2023-11-08 08:26:06 ET
Summary
- FICO has strong fundamentals and a history of annual revenue growth, with the scores business driving growth.
- The company is expected to continue raising prices for its FICO score due to its critical nature and value to lenders.
- The platform software business is poised for significant growth, with a large target market and high ROI for customers.
In this article, I will discuss why I am assigning an initial hold rating to FICO (FICO), despite a premium valuation.
Strong fundamentals
Despite the high valuation, I believe that FICO's strong fundamental performance will compensate for this over time. Since 2015, revenue has compounded at 7% annually. There are 3 factors affecting this; First software divestitures, most recently in 2021 contributed almost 10 % of revenue. These have had a drag on revenue growth. Secondly, the slowdown in scores revenue in 2022 and 2023 due to the macro environment causing a slowdown in score origination volumes, most notably in mortgage scores. Third, the slow growth legacy software business having an outsized impact on the business. In 2015, software contributed 75% of revenues. Today scores contribute just over 50%. This majority weighting to software, hid the higher growing scores business which is evident today.
FICO annual revenue (stratosphere.io)
I expect revenue to grow at a faster rate than it historically has, although not precise, I expect growth in the low to mid double-digit percentages. I believe this for 2 reasons: the scores business is likely to continue growth in the mid-teens rate over the long term. Secondly, I expect total software revenue to accelerate as the 40%+ recent growth rate of the platform software business continues and contributes an increasing part to the total. This high growth will be offset by slower growth non-platform business. Due to a combination of the two factors I expect the overall software business to grow around 15% annually. I will discuss both of these growth drivers below.
Scores
Scores revenue has grown at 15.7% annually since 2013. This growth rate is due to a substantial acceleration since 2018, when the company adopted a new pricing philosophy. FICO began implementing special pricing increases to close the gap between the value they thought they were providing and the price they were charging. Since 2018, revenue growth has accelerated as new pricing increases have been implemented yearly.
FICO scores annual revenue (stratosphere.io)
Over the course of 2022 and into 2023, revenue growth has decelerated as rising interest rates have caused the macro environment to slow down. This has particularly affected mortgage origination volumes and in turn, the B2C side of the business. During this time, the company has continued to implement pricing increases, most notably 100 %+ pricing increase in mortgage scores through a new tiered pricing structure. These pricing increases are starting to become evident as volumes have stabilised. When volumes recover, I expect further revenue acceleration. I expect scores revenue to continue to compound at a mid-teens rate+ as the macro environment normalizes. This growth will be driven by both volume and pricing increases, although pricing will be the main contributor.
How long can they continue increasing the price?
I expect the price increases to be durable, this is because there is still a large gap between the price that FICO charges and the value the score provides. FICO didn't start raising price until 2018. Prior to this, price hadn't been increased for 25 years as the company had fixed priced contracts with channel partners which limited their pricing ability.
There are two reasons pricing can continue to increase. First, is the low pricing that FICO charges today. In a conference CEO William Lansing said ;
we price our scores from basis points to single digit dollars. And, typically they're used in a decision that's worth hundreds or thousands or tens of thousands or hundreds of thousands of dollars.
Although the price they charge is quite a lot higher than recent years, FICO still only collects a small fraction of the total fees that get charged when an individual borrows money.
The second reason is the mission critical nature of the FICO score. The FICO score is
"probably the single best predictor of propensity to repay debt that there is. If you had to rely on just one thing it would be the FICO score" William Lansing, CEO .
Because of the critical nature of the FICO score, I think it's justifiable for the FICO score to garner a greater share of the total fees than it currently does.
I expect FICO to continue to be able to raise prices yearly for the foreseeable future as they continue to close the value gap and gain share of the total set of fees to reflect the value they provide to lenders.
Software acceleration
Software ARR has compounded at 10.5% annually since it was reclassified in 2020. This slower growth is due to divestitures and the outsized weighting that the non-platform business has in the segment.
FICO software annual ARR (stratosphere.io )
As mentioned earlier, I expect total software revenue to accelerate as the 40%+ growth rate of the platform software business contributes an increasing part to the total. I believe this transition has already begun as shown by the growth rate accelerating in the graph above. Despite many software businesses experiencing slower growth over the course of 2022 and 2023, the platform software has continued to grow extremely well thanks to its mission critical nature, high ROI and strategic imperative. This has resulted in sales cycles decreasing when other software companies have reported the opposite. At some point the macro environment for IT spend will no doubt improve. This macro normalization will help sustain outsized growth of the platform business, along with the long track of growth ahead.
How sustainable is platform growth?
I expect the Platform software business will be the biggest growth driver of the business going forward. FICO is currently targeting the largest 200-300 financial institutions globally, of which they are penetrated only 15 %.
William Lansing has said
The software business could be much bigger than the scores business in the fullness of time. The TAM is enormous"
FICO currently has a 15% market penetration of its target market. I expect this to continue increasing for three reasons; first, is the strategic need for banks to adopt the software as they move to digitize their business. Secondly, FICO software has a high ROI, most bank customers achieve over 100 % ROI within the first year. This demonstrates the power of the software. Thirdly, it is the low cost solution, with the FICO software you can start with a single use case before expanding. FICO mainly competes with internally built solutions, in this scenario it would cost a bank far more money to build their own solution rather than adopting FICO's for a single use case, testing it out and expanding. This low cost optionality makes adopting FICO a low risk option compared to spending significant resources in an attempt to replicate it.
Although FICO has not provided specific details on the size of the TAM, I am sure it is multiples of the business they have today. The company salesforce is currently targeting the largest 200-300 financial institutions globally. With only 15% penetration this gives a potential upside of 5x. On top of this, the company is working with distribution partners who are targeting smaller financial institutions and businesses in other industries as well. The third opportunity they have is to expand the use cases within the existing customer base. Based on the 142 % Dollar based net retention rate in Q3 2023, they are already demonstrating their ability to do this. With those opportunities in mind, I expect FICO can continue growing at a rapid pace for many years to come.
Risks
Valuation
The biggest risk to FICO at the moment is valuation. Although FICO looks optically expensive trading at a P/E ratio of 56x, William Lansing laid out the case for valuing FICO at the Morgan Stanley conference on the 8th march 2023 in a sum of the parts valuation.
William Lansing believes that Scores is worth $17billion. In march 2023, the scores business had a TTM EBIT of $ 642 million. This is a 26.5x multiple for a business that has operating margins of 88%, and continues to grow at a mid-teens rate. I do not consider this unreasonable.
The whole FICO business is currently trading for a market cap of $ 21 B, which means the software business is being valued at $4B. The software business has a TTM EBIT of $200m, implying the market is assigning this part a multiple of 20x. For a business with huge future prospects and strong profitability which is set to increase, I consider this a fair valuation.
Although this only uses EBIT, I believe the valuation is in the right ball park.
Conclusion
In conclusion, I believe that the strong fundamental performance FICO has demonstrated and will continue to demonstrate in the future will help accelerate revenue. This accelerated revenue growth will help drive margins ever higher, resulting in EPS growth higher than the S&P 500. Although valuation is a risk, I have explained through a sum of the parts that the valuation isn't as unreasonable as what it first seems on paper.
For further details see:
Fair Isaac: Fundamentals Set To Improve