FICO - Fair Issac Corporation

[Guest Schwab711]

The Credit Scores Unit has 96%+ market share and excellent pricing power, increasing prices annually. They are highly levered to outstanding consumer debt which is decreasing currently but will drive earnings when it begins to recover (similar to WB housing bets).

 

What does everyone think?

FICO_Financial_Statement_History.xlsx

[Guest Schwab711]

Surprisingly under-followed considering its size. Maybe I'm missing something on the investment thesis but I see a D&B pre-Moodys' spin-off.

 

http://seekingalpha.com/article/2456875-fair-isaac-corp-my-forever-stock-would-warren-buffett-invest-with-a-moat-this-wide

[Guest Schwab711]

Non-GAAP eps of ~$3.60 gives a 15 p/e when half of the earnings comes from an incredible monopoly. Split-off, that monopoly would be worth so much more. Not sure they ever will be there exists hidden value.

[merkhet]

If the 71% EBIT margin is correct (haven't dug in to check yet), then this would be incredibly interesting if it's spun out.

 

However, there doesn't seem to be any indication that they want to spin that part of the company off.

[Guest Schwab711]

They are also buying back 14% of the company which gives adjusted earnings power of $4.18 (calculated) to somewhere around $4.50 (due to continued growth while executing buyback plan).

 

I agree with you that management doesn't seem interested in the spin-off even though the Scores unit has little-to-nothing to do with the other operating units.

 

[Guest Schwab711]

http://seekingalpha.com/article/2456875-fair-isaac-corp-my-forever-stock-would-warren-buffett-invest-with-a-moat-this-wide

 

http://seekingalpha.com/article/1902301-fico-a-company-that-may-double-again-in-2014

 

What do folks think of splitting off FICO Scores unit? I think the unit alone if worth the market cap currently. This is an outsiders type company with 70% of all outstanding stocks having been repurchased. They just announced a buyback plan to purchase 14% of the company!

[elevensecsrt4]

will add it to my research list...looks pretty good so far thanks!

[Guest Schwab711]

http://finance.yahoo.com/news/fico-announces-earnings-1-10-210500409.html

 

Huge earnings beat. FCF of $160m from $110m last year. They trade at 12.5x TTM FCF. Expected NI growth of 10% for FY15 and FCF is generally much higher than NI. Not a bad valuation for excellent business.

[no_thanks]

Really great idea Schwab, hope it continues to work out for you. 

[Guest Schwab711]

$160m in FCF ($175m operating cash flow - $12.5m Cap Ex). Should have FCF > NI for quite some time with $55m in Depreciation & share comp vs. $15 Cap Ex Maintenance. $150m FCF is probably a decent base case with FY15 FCF likely ending up between $120m - $200m.

 

$250m share buyback has already been used to lower shares outstanding from 34.8m to 32.0m meaning $5 FCF/share currently of 14 P/FCF  for a company with a monopoly and pricing power (Great business at fair/cheap price).

 

Long runway for reinvestment within company at >15% ROIC. Non-GAAP NI guidance is around $125m for FY15 which supports $150m-$165m FCF. This has WB/CM written all over it; the company would be very difficult to replicate even with $5B+ (vs. $2.2B market cap), well-managed and long history of EPS growth over business cycles (this is highly correlated with consumer debt-level which is near a bottom based on real-debt metrics), buybacks/excellent capital allocation, FICO could be spun-off to unlock value, S&P 500 inclusion in the future, company can reinvest nearly 100% of FCF at >15% ROIC, earnings power is significantly higher than current earnings; when US consumer reverts back to increasing real-debt (long-term secular tailwinds), earnings floor is fairly close to current earnings.

 

FICO could realistically trade at $200+ in 5 years as each potential tailwinds/catalysts are realized.

[Travis Wiedower]

Only spent a few hours on this so far but wanted to put down some initial thoughts. Scores obviously has a large moat and FICO isn't going anywhere but it's mature and even with consumer debt levels increasing I don't see too much growth there.

 

Any major future growth will probably be from the Applications segment which I like a lot. Seems like there could be big switching costs (and some network effects) in these applications which is why I'm surprised how little growth they've shown the past few years. What growth it has shown looks to mostly be from acquisitions, not organic. And the valuation certainly isn't cheap.

 

I haven't listened to any earnings calls yet, has management discussed spinning off Scores or is that pure speculation? I'll have more time to delve into FICO this coming week. Interesting company though.

[Guest Schwab711]

Only spent a few hours on this so far but wanted to put down some initial thoughts. Scores obviously has a large moat and FICO isn't going anywhere but it's mature and even with consumer debt levels increasing I don't see too much growth there.

 

Any major future growth will probably be from the Applications segment which I like a lot. Seems like there could be big switching costs (and some network effects) in these applications which is why I'm surprised how little growth they've shown the past few years. What growth it has shown looks to mostly be from acquisitions, not organic. And the valuation certainly isn't cheap.

 

I haven't listened to any earnings calls yet, has management discussed spinning off Scores or is that pure speculation? I'll have more time to delve into FICO this coming week. Interesting company though.

 

@Travis

 

Management has never even so much as hinted at a spin-off of the Scores Unit. I just think it makes a lot of sense and the cross-selling opportunities are overstated. FICO is trading at 15x FCF when the Scores Unit could easily trade at 25x given similar monopolistic companies like Visa/Mastercard. However, I think FICO's moat is the deepest of any publicly traded company (pretty bold statement but which company is safer?). My valuation of FICO is based on the Scores Unit being valued at 10x - 15x EBIT (since I think Buffett/Most value investors would jump at the opportunity to purchase the Scores Unit at 10x current EBIT). This brings a valuation of $130m * (10x - 15x) = $1.3B - $1.95B. At $61 per share (32m shares outstanding), you would get the Applications/Tools Units (75% revenue) for free.

 

I also really like the Applications/Tools Units since they are #1 or #2 in a lot of important enterprise applications fields with excellent growth potential. They don't push the "Big Data" label as much as you would think (considering the valuations some companies trade at) but they are probably the best pure-play 'Big Data' solutions provider. Look up the white paper on NFL scheduling to get an idea of what some of their software can provide. I think the real money-maker is the Fraud software. This is a fragmented market and FICO is far-and-away the best application in the space. They lost 2 multi-million dollar accounts due to M&A activity around 12-18 months ago I believe; I think this is why the Applications Unit has stagnated growth.

 

Finally, I think the Scores Unit actually has a good deal of growth remaining due to emerging market penetration (a lot of small foreign banks use their own scores calculation) and that they are paid almost like a royalty. They are compensated based on demand for credit which is why I mentioned the huge de-leveraging by the retail consumer in the US (25%+ drop from peak credit demand in mid-2007 and continuing to drop). When the middle class of the US starts to take on debt again in the aggregate, you will see an explosion in revenue and earnings for the FICO Scores Unit. You can see 2005-2007 Annual Reviews to get an idea of the revenue potential. With a number of credit cards giving out free FICO scores, revenue will eventually exceed 2005/2007 peak. FICO is likely tied to the middle class of the US and the housing recovery will ultimately be an excellent proxy for FICO.

[thefatbaboon]

Schwab,

 

Could you talk some more regarding the applications/tools segments?

 

Also, in the Scores segment what allows for their interposition between the three credit reporting agencies on the one hand and the customer/financial institutions on the other?

 

Thanks.

[Guest Schwab711]

Schwab,

 

Could you talk some more regarding the applications/tools segments?

 

Also, in the Scores segment what allows for their interposition between the three credit reporting agencies on the one hand and the customer/financial institutions on the other?

 

Thanks.

 

I'll go in reverse order:

 

Scores:

The Scores Unit makes money through a royalty/toll-bridge business model where FICO provides their Scoring models to the 3 main CRAs . The CRAs will then make unique adjustments to create a branded product for the various models to sell to lenders (banks, auto lenders, ect). Each time a consumer attempts to gain credit, a credit report (CR) is generated and the lender pays a fee to the CRA who provides an 'associated fee' to FICO (business-to-business B2B; B2C through MyFico.com has been increasing at a faster rate than the decrease in revenue from B2B). In general, FICO is a royalty on US consumer credit that represents a very small % of the total financing fees for both lenders and consumers. As a side note, FICO has numerous versions of the popular model, insurance, niche models, transaction-based models, and some scoring models they use for cross-selling purposes in the Fraud and Debt Management software. I tried to make an infographic and if I can ever figure out how I'll post it but it's a very similar business to V/MA in the sense that they collect on every request for credit throughout the country (whether an associated fee through the CRAs or a direct fee from the lenders with their own scoring models).

 

The recent trend is FICO is starting to flex their pricing power. In 2014 they negotiated a higher 'associated fee' from 1 of the CRA and MyFico.com/Discover has increased their B2C revenue (higher margin) while maintaining their B2B revenue (CRAs), squeezing more juice out of the same lemon. I could see more consumers purchasing their credit scores directly on a reoccurring basis while the royalty business through CRAs remaining unchanged due to the clout of the big 3 and the low relative cost of an official credit report. Scores will likely increase revenues faster than GDP while margins will likely continue to slowly expand.

 

 

Applications Segment:

Fraud is the biggest component of FICO's Applications revenue (~25%), the fastest growing, and one of their most fractured markets (they are the market leader with 11% share!). All the major analytic software companies have similar software but the IBM/FICO-Falcon software is the most robust and has excellent reviews. It is very complicated software that is considered a popular job skill that is both a barrier to converting [for companies] but provides excellent customer retention. Their Customer Managment (250+ banks) and Collections software is less interesting due to the lower growth expectations. Their ideal customer is generally a small-to-midsize banking, insurance, or healthcare company that needs to be able to manage a great deal of data with a 'cloud' solution. They have partnered with IBM on a number of projects and have similar solutions for customers. You can think of FICO providing specific solutions for businesses that cannot afford IBM.  They also have some loan origination, marketing, and insurance software that competes against some well-established solutions and is low-ranked in market share. A small piece of the Applications pie is the "Analytics" section. FICO provides the example of "FICO ® Economic Impact Service, which uses time series modeling of the macro economy to allow lenders to forecast future credit risk performance based on their views of the economy" but they more generally create higher specific software for niche needs. Similar to orphan drugs, once this software is created, it often has incredibly high ROIC for the customer and pricing is quite inelastic.

 

Tools Segment:

I figured it was easier to split up Applications and Tools since it will more easily match up with the AR and you just wanted an overview. This would preferably be an add-on suite to customers with the cloud-analytics solution discussed above when I wrote about their enterprise solutions. This is the Big-Data segment where management expects incredible future growth and competition is quite limited [basically IBM and to some extent, SAS]. Pegasystems (PEGA) is considered a rival (though I think a good deal of their revenue comes from other sources) but PEGA has 4x revenue and the same operating income (so FICO has 4x higher margins), yet is valued at $1.5B or 55x P/E.

 

FICO's main offerings in this segment are Rules Management, Predictive Modeling, and Optimization. Some examples are:

  RM: Blaze Advisor - Allows companies to use historical business data to test how changes in policy/corporate strategy would be effected. FICO states that the module ultimately handles very complex decision trees more efficiently than any competitor.

  PM: Model Central Solution - Allows banks (and insurance/healthcare companies) create their own proprietary predictive scoring models . This can be incorporated with Blaze Advisor to create a Decision Management environment that can allow management to see predictions, the expected consequences of those predictions, and execute their decisions automatically.

  O:  Xpress Optimization Suite - Provides software that helps corporations use the most mathematically-efficient methods to solve highly complex problems. The most common example FICO likes to tout is that the NFL uses FICO's software to help create the schedule each year. "......for the season's 256 games, the tool would have to consider 7,000 game options, while accounting for some 20,000 variable and 50,000 constraints.". This allows the NFL to maximize revenue for itself and its sponsors. In 2004, it took 6 people 14 hours a day for 3 months to create a schedule that could only be evaluated at the conclusion of the season. Either way, interesting article.

 

http://www.fico.com/landing/banners/optimization-nfl/NFL_Success_2495CS_EN.pdf

 

 

Tools is growing at 15% with 20% operating margins and Applications is growing at 10% with 35% operating margins! Similar 'Big-Data' businesses with less sticky customers are selling for 40x - 100x current earnings. Not that I necessarily believe they are worth such exorbitant valuations but it goes to show that market tends to think that big-data companies have fairly large barriers to entry and excellent long-term growth prospects to warrant higher than market valuations where as FICO sells at 15x FCF. As I've said way too much, I really think FICO is the greatest business on the US exchanges. They recently expanded their staff significantly (definitely partially due to acquisitions) and revenue is $120m higher over past 2 years while operating income is stagnate as R&D has increased faster than revenue. I am most impressed with FICO because they are performing so well with so many headwinds. Consumers are de-leveraging at a record pace, credit demand is at historical lows, IT investment is low, and they have significantly increased R&D (up 100% over last 2 years). FCF is currently $160m but their earnings power is likely closer to $200 - 225m currently (normal R&D and IT investment). Once consumer debt levels and credit demand revert to mean, earnings will likely be many multiples of the current $160m.

[yadayada]

Im not sure if it is cheap. You gotta add back working capital and share based compensation. You want average FCF. And share based compensation is a real cost.

 

In that case it is closer to about 95-100m. So 23-24x FCF. Seems quite a lot is priced in already.

[rpadebet]

Obviously a good business, but one would expect a much higher operating margin for a business with similar moat and asset intensity right? Operating margin's seem to be 20-22% over the last few years.

 

One thing I am not able to reconcile given the perceived moat is why their SGA/Sales ratio is around 45% consistently. If the product they sell is so valuable and irreplaceable for their customers why do they have to spend so much selling it?

 

Maybe another way to think about this is, its probably an opportunity for some activist to come in and reduce the SG&A, thus driving higher operating margins and a better valuation.

 

Thoughts?

[Guest Schwab711]

Obviously a good business, but one would expect a much higher operating margin for a business with similar moat and asset intensity right? Operating margin's seem to be 20-22% over the last few years.

 

One thing I am not able to reconcile given the perceived moat is why their SGA/Sales ratio is around 45% consistently. If the product they sell is so valuable and irreplaceable for their customers why do they have to spend so much selling it?

 

Maybe another way to think about this is, its probably an opportunity for some activist to come in and reduce the SG&A, thus driving higher operating margins and a better valuation.

 

Thoughts?

 

Messing with SGA as an outsider makes me nervous. Why does an outsider understand the company from arm's length better than the actual operators. What should SG&A be?

 

As to the margins, the Scores Unit is just 25% of revenue yet 50%+ of the profit. It's 1/2 excellent monopoly, 1/3 high-margin applications, 1/6 high gross margin Tools (Big-Data) company. As I mentioned, profit margins should be down almost 5% in 2013 due to ramped up internal investment and R&D (seems to be a theme with my investments...).

 

 

Im not sure if it is cheap. You gotta add back working capital and share based compensation. You want average FCF. And share based compensation is a real cost.

 

In that case it is closer to about 95-100m. So 23-24x FCF. Seems quite a lot is priced in already.

 

Ya, so that's the GAAP earnings, more or less. I'm generally not one for adjusted profits but in this particular case, from what I understand, share compensation is necessary to compete for top programming/engineering talent. They are currently undertaking a $250m share buyback (10%+ of the company) to more than offset this but it is absolutely a real cost that increases the price paid during share buybacks. In turn, the money generated from shares is a real benefit. FCF/share solves this. If the company cannot increase earnings by more than the cost of shares given away this will decrease. Many companies feel the earnings/share headwind is worth it. Some, such as FICO's case, actually are worth it.

 

WC certainly has fallen off significantly but there's reason to believe it could be sustainable. When did 20% margins become ho-hum? How much is expected? I also think it's a fool's errand to make guesses on business quality based purely on financials. You will be tricked be earnings volatility many more times than you will be right. The qualitative thesis should be in your mind as you read about the company and if the financials align with that thesis you really got something.

 

Either way, cool feedback. Always good to have ideas put through the guantlet.

[Guest notorious546]

I like the business and i think their moat is pretty solid! at 18-20x next years earnings doesn't look like the cheapest thing in my opinion. i think this is a great stock to add to watchlist though. i've attached conference notes from their last presentation which could be helpful for some people.

 

FICO-Transcript-2014-12-10T22_301.pdf

[KinAlberta]

Schwab711, thanks for starting this thread.  It's very interesting.

 

As for rabbet and others wondering about underpricing, modest margins.  Edwards Deming once talked about monopolies and how foolish it would be to price gouge.  Not sure how it might apply here but it's sure worth reading. See pages 73 & 74 here:

 

The New Economics: For Industry, Government, Education

By William Edwards Deming

 

https://books.google.ca/books?id=RnsCXffehcEC&pg=PA73&lpg=PA73&dq=demings+foolish++optimize+monopoly&source=bl&ots=qxI7Buai3g&sig=NiZZlkIT_DtJY5VBiWPSbvX9hGs&hl=en&sa=X&ei=acmqVOiWHoP9yQT-qoHwAw&ved=0CB0Q6AEwAA#v=onepage&q=demings%20foolish%20%20optimize%20monopoly&f=false

[rpadebet]

Schwab711, thanks for starting this thread.  It's very interesting.

 

As for rabbet and others wondering about underpricing, modest margins.  Edwards Deming once talked about monopolies and how foolish it would be to price gouge.  Not sure how it might apply here but it's sure worth reading. See pages 73 & 74 here:

 

The New Economics: For Industry, Government, Education

By William Edwards Deming

 

https://books.google.ca/books?id=RnsCXffehcEC&pg=PA73&lpg=PA73&dq=demings+foolish++optimize+monopoly&source=bl&ots=qxI7Buai3g&sig=NiZZlkIT_DtJY5VBiWPSbvX9hGs&hl=en&sa=X&ei=acmqVOiWHoP9yQT-qoHwAw&ved=0CB0Q6AEwAA#v=onepage&q=demings%20foolish%20%20optimize%20monopoly&f=false

 

I wasn't particularly referring to pricing power, but I have a hard time understanding why SGA increases with sales on a 1:1 basis in this business, if they do have a moat. Its a transaction based business, so shouldn't SG&A increase proportional to # of clients instead of being proportional to # of transactions? And once you land clients, your SG&A for that particular client should go down drastically, giving you incremental operating margins closer to the gross margins.

 

As a related observation, transaction based businesses are typically cyclical and we can see that in FICO's performance during the housing downturn. cyclical businesses typical deserve a below average multiple i would think. If they had some sort of licensing/recurring revenue stream instead of transaction based one, then volatility of revenue stream is lower and hence it can command an above average multiple.

 

Lastly, its clear the Scores unit is the crown jewel here. It probably has the moat and is delivering above average ROIC's, but the other businesses seem average at best (if you take a long term view) and I can't see why a better funded competitor like IBM/Oracle can't take away their share in future.

 

 

 

[Guest Schwab711]

Schwab711, thanks for starting this thread.  It's very interesting.

 

As for rabbet and others wondering about underpricing, modest margins.  Edwards Deming once talked about monopolies and how foolish it would be to price gouge.  Not sure how it might apply here but it's sure worth reading. See pages 73 & 74 here:

 

The New Economics: For Industry, Government, Education

By William Edwards Deming

 

https://books.google.ca/books?id=RnsCXffehcEC&pg=PA73&lpg=PA73&dq=demings+foolish++optimize+monopoly&source=bl&ots=qxI7Buai3g&sig=NiZZlkIT_DtJY5VBiWPSbvX9hGs&hl=en&sa=X&ei=acmqVOiWHoP9yQT-qoHwAw&ved=0CB0Q6AEwAA#v=onepage&q=demings%20foolish%20%20optimize%20monopoly&f=false

 

I wasn't particularly referring to pricing power, but I have a hard time understanding why SGA increases with sales on a 1:1 basis in this business, if they do have a moat. Its a transaction based business, so shouldn't SG&A increase proportional to # of clients instead of being proportional to # of transactions? And once you land clients, your SG&A for that particular client should go down drastically, giving you incremental operating margins closer to the gross margins.

 

As a related observation, transaction based businesses are typically cyclical and we can see that in FICO's performance during the housing downturn. cyclical businesses typical deserve a below average multiple i would think. If they had some sort of licensing/recurring revenue stream instead of transaction based one, then volatility of revenue stream is lower and hence it can command an above average multiple.

 

Lastly, its clear the Scores unit is the crown jewel here. It probably has the moat and is delivering above average ROIC's, but the other businesses seem average at best (if you take a long term view) and I can't see why a better funded competitor like IBM/Oracle can't take away their share in future.

 

 

 

 

 

I've heard of the price gouging principle before. I'll definitely read this, thanks.

 

 

RapidBet:

If you read Item #7 (2013 AR) titled "Overview", the company specifically answers your question on margins.

 

Also, I do think you are over-estimating how easy it is to compete in predictive software development. Without going in too much detail, I would imagine it would cost billions (maybe 10's of billions) for another company to develop similar software to FICO's. This ignores the problem of where to find talent to pull this off.

[KinAlberta]

A few years ago, right after the credit crisis hit and all the talk of inflation, the feds operations had me saying buy the credit card companies if hyper inflation hits.  Unfortunately I sold my MasterCard shares as I saw everyone getting into the game (Square, etc.).  A lot of technology and money is going into breaking the oligopoly so I thought I'd best step away from that risk. Of course in hindsight I left a lot of money on the table.  :-(

 

Now I'm wondering if FICO isn't a better safer bet on inflation someday rearing its head.  Maybe MCO and FICO together for a long term buy and hold bet.  Any thoughts?

 

The card processors I really have to wonder about.

[ItsAValueTrap]

Unfortunately I sold my MasterCard shares as I saw everyone getting into the game (Square, etc.).  A lot of technology and money is going into breaking the oligopoly so I thought I'd best step away from that risk. Of course in hindsight I left a lot of money on the table.  :-(

 

Um... Square doesn't compete with Mastercard?

[Guest Schwab711]

Unfortunately I sold my MasterCard shares as I saw everyone getting into the game (Square, etc.).  A lot of technology and money is going into breaking the oligopoly so I thought I'd best step away from that risk. Of course in hindsight I left a lot of money on the table.  :-(

 

Um... Square doesn't compete with Mastercard?

 

As a heads up, Square pays a fee to MA/V to use their networks. Square is a pretty awful business model. They take on all the risk and expenses and give a royalty to MA/V which ends up being a substantial portion of the revenue. It will be a miracle if Square ever makes significant profit. I think they are attempting to cut out the card issuers (major bank credit cards) as opposed to competing with MA/V.

 

 

 

 

Now I'm wondering if FICO isn't a better safer bet on inflation someday rearing its head.  Maybe MCO and FICO together for a long term buy and hold bet.  Any thoughts?

 

 

I don't think the US has any inflation (and certainly not hyper-inflation) issues to worry about for some time. My first post on FICO mentions the incredible de-leveraging of consumers/middle-class Americans that is still on-going. The increase in the Fed BS or US debt obligations is dwarfed by the decrease in debt obligations of tax-payers. Overall, total debt obligations are down in the US. However, I do think inflation will occur in the future and if long-run inflation is 2-3%, this period of 0% inflation will have to be made up for. So I don't think inflation will be as big of an issue as you but I completely agree with your thesis and to further prove the point, MCO is my largest holding and FICO is my 3rd largest (I own 5 stocks). MCO/FICO represent 55% of my portfolio and I consider both to be my only forever stocks. I own BRK-B and I still see MCO/FICO as having a brighter/safer future.

 

I missed on V/MA when the court rulings for transaction caps was announced. Biggest investing mistake I've made thus far. However, as I've mentioned, I actually like FICO better than MA/V due to its low risk and lottery ticket with Big-Data. I think it's incredible FICO made it through the crisis without a single finger pointed at it; the moat is deep, wide, and crocodile-filled. MCO/V/MA and to a slightly lesser extent, MHFI, are all just a small step below FICO with regards to quality in my eyes. I think financial services stocks are the best forever stocks and these are the cream of the crop. Other industries change with technology, fads, or for other reasons but financial services tend to be used for significant periods of time without change. And, any change is usually met with great push-back and can be seen from quite a ways off (bank checks?). I would put 100% of my money equally in FICO, MCO, MA if every stock in the world had the same valuations right now.

[Guest Schwab711]

When do others consider selling? I'm starting to think that with "forever" type companies, you have to gauge how far ahead of growth they are and what expected returns are from the current price? FICO's big data segment is one of the largest Big Data companies yet it is priced at 30x as opposed to 100x - 500x. Obviously I can't expect outrageous valuations but it does show the market's expectation for a high probability of some growth.

 

Should I consider selling at replication cost? Or just never?

 

Interested to hear what others' thought process is.

 

 

Don't want to bump but this could be a game changer...

http://seekingalpha.com/news/2406756-fico-readies-new-credit-scoring-system