Tyler Technologies
Annual Report 2007

Plain-text annual report

On Track Tyler Technologies 2007 Annual Report 2007 Annual Report 00:01 Every day, Tyler Technologies helps local governments more efficiently manage the many facets of their operations. With a broad line of software solutions and over 7,000 installations across North America, we have a distinct advantage in an opportunity-rich market. In fact, we know of no other software company that has a broader presence in the local government market. And with a best-ever performance in 2007, it’s clear that Tyler is right on track. 00:02 Tyler Technologies Maintaining Our Velocity To Our Shareholders: In 2007, Tyler Technologies posted our best operating results ever as a software company, surpassing a record-setting performance in 2006. Ending 2007, our numbers were the highest yet in terms of revenues, operating income, and free cash flow, even as we invested heavily for the future through product development. We also ended 2007 with an all-time high in backlog of signed business at $250 million. We attribute much of our success to the dedication of our employees — a team that now totals more than 1,700 professionals with a deep understanding of both technological innovation and the inner workings of local governments. This knowledge, coupled with our singular focus, broad solutions portfolio, and proven growth strategies, continued to set Tyler apart in 2007. Another Record Year With 27 consecutive quarters of profitability, Tyler marked our most successful year yet by virtually every financial measure. We ended 2007 with our best quarterly results ever in terms of total revenue, license revenue, and operating income in the fourth quarter. For the year, we showed revenue growth of 13 percent over 2006 and operating income of $26.8 million, up 23 percent over the previous year. Our free cash flow hit $30 million, an increase of 35 percent over 2006. Thanks to this consistently strong cash flow, we are well positioned to invest in future growth through product development, acquisitions and stock repurchases. In 2007, we invested a portion of our free cash flow to buy back $14 million of our stock and used $9 million of cash for acquisitions. Our overall software license revenue was off 6 percent from 2006, in part because of an increase in the number and size of customers selecting our subscription-based options, rather than purchasing the software under a perpetual license. Although these software-as-a-service John S. Marr, Jr. President and Chief Executive Officer John M. Yeaman Chairman of the Board 2007 Annual Report 00:03 In 2007, Tyler Technologies far surpassed our record-setting 2006 performance. We ended 2007 with all-time-high revenue, operating income, and free cash flow. We signed new business at a faster pace, ending the year with a $250 million backlog of signed business, up more than 21 percent over last year. By virtually every financial measure, 2007 was our best year yet — illustrating that we are, indeed, right on track. Total Annual Revenues in millions 172.3 170.5 145.5 219.8 195.3 2003 2004 2005 2006 2007 Annual Revenue Free Cash Flow in millions 30.3 (SaaS) revenues accounted for less than five percent of our total, they represented the fastest growing component of revenue — up 43 percent in 2007. While Tyler’s gross margin improved sequentially each quarter, gross margin for the year was basically flat with 2006. Several factors contributed to this, including our revenue mix, as well as significant additions to our development and implementation staff to help deliver Free Cash our growing backlog of business, which increased faster than revenues in 2007. 22.5 18.5 A Proven Strategy Backlog Backlog Annual Revenue Free Cash 2003 2004 2005 2006 2007 14.0 15.3 Backlog in millions 165.4 139.3 142.2 250.1 205.9 2003 2004 2005 2006 2007 Backlog In 2007, Tyler bolstered the strong foundation we had established in recent years. We consistently executed on four key growth strategies: expanding geographically, broadening our product offerings, securing larger opportunities, and cross-selling our solutions. Building on our success in 2006, Tyler’s strong showing in 2007 once again illustrated that we are maintaining the right pace for sustainable growth. Contributing to this growth was the ongoing success of our Odyssey Courts and Justice solution. In fact, in 2007 license revenues from our Courts and Justice solutions were up 26 percent over 2006. We now have four statewide contracts for Odyssey, as well as contracts with some of the largest counties in the nation. Total revenues from our Financial Management and Education solutions also grew in line with our overall growth rate, even as we experienced increased adoption of our subscription-based SaaS model. Acquisitions supplemented our internal growth strategy in 2007 as we added two companies that expand our presence in the education market. Early in the year, we acquired Advanced Data Systems, which provides financial management solutions for some 300 clients, primarily New England school districts. In September, we acquired EDP Enterprises, which provides financial and student information management systems for approximately 80 public school districts in Texas. Early in 2008, we have already completed two promising acquisitions to complement our existing solutions for the education market. These include Schoolmaster, a student information solution that is used in more than 1,900 schools in 40 states, and VersaTrans, which provides transportation management solutions to 1,300 school districts across the U.S. and Canada. Annual Revenue Free Cash 00:04 Tyler Technologies 2007 Annual Report 00:05 A Solid Investment At Tyler, we are always looking for ways to deliver the best return on our shareholders’ investments. We believe our solid performance in 2007 provides us the momentum to continue building on this growth throughout 2008. A strong indicator of our overall performance, Tyler’s free cash flow of $30 million exceeded GAAP net income by more than 73 percent. This gives us the flexibility to invest aggressively in our products and strategically supplement organic growth with acquisitions, as well as return cash to shareholders through our ongoing stock repurchase program. Looking to 2008 and beyond, we expect to continue seeking out and acting upon acquisition opportunities that broaden our Diluted Annual EPS– Continuing Operations 0.42 Dollars 0.34 0.22 0.23 0.19 product offering, while growing our customer base across the markets we serve. We believe Tyler’s joint development partnership with Microsoft also provides considerable long-term growth potential. We are accelerating R&D spending on our development of public sector functionality for Microsoft’s Dynamics AX business management solution. Beginning in 2010, we anticipate this partnership will enable us to generate incremental revenues from new channels, including federal and international markets, while continuing to expand our presence in our traditional markets. A Bright Future As we close 2007 and look to the future, Tyler is poised to play an even more significant role in helping local governments streamline the many aspects of their financial management, education, courts, tax, public safety, citizen services, and document management systems. We are making considerable investments in new products which we believe have great potential in the years to come. With a broad portfolio of feature-rich solutions, deep domain expertise, and exceptional customer service, Tyler is ready to capitalize on a large and growing local government market. We believe the coming year will be one of continued growth as we consistently execute our strategy and tap new opportunities. 2004 2005b 2003a (a) excludes gain on sale of investment of $0.36 (b) includes restructuring charge of $0.02 (c) includes non-cash stock compensation 2006c 2007c expense of $0.04 in 2006 and $0.05 in 2007 2006–2007 Quarterly EPS Dollars 5 .1 0 2 .1 0 1 .1 0 0 .1 0 9 0 . 0 9 0 . 0 6 0 . 0 5 0 . 0 Q1 Q2 Q3 Q4 2007 2006 John S. Marr, Jr. President and Chief Executive Officer Year after year, Tyler Technologies has proven that “Tyler works” for customers. Our robust portfolio of software solutions is designed to help city, county, and state agencies of all sizes more effectively manage the intricate network of services they deliver — financial, education, pension, courts and justice, public safety, tax and appraisal, citizen services, document management, and land and vital records. 2007 Annual Report 00:07 Gaining Momentum As communities from coast to coast experience growth, it’s become increasingly important for local authorities and agencies to keep pace with citizens’ demands for effective, efficient public services. Whether at the state, county, or city level, Tyler works to help our customers work. Whether courts and justice, tax and appraisal, public safety, financial management, education or document management, our software solutions help local agencies of all sizes better manage the many complex services they deliver. With a history of success and a vision for the future, Tyler Technologies is steadily gaining momentum, year after year. The Tyler Advantage With approximately 3,100 counties, 14,200 school districts, 36,000 cities and towns, and over 35,000 other local government agencies in the United States, the market in which Tyler Technologies competes is not only stable but also clearly ripe with opportunity. In fact, local government annual spending on software and external information technology services is currently estimated at around $13.5 billion and is expected to grow at approximately 6 percent a year through 2011. Although we believe Tyler has the largest customer base of any company focused on enterprise software for local governments, we currently have a relatively small market share in this very fragmented market — and there’s clearly room to capture significantly more customers and revenue. Whereas many of our competitors target multiple vertical markets, we serve only local governments, giving us a distinct competitive advantage. This focused approach also means we can devote our attention specifically to the issues and requirements local governments face — developing solutions that grow and adapt with customers as their needs change over time. Through ups and downs of economic cycles, our market has historically been stable. When faced with replacing systems that no longer serve their needs, local governments view purchasing the mission-critical software Tyler delivers as a long-term investment that improves efficiency and provides value. A Commitment to Customers Developing solid, long-term relationships with our customers is a cornerstone of Tyler’s continued success. Our commitment to our customers and the citizens they serve is evident in our high annual customer retention rate of approximately 98 percent. At Tyler, we enjoy the resources and strength of a large company, yet we are agile, flexible software innovators — a combination that helps us to stay a step ahead of our customers’ needs. Tyler’s more than 1,700 employees have extensive knowledge of software innovation and development, as well as a thorough understanding of how public agencies operate. This equates to improved service for our customers — from the types of solutions we design and develop to faster, easier, and more predictable implementations. In 2007, we increased staffing in our software operations by approximately 15 percent, with the majority of that talent devoted to our implementation and development teams. We are excited about the opportunities we have to continue building upon our proven strategy. 00:08 Tyler Technologies At Tyler, our approach is simple: serve only the public sector and provide the most innovative software solutions possible. It is this singular focus and commitment to customers — a promise delivered by our more than 1,700 employees — that has helped us become a market leader. Leading the Pack Operating within a large and growing, but highly fragmented market, Tyler has increasingly taken a leadership role in recent years. Our success has been built upon a simple concept: serve only the public sector and provide it with innovative software solutions that evolve to match their needs. By sharpening our vision over the past few years, we have more clearly identified and executed our core growth strategies — expanding into new geographic areas, continuously expanding our product offerings, securing larger contracts, and cross-selling our solutions. While Tyler is no doubt committed to delivering a strong return on our customers’ and shareholders’ investments, we are equally diligent about ensuring our business operations are as effective as possible. In 2007, for example, we centralized our marketing organization to create a more efficient, targeted approach to marketing, branding and advertising — a strategy that’s helping us stay ahead of the pack. Expanding Geographically Originally, many of Tyler’s products primarily targeted specific geographic areas and customer groups. By unifying and expanding our sales channels and enhancing our marketing activities, we have been successfully expanding into regions where certain products previously had little or no presence. We now offer virtually all of our software solutions nationwide, and in 2007, we continued to build our presence in newer geographies. For example, for our MUNIS financial management solution, we signed our first city in Oregon (City of Hillsboro) and our first client in Minnesota (Blue Earth County), while adding the City of Fairbanks as our second MUNIS customer in Alaska. With our Eagle land and vital records software we entered the Texas market, winning 10 new clients in the state. We also secured our first contracts for that solution in Florida and Wyoming. Enhancing Our Product Offerings While Tyler has a well-established position in the public sector software marketplace, we know that to sustain our leadership we must continually evolve our product offerings. A large part of our development is aimed at improving our existing offerings, regularly giving customers access to new features and functionality and the latest technologies. We will also continue expanding our product offerings through both acquisition and internal development. In 2007, we added new solutions to our product portfolio through acquisitions that further expand our presence in the education market. We acquired EDP Enterprises, which provides financial and student information management systems for schools in Texas, and Advanced Data Systems, a developer of fund accounting solutions, primarily for schools in New England. Tyler also enjoys the added flexibility of having both the financial resources and development expertise to build new solutions in-house. For example, the Tyler Public Safety solution we developed internally for police records management has established a solid presence in small- and mid- sized markets with 113 installations in 11 states. At Tyler, we know that our clients’ needs are as unique as the communities they serve. That is why we have made many of our solutions available on a subscription basis. This software-as-a-service (SaaS) model seamlessly gives customers access to the solutions they require without requiring them to dedicate in-house personnel and equipment to manage the software. Tyler handles all the back-end aspects for them. We now have approximately 90 hosted clients with a 100 percent renewal rate to date. In 2007, subscription-based revenues were our fastest-growing revenue line, increasing almost 43 percent over 2006. In addition to a $6.3 million hosted contract with the Fort Worth Independent School District in Texas, we also signed several other noteworthy SaaS contracts for our MUNIS financial management solution. These included a $3.3 million deal with Richmond, California, a $2.2 million deal with the Village of Schaumburg, Illinois, and a $1.3 million contract with the public schools in Liberty County, Georgia. Revenue Mix 3% 10% 16% 5% 39% 27% Software Licenses Subscriptions Software Services Maintenance Appraisal Services Other 1 31 7 6 2 1 1 196 142 143 32 18 11 30 142 106 8 6 48 115 242 295 63 432 296 177 160 229 117 200 35 14 51 101 45 26 1 47 39 143 34 132 112 191 117 16 1898 54 138 75 36 208 85 8 22 135 1 320 1 1 Installations of Tyler Solutions United States Canada England Puerto Rico and U.S. Virgin Islands 1 00:10 Tyler Technologies 15 Picking Up the Pace Each element of Tyler’s growth strategy has contributed to our solid growth in recent years, and looking to the future, we believe they will continue to offer new avenues. One particularly bright spot is the opportunity to add customers in new markets, while at the same time cross-selling additional solutions to our current customers. With installations in more than 7,000 government offices in all 50 states, Puerto Rico, the U.S. Virgin Islands, Canada, and the United Kingdom, we have established a strong base upon which we plan to continue building. Cross-Selling Our Solutions From development and implementation to training, consulting, and post-implementation support, Tyler understands that our customers want the best possible experience from start to finish. That is why we deliver our solutions to customers directly using our own implementation and consulting professionals, unlike many horizontal software companies that often use third-party integrators. We take our responsibility to customers seriously, recognizing that governments are trusting us to help them deliver mission-critical services for both their employees and local citizens. And as public agencies, they must ensure every resource is allocated wisely. Tyler’s dedication to our customers is evidenced by our exceptional annual retention rate of approximately 98 percent. Thanks to this high level of satisfaction, our customers provide a stable stream of recurring revenues, including maintenance and support renewals, as well as requirements for additional services, such as consulting and training. Increasingly, many of our current customers are turning to Tyler for additional solutions that address other important business functions. In 2007, the Orange County, Florida, Clerk of Courts, which was already a MUNIS financial system client, signed a $5 million contract for our Odyssey courts software. Also during the year, Orange County signed a $1 million deal for our Eagle land records management solution. We secured a number of other arrangements with clients who purchased multiple Tyler software solutions at the same time. Onslow County, North Carolina, for example, bought our MUNIS financial management and iasWorld assessment solutions together in a $1.3 million deal. We believe the education market will provide additional opportunities for cross-selling and multi- suite packages, particularly as our newer products continue to mature. In addition to providing robust financial management solutions for K-12 schools, we 15 1 31 7 6 2 1 1 196 142 143 32 18 11 30 142 106 34 132 6 48 115 112 75 36 208 1 320 432 296 191 177 160 229 117 200 35 14 51 101 45 47 39 143 22 135 85 8 26 1 1 8 242 295 63 117 16 1898 54 Installations of Tyler Solutions United States Canada England Puerto Rico and U.S. Virgin Islands 138 1 1 Tyler’s four key growth strategies were the foundation to our solid growth in 2007 — expanding into new geographic areas, broadening our lineup of products, securing larger opportunities, and cross-selling our solutions to our existing customer base. We will continue building upon these strategies during 2008. can now help school districts address their student information management, grading, scheduling, attendance, and transportation management needs. Over the course of the last year, we added multiple school districts as clients. We secured key deals for our Tyler Education Management Solution in the Tucson, Arizona, Unified School District and Russell County Public Schools of Lebanon, Virginia. Six major school districts in Texas, as well as districts in Park City, Utah, and Bakersfield, California, adopted our MUNIS financial management software. At Tyler, we know it can be quite demanding, both financially and in demands on IT personnel, for local governments to upgrade or replace outdated systems. Building on our established reputation among our customers, we seek to be a trusted one-source partner — connecting agencies to our neighborhood of innovative solutions that address their needs today and well into the future. 00:12 Tyler Technologies A Proven Track Record Regardless of how large or small, all local governments want to ensure their software investments provide long-term value. Over the years, Tyler has developed a strong reputation for not only delivering highly functional, flexible solutions, but also for completing implementations on time and on budget. While we have historically focused on serving the needs of the large number of small and mid-sized cities and counties, we are increasingly building a wider presence in larger governments as well. Securing Larger Opportunities Thanks to the leverage in Tyler’s operating model, larger opportunities provide considerable revenue and margin expansion potential. Investing in current technology is a key to staying competitive at the higher end of the market. With approximately 450 developers, we devote substantial resources to creating new products and enhancing existing ones — adding updated features and functionality and incorporating new technologies. Tyler has been particularly successful selling our Odyssey Courts and Justice solution in larger markets, as it is now used in eight of the 35 largest counties nationwide and in four statewide implementations. In 2007, we secured an $11 million Odyssey deal with the State of Indiana, a $6 million agreement with State of New Mexico, and a $5 million contract with Orange County, Florida. We also added six new counties as Odyssey customers in Texas, some as part of the $12.4 million license agreement we signed in 2006 with the Texas Conference of Urban Counties — a consortium of the 34 largest counties in the state. Our Appraisal and Tax division continues to show steady performance, consistently achieving profitability goals. In 2007, we secured a $12 million property revaluation project with the Parish of Orleans, Louisiana, and expanded our existing relationship with Nassau County, New York, with a $5 million contract for our iasWorld tax software. We’ve signed sizeable deals for our MUNIS financial management product, including At Tyler, we know that no matter how large or small, all local governments want to ensure their technology investments provide value over the long term. We are proud of the solid reputation we have developed delivering software solutions that are as rich in features and easy to use as they are customizable and scalable. contracts with Tulsa County, Oklahoma, and the cities of Newport News, Virginia, and Hartford, Connecticut. Our EDEN financial management solution is also well positioned, adding South San Francisco and Alhambra, California, and the cities of Palm Beach and Ocala in Florida as clients in 2007. Moving forward, it’s clear that Tyler’s proven track record of success in larger implementations is helping us build a strong foundation for the future. We are already off to a great start in early 2008, as we signed our single largest software contract ever in January — a $15.1 million deal with the State of Tennessee for our iasWorld property tax solution. With our proven industry experience and a rich history of innovation, we are confident in our ability to generate future revenue by increasing our presence in “Tier 1” markets. 00:14 Tyler Technologies Moving Forward Based on our strong performance in 2006 followed by another record-setting year in 2007, Tyler Technologies is proving that we are, indeed, moving forward. We notched our best year ever in many categories, including revenues, operating income, and free cash flow. Yet for us, the real measure of Tyler’s success is the value we deliver every day — to our customers, shareholders, and employees. In 2007, we continued to seek out and capitalize on the types of opportunities that would drive revenue and improve our position as a market leader. Our financial agility, supported by our strong free cash flow, positioned us to invest in future growth, through both internal development and acquisitions. These helped strengthen our product portfolio while enabling us to broaden our customer base in the education market. Following this proven avenue to growth, we believe we are right on track for another successful year. Looking Ahead At Tyler, we have taken a focused, steady approach to growth. And based on our outstanding performance 2007, we are confident this model will once again deliver progress toward our long-term objectives. While our financial performance is no doubt an important measure of our success, so too is the Tyler’s strong financial performance in 2007 is a clear indicator we’re moving forward. Yet for us, the real measure of our success is the value we deliver every day — to our customers, shareholders, and employees. We will continue to seek out the types of opportunities that provide sustainable growth for the future. fact that our customers are enthusiastic about the solutions and services we deliver. Closing out 2007, Tyler finished with our highest backlog of signed contracts ever, with more than $250 million in the queue at year end. With our high visibility and a generally stable, healthy market, we have reason to be very positive about the future of Tyler. As we move into 2008, we will draw upon Tyler’s satisfied customer base to grow our distribution channels and expand the reach of our portfolio of products. We will also continue making significant investments in research and development, such as our ongoing investment in Microsoft Dynamics AX — a solution we are jointly developing with Microsoft for the public sector that we believe holds significant long- term opportunity to penetrate new markets. Just as it makes sense for our customers to partner with Tyler rather than develop custom solutions, we realize that broadening Tyler’s offerings through acquisition also offers significant advantages. Therefore, we will continue to look to acquire companies that help us broaden our product line, enhance our technologies, expand the markets we serve, and drive new revenue. Looking ahead, we believe our subscription- based model offers exceptional growth potential and a great value proposition for customers not wanting, or able, to make upfront investments in technology and/or IT personnel. While we have no plans to fundamentally change our business model in the near term, we believe this evolutionary shift toward even greater recurring revenues will help drive long- term margin expansion. Simply put, we believe our strategy is delivering the type of value our shareholders and customers seek, while at the same time providing us consistent, profitable growth. Backed by a committed team and a robust suite of innovative software solutions, it’s clear that Tyler is on track for an even brighter future. 00:16 Tyler Technologies Tyler Technologies’ 13 percent revenue increase in 2007 once again outpaced the overall market growth rate. Our operating income also increased by 23 percent, net income rose 22 percent, and free cash flow expanded 35 percent. Tyler’s success can be attributed to the unyielding dedication of our more than 1,700 employees and a clear vision for success that consistently delivers value to our shareholders and our customers. The following financials highlight the details that shaped our performance over the last year. Performance Graph 2007 Annual Report 00:19 Performance GraPh The following table compares total Shareholder returns for Tyler over the last five years to the Standard and Poor’s 500 Stock Index and the Standard and Poor’s 600 Information Technology Index assuming a $100 investment made on December 31, 2002. Each of the three measures of cumulative total return assumes reinvestment of dividends. The stock performance shown on the graph below is not necessarily indicative of future price performance. comparison of cumulative five Year Total return $400 $300 $200 $100 $0 2002 100 100 100 2003 230.94 128.68 153.87 2004 200.48 142.69 164.09 2005 210.55 149.70 163.70 2006 337.17 173.34 179.13 2007 309.11 182.86 195.80 Tyler S&P 500 Index S&P 600 Index 00:20 Tyler Technologies Stock Market Data Our common stock is traded on the New York Stock Exchange under the symbol “TYL.” At December 31, 2007, we had approximately 2,150 stockholders of record. A number of our stockholders hold their shares in street name; therefore, there are substantially more than 2,150 beneficial owners of our common stock. The following table shows, 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. 2006: First Quarter Second Quarter Third Quarter Fourth Quarter 2007: First Quarter Second Quarter Third Quarter Fourth Quarter hiGh Low $ 11.00 11.50 13.36 14.99 $ 14.93 13.28 15.74 16.20 $ 8.40 9.80 10.27 12.41 $ 12.03 11.70 11.39 12.81 We did not pay any cash dividends in 2007 or 2006. 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. During 2007, we purchased approximately 1.3 million shares of our common stock for an aggregate purchase price of $16.2 million. Our 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, October 2005 and May 2007. On May 17, 2007, our board of directors authorized the repurchase of an additional 2.0 million shares. As of December 31, 2007, we had remaining authorization to repurchase up to 1.8 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. Selected Financial Data 2007 Annual Report 00:21 SeLecTeD financiaL DaTa (in ThouSanDS, excePT Per Share DaTa) 2007 2006 2005 2004 2003 for The YearS enDeD DecemBer 31, STaTemenT of oPeraTionS DaTa (1): Revenues Costs and expenses: Cost of revenues (2) Selling, general and administrative expenses (2) Research and development expense Restructuring charge Amortization of customer and trade name intangibles Operating income Realized gain on sale of investment in H.T.E., Inc. (3) Other income, net Income from operations before income taxes Income tax provision Income from operations Income from operations per diluted share Weighted average diluted shares STaTemenT of caSh fLowS DaTa: Cash flows provided by operating activities Cash flows (used by) provided by investing activities Cash flows used by financing activities BaLance SheeT DaTa: Total assets Shareholders’ equity $ 219,796 $ 195,303 $ 170,457 $ 172,270 $ 145,454 135,371 51,724 4,443 – 1,478 26,780 – 1,800 28,580 11,079 $ 17,501 0.42 $ 41,352 120,499 108,970 108,432 90,627 48,389 43,821 3,322 – 1,318 2,421 1,260 1,266 21,775 12,719 – 1,080 – 906 42,931 2,520 – 1,267 17,120 37,246 1,144 – 925 15,512 – 23,233 317 339 22,855 13,625 17,437 39,084 8,493 5,432 7,309 13,106 $ 14,362 $ 8,193 $ 10,128 $ 25,978 $ 0.34 $ 0.19 $ 0.23 $ 0.58 41,868 42,075 44,566 45,035 $ 34,111 (34,275) (7,406) $ 26,804 $ 21,187 $ 22,159 $ 22,535 (24,326) 1,820 (5,999) (14,847) (9,914) (9,940) (590) (25,421) $ 241,508 137,211 $ 220,276 $ 194,437 $ 190,487 $ 186,396 125,875 112,197 118,400 117,907 (1) In December 2003, we acquired Eden Systems, Inc. (“Eden”), a provider of financial, personnel and citizen services software for local governments. These results include the results of the operations of Eden from the date of its acquisition. (2) Effective January 1, 2006, we adopted the fair value recognition provisions of Statement of Financial Accounting Standards No. 123R, “Share-Based Payment” using the modified-prospective method. In 2007 and 2006, respectively, cost of revenues included $227,000 and $147,000 share-based compensation expense. Selling, general and administrative expenses in 2007 and 2006, respectively, included $2.1 million and $1.8 million share-based compensation expense. In accordance with the standard, results of operations for the years prior to 2006 are reported under the previous accounting standard and no expense was recorded. (3) 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. 00:22 Tyler Technologies Management’s Discussion And Analysis Of Financial Condition And Results Of Operations forwarD LooKinG STaTemenTS In addition to historical information, this Annual Report 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. 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 subscription-based services such as application service provider arrangements and other hosting services as well as property appraisal outsourcing services for taxing jurisdictions. Our products are generally grouped into four major areas: • Financial Management and Education; • Courts and Justice; • Property Appraisal and Tax; and • Document Management. We monitor and analyze several key performance indicators in order to manage our business and evaluate our financial and operating performance. These indicators include the following: • revenues—We derive our revenues from five primary sources: sale of software licenses; subscription-based services; software services; appraisal services; and maintenance and support. Because the majority of the software we sell is “off-the-shelf,” increased sales of software products generally result in incrementally higher gross margins. Thus, the most significant driver to our business is the number and size of software license sales. In addition, new software license sales generally generate implementation services revenues as well as future maintenance and support revenues, which we view as a recurring revenue source. We also monitor our customer base and churn since our maintenance and support revenue should increase due to our historically low customer turnover. • cost of revenues and Gross margins—Our primary cost component is personnel expenses in connection with providing software implementation, subscription-based services and appraisal services to our customers. We can improve gross margins by controlling headcount and related costs and by expanding our revenue base, especially from those products and services that produce incremental revenue with minimal incremental cost, such as software licenses, subscription- based services, and maintenance and support. Our appraisal projects are seasonal in nature, and we often employ appraisal personnel on a short-term basis to coincide with the life of a project. As of December 31, 2007, our total full-time equivalent employee count increased to 1,627 from 1,513 at December 31, 2006. The majority of these additions were to our implementation and support staff, including additions to our capacity to deliver our backlog, particularly for our Odyssey courts and justice solutions. Our implementation and support staff at December 31, 2007 includes 73 full-time equivalent employees added as a result of two acquisitions completed in 2007. Management’s Discussion And Analysis Of Financial Condition And Results Of Operations 2007 Annual Report 00:23 • Selling, General and administrative (“SG&a”) expenses—The primary components of SG&A expense are administrative and sales personnel salaries and commissions, marketing expense, rent and professional fees. Sales commissions generally fluctuate with revenues but other administrative expenses tend to grow at a slower rate than revenues. • Liquidity and cash flows—The primary driver of our cash flows is net income. Uses of cash include acquisitions, capital investments in software development and property and equipment and the discretionary purchases of treasury stock. During 2007 we used cash of $9.0 million to acquire two companies and miscellaneous other software assets. In 2007, we also purchased 1.3 million shares of our common stock at an aggregate purchase price of $16.2 million. Our working capital needs are fairly stable throughout the year with the significant components of cash outflows being payment of personnel expenses offset by cash inflows representing collection of accounts receivable and cash receipts from customers in advance of revenue being earned. • Balance Sheet—Cash, accounts receivable and days sales outstanding and deferred revenue balances are important indicators of our business. 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, cost 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. 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, determination of share-based compensation expense and valuation allowance for receivables. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies 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 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 Securities and Exchange Commission 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 Issue Task Force (“EITF”) No. 00-21, “Revenue Arrangements with Multiple Deliverables.” Our revenues are derived from sales of software licenses, subscription-based services, 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 and sales adjustments, which are provided at the time the revenue is recognized. Because most of our customers are governmental entities, we rarely incur a loss resulting from the inability of a customer to make required payments. In a limited number of cases, we encounter a customer who is dissatisfied with some aspect of the software product or our service, and we may offer a “concession” to such customer. In those limited situations where we grant a concession, we rarely reduce the contract arrangement fee, but alternatively may perform additional services, such as 00:24 Tyler Technologies Management’s Discussion And Analysis Of Financial Condition And Results Of Operations additional training or programming a minor feature the customer had in their prior software solution. These amounts have historically been considered nominal. In connection with our customer contracts and the adequacy of related allowances and measures of progress towards contract completion, our project managers are charged with the responsibility to continually review the status of each customer on a specific contract basis. Also, we review, on at least a quarterly basis, significant past due accounts receivable and the adequacy of related reserves. Events or changes in circumstances that indicate that the carrying amount for the allowances for doubtful accounts and sales adjustments may require revision, include, but are not limited to, deterioration of a customer’s financial condition, failure to manage our customer’s expectations regarding the scope of the services to be delivered, and defects or errors in new versions or enhancements of our software products. For those software arrangements that involve significant production, modification or customization of the software, which is considered essential to its functionality, and for substantially all property appraisal outsourcing projects, we recognize revenue and profit as the work progresses using the 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, and apply the provisions of SOP No. 81-1 “Accounting for Performance of Construction—Type and Certain Production—Type Contracts” for those software arrangements that involve significant production, modification or customization of the software, or where our software services are otherwise considered essential to the functionality of the software. In addition, we recognize revenue using the proportionate performance method of revenue recognition for our property 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. For subscription-based services such as application service provider arrangements and other hosting arrangements, we evaluate whether each of the elements in these arrangements represents a separate unit of accounting, as defined by EITF 00-21, using all applicable facts and circumstances, including whether (i) we sell or could readily sell the element unaccompanied by the other elements, (ii) the element has stand-alone value to the customer, (iii) there is objective reliable evidence of the fair value of the undelivered item, and (iv) there is a general right of return. We consider the applicability of EITF No. 00-03, “Application of SOP 97-2 to Arrangements That Include the Right to Use Software Stored on Another Entity’s Hardware” on a contract-by-contract basis. In hosted term-based agreements, where the customer does not have the contractual right to take possession of the software, hosting fees are recognized on a monthly basis over the term of the contract commencing when the customer has access to the software. For professional services associated with hosting arrangements that we determine do not have stand-alone value to the customer, we recognize the services revenue ratably over the remaining contractual period once hosting has gone live and we may begin billing for the hosting services. We record amounts that have been invoiced in accounts receivable and in deferred revenue or revenues, depending on whether the revenue recognition criteria have been met. In connection with certain of our contracts, we have recorded retentions receivable or unbilled receivables consisting of costs and estimated profit in excess of billings as of the balance sheet date. Many of the contracts which give rise to unbilled receivables at a given balance sheet date are subject to billings in the subsequent accounting period. 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, Management’s Discussion And Analysis Of Financial Condition And Results Of Operations 2007 Annual Report 00:25 we have a sizable amount of deferred revenue which represents billings in excess of revenue earned. The majority of this liability consists of maintenance billings for which payments are made in advance and the revenue is ratably earned over the maintenance period, generally one year. We also have deferred revenue for those contracts in which we receive a deposit and the conditions in which to record revenue for the service or product has not been met. On a periodic basis, we review by customer the detail components of our deferred revenue to ensure our accounting remains appropriate. 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. 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. Share-Based compensation. We have a stock option plan that provides for the grant of stock options to key employees, directors and non-employee consultants. Prior to January 1, 2006, we accounted for share-based compensation utilizing the intrinsic value method in accordance with the provisions of Accounting Principles Board Opinion (“APB”) No. 25, “Accounting for Stock Issued to Employees,” and related Interpretations. Accordingly, no compensation expense was recorded because the exercise prices of the stock options equaled the market prices of the underlying stock on the dates of grants. Effective January 1, 2006, we adopted the provisions of Statement of Financial Accounting Standards (“ SFAS”) No. 123R, “Share-Based Payment,” which establishes accounting for share-based awards exchanged for employee services, using the modified prospective application transition method. Subsequently, we recorded compensation expense in our statement of operations over the service period that the awards are expected to vest. We estimate the fair value of share-based awards on the date of grant using the Black-Scholes option valuation model. Share-based compensation expense includes the estimated effects of forfeitures, which will be adjusted over the requisite service period to the extent actual forfeitures differ, or are expected to differ from such estimates. Changes in estimated forfeitures are recognized in the period of change and will also impact the amount of expense to be recognized in future periods. Forfeiture rate assumptions are derived from historical data. We estimate stock price volatility at the date of grant based on the historical volatility of our common stock. Estimated option life is determined using the “simplified method” in accordance with Staff Accounting Bulletin No. 107. Determining the appropriate fair-value model and calculating the fair value of share-based awards at the grant date requires considerable judgment, including estimating stock price volatility, expected option life and forfeiture rates. 00:26 Tyler Technologies Management’s Discussion And Analysis Of Financial Condition And Results Of Operations 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, 2007, 2006 and 2005. 2007 Compared to 2006 revenues The following table sets forth a comparison of the key components of our revenues for the following years ended December 31: ($ in ThouSanDS) Software licenses Subscriptions Software services Maintenance Appraisal services Hardware and other Total revenues 2007 $ 35,063 10,406 60,283 85,411 21,318 7,315 $ 219,796 % of total 16% 5 27 39 10 3 100% 2006 % of total Change $ % $ 37,247 19% $ (2,184) (6)% 7,298 50,861 73,413 19,755 6,729 4 26 38 10 3 3,108 9,422 11,998 1,563 586 43 19 16 8 9 $ 195,303 100% $ 24,493 13% Software licenses. Software license revenues consist of the following components for the following years ended December 31: ($ in ThouSanDS) Financial management and education Courts and justice Appraisal and tax and other Total revenues 2007 $ 24,988 5,987 4,088 $ 35,063 % of total 71% 17 12 100% 2006 % of total Change $ % $ 27,292 73% $ (2,304) (8)% 4,756 5,199 13 14 1,231 26 (1,111) (21) $ 37,247 100% $ (2,184) (6)% In 2007 we signed 86 material new contracts with average software license fees of approximately $434,000, compared to 78 material new contracts signed in 2006 with average software license fees of approximately $326,000. We consider contracts with a license fee component of $100,000 or more to be material. Although a contract is signed in a particular year, the year in which the revenue is recognized may be different because we recognize revenue according to our revenue recognition policy as described in Note 1 in the Consolidated Financial Statements. Changes in software license revenues consist of the following components: • Software license revenue related to our financial management and education solutions for 2007 decreased 8% compared to the prior year. Over half the decline was due to product mix in 2007 that required less third party software. A portion of the remaining decline was mainly due to a number of customers in 2007 choosing our subscription-based options, rather than purchasing the software under a traditional perpetual software license arrangement. Although these customers represented a relatively small percentage of new customers, the size of those contracts was larger than in the prior year. Subscription-based arrangements result in lower software license revenues in the initial year as compared to traditional perpetual software license arrangement but generate higher overall subscription-based services revenue over the term of the contract. Management’s Discussion And Analysis Of Financial Condition And Results Of Operations 2007 Annual Report 00:27 • Software license revenue related to our courts and justice software solutions increased 26% for 2007 compared to the prior year. In the fourth quarter of 2007 we recorded software license revenue of approximately $1.3 million from a contract which had been deferred in accordance with the terms of the contract. • Appraisal and tax and other software license declined 21% in 2007 compared to the prior year primarily due to the deferral of software license revenue on a customer arrangement pending establishment of a revised timeline for the completion of certain development and implementation services. We currently expect a revised implementation schedule will be established and we will collect the remaining license fees contained in the arrangement. Subscriptions. Subscription-based services revenue primarily consists of revenues derived from application service provider (“ASP”) arrangements and other hosted service offerings, software subscriptions and disaster recovery services. ASP and other software subscriptions agreements are typically for periods of three to six years and automatically renew unless either party cancels the agreement. Disaster recovery and miscellaneous other hosted service agreements are typically renewable annually. New ASP customers provided approximately two-thirds of the subscription revenue increase due to further expansion into existing markets and new markets such as Pennsylvania and Texas. Software services. Changes in software services revenues consist of the following components: • Software services revenue related to financial management and education solutions, which comprises approximately half of our software services revenue in the years presented, experienced modest increases compared to the prior year due to increased contract volume and additions to implementation and training staff which enabled us to deliver our backlog at a faster rate. Excluding the impact of acquisitions we have added approximately 40 people to our financial management and education implementation and training staff over the last twelve months. • Software services revenue related to our courts and justice solutions experienced substantial increases compared to the prior year, reflecting increased contract volume. We had approximately 34 active Odyssey contracts in 2007 compared to approximately 25 active Odyssey contracts in 2006, primarily due to continued expansion in Texas and Florida and a new contract with Indiana. We have added approximately 50 people to our courts and justice implementation and training staff over the last twelve months. • Software services revenue related to appraisal and tax and other solutions, which comprise approximately 25% of our software services revenue in the periods presented, had moderate increases for 2007 compared to the prior year. The majority of the increase is related to one large appraisal and tax software implementation, which was substantially completed by December 31, 2007. The level of appraisal and tax software services revenues for 2008 will depend on our ability to replace the revenues associated with this large implementation. maintenance. We provide maintenance and support services for our software products and third party software. Maintenance revenues increased over the prior year due to growth in our installed customer base and slightly higher maintenance rates on most of our solutions. appraisal services. Appraisal services are project-oriented and are driven in part by revaluation cycles in various states. Appraisal services revenue for 2007 was 8% higher than the prior year period. The increase was due to activity related to Ohio’s revaluation cycle, which occurs every six years, and a $4.0 million contract with Fulton County, Georgia, which began late in 2006. The Ohio revaluation projects began with smaller counties late in the first quarter of 2006 and expanded to larger counties by the third quarter of 2006. A substantial portion of the Ohio revaluation projects was complete by December 31, 2007. We anticipate appraisal services revenues for 2008 will decline moderately compared to 2007 if we are unable to replace the appraisal services revenues associated with the Ohio revaluation. 00:28 Tyler Technologies Management’s Discussion And Analysis Of Financial Condition And Results Of Operations cost of revenues and Gross margins The following table sets forth a comparison of the key components of our cost of revenues and those components stated as a percentage of related revenues for the following years ended December 31: ($ in ThouSanDS) Software licenses Acquired software Software services, maintenance and subscriptions Appraisal services Hardware and other Total cost of revenues 2007 % of related revenues 2006 % of related revenues Change $ % $ 7,953 2,279 104,993 14,467 5,679 $ 135,371 23% 7 67 68 78 62% $ 9,968 27% $ (2,015) (20)% 1,360 90,601 13,563 5,007 4 69 69 74 919 14,392 904 672 68 16 7 13 $ 120,499 62% $ 14,872 12% The following table sets forth a comparison of gross margin percentage by revenue type for the periods presented for the following years ended December 31: GroSS marGin PercenTaGeS Software licenses and acquired software Software services, maintenance and subscriptions Appraisal services Hardware Overall gross margin 2007 2006 Change 69.6% 1.2% 70.8% 32.7 32.1 22.4 31.1 31.3 25.6 38.4% 38.3% 1.6 0.8 (3.2) 0.1% Software license. 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 balance. Once a product is released, we begin to amortize, over the estimated useful life of the product, any capitalized 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, which is generally five years. Development costs consist mainly of personnel costs, such as salary and benefits paid to our developers, and rent for related office space. For 2007 our software license gross margin percentage increased slightly compared to the prior year because our product mix in 2007 included less third party software, which has higher associated costs than proprietary software. The gross margin also benefited from lower amortization expense of software development costs because some products became fully amortized during the first quarter of 2006. Software services, maintenance and subscription-based services. Cost of software services, maintenance and subscriptions primarily consists of personnel costs related to installation of our software, conversion of customer data, training customer personnel and support activities and various other services such as ASP and disaster recovery. For 2007 the software services, maintenance and subscription gross margin percentage increased 1.6% over the prior year because maintenance and various other services such as ASP and disaster recovery costs typically grow at a slower rate than related revenues due to leverage in the utilization of our support and maintenance staff and economies of scale. We have increased our implementation and support staff by 162 full-time equivalent employees since December 31, 2006. This increase includes 73 additional employees related to acquisitions completed in 2007. The remaining additions were to increase our capacity to train and deliver our contract backlog, particularly for our courts and justice solutions. appraisal services. Higher revenues associated with increased activity on the Ohio revaluation projects contributed to the slight appraisal services gross margin percentage increase. Management’s Discussion And Analysis Of Financial Condition And Results Of Operations 2007 Annual Report 00:29 Our blended gross margin for 2007 was flat compared to the prior year due to a revenue mix that included less software license and significant additions to our development and implementation staff to deliver our growing backlog. Software license revenue inherently has higher gross margins than other revenues such as professional services and hardware. Although the revenue mix for 2007 also included less software license than the prior year, the negative impact on the gross margin was offset by lower third party software costs as well as lower amortization expense of software development costs described above. Selling, General and administrative expenses The following table sets forth a comparison of our selling, general and administrative (“SG&A”) expenses for the following years ended December 31: ($ in ThouSanDS) 2007 % of revenues 2006 % of revenues Change $ % Selling, general and administrative expenses $ 51,724 24% $ 48,389 25% $ 3,335 7% SG&A costs grew at a slower rate than revenues in 2007 due to leverage in the utilization of our administrative and sales staff. research and Development expense The following table sets forth a comparison of our research and development expense for the following years ended December 31: ($ in ThouSanDS) Research and development expense 2007 $ 4,443 % of revenues 2% 2006 % of revenues Change $ % $ 3,322 2% $ 1,121 34% For 2007, research and development expense included costs associated with the Microsoft Dynamics AX project, in addition to costs associated with other new product development efforts. In 2007, we reduced our research and development expense by $1.6 million, which was the amount earned under the terms of our strategic alliance with Microsoft. We anticipate these costs and associated reimbursements from Microsoft will continue into 2008; however, the actual amount and timing of those costs and related reimbursements and whether they are capitalized or expensed, may vary. amortization of customer and Trade name intangibles Acquisition intangibles are comprised of the excess of the purchase price over the fair value of net tangible assets acquired that is allocated to acquired software and customer and trade name intangibles. The remaining excess purchase price is allocated to goodwill that is not subject to amortization. Amortization expense related to acquired software is included with cost of revenues while amortization expense of customer and trade name intangibles is recorded as a non-operating expense. The estimated useful lives of both customer and trade name intangibles are 5 to 25 years. The following table sets forth a comparison of amortization of customer and trade name intangibles for the following years ended December 31: ($ in ThouSanDS) 2007 2006 $ % Change Amortization of customer and trade name intangibles $ 1,478 $ 1,318 $ 160 12% 00:30 Tyler Technologies Management’s Discussion And Analysis Of Financial Condition And Results Of Operations Estimated annual amortization expense relating to customer and trade name acquisition intangibles, excluding acquired software for which the amortization expense is recorded as cost of revenues, for the next five years is as follows (in thousands): 2008 2009 2010 2011 2012 other $1,561 1,475 1,475 1,460 1,393 In 2007 interest income is the main component of other income. Other income in 2006 also includes non-usage and other fees associated with a credit agreement we terminated in January 2007 and gains and losses on risk management liabilities and assets associated with a foreign exchange contract. Interest income in 2007 was $1.8 million compared to $1.4 million in 2006. The increase in interest income is due to higher invested cash balances as the result of positive cash flow in 2007. income Tax Provision The following table sets forth a comparison of our income tax provision for the following years ended December 31: ($ in ThouSanDS) Income tax provision Effective income tax rate 2007 2006 $ % Change $ 11,079 $ 8,493 $ 2,586 30% 38.8% 37.2% The effective income tax rates were different from the statutory United States federal income tax rate of 35% primarily due to state income taxes, non-deductible share-based compensation expense, the qualified manufacturing activities deduction, and non-deductible meals and entertainment costs. The effective rate for 2006 was lower than the 2007 effective tax rate mainly due to changes in the Texas franchise tax law and rates enacted in the second quarter of 2006 and favorable state income tax audit results. Slightly more than half of our stock option awards granted qualify as incentive stock options (“ISO”) for income tax purposes. As such, a tax benefit is not recorded at the time the compensation cost related to the options is recorded for book purposes due to the fact that an ISO does not ordinarily result in a tax benefit unless there is a disqualifying disposition. Stock option grants of non-qualified options result in the creation of a deferred tax asset, which is a temporary difference, until the time that the option is exercised. Due to the treatment of incentive stock options for tax purposes, our effective tax rate from year to year is subject to variability. Management’s Discussion And Analysis Of Financial Condition And Results Of Operations 2007 Annual Report 00:31 2006 Compared to 2005 revenues The following table sets forth a comparison of the key components of our revenues for the following years ended December 31: ($ in ThouSanDS) Software licenses Subscriptions Software services Maintenance Appraisal services Hardware and other Total revenues 2006 % of total 2005 % of total Change $ % $ 37,247 19% $ 29,418 17% $ 7,829 27% 7,298 50,861 73,413 19,755 6,729 4 26 38 10 3 5,852 46,233 64,728 18,374 5,852 3 27 38 11 4 1,446 4,628 8,685 1,381 877 25 10 13 8 15 $ 195,303 100% $ 170,457 100% $ 24,846 15% Software licenses. Changes in software license revenues consist of the following components: • Software license revenue related to financial management and education solutions, which comprise approximately 70% of our software license revenues in the years presented, increased significantly compared to the prior year primarily due to growth from geographic expansion and increased success in winning larger contracts. Third party software revenue also increased over the comparable prior year because we sold more financial software modules that utilize third party software. Also, in late 2005 we simplified the implementation process for one of our financial products, which has enabled us to deliver the product more rapidly. • In 2006 software license revenue related to our products other than financial management and education solutions experienced strong increases in the aggregate compared to 2005. Software license revenues from our Odyssey courts and justice products experienced a substantial increase over the prior year as a result of the product maturing following successful early implementations and leveraging our existing customer base. In addition, licenses of our tax and appraisal products and a document management product were much higher than the prior year due to several new Java based product releases and increased appraisal revaluation activity. Our appraisal software license volume varies from period to period dependent upon the special needs and timing of our customers. Local government taxing entities normally reappraise properties from time to time to update values for tax assessment purposes and to maintain equity in the taxing process. While certain of these taxing jurisdictions contract with our appraisal services division to perform the reappraisals, it is not always necessary for the customer to purchase new software in order to process the appraisals. In some cases, a customer may simply add additional appraisal software modules to enhance the functionality of its existing software. Subscriptions. Subscription-based services increased primarily due to new customers for ASP and disaster recovery services as a result of geographic expansion, primarily in the South in the aftermath of hurricane Katrina. Software services. Changes in software services revenues consist of the following components: • Software services revenue related to financial management and education solutions, which comprise more than half of our software service revenue in the years presented, increased significantly in 2006 compared to the prior year reflecting increased contract volume and additions to training staff which enabled us to deliver our backlog at a faster rate. • Software services revenue related to Odyssey courts and justice solutions was up moderately in 2006 compared to 2005 reflecting increased contract volume. Since March 31, 2005, we have increased our presence with Odyssey in Texas, Florida and Michigan and added one contract in Nevada. Odyssey software services revenue did not increase as 00:32 Tyler Technologies Management’s Discussion And Analysis Of Financial Condition And Results Of Operations strongly as Odyssey software license revenue because the prior year included a $1.4 million contract for follow-on services to an existing customer that had previously implemented and accepted the software. • Software services revenue related to our document management solutions experienced strong increases in 2006 due to several new Java based product releases. maintenance. We provide maintenance and support services for our software products and third party software. Maintenance revenues increased due to growth in our installed customer base as evidenced by our software license revenue and slightly higher maintenance rates on most of our product lines. appraisal services. The appraisal services business is driven in part by revaluation cycles in various states. Appraisal services revenue increased over the prior year mainly due to activity related to Ohio’s revaluation cycle, which occurs every six years as well as the addition of new customers. The Ohio revaluation projects began with smaller counties late in the first quarter of 2006 and expanded to larger counties by the third quarter of 2006. cost of revenues and Gross margins The following table sets forth a comparison of the key components of our cost of revenues and those components stated as a percentage of related revenues for the following years ended December 31: ($ in ThouSanDS) Software licenses Acquired software Appraisal services Hardware and other Total cost of revenues Software services, maintenance and subscriptions 90,601 2006 % of related revenues 2005 % of related revenues Change $ % $ 9,968 27% $ 9,087 31% $ 881 10% 1,360 13,563 5,007 4 69 69 74 794 80,614 14,188 4,287 3 69 77 73 566 9,987 (625) 720 71 12 (4) 17 $ 120,499 62% $ 108,970 64% $ 11,529 11% The following table sets forth a comparison of gross margin percentage by revenue type for the periods presented for the following years ended December 31: GroSS marGin PercenTaGeS Software licenses and acquired software Software services, maintenance and subscriptions Appraisal services Hardware Overall gross margin 2006 2005 chanGe 69.6% 66.4% 3.2% 31.1 31.3 25.6 31.0 22.8 26.7 0.1 8.5 (1.1) 38.3% 36.1% 2.2% Software license. Our software license gross margin percentage in 2006 increased due to substantially higher software license revenues and slightly lower amortization expense of software development costs as some products became fully amortized during the first quarter of 2006. Software services, maintenance and subscription-based services. The software services, maintenance and subscriptions gross margin percentage in 2006 was comparable to 2005. The cost of software services, maintenance and subscriptions increased because we added to our implementation and support staff to increase our capacity to support new sales growth and deliver sales backlog. appraisal services. The appraisal services gross margin percentage increased in 2006 compared to 2005 mainly due to significant organizational changes and headcount reductions we made in the second quarter of 2005 to our appraisal Management’s Discussion And Analysis Of Financial Condition And Results Of Operations 2007 Annual Report 00:33 services business to bring costs in line with expected levels of revenue. In addition, margins in 2005 were negatively affected by cost inefficiencies associated with one large contract. The overall gross margin percentage rose mainly due to a revenue mix that included more software license revenues, as well as lower costs as a result of the restructuring of our appraisal services business in the second quarter of 2005. Software license revenue inherently has higher gross margins than other revenues such as services and hardware. Selling, General and administrative expenses The following table sets forth a comparison of our SG&A expenses for the following years ended December 31: ($ in ThouSanDS) 2006 % of revenues 2005 % of revenues Change $ % Selling, general and administrative expenses $ 48,389 25% $ 43,821 26% $ 4,568 10% In 2006 SG&A includes $2.0 million of non-cash share-based compensation expense as a result of implementing SFAS No. 123R in January 2006. Partially offsetting these charges were lower SG&A expenses relating to our appraisal services and appraisal and tax software businesses due to the restructuring of those businesses in the second quarter of 2005. research and Development expense The following table sets forth a comparison of our research and development expense for the following years ended December 31: ($ in ThouSanDS) 2006 % of revenues 2005 % of revenues Change $ % Research and development expense $ 3,322 2% $ 2,421 1% $ 901 37% restructuring charge Because of unsatisfactory financial performance early in 2005, 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 reorganized the appraisal services business 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 eliminated approximately 120 positions, including management, staff and project-related personnel. In connection with the reorganization, we incurred certain charges which were primarily comprised of employee severance costs and related fringe benefits, and totaled approximately $1.3 million before income taxes. The related payments were paid in 2005. other Interest income is the main component of other income, which also includes non-usage and other fees associated with a credit agreement we terminated in January 2007, gain on sale of certain assets, gains and losses on risk management liabilities and assets associated with a foreign exchange contract and miscellaneous other items. Interest income in 2006 was $1.4 million compared to $900,000 in 2005. 00:34 Tyler Technologies Management’s Discussion And Analysis Of Financial Condition And Results Of Operations income Tax Provision The following table sets forth a comparison of our income tax provision for the following years ended December 31: ($ in ThouSanDS) Income tax provision Effective income tax rate 2006 2005 $ % Change $ 8,493 $ 5,432 $ 3,061 56% 37.2% 39.9% The effective rate for 2006 was lower than the prior year mainly due to changes in the Texas franchise tax law and rates enacted in the second quarter of 2006, favorable state income tax audit results and lower state income taxes as a result of a change in our corporate structure implemented in early 2005. The decline in the effective tax rate for 2006 was offset somewhat by non-deductible share-based compensation expense included in 2006 operating results. financiaL conDiTion anD LiQuiDiTY The following table sets forth a summary of cash flows for the years ended December 31: ($ in ThouSanDS) Cash flows provided by (used by): Operating activities Investing activities Financing activities Net (decrease) increase in cash and cash equivalents 2007 2006 2005 $ 34,111 (34,275) (7,406) $ (7,570) $ 26,804 $ 21,187 (24,326) 1,820 (5,999) (14,847) $ (3,521) $ 8,160 Historically, we have funded our operations and capital expenditures primarily with cash generated from operating activities. As of December 31, 2007, our combined cash and cash equivalents (including restricted cash equivalents) and short-term investments balance was $55.7 million compared to $41.7 million at December 31, 2006. Cash and short-term investments increased primarily due to continued strong operating performance and higher deferred revenue due to additional maintenance customers and new contract signings. Our short-term investments are comprised of auction rate municipal securities (“ARS”). ARS are long-term variable rate bonds tied to short-term interest rates that are reset through a “Dutch Auction” process that occurs every 28 to 35 days. We have the option to participate in the auction and sell ARS to prospective buyers through a broker-dealer. We do not have the right to put the security back to the issuer. Our investments in ARS all had AAA credit ratings at the time of purchase and represent interests in collateralized debt obligations supported by municipal and state agencies. ARS are considered highly liquid because of the auction process, which have historically provided a liquid market for these securities. However, because the ARS have long-term maturity dates, there is no guarantee that the holder will be able to liquidate its holdings in the short term. As of February 22, 2008, our investment in ARS was $18.6 million compared to $41.6 million at December 31, 2007. In 2008, the majority of the auctions we participated in were successful and we expect that we will collect the principal associated with these ARS. Based on the nature of the debt obligations and our ability to liquidate our ARS in 2008 we do not believe that any change in the liquidity of the ARS market will have a material impact on our liquidity, cash flow or ability to fund operations. At December 31, 2007, our days sales outstanding (“DSOs”) were 95 days compared to DSOs of 102 days at December 31, 2006. DSOs are calculated based on accounts receivable (excluding long-term receivables) divided by the quotient of annualized quarterly revenues divided by 360 days. The decline in DSOs is primarily due to timing of billings. Investing activities in 2007 include cash payments of $9.0 million for the acquisitions of EDP Enterprises, Inc., Advanced Data Systems, Inc. and certain other software assets. Other investing activities during 2007 were $22.1 million, net of Management’s Discussion And Analysis Of Financial Condition And Results Of Operations 2007 Annual Report 00:35 sales, to purchase short-term investments and $3.7 million in property and equipment. The property and equipment expenditures were related to computer hardware and software and other asset additions to support internal growth. Investing activities in 2006 include total cash payments of $12.2 million and 325,000 shares of Tyler common stock for the acquisitions of MazikUSA, Inc. and TACS, Inc. and certain maintenance and support agreements associated with one of our financial solutions. Other investing activities during 2006 were capital expenditures of $4.3 million, including $4.1 million for computer hardware and purchased software for internal use, including a new enterprise-wide customer relationship management system, and other asset additions to support internal growth. In 2005 investing activities primarily consisted of investments in software development and property and equipment. Cash used in financing activities was primarily comprised of purchases of treasury shares, net of proceeds from stock option exercises and contributions from our employee stock purchase plan. During 2007, we purchased approximately 1.3 million shares of our common stock for an aggregate purchase price of $16.2 million ($14.1 million in cash and $2.1 million in accrued liabilities at December 31, 2007.) In 2006 we purchased approximately 1.0 million shares of our common stock for an aggregate cash purchase price of $10.5 million and during 2005 we purchased approximately 2.5 million shares of our common stock for an aggregate cash purchase price of $17.7 million. In 2007, we received $3.6 million from the exercise of options to purchase approximately 878,000 shares of our common stock under our employee stock option plan. During 2006 we issued 623,000 shares of common stock and received $2.9 million in aggregate proceeds, upon exercise of stock options and during 2005 we issued 436,000 shares of common stock and received $1.8 million in aggregate proceeds upon exercise of stock options. In 2007 we received $1.2 million from contributions to the Tyler Technologies, Inc. Employee Stock Purchase Plan (“ESPP”). In both 2006 and 2005, we received $1.0 million from contributions to the ESPP. Subsequent to December 31, 2007 and through February 22, 2008 we purchased approximately 814,000 shares of our common stock for an aggregate cash purchase price of $10.5 million. We maintain a $5.0 million Letter of Credit facility under which the bank issues cash collateralized letters of credit. As of December 31, 2007 we had outstanding letters of credit totaling $4.5 million to secure surety bonds required by some of our customer contracts. In the first quarter of 2008 we acquired two companies for a combined cash purchase price (net of cash acquired) of approximately $13.8 million and 126,000 shares of Tyler common stock. We have not finalized the allocation of the purchase price of the acquired companies but expect this allocation will result in non-cash charges that may have a slightly dilutive effect on earnings per share in 2008. Excluding acquisitions, we anticipate that 2008 capital spending will be between $4.5 million and $5.5 million, the majority of which will be related to computer equipment and software for infrastructure expansions. We currently do not expect to capitalize significant amounts related to software development in 2008 but the actual amount and timing of those costs, and whether they are capitalized or expensed may result in additional capitalized software development. Capital spending in 2008 is expected to be funded from existing cash balances and cash flows from operations. From time to time we engage in discussions with potential acquisition candidates. In order to pursue such opportunities, which could require significant commitments of capital, we may be required to incur debt or to issue additional potentially dilutive securities in the future. No assurance can be given as to our future acquisition opportunities and how such opportunities will be financed. 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 believe that credit would be available to us. 00:36 Tyler Technologies Management’s Discussion And Analysis Of Financial Condition And Results Of Operations 00:36 Tyler Technologies Management’s Discussion And Analysis Of Financial Condition And Results Of Operations We lease office facilities, as well as transportation, computer and other equipment used in our operations under non-cancelable operating lease agreements expiring at various dates through 2013. Most leases contain renewal options and some contain purchase options. Following are the future obligations under non-cancelable leases at December 31, 2007 (in thousands): Future rental payments under operating leases $ 4,811 $ 4,517 $ 3,034 $ 2,094 $ 1,319 $ 148 $ 15,923 2008 2009 2010 2011 2012 thereafter total It is not our usual business practice to enter into off-balance sheet arrangements or to issue guarantees to third parties. As of December 31, 2007 we have no material purchase commitments, except for the operating lease commitments listed above. caPiTaLiZaTion At December 31, 2007, our capitalization consisted of $137.2 million of shareholders’ equity, with no debt. new accounTinG PronouncemenTS In September 2006, the Financial Accounting Standards Board issued SFAS No. 157, “Fair Value Measurements.” SFAS No. 157 defines fair value, establishes a framework for measuring fair value in accordance with accounting principles generally accepted in the United States, and expands disclosures about fair value measurements. We are subject to the provisions of SFAS No. 157 beginning January 1, 2008. The adoption of SFAS No. 157 is not expected to have a material impact on our consolidated financial statements or related disclosures. 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, 2007, we had funds invested in auction rate municipal securities, 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. Due to the nature of these investments, we are not subject to significant market rate risk. We have no outstanding debt at December 31, 2007, and we therefore are not subject to any interest rate risk. Report of Independent Registered Public Accounting Firm 2007 Annual Report 00:37 Management’s Discussion And Analysis Of Financial Condition And Results Of Operations 2007 Annual Report 00:37 rePorT of inDePenDenT reGiSTereD PuBLic accounTinG firm The Board of Directors and Shareholders Tyler Technologies, Inc. We have audited the accompanying consolidated balance sheets of Tyler Technologies, Inc. as of December 31, 2007 and 2006, and the related consolidated statements of operations, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2007. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements 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. at December 31, 2007 and 2006, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2007, in conformity with U.S. generally accepted accounting principles. As discussed in Note 1 in the Notes to the Consolidated Financial Statements, the Company changed its method of accounting for share-based compensation effective January 1, 2006. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Tyler Technologies, Inc.’s internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 22, 2008 expressed an unqualified opinion thereon. Dallas, Texas February 22, 2008 00:38 Tyler Technologies Report of Independent Registered Public Accounting Firm rePorT of inDePenDenT reGiSTereD PuBLic accounTinG firm The Board of Directors and Shareholders Tyler Technologies, Inc. We have audited Tyler Technologies, Inc.’s internal control over financial reporting as of December 31, 2007, 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 is included in the accompanying “Managements’ Report on Internal Control Over Financial Reporting.” Our responsibility is to express an opinion on 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, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, 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, Tyler Technologies, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007, 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, 2007 and 2006, and the related consolidated statements of operations, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2007 and our report dated February 22, 2008 expressed an unqualified opinion thereon. Dallas, Texas February 22, 2008 Management’s Report on Internal Control Over Financial Reporting 2007 Annual Report 00:39 manaGemenT’S rePorT on inTernaL conTroL oVer financiaL rePorTinG 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, 2007. Based on such evaluation, our chief executive officer and chief financial officer have concluded that as of December 31, 2007 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 Securities and Exchange Commission’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, 2007, there were no changes in our internal controls over financial reporting, as defined in Securities Exchange Act Rule 13a-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. 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, 2007. 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, 2007, 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, 2007 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 36 hereof. 00:40 Tyler Technologies Consolidated Statements of Operations conSoLiDaTeD STaTemenTS of oPeraTionS for The YearS enDeD DecemBer 31 in ThouSanDS, excePT Per Share amounTS Revenues: Software licenses Subscriptions Software services Maintenance Appraisal services Hardware and other Total revenues Cost of revenues: Software licenses Acquired software Software services, maintenance and subscriptions Appraisal services Hardware and other Total cost of revenues Gross profit Selling, general and administrative expenses Research and development expense Restructuring charge Amortization of customer and trade name intangibles Operating income Other income, net Income before income taxes Income tax provision Net income Earnings per common share: Basic Diluted Basic weighted average common shares outstanding Diluted weighted average common shares outstanding See accompanying notes. 2007 2006 2005 $ 35,063 10,406 60,283 85,411 21,318 7,315 219,796 7,953 2,279 104,993 14,467 5,679 135,371 $ 37,247 $ 29,418 7,298 5,852 50,861 46,233 73,413 64,728 19,755 6,729 18,374 5,852 195,303 170,457 9,968 1,360 9,087 794 90,601 80,614 13,563 5,007 14,188 4,287 120,499 108,970 84,425 74,804 61,487 51,724 4,443 – 1,478 48,389 43,821 3,322 – 1,318 2,421 1,260 1,266 26,780 21,775 12,719 1,800 28,580 11,079 $ 17,501 1,080 906 22,855 13,625 8,493 5,432 $ 14,362 $ 8,193 $ $ 0.45 0.42 38,735 41,352 $ $ 0.37 0.34 $ $ 0.21 0.19 38,817 39,439 41,868 42,075 Consolidated Balance Sheets 2007 Annual Report 00:41 conSoLiDaTeD BaLance SheeTS DecemBer 31 in ThouSanDS, excePT Share anD Per Share amounTS aSSeTS Current assets: Cash and cash equivalents Restricted cash equivalents Short-term investments available-for-sale Accounts receivable (less allowance for losses of $1,851 in 2007 and $2,971 in 2006) Prepaid expenses Other current assets Deferred income taxes Total current assets Accounts receivable, long-term portion Property and equipment, net Other assets: Goodwill Customer related intangibles, net Software, net Trade name, net Sundry LiaBiLiTieS anD SharehoLDerS’ eQuiTY Current liabilities: Accounts payable Accrued liabilities Deferred revenue Income taxes payable Total current liabilities Deferred income taxes Commitments and contingencies Shareholders’ equity: Preferred stock, $10.00 par value; 1,000,000 shares authorized, none issued Common stock, $0.01 par value; 100,000,000 shares authorized; 48,147,969 shares issued in 2007 and 2006 Additional paid-in capital Accumulated other comprehensive loss, net of tax Retained earnings Treasury stock, at cost; 9,528,467 and 9,255,783 shares in 2007 and 2006, respectively Total shareholders’ equity See accompanying notes. 2007 2006 $ 9,642 4,462 41,590 63,965 7,726 1,324 2,355 131,064 $ 17,212 4,962 19,543 58,188 6,864 2,326 2,579 111,674 398 9,826 1,675 7,390 71,677 17,706 9,588 1,074 175 $ 241,508 66,127 17,502 14,554 1,188 166 $ 220,276 $ 3,323 18,905 73,714 632 96,574 $ 5,063 17,735 62,387 – 85,185 7,723 9,216 – 481 149,568 – 35,632 (48,470) 137,211 $ 241,508 – 481 151,627 (10) 18,131 (44,354) 125,875 $ 220,276 00:42 Tyler Technologies Consolidated Statements of Shareholders’ Equity conSoLiDaTeD STaTemenTS of SharehoLDerS’ eQuiTY for the years ended deCember 31, 2007, 2006 and 2005 Common stoCk shares amount additional paid-in Capital aCCumulated other retained Comprehensive earnings (defiCit) inCome (loss) treasury stoCk shares amount total shareholders’ equity 48,148 $ 481 $ 152,870 $ – $ (4,424) (7,423) $ (30,527) $ 118,400 – – – – – – – – – – – – – – – – – (1,570) 18 – (116) – 48,148 – 481 313 151,515 – – 48,148 – – – – – – – – – – – – – – (3,158) 1,960 – 22 – – 481 1,150 138 151,627 – – – – – – – – (7,339) 2,365 – (2) – – – – – – – (8) 8 – – – – – – – (10) – – – – – – (10) 8,193 – – – – – – – – – – – – 8,193 (8) 8 8,193 436 – (2,457) 3,370 – (17,683) 1,800 18 (17,683) 171 1,272 1,156 – 3,769 – (9,273) – (43,568) 313 112,197 14,362 – – – – – – – – – 14,362 (10) 14,352 623 – (1,033) 6,074 – (10,531) 2,916 1,960 (10,531) 102 918 940 – – 18,131 – 325 (9,256) – 2,753 (44,354) 1,150 2,891 125,875 – 17,501 10 – – – – – – – – – – – – – 878 – (1,250) 10,928 – (16,163) 17,501 10 17,511 3,589 2,365 (16,163) 100 1,119 1,117 – 48,148 – $ 481 2,917 $ 149,568 – $ – – $ 35,632 – (9,528) – $ (48,470) 2,917 $ 137,211 in ThouSanDS Balance at December 31, 2004 Comprehensive income: Net income Unrealized loss on investment securities, net of tax Reclassification adjustment, net of income taxes of $5 Total comprehensive income Issuance of shares pursuant to stock compensation plan Stock compensation Treasury stock purchases Issuance of shares pursuant to Employee Stock Purchase Plan Federal income tax benefit related to exercise of stock options Balance at December 31, 2005 Comprehensive income: Net income Unrealized loss on investment securities, net of tax Total comprehensive income Issuance of shares pursuant to stock compensation plan Stock compensation Treasury stock purchases Issuance of shares pursuant to Employee Stock Purchase Plan Federal income tax benefit related to exercise of stock options Issuance of shares for acquisitions Balance at December 31, 2006 Comprehensive income: Net income Unrealized gain on investment securities, net of tax Total comprehensive income Issuance of shares pursuant to stock compensation plan Stock compensation Treasury stock purchases Issuance of shares pursuant to Employee Stock Purchase Plan Federal income tax benefit related to exercise of stock options Balance at December 31, 2007 See accompanying notes. Consolidated Statements of Cash Flows 2007 Annual Report 00:43 conSoLiDaTeD STaTemenTS of caSh fLowS for The YearS enDeD DecemBer 31 2007 2006 2005 in ThouSanDS Cash flows from operating activities: Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization Share-based compensation expense Purchased in-process research and development charge Non-cash interest and other charges Provision for losses – accounts receivable Deferred income tax benefit Changes in operating assets and liabilities, exclusive of effects of acquired companies: Accounts receivable Income tax payable Prepaid expenses and other current assets Accounts payable Accrued liabilities Deferred revenue Net cash provided by operating activities Cash flows from investing activities: Purchases of short-term investments Proceeds from sales of short-term investments Cost of acquisitions, net of cash acquired Decrease in restricted investments Investment in software development costs Additions to property and equipment Other Net cash (used by) provided by investing activities Cash flows from financing activities: Purchase of treasury shares Contributions from employee stock purchase plan Proceeds from exercise of stock options Excess tax benefits from share-based compensation expense Net cash used by financing activities Net (decrease) increase in cash and cash equivalents Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year See accompanying notes. $ 17,501 $ 14,362 $ 8,193 11,211 2,365 – – 753 (1,598) (1,575) 2,028 (304) (1,955) (1,619) 7,304 34,111 (67,545) 45,480 (9,005) 500 (167) (3,678) 140 (34,275) (14,037) 1,151 3,589 1,891 (7,406) (7,570) 17,212 $ 9,642 10,102 10,443 1,960 140 220 2,077 (2,520) (10,400) (78) (1,496) 1,626 972 9,839 26,804 – – (73) 1,641 (2,200) (7,031) (421) (2,117) 561 2,428 9,763 21,187 (26,825) (16,882) 19,016 18,964 (12,237) 38 (236) (4,088) 6 (24,326) – 2,500 (1,002) (1,734) (26) 1,820 (10,531) (17,683) 1,002 2,916 614 1,036 1,800 – (5,999) (14,847) (3,521) 8,160 20,733 12,573 $ 17,212 $ 20,733 00:44 Tyler Technologies Notes to Consolidated Financial Statements (TaBLeS in ThouSanDS, excePT Per Share DaTa) (1) SummarY of SiGnificanT accounTinG PoLicieS DESCRIPTION OF BUSINESS We provide integrated software systems and related services for local governments. We develop and market a broad line of software solutions 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, including software and hardware installation, data conversion, training, and for certain customers, product modifications, along with continuing maintenance and support for customers using our systems. We also provide subscription-based services such as application service provider arrangements and other hosting services as well as property appraisal outsourcing services for taxing jurisdictions. Tyler’s business is subject to risks and uncertainties including dependence on IT 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. In addition, our products are complex and we run the risk of errors or defects with new product introductions or enhancements. PRINCIPLES OF CONSOLIDATION In 2005, we merged all of our subsidiaries into the parent company. CASH AND CASH EQUIVALENTS Cash in excess of that necessary for operating requirements is invested in short-term, highly liquid, income-producing investments. Investments with original maturities of three months or less are classified as cash and cash equivalents, which primarily consist of money market funds. Cash and cash equivalents are stated at cost, which approximates market value. SHORT-TERM INVESTMENTS Short-term investments mainly consist of auction rate municipal securities with auction reset periods that occur every 28 to 35 days. These investments are classified as available-for-sale securities and are stated at fair value. 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. At each reset period, we account for the transactions as “Proceeds from sales of short-term investments” for the security relinquished, and a “Purchase of short-term investments” for the security purchased, in the accompanying Consolidated Statement of Cash Flows. Following is a summary of short-term investments: deCember 31, 2007 Auction rate municipal securities deCember 31, 2006 Auction rate municipal securities State and municipal bonds Cost unrealized gains unrealized losses estimated fair value $ 41,590 $ – $ – $ 41,590 Cost $ 14,875 4,684 $ 19,559 unrealized gains unrealized losses estimated fair value $ $ – – – $ – (16) $ (16) $ 14,875 4,668 $ 19,543 We maintain a $5.0 million Letter of Credit facility under which the bank issues cash collateralized letters of credit. As of December 31, 2007 approximately $4.5 million of our cash equivalents are restricted and designated as collateral for our letters of credit issued in connection with our surety bond program. These letters of credit expire through mid 2008. Notes to Consolidated Financial Statements 2007 Annual Report 00:45 REVENUE RECOGNITION Software Arrangements: We earn revenue from software licenses, subscriptions, software related services, post-contract customer support (“PCS” or “maintenance”), and hardware. 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 involve significant production, modification or customization 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 Statement of Position (“SOP”) 81-1 “Accounting for Performance of Construction— Type and Certain Production—Type Contracts.” If the arrangement does not require significant production, modification or customization or where the software services are not considered essential to the functionality of the software, revenue is recognized when all of the following conditions are met: i. persuasive evidence of an arrangement exists; ii. delivery has occurred; iii. our fee is fixed or determinable; and iv. collectibility is probable. 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 objective 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. We monitor our transactions to insure we maintain and periodically revise VSOE to reflect fair value. 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. 00:46 Tyler Technologies Notes to Consolidated Financial Statements 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 involve significant production, modification or customization 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 method generally results in the recognition of reasonably consistent profit margins over the life of a contract because 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. For arrangements that include new product releases for which it is difficult to estimate final profitability except to assume that no loss will ultimately be incurred, we recognize revenue under the completed contract method. Under the completed contract method, revenue is recognized only when a contract is completed or substantially complete. Historically these amounts have been immaterial. Subscription-Based Services Subscription-based services primarily consists of revenues derived from application service provider (“ASP”) arrangements and other hosted service offerings, software subscriptions and disaster recovery services. We recognize revenue for ASP and other hosting services, software subscriptions and disaster recovery ratably over the period of the applicable agreement as services are provided. Disaster recovery agreements and other hosting services are typically renewable annually. ASP and software subscriptions are typically for periods of three to six years and automatically renew unless either party cancels the agreement. The majority of the ASP and other hosting services and software subscriptions also include professional services as well as maintenance and support. In certain ASP arrangements, the customer also acquires a license to the software. For ASP and other hosting arrangements, we evaluate whether each of the elements in these arrangements represents a separate unit of accounting, as defined by Emerging Issues Task Force (“EITF”) 00-21, using all applicable facts and circumstances, including whether (i) we sell or could readily sell the element unaccompanied by the other elements, (ii) the element has stand-alone value to the customer, (iii) there is objective reliable evidence of the fair value of the undelivered item, and (iv) there is a general right of return. We consider the applicability of EITF No. 00-03, “Application of SOP 97-2 to Arrangements That Include the Right to Use Software Stored on Another Entity’s Hardware” on a contract-by-contract basis. In hosted term-based agreements, where the customer does not have the contractual right to take possession of the software, hosting fees are recognized on a monthly basis over the term of the contract commencing when the customer has access to the software. For professional services associated with hosting arrangements that we determine do not have stand-alone value to the customer, we recognize the services revenue ratably over the remaining contractual period once hosting has gone live and we may begin billing for the hosting services. We record amounts that have been invoiced in accounts receivable and in deferred revenue or revenues, depending on whether the revenue recognition criteria have been met. Notes to Consolidated Financial Statements 2007 Annual Report 00:47 If we determine that the customer has the contractual right to take possession of our software at any time during the hosting period without significant penalty, and can feasibly maintain the software on the customer’s hardware or enter into another arrangement with a third party to host the software, we recognize the license, professional services and hosting services revenues pursuant to SOP 97-2. 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. Computer Hardware Equipment Revenue allocable to computer hardware equipment, which is based on VSOE, 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 typically renewable annually. 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. Appraisal Services: For our property 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. Other: The majority of deferred revenue consists of unearned support and maintenance revenue that has been billed based on contractual terms in the underlying arrangement with the remaining balance consisting of payments received in advance of revenue being earned under software licensing, subscription-based services, software and appraisal services and hardware installation. 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 commissions associated with arrangements for which revenue recognition has been deferred and third party subcontractor payments. Such costs are expensed at the time the related revenue is recognized. 00:48 Tyler Technologies Notes to Consolidated Financial Statements 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, determination of share-based compensation expense and valuation allowance for receivables. Actual results could differ from 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. RESEARCH AND DEVELOPMENT COSTS We expensed research and development costs of $4.4 million during 2007, $3.3 million during 2006 and $2.4 million during 2005. In 2007, we reduced our research and development expense by $1.6 million, which was the amount earned under the terms of our strategic alliance with a development partner. 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 Prior to January 1, 2006, we accounted for stock options using the intrinsic value method under Accounting Principles Board Opinion (“APB”) No. 25, “Accounting for Stock Issued to Employees” and related interpretations, as permitted by Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation,” under which no compensation expense was recognized for stock option grants. Accordingly, share-based compensation related to our stock options for periods prior to 2006 are included as a pro forma disclosure in the financial statement footnotes. Effective January 1, 2006, we adopted the fair value recognition provisions of SFAS No. 123R, “Share-Based Payment” using the modified-prospective method. Under this transition method, compensation cost recognized in 2007 and 2006 includes the applicable amounts of: (a) compensation cost of all share-based payments granted prior to, but not yet vested as of, January 1, 2006 (based on the grant-date fair value estimated in accordance with the original provisions of SFAS No. 123, and previously presented in the pro forma footnote disclosures), and (b) compensation cost for all share- based payments granted subsequent to January 1, 2006 (based on the grant-date fair value estimated in accordance with the new provisions of SFAS No. 123R). Results for prior periods have not been restated. Prior to the adoption of SFAS No. 123R, we presented all tax benefits of deductions resulting from the exercise of options as operating cash flows in the Consolidated Statements of Cash Flows. SFAS No. 123R requires the cash flows resulting from tax deductions in excess of the compensation cost recognized for those options (excess tax benefits) to be classified as financing cash flows. See Note 8—Share-Based Compensation for further information. Notes to Consolidated Financial Statements 2007 Annual Report 00:49 SEGMENT AND RELATED INFORMATION Although we have a number of operating divisions, 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 first allocate the cost of acquired companies 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 evaluate goodwill for impairment annually as of April, 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. There have been no significant impairments of goodwill or other intangibles. 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 for 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. There have been no significant impairments of long-lived assets. 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 $167,000 during 2007, $236,000 during 2006, and $1.0 million during 2005. Software development costs primarily consist of personnel costs and rent for related office space. 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, but not to exceed five years. Amortization of software development costs was approximately $4.6 million in 2007, $5.1 million in 2006, and $5.9 million in 2005 and is included in cost of software license revenue in the accompanying consolidated statements of operations. 00:50 Tyler Technologies Notes to Consolidated Financial Statements FAIR VALUE OF FINANCIAL INSTRUMENTS Cash and cash equivalents, accounts receivables, accounts payables, deferred revenues and certain other assets at cost approximate fair value because of the short maturity of these instruments. Our available-for-sale investments are recorded at fair value based on quoted market prices. CONCENTRATIONS OF CREDIT RISK AND UNBILLED RECEIVABLES Concentrations of credit risk with respect to receivables are limited due to the size and geographical diversity of our customer base. 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, 2007. We maintain allowances for doubtful accounts and sales adjustments, which are provided at the time the revenue is recognized. Since most of our customers are domestic 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 and sales adjustments may require revision, include, but are not limited to, deterioration of a customer’s financial condition, failure to manage our customer’s expectations regarding the scope of the services to be delivered, and defects or errors in new versions or enhancements of our software products. The following table summarizes the changes in the allowances for doubtful accounts and sales adjustments: YearS enDeD DecemBer 31, Balance at beginning of year Provisions for losses—accounts receivable Collection of accounts previously written off Deductions for accounts charged off or credits issued Balance at end of year 2007 2006 2005 $ 2,971 753 – (1,873) $ 1,851 $ 1,991 2,077 11 (1,108) $ 2,971 $ 986 1,641 – (636) $ 1,991 The termination clauses in most of our contracts provide for the payment for the fair value of products delivered or services performed in the event of early termination. 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 work prior to when the software and services are billable and/or payable pursuant to the contract. We have historically recorded such unbilled receivables (costs and estimated profit in excess of billings) in connection with (1) property appraisal services contracts accounted for using proportionate performance accounting in which the revenue is earned based upon activities performed in one accounting period but the billing normally occurs shortly thereafter and may span another accounting period; (2) software services contracts accounted for using the percentage-of-completion method of revenue recognition using labor hours as a measure of progress towards completion in which the services are performed in one accounting period but the billing for the software element of the arrangement may be based upon the specific phase of the implementation; (3) software revenue for which we have objective evidence that the customer-specified objective criteria has been met but the billing has not yet been submitted to the customer; and (4) in a limited number of cases, we may grant extended payment terms generally to existing customers with whom we have a long-term relationship and favorable collection history. In addition, certain of our property appraisal outsourcing contracts are required by law to have an amount withheld from a progress billing (generally a 10% retention) until final and satisfactory project completion is achieved, typically upon the completion of fieldwork or formal hearings. In connection with this activity, we have recorded unbilled receivables of $11.2 million and $10.1 million at December 31, 2007 and 2006, respectively. We also have recorded retention receivable of $3.9 million and $3.8 million at December 31, 2007 and 2006, respectively, and these retentions become payable upon the completion of the contract or completion of our field work and formal hearings. Unbilled receivables and retention receivables expected to be collected in excess of one year have been classified as accounts receivable, long-term portion in the accompanying consolidated balance sheets. Notes to Consolidated Financial Statements 2007 Annual Report 00:51 INDEMNIFICATION 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 these indemnifications, 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 was filed as Exhibit 10.1 to our Form 10-K for the year ended December 31, 2002. We maintain directors’ and officers’ insurance coverage to protect against any such losses. We have recorded no liability associated with these indemnifications. Because of our insurance coverage, we believe the estimated fair value of these indemnification agreements is minimal. NEW ACCOUNTING PRONOUNCEMENTS In September 2006, the Financial Accounting Standards Board issued statement SFAS No. 157, “Fair Value Measurements.” SFAS No. 157 defines fair value, establishes a framework for measuring fair value in accordance with accounting principles generally accepted in the United States, and expands disclosures about fair value measurements. We are subject to the provisions of SFAS No. 157 beginning January 1, 2008. The adoption of SFAS No. 157 is not expected to have a material impact on our consolidated financial statements or related disclosures. RECLASSIFICATIONS Certain amounts for previous years have been reclassified to conform to the current year presentation. (2) acQuiSiTionS In September 2007, we completed the acquisition of all the capital stock of EDP Enterprises, Inc. (“EDP”), which develops and sells financial and student information and management systems for public school districts in Texas. In February 2007, we completed the acquisition of all of the capital stock of Advanced Data Systems, Inc. (“ADS”), which develops and sells fund accounting solutions, primarily in New England. The combined purchase price, including transaction costs along with an office building used in ADS’s business and excluding cash balances acquired, for these acquisitions as well as miscellaneous other software asset purchases was $9.0 million. We believe these acquisitions will complement our business model by broadening our customer base and will give us additional opportunities to provide our customers with solutions tailored specifically for the public sector. In connection with these transactions, we acquired total assets of approximately $5.3 million and assumed total liabilities of approximately $5.2 million. We recorded goodwill of $5.6 million, of which $2.4 million is expected to be deductible for tax purposes, and other intangible assets of $3.3 million. The $3.3 million of intangible assets is attributable to acquired software and customer relationships that will be amortized over a weighted average period of approximately 6 years. Our consolidated balance sheet as of December 31, 2007 reflects the allocation of the purchase price to the assets acquired and liabilities assumed based on their estimated fair values at the dates of acquisition. The operating results of these acquisitions are included in our results of operations since their respective dates of acquisition. In January 2006, we completed the acquisitions of all of the capital stock of MazikUSA, Inc. (“Mazik”) and TACS, Inc. (“TACS”). The total value of these transactions, including transaction costs, was approximately $14.6 million, which was comprised of $11.7 million in cash and 325,000 shares of Tyler common stock valued at $2.9 million. Mazik provides an integrated software solution for schools that combines the functionalities of student performance monitoring, student 00:52 Tyler Technologies Notes to Consolidated Financial Statements tracking, financial accounting, human resources and reporting. TACS provides pension and retirement software solutions that assist public and private pension institutions in increasing operational efficiency and accuracy. In September 2006, we also purchased certain maintenance and support agreements associated with one of our financial software products for approximately $580,000. (3) ProPerTY anD eQuiPmenT, neT Property and equipment, net consists of the following at December 31: Land Computer equipment and purchased software Furniture and fixtures Building and leasehold improvements Transportation equipment Accumulated depreciation and amortization Property and equipment, net uSefuL LiVeS (YearS) 2007 2006 – 3–5 5 5–35 5 179 $ 18,502 4,625 4,099 279 27,684 (17,858) $ 9,826 $ 115 15,240 4,452 2,426 359 22,592 (15,202) $ 7,390 Depreciation expense was $2.8 million during 2007, $2.4 million during 2006, and $2.5 million during 2005. (4) GooDwiLL anD oTher inTanGiBLe aSSeTS Intangible assets and related accumulated amortization consists of the following at December 31: Gross carrying amount of acquisition intangibles: Goodwill Customer related intangibles Software acquired Trade name Accumulated amortization Acquisition intangibles, net Post acquisition software development costs Accumulated amortization Post acquisition software costs, net 2007 2006 $ 71,677 26,858 20,093 1,681 120,309 (26,450) $ 93,859 $ 36,701 (30,515) $ 6,186 $ 66,127 25,291 19,113 1,681 112,212 (23,449) $ 88,763 $ 36,715 (26,107) $ 10,608 Total amortization expense for acquisition related intangibles and post acquisition software development costs was $8.4 million during 2007, $7.7 million during 2006, and $8.0 million during 2005. Notes to Consolidated Financial Statements 2007 Annual Report 00:53 The allocation of acquisition intangible assets is summarized in the following table: deCember 31, 2007 deCember 31, 2006 gross Carrying amount weighted average amortization period aCCumulated amortization gross Carrying amount weighted average amortization period aCCumulated amortization Non-amortizable intangibles: Goodwill Amortizable intangibles: Customer related intangibles Software acquired Trade name $ 71,677 26,858 20,093 – $ – $ 66,127 – $ – 21 years 5 years 1,681 21 years 9,152 16,691 607 25,291 21 years 19,113 1,681 5 years 21 years 7,789 15,167 493 The changes in the carrying amount of goodwill for the two years ended December 31, 2007 are as follows: Balance as of December 31, 2005 Goodwill acquired during the year related to the purchase of Mazik Goodwill acquired during the year related to the purchase of TACS Balance as of December 31, 2006 Goodwill acquired during the year related to the purchase of ADS Goodwill acquired during the year related to the purchase of EDP Other Balance as of December 31, 2007 $ 53,709 10,198 2,220 66,127 2,240 3,187 123 $ 71,677 Estimated annual amortization expense relating to acquisition intangibles, including acquired software for which the amortization expense is recorded as cost of revenues, is as follows: YearS enDinG DecemBer 31, 2008 2009 2010 2011 2012 (5) accrueD LiaBiLiTieS Accrued liabilities consist of the following at December 31: Accrued wages, bonuses and commissions Other accrued liabilities Accrued treasury stock purchases Accrued health claims Accrued third party contract costs $3,056 2,289 2,289 1,707 1,425 2007 2006 $ 10,029 3,744 2,126 1,806 1,200 $ 18,905 $ 10,392 4,416 – 1,302 1,625 $ 17,735 00:54 Tyler Technologies Notes to Consolidated Financial Statements (6) income Tax The income tax provision (benefit) on income from operations consists of the following: YearS enDeD DecemBer 31, 2007 2006 2005 Current: Federal State Deferred $ 10,593 2,084 12,677 (1,598) $ 11,079 $ 9,701 1,312 11,013 $ 6,340 1,292 7,632 (2,520) (2,200) $ 8,493 $ 5,432 Reconciliation of the U.S. statutory income tax rate to our effective income tax expense rate for operations follows: YearS enDeD DecemBer 31, Income tax expense at statutory rate State income tax, net of federal income tax benefit Non-deductible business expenses Qualified manufacturing activities Other, net 2007 2006 2005 $ 10,003 1,321 608 (490) (363) $ 11,079 $ 7,999 $ 4,769 430 518 (263) (191) 778 182 (149) (148) $ 8,493 $ 5,432 Slightly more than half of our stock option awards granted qualify as incentive stock options (“ISO”) for income tax purposes. As such, a tax benefit is not recorded at the time the compensation cost related to the options is recorded for book purposes due to the fact that an ISO does not ordinarily result in a tax benefit unless there is a disqualifying disposition. Stock option grants of non-qualified options result in the creation of a deferred tax asset, which is a temporary difference, until the time that the option is exercised. Due to the treatment of incentive stock options for tax purposes, our effective tax rate from year to year is subject to variability. The tax effects of the major items recorded as deferred tax assets and liabilities as of December 31 are: Deferred income tax assets: Operating expenses not currently deductible Employee benefit plans Property and equipment Total deferred income tax assets Deferred income tax liabilities: Intangible assets Other Total deferred income tax liabilities Net deferred income tax liabilities 2007 2006 $ 1,502 1,687 114 3,303 (8,504) (167) (8,671) $ (5,368) $ 1,801 1,224 49 3,074 (9,535) (176) (9,711) $ (6,637) Although realization is not assured, we believe it is more likely than not that all the deferred tax assets at December 31, 2007 and 2006 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. Notes to Consolidated Financial Statements 2007 Annual Report 00:55 We adopted the provisions of Financial Standards Accounting Board Interpretation (“FIN”) No. 48, “Accounting for Uncertainty in Income Taxes,” on January 1, 2007. As a result of the implementation of FIN 48, we recognized no material adjustments in the liability for unrecognized income tax benefits. At the adoption date we did not have any unrecognized tax benefits and did not have any interest or penalties accrued. We are subject to U.S. federal tax as well as income tax of multiple state and local jurisdictions. We are no longer subject to United States federal income tax examinations for years before 2004 and are no longer subject to state and local income tax examinations by tax authorities for the years before 2002. The Internal Revenue Service concluded an examination of our U. S. Federal tax return for 2005 in the second quarter of 2007, which did not result in any material adjustments. We paid income taxes, net of refunds received, of $8.7 million in 2007, $10.4 million in 2006, and $8.1 million in 2005. (7) SharehoLDerS’ eQuiTY The following table details activity in our common stock: YearS enDeD DecemBer 3 1, Purchases of common stock Stock option exercises Employee stock plan purchases Shares issued for acquisitions 2007 2006 2005 shares amount shares amount shares amount (1,250) 878 100 – $ (16,163) 3,589 1,117 – (1,033) $ (10,531) (2,457) $ (17,683) 623 102 325 2,916 940 2,891 436 171 – 1,800 1,156 – Subsequent to December 31, 2007 and through February 22, 2008, we repurchased 814,00 shares for an aggregate purchase price of $10.5 million. As of February 22, 2008 we had authorization from our board of directors to repurchase up to 967,000 additional shares of our common stock. (8) Share-BaSeD comPenSaTion Share-based compensation plan We have a stock option plan that provides for the grant of stock options to key employees, directors and non-employee consultants. Stock options vest after three to five years of continuous service from the date of grant and have a contractual term of ten years. Once options become exercisable, the employee can purchase shares of our common stock at the market price on the date we granted the option. Effective January 1, 2006, we adopted the provisions of SFAS No. 123R, “Share-Based Payment,” which establishes accounting for share-based awards exchanged for employee services, using the modified prospective application transition method. Under this transition method, compensation cost recognized in 2007 and 2006 includes the applicable amounts of: (a) compensation cost of all share-based payments granted prior to, but not yet vested as of, January 1, 2006 (based on the grant-date fair value estimated in accordance with the original provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” and previously presented in the pro forma footnote disclosures), and (b) compensation cost for all share-based payments granted subsequent to January 1, 2006 (based on the grant-date fair value estimated in accordance with the new provisions of SFAS No. 123R). Results for prior periods have not been restated. For prior periods we applied APB No. 25, “Accounting for Stock Issued to Employees,” and related Interpretations, and provided the required pro forma disclosures under SFAS No. 123. 00:56 Tyler Technologies Notes to Consolidated Financial Statements If compensation expense for our stock-based awards to employees had been recognized using the fair value method of SFAS No. 123R rather than the intrinsic value method under APB No. 25, net income and earnings per share would have been reduced to the pro forma amounts below for the year ended December 31, 2005: Net income as reported Add stock based employee compensation cost included in net income, net of related tax benefit Deduct total stock based employee compensation expense determined under fair value based method for all awards, net of related tax benefit Pro forma net income Basic earnings per share: As reported Pro forma Diluted earnings per share: As reported Pro forma $ 8,193 – (831) $ 7,362 $ 0.21 $ 0.19 $ 0.19 $ 0.17 As of December 31, 2007, there were 211,000 shares available for future grants under the plan from the 8.5 million shares previously approved by the stockholders. Determining Fair Value Under SFAS No. 123R Valuation and Amortization Method. We estimate the fair value of share-based awards granted using the Black-Scholes option valuation model. We amortize the fair value of all awards on a straight-line basis over the requisite service periods, which are generally the vesting periods. Expected Life. The expected life of awards granted represents the period of time that they are expected to be outstanding. We determine the expected life using the “simplified method” in accordance with Staff Accounting Bulletin No. 107. Expected Volatility. Using the Black-Scholes option valuation model, we estimate the volatility of our common stock at the date of grant based on the historical volatility of our common stock. Risk-Free Interest Rate. We base the risk-free interest rate used in the Black-Scholes option valuation model on the implied yield currently available on U.S. Treasury zero-coupon issues with an equivalent remaining term equal to the expected life of the award. Expected Dividend Yield. We have not paid any cash dividends on our common stock in the last ten years and we do not anticipate paying any cash dividends in the foreseeable future. Consequently, we use an expected dividend yield of zero in the Black-Scholes option valuation model. Expected Forfeitures. We use historical data to estimate pre-vesting option forfeitures. We record stock-based compensation only for those awards that are expected to vest. The following weighted average assumptions were used for options granted: YearS enDeD DecemBer 31, Expected life (in years) Expected volatility Risk-free interest rate Expected forfeiture rate 2007 2006 2005 6.5 42.6% 4.5% 3% 6 45.0% 4.9% 3% 5 48.4% 4.1% 0% Notes to Consolidated Financial Statements 2007 Annual Report 00:57 Share-Based Compensation Under SFAS No. 123R The following table summarizes share-based compensation expense related to share-based awards under SFAS No. 123R which is recorded in the statement of operations: YearS enDeD DecemBer 31, Cost of software services and maintenance Selling, general and administrative expense Total share-based compensation expense Tax benefit Net decrease in net income 2007 2006 $ 227 2,138 2,365 (451) $ 1,914 $ 147 1,813 1,960 (336) $ 1,624 Share-based compensation expense recorded in the statement of operations for 2005 was zero. At December 31, 2007 we had unvested options to purchase 1.7 million shares with a weighted average grant date fair value of $5.28. As of December 31, 2007, we had $7.4 million of total unrecognized compensation cost related to unvested options, net of expected forfeitures, which is expected to be amortized over a weighted average amortization period of 2.4 years. Stock Option Activity Options granted, exercised, forfeited and expired are summarized as follows: numBer of ShareS weiGhTeD aVeraGe exerciSe Price weiGhTeD aVeraGe remaininG conTracTuaL Life (YearS) aGGreGaTe inTrinSic VaLue Options outstanding at December 31, 2004 Granted Exercised Forfeited Options outstanding at December 31, 2005 Granted Exercised Forfeited Expired Options outstanding at December 31, 2006 Granted Exercised Forfeited Options outstanding at December 31, 2007 Options exercisable at December 31, 2007 3,964 1,135 (436) (55) 4,608 237 (623) (127) (8) 4,087 773 (878) (10) 3,972 2,281 $ 4.21 7.49 4.12 7.49 4.99 10.76 4.68 6.42 5.21 5.32 13.42 4.09 8.29 7.16 $ 4.83 6 5 $ 23,350 $ 18,387 Other information pertaining to option activity was as follows during the twelve months ended December 31: Weighted average grant-date fair value of stock options granted Total fair value of stock options vested Total intrinsic value of stock options exercised 2007 2006 2005 $ 6.69 1,710 8,793 $ 6.13 1,757 4,227 $ 3.47 1,519 1,753 00:58 Tyler Technologies Notes to Consolidated Financial Statements Employee Stock Purchase Plan Under our Employee Stock Purchase Plan (“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 the last day of each quarterly offering period. As of December 31, 2007, there were 554,000 shares available for future grants under the ESPP from the 1.0 million shares originally reserved for issuance. (9) earninGS Per Share Basic earnings and diluted earnings per share data was computed as follows: YearS enDeD DecemBer 31, 2007 2006 2005 Numerator for basic and diluted earnings per share Net income Denominator: Weighted-average basic common shares outstanding Assumed conversion of dilutive securities: Stock options Warrants Potentially dilutive common shares Denominator for diluted earnings per share—Adjusted weighted-average shares Earnings per common share: Basic Diluted $ 17,501 $ 14,362 $ 8,193 38,735 38,817 39,439 1,715 902 2,617 41,352 $ 0.45 $ 0.42 1,799 1,252 1,561 1,075 3,051 2,636 41,868 42,075 $ 0.37 $ 0.21 $ 0.34 $ 0.19 Stock options representing the right to purchase common stock of 128,000 shares in 2007, 13,000 shares in 2006, and 229,000 shares in 2005, had exercise prices greater than the average quoted market price of our common stock. These options were outstanding during 2007, 2006 and 2005, but were not included in the computation of diluted earnings per share because their inclusion would have had an antidilutive effect. Effective September 10, 2007, warrants to purchase 1.6 million shares of common stock at $2.50 per share expired and the effect of these warrants is not included in the potentially dilutive common shares after that date. See Note 13— Commitments and Contingencies for further information. (10) LeaSeS We lease office facilities for use in our operations, as well as transportation, computer and other equipment. We also have two office facility lease agreements with a shareholder and certain division managers. Most of our 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 $4.9 million in 2007 and 2006, and $4.6 million in 2005, which included rent expense associated with related party lease agreements of $1.8 million in 2007, $1.7 million in 2006, and $1.5 million in 2005. Notes to Consolidated Financial Statements 2007 Annual Report 00:59 Future minimum lease payments under all noncancelable leases at December 31, 2007 are as follows: YearS enDinG DecemBer 31, 2008 2009 2010 2011 2012 Thereafter $ 4,811 4,517 3,034 2,094 1,319 148 $ 15,923 Included in future minimum lease payments are noncancelable payments due to related parties of $1.7 million each in 2008 and 2009; $559,000 in 2010 and none thereafter. (11) 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 30% of their current compensation to the plan subject to certain statutory limitations. We contribute up to a maximum of 2.5% of an employee’s compensation to the plan. We made contributions to the plan and charged operations $1.7 million during 2007, $1.6 million during 2006, and $1.0 million during 2005. (12) reSTrucTurinG charGe Because of unsatisfactory financial performance early in 2005, 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 reorganized the appraisal services business 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 eliminated approximately 120 positions, including management, staff and project-related personnel. In connection with the reorganization, we incurred certain charges which were primarily comprised of employee severance costs and related fringe benefits, and totaled approximately $1.3 million before income taxes. The related payments were paid in 2005. (13) commiTmenTS anD conTinGencieS Prior to September 11, 2007, we had warrants outstanding to purchase 1.6 million shares of common stock at $2.50 per share, which were held by Bank of America, N. A. (“BOA”) pursuant to the terms of two Amended and Restated Stock Purchase Warrants (collectively, the “Warrants”). The exercise price could be paid either in cash or by a “cashless exercise” in which the holder was required to surrender the Warrants in exchange for warrant shares based on the following formula: [(Market Price – $2.50) / (Market Price)] x 1. 6 million shares, with the Market Price calculated as the immediately preceding 60-day trading average of our common stock. The Warrants identified specific exercise procedures for each method of exercise and further provided that any exercise would not be effective until we received all applicable documents, instruments, and the purchase price. The Warrants were originally issued on September 10, 1997 and were exercisable from that date until 5 p.m., Central Time, September 10, 2007, when they expired. 00:60 Tyler Technologies Notes to Consolidated Financial Statements On September 10, 2007, at 4:44 p.m., Central Time, BOA attempted to effectuate a “cashless exercise” of the Warrants via email; however, we believe BOA did not comply with all of the requirements set forth in the Warrants for an effective exercise. At 5:37 p.m., Central Time, BOA recalled this email exercise notice, which we subsequently accepted. At 6:10 p.m., Central Time, BOA attempted to effectuate a cash exercise of the Warrants by emailing a different notice of exercise, which we believe also failed to comply with all of the requirements set forth in the Warrants for an effective exercise, and in any event, was after the expiration date of the Warrants. As a result, we believe these Warrants expired as of September 10, 2007 and have excluded the effect of the Warrants from potentially dilutive common shares as of such date in our earnings per share computation. On October 12, 2007, we filed a declaratory judgment action against BOA in the District Court of Dallas County, Texas, 101st Judicial District requesting the court to declare, among other things, that the Warrants have expired pursuant to their terms. On November 14, 2007, BOA filed an original answer and counterclaim asserting, among other things, that the parties modified the exercise requirements of the Warrants, that Tyler breached the alleged modified contracts by refusing to deliver the warrant shares to BOA, and that BOA is therefore entitled to specific performance of the Warrants by us delivering the warrant shares or, in the alternative, to a recovery of damages, including attorneys’ fees, interest, and costs. While we believe the Warrants expired as of September 10, 2007, there can be no assurance as to the ultimate resolution of this matter. At this time it is not possible to reasonably estimate the potential loss or range of loss, if any. 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 are party or to which any of our properties are subject. (14) SuBSeQuenT eVenTS In the first quarter of 2008 we acquired two companies for a combined cash purchase price (net of cash acquired) of approximately $13.8 million and 126,000 shares of Tyler common stock. We have not finalized the allocation of the purchase price of the acquired companies but expect this allocation will result in non-cash charges that may have a slightly dilutive effect on earnings per share in 2008. (15) QuarTerLY financiaL informaTion (unauDiTeD) The following table contains selected financial information from unaudited consolidated statements of operations for each quarter of 2007 and 2006. quarters ended deC. 31 sep. 30 June 30 mar. 31 deC. 31 sep. 30 June 30 mar. 31 2007 2006 Revenues Gross profit Income before income taxes Net income Earnings per diluted share Shares used in computing $ 60,420 $ 54,932 $ 54,112 24,436 21,630 20,337 10,128 6,190 0.15 8,369 5,160 0.12 6,160 3,750 0.09 $ 50,332 18,022 3,923 2,401 0.06 $ 51,155 $ 50,139 $ 49,151 $ 44,858 20,239 20,157 18,946 15,462 6,732 4,177 0.10 6,936 4,413 0.11 5,828 3,760 0.09 3,359 2,012 0.05 diluted earnings per share 40,358 41,395 41,448 42,066 42,163 41,898 41,946 41,894 Corporate Officers John M. Yeaman Chairman of the Board John S. Marr, Jr. President and Chief Executive Officer Dustin R. Womble Executive Vice President Brian K. Miller Executive Vice President Chief Financial Officer and Treasurer H. Lynn Moore, Jr. Executive Vice President General Counsel and Secretary Rick L. Hoff Chief Technology Officer W. Michael Smith Vice President Chief Accounting Officer Terri L. Alford Controller Board of Directors John M. Yeaman 1 Chairman of the Board Tyler Technologies, Inc. John S. Marr, Jr. 1 President and Chief Executive Officer Tyler Technologies, Inc. Donald R. Brattain 2,3 President Brattain and Associates, LLC J. Luther King, Jr. 2,4 Chief Executive Officer Luther King Capital Management G. Stuart Reeves 2,3,4 Retired Executive Vice President Electronic Data Systems Corporation Michael D. Richards 3,4 Executive Vice President Republic Title of Texas, Inc. Dustin R. Womble 1 Executive Vice President Tyler Technologies, Inc. 1 Executive Committee 2 Audit Committee 3 Nominating and Governance Committee 4 Compensation Committee Corporate Headquarters 5949 Sherry Lane Suite 1400 Dallas, Texas 75225 972.713.3700 www.tylertech.com Transfer Agent and Registrar American Stock Transfer & Trust Company 59 Maiden Lane Plaza Level New York, New York 10038 800.937.5449 tel 718.236.2641 fax www.amstock.com Independent Registered Public Accounting Firm Ernst & Young LLP Dallas, Texas Annual Meeting of Stockholders Our Annual Meeting will be held on Thursday, May 15, 2008, at 9:30 a.m. Central time at The Park City Club, 5956 Sherry Lane, Suite 1700, Dallas, Texas 75225. Certifications We submitted an unqualified Annual CEO Certification to the New York Stock Exchange (NYSE) as required by the NYSE Listed Company rules. We also filed with the Securities and Exchange Commission the Chief Executive Officer and Chief Financial Officer certifications required under Section 302 of the Sarbanes-Oxley Act as exhibits to our Annual Report on Form 10-K. Investor Information Our Annual Report on Form 10-K is available on the Company’s Web site at www.tylertech.com. A copy of the Form 10-K or other information may also be obtained by contacting the Investor Relations Department at corporate headquarters. Investor Relations Tyler Technologies, Inc. 972.713.3714 info@tylertech.com Common Stock Listed on the New York Stock Exchange under the symbol “TYL” 5949 Sherry Lane Suite 1400 Dallas, Texas 75225 972.713.3700 www.tylertech.com 

Continue reading text version or see original annual report in PDF format above