2023-08-16 23:48:14 ET
Summary
- Fair Isaac's stock price has appreciated by over 1,500% in the last ten years due to low-interest rates.
- The looming credit crunch and uncertain economic conditions pose a risk to FICO's stock.
- Despite strong financial performance, the stock is far overvalued.
Investment thesis
Fair Isaac's ( FICO ) stock was one of the major beneficiaries of the low-interest rates era, which lasted over the last decade. The stock price appreciated by more than 1,500% in the last ten years.
While Federal Funds rates are currently at their highest levels in the last twenty years, FICO's market cap seems far beyond underlying fundamentals. The credit crunch is looming for the U.S., and the ability of the American economy to avoid recession in 2023-2024 is highly uncertain. In case these events unfold, this would be a massively adverse catalyst for FICO stock. That said, I do not recommend buying and assigning the stock a "Hold" rating.
Company information
Fair Isaac Corporation is a leading applied analytics company. FICO's "Score" B2B scoring offering is the standard measure of consumer credit risk in the U.S., which is used by major banks, credit card issuers, mortgage lenders, and auto loan originators. The company's software offerings leverage analytics and digital decisioning to automate and enhance customers' business decisions.
The company's fiscal year ends on September 30. The business consists of two operating segments: Scores and Software. According to the latest 10-K report , sales were split almost evenly among two segments. The financial services market represented 90% of FICO's total FY 2022 revenue. From a geographical perspective, 82% of FY 2022 revenue was generated within the Americas.
Financials
The company's financial performance has been stellar over the past decade, especially from the profitability metrics perspective. While revenue compounded at a relatively modest 7% rate, margins expanded rapidly. The operating margin expanded from 22% to almost 40% over the last ten years. That ultimately made the company a free cash flow [FCF] machine, even if we deduct stock-based compensation [SBC].
Despite generating a substantial FCF margin, FICO stopped paying its insignificant dividends in 2017. Instead, the company consistently conduct substantial buyback programs. In FY 2022, FICO repurchased stocks worth $1.2 billion, which almost equals the annual revenue. The company also reinvests a substantial portion of revenue to innovation. Over the last several years, FICO's R&D to revenue ratio has consistently been above 10% despite notable cumulative revenue growth. The business requires almost no capital expenditures with a cumulative capex over the past decade below $30 million, a tiny 0.3% portion of the total sales over the same period.
FICO's balance sheet looks healthy despite a massive net debt position. I do not consider high leverage risky due to the company's wide FCF margin and a solid above-six covered ratio. Liquidity metrics are in excellent shape as well.
The latest quarter's earnings were released on August 2, when the company topped consensus estimates by a solid margin. Revenue demonstrated strong growth momentum with a 14% YoY increase. The non-GAAP EPS also showed strength, expanding from $4.47 to $5.66. The profitability metrics dynamic was stellar. The gross margin grew to 82%, more than a five percentage points expansion. So did the operating margin, which expanded from 40.3% to 44.4%.
The upcoming quarter's earnings are scheduled on November 9. Consensus expects revenue at $389.5 million, which means a solid 12% YoY growth. The adjusted EPS is expected to follow the top line with a notable expansion from $4.40 to $5.31.
Valuation
The stock significantly outperforms the broader U.S. market with a 47% year-to-date rally. Seeking Alpha Quant assigns FICO a low "D" valuation grade because of substantially higher multiples than the sector median and historical averages. While a premium to the sector median might be fair, given the company's wide moat and stellar profitability, the comparison with five-year averages is likely to indicate overvaluation.
I want to proceed with the discounted cash flow [DCF] approach to get more evidence regarding valuation fairness. I use a 9% WACC due to the company's wide moat and stellar profitability. I have revenue consensus estimates up to FY 2027 and project a 10% CAGR for the years beyond. I use the last five year's average for the FCF margin and expect it to expand by one percentage point yearly.
According to the base case DCF simulation, the business's fair value is about $12 billion indicating about a hundred percent overvaluation. FICO's bulls might argue that deducting SBC from FCF is too conservative and unfair. Therefore, let me use FY 2022 FCF margin with SBC included, which was at 30.8%, and expect a one percentage point expansion each year. All other assumptions were unchanged.
As you see, even with a massively optimistic FCF scenario, the stock is still about 7% overvalued. If I incorporate a substantial net debt position into fair value calculation, the extent of overvaluation would be even more expansive. My valuation analysis suggests that the stock is not attractively valued.
Risks to consider
While Fair Isaac is a high-quality business with wide margins, there are risks inherent to investing in this stock.
As I mentioned in the "Company Information" section, the company generates 90% of its sales from the financial market. That said, FICO is substantially exposed to credit market conditions. Economic downturns or disruptions in the Financial industry might lead to reduced demand for the company's offerings and ultimately undermine the company's earnings. We already saw this during the Great Recession, when FICO's revenue in FY 2009 was 20% lower compared to FY 2007. The top line recovered to FY 2007 level only after seven years, in FY 2014.
While we are currently at the hawkish stage of the Federal Funds rates secular life-cycle, the credit crunch is looming . This will likely adversely disrupt FICO's earnings in the near term. While the Scores segment represents only a part of the total sales, this part is still notable. There is also a substantial level of uncertainty regarding the ability of the U.S. economy to avoid recession and have a soft landing instead.
The financial services industry, the major source of income for FICO, is subject to extensive and complex regulations. That said, Fair Isaac's operations are also subject to compliance challenges and legal considerations. Business operations and earnings might be disrupted in case of failing to comply with complex regulations.
Bottom line
To conclude, FICO is a "Hold". I have no doubt that the business is of high quality and the management's execution is stellar. High and ever-expanding profitability metrics together with stellar FCF margin indicate robust fundamentals. But the valuation is too generous even for a wonderful business like FICO and is very far from underlying fundamentals. Potential massively adverse catalysts for the financial markets are probable as well.
For further details see:
Fair Isaac: Valuation Too High Even For This FCF Star