Tyler Technologies - 10-Q quarterly report FY

We prepared the accompanying condensed consolidated financial statements following the requirements of the Securities and Exchange Commission (“SEC”) and accounting principles generally accepted in the United States, or GAAP, for interim reporting. As permitted under those rules, certain footnotes or other financial information that are normally required by GAAP can be condensed or omitted for interim periods. Balance sheet amounts are as of September 30, 2005 and December 31, 2004 and operating result amounts are for the three and nine months ended September 30, 2005 and 2004, and include all normal and recurring adjustments that we considered necessary for the fair summarized presentation of our financial position and operating results. As these are condensed financial statements, one should also read the financial statements and notes included in our latest Form 10-K for the year ended December 31, 2004. Revenues, expenses, assets and liabilities can vary during each quarter of the year. Therefore, the results and trends in these interim financial statements may not be the same as those for the full year.

Although we have a number of divisions, separate segment data has not been presented as they meet the criteria set forth in Statement of Financial Accounting Standards (“SFAS”) No. 131, “Disclosures About Segments of an Enterprise and Related Information” to be presented as one segment.

We recognize revenue related to our software arrangements pursuant to the provisions of Statement of Position (SOP) 97-2, Software Revenue Recognition, as amended by SOP 98-4 and SOP 98-9, and related interpretations, as well as the SEC Staff Accounting Bulletin No. 104 “Revenue Recognition.” We recognize revenue on our appraisal services contracts using the proportionate performance method of accounting, with considerations for the provisions of Emerging Issues Task Force (“EITF”) No. 00-21, Revenue Arrangements with Multiple Deliverables.

We earn revenue from software licenses, post-contract customer support (“PCS” or “maintenance”), hardware, and software related 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.

We typically enter into multiple element arrangements, which include software licenses, software services, PCS and occasionally hardware. The majority of our software arrangements are multiple element arrangements, but for those arrangements that include customization or significant modification of the software, or where software services are otherwise considered essential to the functionality of the software in the customer’s environment, we use contract accounting and apply the provisions of SOP 81-1.

If the arrangement does not require significant modification or customization, revenue is recognized when all of the following conditions are met:

For multiple element arrangements, each element of the arrangement is analyzed and we allocate a portion of the total arrangement fee to the elements based on the fair value of the element using vendor-specific evidence of fair value (“VSOE”), regardless of any separate prices stated within the contract for each element. Fair value is considered the price a customer would be required to pay if the element was sold separately based on our historical experience of stand-alone sales of these elements to third parties. For PCS, we use renewal rates for continued support arrangements to determine fair value. For software services, we use the fair value we charge our customers when those services are sold separately. In software arrangements in which we have the fair value of all undelivered elements but not of a delivered element, we apply the “residual method” as allowed under

SOP 98-9 in accounting for any element of a multiple-element arrangement involving software that remains undelivered such that any discount inherent in a contract is allocated to the delivered element. Under the residual method, if the fair value of all undelivered elements is determinable, the fair value of the undelivered elements is deferred and the remaining portion of the arrangement fee is allocated to the delivered element(s) and is recognized as revenue assuming the other revenue recognition criteria are met. In software arrangements in which we do not have VSOE for all undelivered elements, revenue is deferred until fair value is determined or all elements for which we do not have VSOE have been delivered. Alternatively, if sufficient VSOE does not exist and the only undelivered element is services that do not involve significant modification or customization of the software, the entire fee is recognized over the period during which the services are expected to be performed.

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 generally 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.

For our real estate appraisal projects, we recognize revenue using the proportionate performance method of revenue recognition since many of these projects are implemented over one to three year periods 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 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.

Revenue allocable to computer hardware equipment, which is based on VSOE, is recognized when we deliver the equipment and collection is probable.

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. 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.

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.

Cash equivalents include items almost as liquid as cash, such as money market investments and certificates of deposits 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 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. We have classified these investments in auction rate securities and bond funds as available-for-sale securities pursuant to SFAS No. 115. Investments which are classified as available-for-sale are recorded at fair value 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 the securities is determined using the average cost method.

The following table summarizes short-term investments, classified as available-for-sale, as of September 30, 2005:

The following table summarizes short-term investments, classified as available-for-sale, as of December 31, 2004:

We had no realized gains or losses for the three and nine months ended September 30, 2005 and generated immaterial realized losses for the three and nine months ended September 30, 2004.

As of September 30, 2005, we had $7.5 million invested in a certificate of deposit with a maturity date in excess of one year included in other assets, of which $4.8 million was restricted to collateralize letters of credit required under our surety bond program. These letters of credit expire in 2006. In October 2005 we redeemed the certificate of deposit and reinvested $5.0 million in a certificate of deposit with a maturity date of one year of which $4.8 million is restricted to collateralize letters of credit. The remaining balance was reinvested in short term investments.

As of September 30, 2005, we have authorization from our board of directors to repurchase up to 340,000 additional shares of Tyler common stock. On October 25, 2005 our board of directors authorized the repurchase of up to an additional 2.0 million shares of Tyler common stock. In October 2005, we repurchased approximately 143,000 shares of Tyler common stock resulting in a total authorization of $2.2 million as of October 25, 2005.

In May 2004, the shareholders of Tyler voted to adopt the Tyler Technologies, Inc. Employee Stock Purchase Plan (“ESPP”). Under the ESPP, participants may contribute up to 15% of their annual compensation to purchase common shares of Tyler. On March 8, 2005, the board of directors amended the plan to the effect that the purchase price of the shares is equal to 85% of the closing price of Tyler common stock on the last day of each quarterly offering period. Previously, the purchase price of the shares was equal to 85% of the closing price of Tyler common stock on either the first or last day of each quarterly offering period, whichever was lower. Employee contributions are received during the quarter and the related Tyler common shares are issued in the month after the quarter ends. In October 2005 and October 2004, respectively, we issued 37,000 and 44,000 shares of common stock to the ESPP.

Comprehensive income is comprised of net income and unrealized gains and losses on investment securities. For the three and nine months ended September 30, 2004 comprehensive income was $2.0 million and $7.1 million, respectively, which included minimal unrealized losses, on investment securities. In 2005, we had no unrealized gains or losses and comprehensive income was the same as net income.

The following table sets forth a comparison of our income tax provision for the following periods:

We made federal and state income tax payments, net of refunds, of $5.9 million in the nine months ended September 30, 2005, compared to $5.5 million in net payments for the same period of the prior year. The effective income tax rates were different from the statutory United States federal income tax rate of 35% primarily due to the state income taxes and non-deductible meals and entertainment costs. During the third quarter of 2005, we lowered our estimated annual effective income tax rate from 41.3% that was initially used for the six months ended June 30, 2005 to 40.5%. The reduction in the effective income tax rate reflects a corporate reorganization in 2005 which favorably impacted our state income tax provision, lower estimated non-deductible meals and entertainment costs and higher estimated tax-free interest income.

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 FASB Interpretation No. 44, “Accounting for Certain Transactions Involving Stock Compensation,” an interpretation of APB Opinion No. 25, issued in June 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.

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, and 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 had been set for the first reporting period beginning after June 15, 2005, which is the third quarter 2005 for calendar year companies. However, on April 14, 2005, the SEC announced that the effective date of SFAS No. 123R was suspended until January 1, 2006 for calendar year companies. 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 it 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 and directors. 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 determined which model we will use to measure the fair value of 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.

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 and we expect to record a related compensatory charge after SFAS No. 123R becomes effective January 1, 2006.

We currently expect to adopt SFAS No. 123R effective January 1, 2006, based on the new effective date announced by the SEC; however, we have not yet determined which of the aforementioned adoption methods we will use. In addition, we have not yet determined the financial statement impact of adopting SFAS No. 123R for 2006.

Because of unsatisfactory financial performance early in the fiscal year, we made significant organizational changes in the second quarter of 2005 to those areas of our business that were not performing to our expectations. Our goal was to bring costs in line with expected levels of revenue while improving the efficiency of our organizational structure to ensure that clients continue to receive superior service.

We currently anticipate that revenues in our appraisal services business are likely to remain at historically low levels in the coming quarters and we reorganized that division to eliminate levels of management and reduce overhead expense. We also took actions to reduce headcount and costs in our appraisal and tax software division, and we consolidated certain senior management positions at the corporate office. These cost reductions were made in the second quarter of 2005. As a result, we reduced headcount in the appraisal services and appraisal and tax software businesses, as well as in the corporate office, by eliminating approximately 120 positions, including management, staff and project-related personnel.

In connection with the reorganization, we incurred certain charges in the second quarter of 2005. Those charges, which are primarily comprised of employee severance costs and related fringe benefits, totaled approximately $1.3 million before income taxes. The related payments were substantially paid during the quarter ended June 30, 2005, with the remainder paid during the quarter ended September 30, 2005.

The following is a summary of the restructuring liability:

On September 9, 2005, Affiliated Computer Services, Inc. (“ACS”) filed litigation in Dallas County, Texas against thirty-three defendants, including Tyler and John M. Yeaman, our Chairman of the Board. The other named defendants include entities affiliated with William D. Oates (“Oates”), a former director of ours, and certain individuals employed by such entities. The lawsuit alleges, among other things, that we breached the non-competition and non-solicitation covenants set forth in the Stock Purchase Agreement dated December 29, 2000 (the “SPA”) between ACS and us pursuant to which we sold to ACS for cash all of the issued and outstanding capital stock of Business Resources Corporation (“BRC”), which comprised a significant portion of our then existing property records business. In the SPA, we agreed to certain five-year non-competition and non-solicitation covenants, which are due to expire on December 29, 2005. In addition, the SPA contained a closing condition pursuant to which Oates agreed to amend his then existing three-year non-competition and non-solicitation covenants so that the restricted activities would conform to the language of our restricted activities, which covenants would expire on December 29, 2003. The lawsuit alleges that Oates (or entities owned by Oates) solicited ACS employees and re-entered the land records business after the expiration of his three-year covenants, but prior to the expiration of our five-year covenants, and further alleges that we, through our non-competition covenants, are legally responsible for Oates’ actions. The lawsuit further alleges that Oates “controlled Tyler”, “manipulated Tyler”, and was a “legal representative” of ours for a significant, but unspecified, period of time following the sale of BRC, even though Oates has not been a member of our board since 2001, has not been employed by us since the sale of BRC, has had limited contact with our management since the sale of BRC, and to our knowledge, has not owned any stock in us since May 2003. The lawsuit further alleges that we fraudulently induced ACS to enter into the SPA because we allegedly knew that Oates (or entities owned by Oates) would re-enter the land records business after three years, even though the SPA specifically contained different covenants with respect to Oates and us.

We vehemently deny all allegations contained in the lawsuit. Management believes that we have not breached any non-competition covenants, have not solicited ACS employees, and have not misappropriated ACS confidential information. Management further believes that the “factual” allegations made against us are false and inaccurate and that the legal theories asserted by ACS are without merit. We have filed counterclaims against ACS, including claims for business disparagement and defamation, alleging that ACS has published factually inaccurate and defamatory statements about us to third parties, including our customers and prospective customers, with malice and/or negligence regarding the truth of those statements. We intend to defend the lawsuit vigorously. The future costs associated with such defense and in pursuit of the counterclaims are uncertain and difficult to predict and may be material.

FORWARD-LOOKING STATEMENTS

The statements in this discussion that are not historical statements are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements include statements about our business, financial condition, business strategy, plans and the objectives of our management, and future prospects. In addition, we have made in the past and may make in the future other written or oral forward-looking statements, including statements regarding future operating performance, short- and long-term revenue and earnings growth, the timing of the revenue and earnings impact for new contracts, backlog, the value of new contract signings, business pipeline, and industry growth rates and our performance relative thereto. Any forward-looking statements may rely on a number of assumptions concerning future events and be subject to a number of uncertainties and other factors, many of which are outside our control, which could cause actual results to differ materially from such statements. These include, but are not limited to: our ability to improve productivity and achieve synergies from acquired businesses; technological risks associated with the development of new products and the enhancement of existing products; changes in the budgets and regulating environments of our governmental customers; competition in the industry in which we conduct business and the impact of competition on pricing, revenues and margins; with respect to customer contracts accounted

for under the percentage-of-completion and proportionate performance methods of accounting, the performance of such contracts in accordance with our cost and revenue estimates; our ability to maintain health and other insurance coverage and capacity due to changes in the insurance market and the impact of increasing insurance costs on the results of operations; the costs to attract and retain qualified personnel, changes in product demand, the availability of products, economic conditions, costs of compliance with corporate governance and public disclosure requirements as issued by the Sarbanes-Oxley Act of 2002 and New York Stock Exchange rules, changes in tax risks and other risks indicated in our filings with the Securities and Exchange Commission (“SEC”). The factors described in this paragraph and other factors that may affect management or future financial results, as and when applicable, are discussed in our Form 10-K filed with the SEC, for the year ended December 31, 2004. Except to the extent required by law, we are not obligated to update or revise any forward-looking statements whether as a result of new information, future events or otherwise. When used in this Quarterly Report, the words “believes,” “plans,” “estimates,” “expects,” “anticipates,” “intends,” “continue,” “may,” “will,” “should,” “projects,” “forecast,” “might,” “could” or the negative of such terms and similar expressions as they relate to Tyler or our management are intended to identify forward-looking statements.

GENERAL

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 governmental 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.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The discussion and analysis of our financial condition and results of operations are based upon our condensed consolidated financial statements. These condensed consolidated financial statements have been prepared following the requirements of accounting principles generally accepted in the United States (GAAP) for interim periods and require us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on going basis, we evaluate our estimates, including those related to revenue recognition and amortization and potential impairment of intangible assets and goodwill. As these are condensed financial statements, one should also read our Form 10-K for the year ended December 31, 2004 regarding expanded information about our critical accounting policies and estimates.

ANALYSIS OF RESULTS OF OPERATIONS

The following table sets forth the key components of our revenues for the periods presented as of September 30:

Software licenses. Changes in software license revenues consist of the following components:

Software services. Changes in software services revenues consist of the following components:

Maintenance. We provide maintenance and support services for our software products and third party software. Maintenance revenues increased due to growth in our installed customer base as evidenced by our software license revenue and slightly higher maintenance rates on certain product lines.

Appraisal services. The decrease in appraisal services revenues is due to the recent completion of certain significant appraisal contracts. These larger projects are often relatively discretionary in nature compared to smaller projects which tend to occur on a more consistent basis, and the larger projects we recently completed have not been replaced by similar projects. The appraisal services business is driven in part by revaluation cycles in various states and based on our new business pipeline, we expect that appraisal services revenues will remain at historically low levels consistent with the quarter ended September 30, 2005.

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 related revenues for the periods presented as of September 30:

Cost of software license revenues. The main component of our cost of software license revenues is amortization expense for capitalized development costs on certain software products, with third party software costs making up the remaining balance. Once a new product is released, we begin to amortize the costs associated with its development. 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, but not to exceed five years. Development costs consist mainly of personnel costs, such as salary and benefits paid to our developers. Amortization expense for capitalized software products declined from $1.6 million for the three months ended September 30, 2004 to $1.4 million for the three months ended September 30, 2005, because certain software products became fully amortized during 2005, which offset new amortization expense from software products released in 2004. Amortization expense for capitalized software products for the nine months ended September 30, 2005 was flat compared to the corresponding prior year period.

Cost of software services and maintenance revenues. For the three month period ended September 30, 2005 cost of software services and maintenance grew 9% while the related software services and maintenance revenues increased 11% compared to the prior year period. For the nine months ended September 30, 2005 cost of software services and maintenance grew 11% while the related software services and maintenance revenues increased 8% compared to the prior year period. Cost of software services and maintenance primarily consists of expenses such as personnel costs related to installation of our software, conversion of customer data, training customer personnel and support activities. For the nine months ended September 30, 2005, costs increased at a faster rate than related software services and maintenance revenues for the same period, which reflects lower utilization of personnel in our appraisal and tax software division, efforts and costs to support our recently released Orion products, a shift in the roles of certain of our development personnel whose costs were capitalized in 2004 to projects that are being expensed in 2005, and higher health care costs.

Cost of appraisal services revenues. The decline in the cost of appraisal services revenues is consistent with lower appraisal services revenues. We often hire temporary employees to assist in appraisal projects whose term of employment generally ends with the projects’ completion. In addition, in the second quarter of 2005 we made significant organizational changes to our appraisal services division. See “Restructuring Charge.”

Gross margin. The overall gross margin for the quarter ended September 30, 2005 was 37.9%, compared to 36.6% in the quarter ended September 30, 2004. This increase was due to slightly lower amortization expense for capitalized software products which became fully amortized in 2005 and a decline in appraisal services as a proportion of total revenues. The overall gross margin for the nine months ended September 30, 2005 was 36.0%, compared to 37.0% for the nine months ended September 30, 2004. This decline in the year-to-date gross margin was due to cost inefficiencies associated with lower appraisal services revenues and efforts and costs to support our recently released Orion products, as well as a shift in the roles of certain of our development personnel whose costs were capitalized in 2004 to projects that are being expensed in 2005.

The following table sets forth a comparison of our selling, general and administrative expenses:

Selling, general and administrative expenses as a percent of revenues were slightly higher for the nine months ended September 30, 2005 compared to the prior year period, mainly due to the level of costs associated with the appraisal and tax business, where revenues have declined. In late April 2005, we made significant organizational changes to areas of our business that were not performing to our expectations in an effort to bring costs in line with expected levels of revenue. See “Restructuring Charge.”

Because of unsatisfactory financial performance early in the fiscal year, we made significant organizational changes to those areas of our business that were not performing to our expectations. Our goal was to bring costs in line with expected levels of revenue while improving the efficiency of our organizational structure to ensure that clients continue to receive superior service.

We currently anticipate that revenues in our appraisal services business are likely to remain at historically low levels in the coming quarters and have reorganized that division to eliminate levels of management and reduce overhead expense. We have also taken actions to reduce headcount and costs in our appraisal and tax software division. These cost reductions were made in the second quarter of 2005. As a result, we reduced headcount in the appraisal services and appraisal and tax software businesses, as well as in the corporate office, by eliminating approximately 120 positions, including management, staff and project-related personnel. Additionally we have made changes in both management personnel and organizational structures at those business units and have reorganized our corporate structure to consolidate certain senior management positions.

In connection with the reorganization, we incurred certain charges in the second quarter of 2005. Those charges, which are primarily comprised of employee severance costs and related fringe benefits totaled approximately $1.3 million before income taxes. The related payments were substantially paid during the quarter ended June 30, 2005, with the remainder paid during the quarter ended September 30, 2005.

The following table sets forth a comparison of amortization of acquisition intangibles:

Amortization expense of acquisition intangibles declined due to certain intangible assets recorded for previous acquisitions which became fully amortized in 2004. Acquisition intangibles are comprised of the excess of the purchase price over the fair value of net tangible assets acquired, which is allocated to acquired and amortizable software, customer base and trade name, with the remainder allocated to goodwill that is not subject to amortization.

In May 2005, we sold certain assets of our appraisal and tax software division for $75,000 in cash plus future contingent consideration. Proceeds consisted of $75,000 cash at closing and sixteen quarterly payments of $25,000, which are subject to reduction in the event of customer contract losses. Because the collection of the remaining proceeds is highly dependent upon future operations of the buyer and due to certain capitalization characteristics of the buyer, we are unable to estimate the degree of recoverability and we are recording the value of the contingent payments as cash is received. We recorded a gain on sale of $62,000 during the quarter ended June 30, 2005 and an additional gain of $23,000 in the quarter ended September 30, 2005 upon receipt of cash.

The following table sets forth a comparison of our income tax provision:

The effective income tax rates for the nine months ended September 30, 2005 and 2004 were different from the statutory United States federal income tax rate of 35% primarily due to the state income taxes and non-deductible meals and entertainment costs. During the third quarter of 2005, we lowered our estimated annual effective income tax rate from 41.3% that was initially used for the six months ended June 30, 2005 to 40.5%. The reduction in the effective income tax rate reflects a corporate reorganization in 2005 which favorably impacted our state income tax provision, lower estimated non-deductible meals and entertainment costs and higher estimated tax-free interest income.

The following table sets forth a comparison of our net income, earnings per diluted share, and diluted weighted average shares outstanding:

FINANCIAL CONDITION AND LIQUIDITY

As of September 30, 2005, our balance in cash and cash equivalents was $16.0 million and we had short-term investments of $10.7 million, compared to cash and cash equivalents of $12.6 million and short-term investments of $13.8 million at December 31, 2004. Cash provided by operating activities was $16.7 million in the nine months ended September 30, 2005 compared to $18.6 million for the same period in 2004. The decline in cash provided by operating activities is attributable primarily to lower net earnings, including the restructuring charge. Cash from operations in the prior year period included substantial collections of accounts receivable primarily due to the completion of two large appraisal contracts. Cash provided from operations in both years is strong primarily due to continued strong collections of receivables, specifically those related to maintenance contracts. At September 30, 2005, our days sales outstanding (“DSO”) were 86 days compared to DSO of 92 days at December 31, 2004. DSO decreased compared to the fourth quarter because of annual maintenance billing collections. Our maintenance billings typically peak in December and June each year and are followed by collections in the subsequent quarter. DSO is calculated based on accounts receivable divided by the quotient of annualized quarterly revenues divided by 360 days.

Investing activities provided cash of $1.0 million in the nine months ended September 30, 2005 compared to $10.7 million used for investing activities for the same period in 2004. In both years investing activities were primarily comprised of changes in short term investments and investments in software development and property and equipment, while 2004 also included certain post closing acquisition payments. The increase in cash provided from investing activities was due to a small liquidation of short term investments and lower investments in software development costs because we completed development of a major appraisal and tax product, as well as an enhancement to certain financial products, in 2004. The other expenditures related to computer equipment and expansions to support internal growth. Capital expenditures were funded from cash generated from operations.

On February 11, 2005, we entered into a new revolving bank credit agreement. The credit agreement 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%. As of September 30, 2005, our effective interest rate was 5.4%. The credit agreement is secured by substantially all of our personal property and contains covenants that require us to maintain certain financial ratios and other financial conditions and prohibits us from making certain investments, advances, cash dividends or loans and limits the amount of Tyler common stock we can repurchase. As of September 30, 2005, we are in compliance with those covenants. The credit agreement also includes a $10.0 million Letter of Credit facility under which the banks will issue cash collateralized letters of credit.

At September 30, 2005, we had no outstanding borrowings under the credit agreement and our bank had issued letters of credit totaling $4.8 million to secure surety bonds required by some of our customer contracts. All of the outstanding letters of credit were collateralized with a certificate of deposit; thus, we had available credit of $30.0 million under the credit agreement.

Financing activities used cash of $14.2 million in the nine months ended September 30, 2005 compared to $5.5 million used for financing activities for the same period in 2004. Cash used in financing activities was primarily comprised of purchases of treasury shares, net of proceeds from stock option exercises and employee stock plan purchases.

As of September 30, 2005 we have board authorization to repurchase up to 340,000 additional shares of Tyler common stock. On October 25, 2005 our board of directors authorized the repurchase of up to an additional 2.0 million shares of Tyler common stock. In October 2005, we repurchased approximately 143,000 shares of Tyler common stock resulting in a total authorization of $2.2 million as of October 25, 2005. A summary of the repurchase activity during the nine months ended September 30, 2005 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, October 2004, and October 2005. 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. Our credit agreement includes covenants which limit repurchases of our common stock to $20.0 million in any trailing twelve month period beginning after February 11, 2005.

We made federal and state income tax payments, net of refunds, of $5.9 million in the nine months ended September 30, 2005, compared to $5.5 million in the comparable prior year.

Pursuant to our purchase agreement with Eden Systems, Inc (“Eden”), two of the shareholders of Eden were granted the right to “put” their remaining shares to Tyler and we were granted the right to “call” the remaining shares. In January 2004, we purchased 500 shares for $145,000 and paid $221,000 in other post closing settlement adjustments. In July 2004, we purchased the remaining 2,000 shares for a cash purchase price of $580,000.

From time to time we engage in discussions with potential acquisition candidates. In order to consummate any 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.

We have no outstanding debt at September 30, 2005, and are therefore not subject to any interest rate risk.

We maintain disclosure controls and procedures designed to ensure that we are able to collect the information we are required to disclose in the reports we file with the SEC, and to process, summarize and disclose this information within the time periods specified in the rules of the SEC. Based on an evaluation of our disclosure controls and procedures as of the end of the period covered by this report conducted by our management, with the participation of the Chief Executive and the Chief Financial

Officer, the Chief Executive and Chief Financial Officer believe that these controls and procedures are effective to ensure that we are able to collect, process and disclose the information we are required to disclose in the reports we file with the SEC within the required time periods.

On September 9, 2005, Affiliated Computer Services, Inc. (“ACS”) filed litigation in Dallas County, Texas against thirty-three defendants, including Tyler and John M. Yeaman, our Chairman of the Board. The other named defendants include entities affiliated with William D. Oates (“Oates”), a former director of ours, and certain individuals employed by such entities. The lawsuit alleges, among other things, that we breached the non-competition and non-solicitation covenants set forth in the Stock Purchase Agreement dated December 29, 2000 (the “SPA”) between ACS and us pursuant to which we sold to ACS for cash all of the issued and outstanding capital stock of Business Resources Corporation (“BRC”), which comprised a significant portion of our then existing property records business. In the SPA, we agreed to certain five-year non-competition and non-solicitation covenants, which are due to expire on December 29, 2005. In addition, the SPA contained a closing condition pursuant to which Oates agreed to amend his then existing three-year non-competition and non-solicitation covenants so that the restricted activities would conform to the language of our restricted activities, which covenants would expire on December 29, 2003. The lawsuit alleges that Oates (or entities owned by Oates) solicited ACS employees and re-entered the land records business after the expiration of his three-year covenants, but prior to the expiration of our five-year covenants, and further alleges that we, through our non-competition covenants, are legally responsible for Oates’ actions. The lawsuit further alleges that Oates “controlled Tyler”, “manipulated Tyler”, and was a “legal representative” of ours for a significant, but unspecified, period of time following the sale of BRC, even though Oates has not been a member of our board since 2001, has not been employed by us since the sale of BRC, has had limited contact with our management since the sale of BRC, and to our knowledge, has not owned any stock in us since May 2003. The lawsuit further alleges that we fraudulently induced ACS to enter into the SPA because we allegedly knew that Oates (or entities owned by Oates) would re-enter the land records business after three years, even though the SPA specifically contained different covenants with respect to Oates and us.

We vehemently deny all allegations contained in the lawsuit. Management believes that we have not breached any non-competition covenants, have not solicited ACS employees, and have not misappropriated ACS confidential information. Management further believes that the “factual” allegations made against us are false and inaccurate and that the legal theories asserted by ACS are without merit. We have filed counterclaims against ACS, including claims for business disparagement and defamation, alleging that ACS has published factually inaccurate and defamatory statements about us to third parties, including our customers and prospective customers, with malice and/or negligence regarding the truth of those statements. We intend to defend the lawsuit vigorously. The future costs associated with such defense and in pursuit of the counterclaims are uncertain and difficult to predict and may be material.

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