2023-08-18 19:54:17 ET
Summary
- Fair Isaac Corporation is mostly known for its FICO score, but is also offering software and analytics.
- Due to the brand name and switching costs the company has a wide economic moat around its business and outperformed the S&P 500 in an impressive way.
- While the balance sheet is not perfect, retained earnings due to huge share buybacks disturb the picture a little bit.
- Right now, the stock seems overvalued at is trading for 50 times earnings and free cash flow.
Fair Isaac Corporation ( FICO ) is certainly an interesting business. To be honest, I wasn’t aware about the company until a few weeks ago. But I certainly knew its most prominent product – the FICO score. And I assume for many others it is quite similar – many people know the FICO score (at least in the United States), but the business seems to remain nameless for many.
In the last few months, I started covering several high-quality businesses with a wide economic moat around the business which I did not cover before – and Fair Isaac Corporation is fitting that description. The company is another business covered in the podcast “ Business Breakdowns ” which was also the inspiration for the other businesses I covered in the last few weeks for the first time. And as always when covering a business for the first time, we start with a short description.
Business Description
Fair Isaac Corporation was founded in 1956 by engineer William R. Fair and mathematician Earl Judson Isaac on the premise that data used intelligently can improve business decisions. And the first product the company was selling was the FICO score – a standardized metric to measure consumer credit risk. Today, the business is not only offering the FICO score but also software and analytics. It has about 3,300 employees in locations all over the world and is operating in nearly 120 countries. The largest market for the business is financial services (representing over 90% of total revenue right now) and the largest geographical market is “America” (which is responsible for 82% of total revenue).
And in fiscal 2022, the company generated $1,377 million in revenue and compared to $1,317 million in fiscal 2022 the top line increased 4.6% year-over-year. Operating income grew 7.3% year-over-year from $505 million in fiscal 2021 to $542 million in fiscal 2022. And finally, diluted earnings per share increased from $13.40 in fiscal 2021 to $14.18 in fiscal 2022 – resulting in 5.8% year-over-year growth.
While these are solid growth rates, FICO is expecting higher growth rates again for fiscal 2023. For the full year, management is expecting revenue to increase almost 9% to $1.50 billion and earnings per share (on GAAP basis) are expected to increase about 19% YoY to $16.90.
And FICO also grew with much higher growth rates in the last few years than in fiscal 2022. In the last five years, revenue grew with a CAGR of 8.12%, operating income grew with a CAGR of 24.45% and earnings per share grew with a CAGR of 28.93%.
FICO is reporting in two different business segments – the score business and the software business. Sometimes, FICO is also reporting three different types of revenue: First, revenue generated by scores which was $707 million in fiscal 2022, second $565 million in revenue generated by on-premise and SaaS software and additionally $106 million in revenue generated by professional services.
The scores business includes business-to-business scoring solutions and services giving clients access to predictive credit and other scores. The segment also includes business-to-consumer scoring solutions including subscription offerings. The software business is including analytic and decision software for specific types of businesses and process – including services like account origination, customer management, fraud detection, financial crimes compliance or marketing. These offerings are available as software-as-a-service (SaaS) or as “On-premise-software”.
Economic Moat
If you have read some of my past articles you know my goal is to identify companies that can be seen as long-term investments. I am trying to identify stocks I can hold for one or several decades. And while I am also searching for undervalued stocks and don’t think we should overpay for a business, the most important aspect is the wide economic moat around a business.
And while an economic moat is mostly a qualitative aspect of a business, an economic moat should always be visible in the reported metrics of a business. We can start by looking at the impressive outperformance of FICO since the IPO of the business in 1987. While the S&P 500 gained 1,340% during these 36 years, FICO gained 28,240%.
And in case of FICO a multiple expansion during the last decade clearly contributed to this impressive performance (we will get to this) but the outperformance of FICO is so impressive. Aside from the stock outperformance, a stable (or improving) gross and operating margin is also another hint for an economic moat and a company having pricing power. And in case of FICO, we see a constantly improving gross margin during the last decade. And especially the operating margin improved in the last few years.
FICO Profitability and Efficiency (Author's work)
And not only margins can hint towards a wide economic moat – a high return on invested capital is also a strong sign. Aside from 2022 (for that year we don’t have numbers), the average return on invested capital was 17.3% in the previous nine years – a strong hint for an outperformance of the business.
FICO: Revenue, EPS and free cash flow (Author's work)
High growth rates by themselves are not reason enough to assume a wide economic moat around a business. Instead, we are looking for stable growth rates over a long period of time. And in the last ten years, FICO increased revenue, earnings per share and free cash flow with some consistency.
FICO 2022 Investor Presentation
And not only the metrics are showing a wide economic moat, we also can clearly identify two different sources for the economic moat around the business – the brand name and switching costs.
Let’s start with the brand name. Not only has Fair Isaac Corporation a strong and recognizable brand name for its most important product – the FICO score – with many people knowing the score and it also being mentioned in popular movies like “The Big Short”. The FICO score is also deeply embedded in the financial world – comparable to ratings from Moody’s Corporation ( MCO ) or Standard & Poor’s. And that brand name is a valuable intangible asset for the business as a customer needing a credit score will almost always use a FICO score as a consumer credit score is synonymous with the FICO score for most Americans. Maybe U.S. residents know other consumer credit scores, I personally don’t know any other by name (but I don’t live in the United States). And such a powerful brand name is like a short cut with a customer always picking the FICO score when needing a credit score.
But not only the brand name is important, we can also identify high switching costs. With FICO scores being used (according to the 2022 Annual Report) by 92 of the 100 largest financial institutions in the United States and three quarters of the 100 largest banks in the world as well as more than 600 insurers (including eight of the top ten U.S. property and casualty insurers) it seems like everybody is using the FICO score and using something else isn’t even considered. The FICO score is also used by more than 300 retailers and general merchandisers as well as 200 government and public agencies.
The switching costs are not only high as using the FICO score seems like the natural pick, they are high for different reasons. First, the end consumer is paying for the credit score while other institutions – like the bank granting a loan – is deciding what score and data to use. Additionally, the majority of these scores are marketed and sold through the three major consumer reporting agencies – Experian plc ( EXPGF ), TransUnion and Equifax Inc. ( EFX ) – and they most likely will accept all price increases as the end consumer is paying in most cases.
And consumers will also pay for higher prices as the FICO score is offering huge value but costs only a few bucks. Having a FICO score – compared to another nameless consumer credit score – will offer value for the consumer as almost every bank and financial institution will accept a FICO score. On the other hand, the FICO score costs only a few dollars and in case of consumer loans (when a FICO score is required), we quickly reach amounts of $10,000 and higher for cars or amounts of $500,000 and higher for buying a house. And when dealing with such huge amounts, nobody will care if a FICO score costs $1, $5 or $50. When getting an interest rate of only 1% lower due to a good FICO score (compared for example to having no FICO score), I can save $1,000 in interest annually on a $100k mortgage and nobody cares in such a scenario if a FICO score costs $5 or $50. The FICO score is the perfect combination of a mission-critical product that is extremely cheap.
Performance During Recession
Aside from having a wide economic moat, it would also be great to have a business that is not vulnerable to business cycles. I am still expecting a recession in the foreseeable future (although the stock market seems to think otherwise), but even if we fall into a recession in the next few quarters – at some point it will happen, and I like to know how a business is usually performing during these times.
When looking at the more than three decades we have numbers for FICO, we can see the business performing quite well. Earnings per share declined several times – and at least in two cases (the Asian Financial Crisis and the Great Financial Crisis) these declines can be associated with a recession. However, when looking at revenue we hardly see any reaction to the different recessions in the past with one exception – the Great Financial Crisis.
And I would expect a similar performance for FICO in the years and decades to come. In some ways we are dealing with a cyclical business as demand for loans will decline during economic downturns – and from time to time we will see a major crisis like the GFC again with mortgage volume declining steep. But overall, Fair Isaac Corporation will perform quite well during economic downturns – and the subscription services are also helpful for stable revenue generation.
Balance Sheet
We already mentioned above that FICO was not able to calculate a return on invested capital or return on equity in the last few quarters and return on equity increased to the triple digits. This is showing us that FICO’s equity constantly declined during the last few years, and this is reason enough to take a closer look at the balance sheet.
On June 30, 2023, FICO’s balance sheet was not perfect. The company had $115 million in current maturities on debt as well as $1,815 million in long-term debt. Usually, we would compare the total debt to shareholder’s equity, but FICO is currently reporting a shareholder’s deficit of $704 million. Instead, we can compare the total debt to the operating income FICO generated in the last four quarters ($609.3 million) and it would take about 3.15 years for FICO to repay the outstanding debt. Additionally, FICO has $163 million in cash and cash equivalents on its balance sheet that could be used to repay outstanding debt lowering the time to about three years, which is certainly acceptable for a business growing with a high pace.
When talking about the balance sheet, we also must mention $777 million in goodwill due to the many acquisitions FICO made and with $1,585 million in total assets almost half of the company’s assets is goodwill – which is also not great.
The balance sheet of FICO is certainly not perfect, but one aspect is important when talking about the balance sheet. There is one major reason for the shareholder’s deficit: FICO has $5,209 million in treasury stock on its balance sheet resulting in the negative amount. And although treasury stocks can be resold to the open market (and are not permanently canceled like retired shares) I don’t think this will happen as FICO has been mostly focused on reducing the number of outstanding shares in the last two decades.
All in all, the balance sheet is not perfect and the constantly increasing debt levels are not great, but I don’t see reasons to worry yet.
Share Buybacks
This huge amount in treasury stock on the balance sheet is leading us to another important point – share buybacks. In the early 2000s, the company still had 83 million outstanding shares but in the following years the company repurchased shares with a rather aggressive pace and reduced the number to only 25.34 million right now. This is resulting in a CAGR of 6% with which the company was reducing the number of outstanding shares.
FICO can – in theory – use a huge part of its free cash flow to repurchase outstanding shares. At this point, FICO is not paying a dividend and I don’t think the company intends to do so in the foreseeable future (but obviously the company was paying a dividend until 2017 ). And with free cash flow being rather high due to extremely low capital expenditures, FICO has large amounts of cash to put to work.
In the last four quarters, FICO generated a free cash flow of $445.7 million and with a current market capitalization of $21.38 billion this is enough to repurchase about 2% of outstanding shares annually, which is not a lot and nowhere close to 6% the company repurchased on average in the past. This metric is already indicating that FICO might be rather overvalued and repurchasing shares at this point in time is probably not the smartest idea.
Intrinsic Value Calculation
We already indicated above that FICO’s valuation multiples increased over the last ten years and that the stock does not seem cheap. And when looking at the valuation multiples – the price-earnings ratio and price-free cash flow ratio – FICO does not seem cheap. In the last ten years, FICO was trading for an average P/E ratio of 39.44 (which seems high) and right now the stock is trading for 53 times earnings. When looking at the P/FCF ratio, the average P/FCF ratio was 29.11 during the last ten years and right now the stock is trading for 50 times free cash flow.
And we saw above that FICO is growing with a high pace, but valuation multiples of 50 are hardly justified for any business. To get a better picture, we are also using a discount cash flow analysis to determine an intrinsic value for the stock. As basis for our calculation, we use 25.337 million outstanding shares and – as always – a 10% discount rate. As basis for our calculation, we can use the free cash flow of the last four quarters, which was $445.7 million. Analysts are estimating FICO to grow its bottom line with a CAGR of 16% in the next five years and when looking at past growth rates, this seems like a reasonable assumption.
CAGR | Since 1991 | Since 2000 | Since 2010 | Since 2015 |
---|---|---|---|---|
Revenue | 12.93% | 7.22% | 7.10% | 7.37% |
EPS | 18.69% | 15.82% | 21.14% | 27.08% |
However, I would be a little more cautious. For starters, I assume free cash flow to stagnate for one year to reflect the potential of a recession in the foreseeable future. And for the following years I will calculate with 14% growth until ten years from now followed by 6% growth till perpetuity. And in a second scenario I will calculate only with 12% growth (instead of 14%).
The first calculation leads to an intrinsic value of $680.25 for FICO while the second calculation leads to an intrinsic value of $601.75 for the stock.
Conclusion
As I am a rather cautious investors, I probably will not buy FICO above $600 at this point. Fair Isaac Corporation is a great business with a wide economic moat around the business, but the stock seems to be overvalued. Or to put it a little different: Assuming high growth rates and everything working out for Fair Isaac Corporation the stock might be fairly valued – but the business has to perform great to justify the price and the downside risk is rather huge.
And especially when looking at the stock price performance during past recessions lower stock prices are not unlikely. Especially during the Asian Financial Crisis and the Great Financial Crisis the stock declined steep. During the Great Financial Crisis, the stock lost almost 80% of its previous value. And I don’t know if we will see a similar scenario this time, but I would wait for FICO to correct before I consider an investment in the company.
For further details see:
Fair Isaac Corporation: An Overvalued Business Based On Embeddedness