Find a niche and dominate it: this tech stock’s formula for long-term profitability
You don’t have to be big, you just need to understand your market in order to make strong returns year after year
It’s quite a transformation: in the 1960s Tyler Technologies, this week’s American stock pick, made sewage pipes; now it is a leading provider of software to the public sector in the US. It is one of those relatively unknown but cleverly positioned companies that this column likes so much. It has created a niche and has adapted itself so well to its chosen market that its customers hardly ever leave (retention rates are almost 100pc) and competitors find it all but impossible to establish a foothold. From this happy position naturally flow all those financial characteristics we also seek: high margins and returns on capital and excellent conversion of profits into cash. The company also has a strong record of double-digit growth. Of course, companies do not find themselves in such advantageous circumstances by accident. It normally takes decades of patient building of expertise, customer relationships and reputation, and Tyler is no different in this respect. “Through decades of investment in research and development and targeted acquisitions it has established the broadest suite of software in the industry,” says Guido Dacie-lombardo, whose Montanaro UK Income fund has a stake in the company. “Its software helps local authorities to run a range of functions, from handling their finances and property valuations to managing prisons and the dispatch of emergency services.”
One of the benefits of operating in a niche such as this is that you don’t have to be a huge company in order to dominate it; in fact you can outcompete much larger rivals if they lack your focus.
“Tyler’s exclusive focus on the public sector positions it well against larger but more diversified software players such as Oracle and SAP, which don’t have the depth of industry-specific functionality,” adds Dacie-lombardo.
“At the same time, the breadth of its suite is a key differentiator against smaller players that offer solutions only for individual functions; a local government’s systems can share data and be better integrated if they are all from the same provider.”
The result, he says, is that Tyler “has established itself as the market leader in local government”.
He adds: “The barrier to switching away from its software is extremely high, highlighted by its 98pc customer retention rate, so Tyler enjoys ‘sticky’ clients and long customer relationships.
“With tens of thousands of customers and 80pc of revenues being recurring, Tyler has a well diversified revenue stream and good order visibility.”
On top of all this, the company operates in a market with built-in opportunities for growth. “The public sector is one of the least digitally advanced markets, with systems that are often decades old and programmed in computer ‘languages’ from a bygone era,” says Dacie-lombardo. “There is a drive to modernise these systems, not just to benefit from the superior functionality of modern software but also because the number of programmers with knowledge of those old computer coding languages is rapidly dwindling.”
He says Tyler also stands to benefit from Joe Biden’s Covid stimulus programme, which provided $350bn (£300bn) in funding for state and local governments, much of which has yet to be spent.
“Cross-selling opportunities that derive from its recent transformational acquisition of a ‘digital government’ company called NIC also represent a significant growth driver for the coming years,” he adds.
Dacie-lombardo concludes: “With a compound annual growth rate over 15 years of about 15pc, of which about two thirds is organic, margins on an “Ebit” [earnings before interest and tax] basis of about 25pc, an ‘assetlight’ business model that results in high returns on capital and good cash conversion, we believe Tyler’s financial profile is attractive.”
Like virtually all technology stocks, Tyler sold off heavily after a peak late last year and the share price stands 32pc below its record high, although it has experienced a recovery in the past couple of months. We should be prepared for further share price volatility but this looks like a profitable growth story that should play out well over the years ahead.
Questor says: buy
Ticker: NYSE: TYL
Share price at 5.45pm: $373.55