2023-10-25 09:21:47 ET
Summary
- Fair Isaac Corporation is a dominant player in the loan rating market, with a 90% market share.
- FICO's Scores segment, which represents 51% of sales, has seen its operating margin increase from 77% to 88% in recent years.
- FICO faces minimal competition from Vantage Score due to its strong network effect and universal adoption by lenders.
Fair Isaac Corporation (FICO) was founded in 1956 by William Fair and Earl Isaac, hence the name Fair Isaac Corporation. FICO is known for having a 90% market share in loan ratings, not to be confused with the credit rating of Moody's (MCO) or Standard & Poor's (SPGI), since these two rate the issuance of debt by governments, corporations, etc., while FICO rates possible candidates for a loan. For example, perform an analysis and assign a rating to someone who requests a loan for a house or a car.
Business model
The company segments its sales into two categories. The "Scores" part, which is what we talked about in the introduction and represents 51% of sales, and the software part, which represents 49%To give you an idea of how positively the business is evolving, Scores had an operating margin of 77% in 2016, and now it is 88% (I would say it is the highest I have seen in any company), and its percentage of sales has increased from 27% in 2016 to 51% now. This means that the company's total operating margins have increased from 19% to 39% in 7 years! This is spectacular and will also surely continue to grow since the scores segment grows faster than the software segment.
The FICO Scores segment is its flagship segment. It is a natural monopoly in a market that will always exist (debt rating), with operating margins of 88%. To give some data on its importance, 90% of the largest lenders use FICO scores, and 98.8% of the total dollars lent in the US use FICO scores. And what does this mean? Well, it has become the language par excellence spoken between financial institutions and clients. It is like a network effect between customers and financial institutions. Another strong point is that many mortgages loans in the US include FICO ratings. According to Will Lansing in the 2022 Q4 conference call: "Finally, as you are aware, the Federal Housing Finance Agency announced that Fannie Mae and Freddie Mac have completed their validation and approval of new credit score models. I'm pleased the process has concluded and that the FICO scores have again been approved for conforming mortgages by the enterprises. This decision means that FICO Score 10T will be required to be used when available, as classic FICO is today for each conforming mortgage delivered to the enterprises."
FICO scores are numbers that range from 300 to 850 and indicate the risk of default that a client could have (that is, their quality as a borrower). The lower, the worse, but below 660, it is considered junk loans. The worse the FICO score, the worse the loan conditions; they may not even grant it to you. It is like a universal language since all large banks and lenders have their own scores and algorithms, but they are all based on FICO, and they always end up including a FICO Score to understand each other (they are complementary goods with a ridiculous cost). Although they are already using the 10T version of their FICO Score, the majority of scores generated by the company are types 8 and 9, created almost 10 years ago. This gives us an idea of the long lifespan of the company's products, which is one reason for its high margins.
The software segment's offerings are numerous: account creation, customer management, customer engagement, fraud detection, financial crime compliance, and marketing software. Software is purchased in multi-year subscriptions, with payments based on usage metrics such as the number of accounts, transactions, or decision use cases deployed. It is the market leader in fraud detection and customer management; in fact, they protect around two-thirds of card transactions globally. This segment is the one that has taken up capital investments in recent years (around 13% of sales are allocated to R&D each year). The objective, just as companies like Adobe (ADBE) or Microsoft (MSFT) did, is to move all demand to the SAAS (software as a service) format through cloud subscriptions (this year, the ARR (annual recurring revenue) has already accounted for 85% of the income from this segment). They will achieve this through their FICO Platform, which currently only represents 20% of the software segment's revenue, so there is still a long way to go, and it should improve the segment's metrics as well as the amount of data in possession of the company, making it progressively less dependent on the Big 3 data companies (I will give more information in the risk section). Despite the attractiveness of the segment, its operating margins are much lower than those of the ratings; it also grows slower, so it weighs less and less in the company's revenue mix. Although the transition to a subscription model will have positive effects on the recurrence and margins of the segment.
Competence
This part seems somewhat anecdotal to me; if FICO has 90% of the market, Vantage Score has the remaining 10%. The point is that in this industry, the network effect is the most important advantage there is. This leaves Vantage almost out of the game, since both consumers and loan issuers are almost only familiar with the FICO rating; it is the universal language, and it is normal that they do not know how to interpret another rating. These Vantage ratings were created by the three largest data agencies in the country (TransUnion, Equifax, and Experian). FICO competitors are, at the same time, their biggest customers. These 3 agencies are gaining more and more weight in total FICO sales, and this may be due to some reasons. We have already seen that the adoption of FICO ratings is increasing, despite price increases. This means either that the rating volumes issued by the agencies are increasing (increase in volume) or that despite the price increases, they cannot do anything to avoid it since their clients continue to demand the industry benchmark. Although, without being strictly necessary for the granting of mortgage loans, they are usually present in many: "On October 24, 2022, FHFA announced the validation and approval of two new credit score models, FICO 10T and VantageScore 4.0, for use by the Enterprises. Once implemented, lenders will be required to deliver both FICO 10T and VantageScore 4.0 credit scores, when available, with each single-family loan sold to the Enterprises". In the end, clients choose FICO Scores because they are the ones that offer the best value proposition; they are a natural monopoly protected by regulation, but they are really the best for the end client (providers and borrowers). I already said that FICO has achieved a natural monopoly due to the massive adoption it had for 25 years, in which the company did not raise the price of its products (they started doing so in 2016). Until then, they had only grown this segment by volumes. This new regulation makes FICO and Vantage Scores complementary and not rivals.
Robustness ratio
This concept was created by Nick Sleep. The robustness ratio is the still-untapped pricing power over the customer that a company has. That is, how much more can you raise the price of a product without affecting demand because the value you add to it is much greater? In the case of Fico, the average cost of each score for the issuer is between a cent and a dollar (scores for mortgages are the most expensive, while marketing scores can cost a cent). In his presentations to investors, he does not say an exact figure but rather more than 10 billion dollars in sales, so it gives about 6.5 cents on average. This minuscule expense can guarantee a client's ability to repay a loan of half a million dollars. It is a toll bridge that banks will never do without because of the zero cost it entails and everything it saves them. Furthermore, the marginal cost of providing the scores is almost zero once FICO has the data and the algorithms. This makes the business outstanding and its terminal value enormous, thus reflected in a very high multiple.
Capital allocation
Fico's capital allocation has been clear, going into debt to buy back shares. In total, in recent years, it has repurchased more than $3.5 billion in shares, or approximately 17% of its capitalization, generating $1.46 billion in FCF. The difference? Debt issuance. FICO is always between 2x and 3x net debt/EBITDA. The average interest rate ranges between 4% and 5.5%. 70% is at a fixed rate, and the rest is repayable at any time. Therefore, despite the apparent high debt ratio, it does not represent any problem for the company and its large cash generation. It does not distribute dividends and has barely done M&A. The average conversion of profit to FCF is 98%, mainly impacted by stock options, which, as we have said before, seem very high to me, although their percentage is decreasing with respect to net income and FCF. The repurchase timing has been very good, increasing a lot when the stock price was around $400 in 2022.
Financials
FICO has what you could ask for in a great business. With high cash generation, recurring demand, strong competitive advantages, high returns on invested capital, expanding margins, a light CAPEX business, and controlled debt, despite being optically high, we have already seen that it does not pose problems for the company.
Valuation
This is the part of the analysis that can turn one of the best companies in the world into a bad investment.
Taking into account that the scores segment has grown at rates of more than 16% annually, I estimate a growth of 12%, which could come almost entirely from prices alone, so I see it as feasible, as can be assumed. If not, another way to achieve this growth could be: 3%-4% in the form of volume, 3%-4% increases due to inflation, and the rest in the form of special price increases. On the software side, I estimate that growth of 3-5% thanks to cross-selling and increases in switching costs due to the transition to the SAAS model could also be achieved. Improving operating margins due to price increases and transition to the SAAS business model in both segments (90% ratings, from the current 88% and 30% to the software, from the current 28%) and assuming that they repurchase 12% of the shares during the next 5 years at a multiple of 25x EBIT (it is currently at 30x) gives us a price of around $1,200 by 2027. From current prices, they don't seem like great returns to me (6% CAGR), but it is undoubtedly a stock that, if it went down to $650 levels, would be a no-brainer buy for me. I am quite reluctant to go short these high-quality stocks, so I rate the company as a hold.
Source: Author's calculations based on data from Seeking Alpha
Other important graphs
FICO almost never trades below 20x EBIT.
Despite being at historical highs, it has considerable drawdowns from highs; in the end, it is still a somewhat cyclical business. From a 20% drop, you can start to think, although during the COVID it fell by 50% and almost reaches -40% during 2022. It is in these situations that great purchasing opportunities are generated.
FICO has beaten the SP500 for the last 20 years by a huge margin, and I really think that bought at an attractive valuation, it will continue to do so.
Risks
Like any stock FICO is not without risks. The biggest risk for FICO is customer concentration. The 3 big data agencies (Trasunion, Experia and Equifax), which in turn are the owners of Vantage scores, are Fico's largest clients. The three together represented 39%, 38%, and 33% of the company's sales in the last 3 years, so they may have a high concentration of clients. 82% of sales come from the USA. These three together only represented 20% in 2017, so the concentration has doubled in six years. They compete for discounts based on the volume of loans rated by Fico. So the greater the number of loans, the less they have to pay per unit, competing for the best prices among themselves. This ties these companies even more closely to FICO, and it is not strange to me to have seen these growths in recent years.
However, a colleague on Twitter asked me, "Taking into account the scoring margins (88%), why don't credit agencies start selling their data more expensively? It is not clear if it is a sign of the strength of 's competitive position, if the data from the 3 agencies is a commodity (precisely because there are 3), or if it is a threat to in the medium or long term?". It's really a question I can't answer. The fact that the prices of the data used to prepare the scores increase can erode Fico's margins and end up affecting the terminal value of the company. The segment's operating margins will undoubtedly be something to monitor if this occurs.
Conclusion
Honestly, FICO is a company that I love and that I believe is destined to do well for a long time. It is a monopoly in its best segment, and its transformation in the legacy segment can open new growth drivers. The valuation right now is very tight, but I will definitely be keeping an eye on it to be able to add it to the portfolio one day. The aforementioned risk will be a factor to monitor, but if they have not yet managed to harm Fico, there may be reasons that prevent this from happening.
For further details see:
Fair Isaac: A Super Profitable Monopoly