TAX
The income tax provision on income from continuing operations consisted of the following:
Reconciliation of the U.S. statutory income tax rate to our effective income tax expense rate for continuing operations follows:
The tax effects of the major items recorded as deferred tax assets and liabilities as of December 31 are:
In 2003, we utilized our capital loss carryforward of $1.1 million on a tax-effected basis in connection with a realized gain from the sale of our investment in HTE. See Note 6 – Investment Security Available-For-Sale.
Although realization is not assured, we believe it is more likely than not that all the deferred tax assets at December 31, 2004 and 2003 will be realized. Accordingly, we believe no valuation allowance is required for the deferred tax assets. However, the amount of the deferred tax asset considered realizable could be adjusted in the future if estimates of reversing taxable temporary differences are revised.
We paid income taxes, net of refunds received, of $6.5 million in 2004, $6.5 million in 2003, and $455,000 in 2002.
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(11) SHAREHOLDERS’ EQUITY
In 2004, we repurchased in the open market 1.5 million shares of our common stock for an aggregate purchase price of $12.5 million. Subsequent to December 31, 2004 and through February 28, 2005, we have repurchased 915,000 shares for an aggregate purchase price of $6.3 million. As of March 1, 2005 we have authorization from our board of directors to repurchase up to 1.6 million additional shares of our common stock.
In April 2003, we commenced a modified Dutch Auction tender offer to purchase up to 4.2 million shares of our common stock at a price not greater than $4.00 and not less than $3.60 per share. In accordance with the Securities and Exchange Commission rules, we had the right to purchase an additional amount of shares not to exceed 2% of our outstanding shares (approximately 907,000 shares) without amending or extending our offer. Approximately 6.0 million shares of common stock were properly tendered and not withdrawn at prices at or below $4.00 per share. We exercised our right to purchase an additional 2% of our outstanding shares without amending or extending our offer. As a result, in May 2003, we purchased 5.1 million shares of our common stock at a cash purchase price of $4.00 per share and transaction costs of approximately $150,000, for a total cost of $20.6 million. The final shares purchased reflect a pro-ration factor equal to 85% of the shares tendered. In addition during 2003 we also repurchased 912,800 shares of common stock on the open market for an aggregate purchase price of $3.5 million.
In August 2002, we consummated an agreement to purchase 1.1 million of our common shares from William D. Oates, a former director of Tyler, for a cash purchase price of $4.0 million. In October 2002, we repurchased an additional 400,000 of our shares as part of the initial agreement by assigning our rights and obligations under a Data License and Update Agreement associated with our discontinued information property records service business to eiStream. eiStream is an affiliate of William D. Oates. The repurchase of all 1.5 million shares was charged to treasury stock to the extent cash was paid.
In 2004, we issued 680,000 shares of common stock and received $1.9 million in aggregate proceeds, upon exercise of stock options. During 2003 we issued 554,000 shares of common stock and received $1.7 million in aggregate proceeds, upon exercise of stock options and during 2002 we issued 491,000 shares of common stock and received $1.6 million in aggregate proceeds upon exercise of stock options.
In May 2004, our shareholders voted to adopt the Tyler Technologies, Inc. Employee Stock Purchase Plan (“ESPP”). For the year ended December 31, 2004, employees had contributed $673,000 to the ESPP and as a result we issued approximately 44,000 shares of common stock in October 2004 and 48,000 shares of common stock in January 2005 to the ESPP.
In November 2003, we exchanged a warrant issued in July 1997 to purchase 2.0 million shares of our common stock at $2.50 per share into six separate warrants to purchase a total of 2.0 million shares of our common stock at $2.50 per share. Subsequent to the exchange in 2003, several parties exercised their warrants to purchase 375,000 shares of our common stock by way of cashless exercise and were issued, on a net basis, 247,620 shares of our common stock from our treasury. In March 2004, another warrant holder exercised his warrant to purchase 21,234 shares of our common stock by way of cashless exercise and was issued on a net basis, 15,780 shares of our common stock from our treasury. As of December 31, 2004, we have warrants outstanding to purchase 1.6 million shares of common stock at $2.50 per share. These warrants expire in September 2007.
In August 2003, Sanders Morris Harris Inc. (“SMH”) exercised its warrant issued in May 2000 to purchase 333,380 shares of our common stock. The exercise price per share was $3.60 payable either in cash or by the surrender of shares subject to the warrant with a value equal to the aggregate exercise price as determined by the market price of our stock on the date of exercise. On August 27, 2003, SMH exercised the full amount of the warrant by way of cashless exercise and was issued, on a net basis, 145,413 shares of our common stock from our treasury.
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(12) STOCK PLANS
We have a stock option plan that provides for the grant of stock options to key employees and directors. Options become fully exercisable after three to five years of continuous employment and expire ten years after the grant date. Once exercisable, the employee can purchase shares of our common stock at the market price on the date we granted the option. As of December 31, 2004, there were 1.2 million shares available for future grants under the plan from the 7.5 million shares approved by the stockholders.
The following table summarizes our stock option plan’s transactions for the three-year period ended December 31, 2004:
The following table summarizes information concerning outstanding and exercisable options at December 31, 2004:
In May 2004, our shareholders voted to adopt the Tyler Technologies, Inc. Employee Stock Purchase Plan (“ESPP”) and to reserve 1.0 million shares of our common stock for issuance under the ESPP. Under the ESPP, participants may contribute up to 15% of their annual compensation to purchase common shares of Tyler. The purchase price of the shares is equal to 85% of the closing price of Tyler shares on either the first or last day of each quarterly offering period, whichever is lower. As of December 31, 2004, employees had contributed $673,000 to the ESPP. During October 2004 and January 2005, we issued approximately 44,000 and 48,000 shares of common stock, respectively to the ESPP.
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(13) EARNINGS PER SHARE
Basic earnings and diluted earnings per share data was computed as follows:
Stock options representing the right to purchase common stock of 110,000 shares in 2004, 1.1 million shares during 2003, and 1.3 million shares during 2002 had exercise prices greater than the average quoted market price of our common stock. These options were outstanding during 2004, 2003 and 2002, but were not included in the computation of diluted earnings per share because their inclusion would have had an antidilutive effect.
(14) LEASES
We primarily lease offices for use in our operations as well as transportation, computer and other equipment. Most of these leases are noncancelable operating lease agreements and they expire at various dates through 2013. In addition to rent, the leases generally require us to pay taxes, maintenance, insurance and certain other operating expenses.
Rent expense was approximately $4.6 million in 2004, $4.3 million in 2003, and $3.4 million in 2002.
Future minimum lease payments under all noncancelable leases at December 31, 2004 are as follows:
(15) EMPLOYEE BENEFIT PLANS
We provide a defined contribution plan for the majority of our employees meeting minimum service requirements. The employees can contribute up to 15% of their current compensation to the plan subject to certain statutory limitations. We contribute up to a maximum of 2% of an employee’s compensation to the plan. We made contributions to the plan and charged continuing operations $801,000 in 2004, $931,000 during 2003, and $881,000 during 2002.
(16) COMMITMENTS AND CONTINGENCIES
Other than ordinary course, routine litigation incidental to our business, there are no material legal proceedings pending to which we or our subsidiaries are parties or to which any of our properties are subject.
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(17) QUARTERLY FINANCIAL INFORMATION (unaudited)
The following tables contain selected financial information from unaudited consolidated statements of operations for each quarter of 2004 and 2003.
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SCHEDULE II — VALUATION AND QUALIFYING ACCOUNTS(IN THOUSANDS)
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