2023-12-19 03:25:40 ET
Summary
- I maintain a sell rating for Fair Isaac Corporation due to its exceptionally high valuation surpassing 45x forward P/E.
- FICO's business performance in 4Q23 was positive, with revenue growth of 11.8% and strong software ARR growth.
- The shift away from tier-based pricing for mortgages in 2024 presents a near-term growth catalyst, but the current valuation is still not justified.
Summary
Following my coverage on Fair Isaac Corporation ( FICO ), which I recommended a sell rating as I thought the valuation was too high at 37x forward PE, this post is to provide an update on my thoughts on the business and stock. I remain sell rated on the stock as the valuation has gotten even more expensive than it was previously. While I agree that there are strong near-term growth catalysts, I don’t think it justifies such a high premium compared to peers and FICO’s own trading history. Even with very optimistic assumptions, I do not see an attractive upside for the stock.
Investment thesis
I would like to first congratulate the bullish risk takers who are willing to go long the stock at 37x forward PE as the stock price showed insane strength, increasing to near $1,200 with no signs of slowing down. The main reason for the share price jump was an increase in valuation, from 37x forward PE to 45x forward PE. While I am bearish on the valuation front, I must say FICO has done very well in the 4Q23 quarter and has a very promising near-term outlook, which I believe is the key reason for the market’s optimism. I will first start with the business aspect, of which I am positive, followed by why I think the valuation still doesn’t make sense, even if one were to take an aggressive approach to modeling.
As I mentioned, 4Q23 was a strong quarter for FICO. Revenue grew 11.8% y/y to $389.7 million, with Scores revenue growing 12.3% to $195.6 million despite ongoing macro uncertainty. Software revenue also performed very strongly, growing 16%, and from an ARR perspective, software ARR grew 22% y/y. The strong ARR growth was driven by 53% y/y platform ARR growth and 14% y/y non-platform ARR growth, both of which remain at very healthy levels. Profitability also continues to move in the right direction as EBIT margins expanded by 440bps to 51.3%. That said, EPS came in at $5.01, missing consensus estimate due to higher interest expenses and taxes.
The key near-term bull case for FICO is the shift away from tier-based pricing for mortgages in 2024. This is a huge announcement, as it is likely to drive significant growth acceleration in the Score segment. To put things in perspective, FICO currently charges $2–8 for each of the three scores that are part of a $40–50 tri-merge mortgage report and score bundle. The precise cost is determined by the number of mortgage lenders. The first major benefit from this is the major step up in pricing, which is almost 100% incremental margins to FICO. Going forward, regardless of the volume of mortgage lenders, FICO will charge $10 for all three scores. Assuming $5 (the midpoint of the $2–$8 range) is the average price, this literally implies a 100% increase in pricing. What’s more notable is that I don’t expect to see any resistance from mortgage lenders as mortgage score prices remain low relative to closing costs. When compared to other mortgage closing costs and regulatory requirements, the cost of a mortgage score is relatively low. In 2024, a tri-merge report and score bundle will cost $40 to $50 , with FICO collecting $10 for all three scores. This amount is less than 25% of the total cost. Looking at it another way, the $10 is just a tiny percentage (0.3%) of the average $3,800 in closing costs for a mortgage. One regulatory advantage of FICO is that, following a multi-year transition period, lenders are required by the FHFA to use a FICO 10T score and, if available, a VantageScore 4.0 score when selling mortgages to Fannie Mae and Freddie Mac. Another factor that will drive up effective pricing is the elimination of volume discounts offered to major mortgage lenders, as prices are going to be more standardized.
Valuation
Valuation matters for equity investors, especially public equity, as we do not literally buy the business and operate it. That is to say, we do not receive cash flow from the day-to-day business unless it is distributed as dividends from share repurchases. The long-term stock return still depends on how much the market values the business (i.e., the multiple) and the earnings growth. Before I go into details about my model, I point readers to this relative valuation chart of FICO vs. its peers. FICO is currently trading at a 40% premium to its peers, which has almost never happened before. Throughout FICO's entire trading history, the stock has almost never traded at >40x until COVID happened. Has there been a structural change in the long-term growth trajectory that warrants such a significant premium? The change in pricing might be a near-term growth accelerator, but it is unlikely to be a long-term growth driver as it is unlikely to grow pricing at 100% every year.
Nonetheless, I give it the benefit of doubt that FICO has managed to alter its growth trajectory for the next 2 years. Over the past 2 decades, post-subprime crisis, the fastest it has ever grown was 18% in 2002 (aside from the abnormal growth in 2003). I bumped that figure out to 20% for FY24 and FY25. Margins will take a dip in FY24 due to a higher tax rate and interest expense, but I assumed they would rebound strongly to an all-time-high earnings margin of 36%, topping consensus FY25 estimates. With these assumptions, FICO should generate $810 million in earnings in FY25. At that point, assuming FICO trades back to its historical premium vs. peers, at 36x forward PE, my target price for the stock is $1,174 (or just 4% above the current share price). I would also point out that whenever FICO trades above the 26% premium, valuation quickly re-rates downward. This has happened six times over the past five years, and I don’t see any reason for this time to be different as there is no structural fundamental change to the FICO business value proposition (I get that pricing is important, but it is not as if FICO has rolled out a new product that revolutionizes the industry).
Own calculation
Note that my model uses the very optimal and aggressive assumptions. Any performance below these assumptions leads to negative returns. For example management themselves are guiding to FY24 revenue growth of 11% ($1.67 billion revenue). If FICO grows 11% for FY24 and FY25, with my earnings margin assumption, the stock is worth $1,005 (11% downside)
Own calculation
Risk
The risk is that multiples can stay higher for longer than I expected, which was what happened in the past few months. If multiples can go to 46x, they can go to 50x or 60x, which will drive strong returns in the near term.
Conclusion
I reiterate my sell rating due to FICO. While I do acknowledge the strong business performance in 3Q23, I find the valuation unsustainable even with anticipated near-term growth catalysts. The shift in pricing starting 2024 is certainly positive for FICO's Score segment, presenting potential for substantial pricing increases and incremental margins. However, I believe this does not doesn't justify the current high valuation, especially considering the historical relative valuation to peers and its own trading history.
For further details see:
Fair Isaac Corporation: Stock Trading At 46x Forward P/E Is Too Expensive