2023-06-08 00:23:55 ET
Summary
- Fair Isaac trades at 40x '23 non-GAAP net income with modest growth projections, indicating great forward expectations.
- Household debt data shows FICO is extracting similar value from their respective lending ecosystem as peer Moody's.
- FICO's competitive advantage and pricing power are strong, but expecting scores revenue to perpetuate 20%+ growth is unrealistic.
- Despite FICO's strength, its stock has doubled in the past year, compressing forward returns and making it a good time to sell.
Poker players must be able to fold premium hands to be successful. Investors must also sometimes fold premium hands by selling great businesses with high valuations. This can be difficult and takes a great deal of discipline.
This is the reality for investors holding shares of Fair Isaac ( FICO ). FICO stock trades at 40x '23 non-GAAP net income with modest growth projections, a profile that was more common during the 2021 mania than it is today.
"Unlimited" Pricing Power:
FICO checks many boxes that investors use when looking for competitive advantage. FICO is the undisputed benchmark for consumer credit scores, a component of a variety of loan approval processes. Consumer loans are essential for the economy to function properly.
Today, over 250 million Americans can be scored using a FICO score. And scores are very inexpensive, generally less than $1 each. And some scores are even $0.01 or a fraction of $0.01, depending on the use case. To give you an idea of the far reach of FICO scores, they're used in over 90% of the credit lending decisions - Dev Kantesaria
The cost of a FICO score is minuscule compared to the volume of consumer debt being issued. When a high quality service is cheap, it leaves little desire for customers to switch. It gets the job done. This cheapness has led many bulls to the belief that scores are vastly underpriced, and FICO's revenue could perpetually smash expectations.
About 40% of FICO's revenue is derived from the 3 credit bureaus, Experian ( OTCQX:EXPGY ), TransUnion ( TRU ), and Equifax ( EFX ). The bureaus are not the end customers, they are distributers of scores. The bureaus own FICO's closest rival, VantageScore. But even with the bureaus plugged in closer to end customers, VantageScore has taken no meaningful bite out of FICO's lunch.
Because FICO's cash cow is essentially just an algorithm, it requires little investment or capital expenditure. Scores are higher margin than FICO's software business, and becoming a larger portion of total revenue, meaning margins should rise for the overall business. FICO's management team has been aggressive with raising prices and repurchasing shares over the past several years, combining to create a perfect storm for investor enthusiasm.
This is a compelling narrative, but the promise of boundless growth is exactly how investors talk themselves into owning bubbles. When a stock trades at an expensive multiple, the burden of proof is on the buyer. This investor must have great reasoning for calling the bet when it's likely they are beat.
A More Sobering View:
The FICO score is ultimately just one tool for lenders in a loan origination process. For larger loans, FICO scores are a bigger determinant in the pre-approval process, where buyers receive a letter that a lender is willing to work with them. The approval process is a much more thorough credit check.
If the FICO score disappeared tomorrow, it would temporarily make the lending process clunkier. But, by no means is FICO the gatekeeper to consumer loans, lenders use lots of other data in the process.
With that in mind, the bull case is resting on the hope for outsized pricing power. FICO does update its models every few years, but the product is mostly unchanged. To understand the value FICO can extract from the lending ecosystem, investors should compare FICO's score revenue to household debt :
This is an aggregate debt level, as opposed to annual issuance. To put in perspective, Moody's ( MCO ) Investor Services generated $2.7B in revenue last year with $73T of aggregate debt outstanding. This equates to a 0.004% take, in line with FICO.
These are complex macro numbers, but this throws cold water on the fantasy that FICO's pricing power is boundless. This tells us FICO is now extracting value that is in line with peers. This wasn't always the case, as the data above shows FICO has taken price since scores revenue was broken out.
Moody's competitive advantage is arguably much more significant than FICO's, given its government granted position as a NRSRO. Even so, competitive advantage does not allow a business to entirely ignore the balance between taking price and adding value to customers.
Prior to 2016, FICO had not increased the prices of its scores for 25 years...The company began instituting special price increases for its various scores in 2018. They first started with mortgage scores and raised prices there 30% - Dev Kantesaria
FICO scores were underpriced, and this enabled FICO to ratchet up pricing aggressively over a short window of time. Today's valuation implies the bulls believe this new level of price aggression is here to stay, while this seems probabilistically unlikely:
With respect to guidance, the 7%, we have a fairly significant CPI increase, in years past has been there, but it was always a much smaller number. This year, we're talking about a reasonably significant number, which is driving a fair bit of that. - FICO Q1 Earnings Call
FICO's guidance for 2023 does not imply any special pricing increases. At 40% FCF margins and a 25x multiple, investors would need scores revenue growth to reaccelerate back north of 20% to earn a double digit return over 5 years. Simplistically, a business with 8% growth trading at 40x is very aggressive.
Valuation:
Confidently holding a business over the long run requires investor to have a rock solid idea of a business's growth formula.
NRSROs like Moody's think about their growth formula as GDP growth + pricing power. As with enterprise debt, household debt should generally track GDP growth, which has historically been about 3%. Moody's management has assessed pricing power can add another 3-4 points of growth.
The Moody's growth formula seems to be the most likely FICO growth formula. Expecting gravity defying price increases beyond 3-4% over the long run is unrealistic. A $1 FICO score with a compounded annual price increase of 20% would cost $31.20 in year 20. 3-4% pricing is still nothing to scoff at.
While it's a near certainty FICO will be generating more free cash flow 5 years from now, past returns have been juiced by multiple expansion and buybacks.
Roughly speaking, FICO's stock price has gone from 30x earnings to 40x earnings over the past 5 years while the company has reduced its shares outstanding from 30M to 25M. Naturally, a higher share price makes any current buybacks much less accretive. Even for a business this strong, 25x is a more appropriate exit multiple given the 10 year treasury is yielding 3.7%.
The final component to the valuation is margins. Non-GAAP net income margin is expected to be 33% in 2023, that can be modeled to increase over the next handful of years as scores becomes a larger component of revenue. Taking all of these factors into consideration, forward returns don't look great.
Conclusion:
FICO's business is as good as advertised. Having the confidence to forecast a business even just taking 3-4% pricing over a multi-decade period is incredibly rare. Apple has taken less than 1% annual pricing on the iPhone since 2007, adjusted for inflation.
That said, FICO's stock has doubled over the past year and forward returns have compressed. It's much better buying a stock at 25x and having growth surprise to the upside, rather than buying at 40x with downside surprise.
Euphoria arrives in all shapes and sizes, which makes it difficult to avoid entirely over an investing career. The common boundless pricing power narrative amongst FICO bulls is exhibiting signs similar to past bubbles. It's time to muck shares of FICO.
For further details see:
Fair Isaac: Time To Fold On Pricing Power Questions