Description

Thesis Punchline

I believe Fair Isaac Corp (FICO) is a uniquely dominant franchise with two under-earning profit streams both deserving scarcity value in today’s low interest rate environment. The “Scores” business is a royalty-based monopoly with a tremendous pricing power runway that can justify the stock’s valuation alone, which means you are getting the digital decisioning software business for free. The nose-bleeding headline valuation (35x FY2021 Consensus EPS) has scared many investors away over the years, yet it is actually what creates the opportunity if you are willing to look underneath the hood – because FICO’s software businesses are going through a heavy investment phase through both On-Prem-to-SaaS conversion and product development (such that the valuable Decision Management Software sub-segment is currently loss-making). With the appropriate valuation framework, I believe the stock has 50% upside to its intrinsic value over the next 18 months and can continue to compound at a low-teen % IRR from there.

Background

FICO operates in the global predictive analytics industry with two businesses. The first business is FICO Scores business, and that is widely used by major financial institutions in the US to make all sorts of consumer credit decisions. The second business provides software and solutions to help businesses both manage and optimize their decision-making processes when it comes to credit origination, monitoring and CRM.

FICO Scores is the fastest-growing segment, accounting for 36% of revenue and ~70% of Adj EBITDA before unallocated corporate costs. It offers a range of general purpose and industry specific scoring solutions. In fact, over 90% of the lending decisions made by major financial institutions are based on FICO scores. 75% of Scoring service is distributed B2B – through major credit bureaus (like Experian), while the other 25% come from FICO’s B2C offering.

FICO Software consists of two reported segments – Applications (52% of revenue) and Decision Management Software (DMS, 12% of revenues). Applications offers pre-configured decision management applications that are designed and tailored for specific business problems – such as credit origination, fraud / security management, customer acquisition, etc.   DMS offers tools that can be used to incorporate customized analytics and decision management solutions into customers’ existing business processes. These two businesses should be viewed as a collective software solution segment, given DMS conceptually offers many of the same products Application segment but with more modern architecture and greater configurability.

Thesis Details

1) While the base volume of FICO Scores is tied to general consumer credit activities (grows slightly faster than GDP), this business has tremendous runway for continued pricing increases that can continue to drive super-normal profit growth

• Scores generated extremely strong adjusted organic growth (adjusted for ASC 605 to 606 transition noise) of 16.4%, 10.5%, 29.4% and 25.4% in FY2016, FY2017, FY2018, and FY2019 – you may ask: how the heck did it do that?

• Before 2018, FICO hadn’t changed Mortgage Score’s pricing in ~25 years because Credit Bureaus prevented pricing increases – subsequently FICO renegotiated with Credit Bureaus to get “pricing power” back, and decided to hike price up to equate to the value it offers

• Ever since, it has used “special pricing” increases to drive enormous revenue growth at ~100% incremental margin – first in Mortgage Scores, then Auto Scores, now moving onto Credit Card Scores

• Since FICO Scores’ costs represent just a tiny fraction of the cost of an entire credit underwriting process (from less than 1 penny to 50 cents depending on the applications / use cases of the particular Scores), there has been absolutely no customer pushback.

• There is real durability of above-inflation price increases, as the company is still in the early-to-mid innings of the “special price” increase game. FICO mgmt is committed to evaluating every type of Score and taking surgical approach to extract value from all possible channels. There are also inflationary escalators in these contracts.

• This business is essentially a high-margin monopoly (~85% EBITDA margin) with 90%+ market share in B2B credit scoring despite having competition in non-Mortgage markets. VantageScore (owned by a bunch of money center banks) is a competitor but has not materially impacted FICO’s market share, volume or revenues over the years

• Watch out for strong mortgage volume this year given the low interest rate environment (lots of refi’s in Q1)

• Note: FICO’s strong 16.4% revenue growth in 2016 benefited from its new B2C product launch called myFICO (contributed ~900bps to growth that year), that was before pricing was part of the thesis

2) Given the business quality and comparable multiples, FICO’s Scores business itself can justify the stock’s valuation alone

• FICO has a habit of guiding extremely conservative on its Scores business, because it excludes benefit from special pricing

o In 2016, it guided to Scores growth of 3-4%, achieved 16%

o In 2017, it guided to Scores growth of 5%, achieved 11%

o In 2018, it guided to Scores growth of MSD%+, it achieved 29%

o In 2019, it guided to Scores growth of ~10%, it achieved +25%

o For 2020, FICO is guiding to ~8% Scores growth….I think it will be another 20%+ revenue growth year for Scores given Mortgage Refi boom and Credit Card pricing hike

• One can get to almost $12 of “Scores” earning power per share by 2022 if we load 50% of unallocated corporate costs onto Scores segment and load all the interest expense on Scores given it is a more leverageable asset

• Who are the right comps of FICO? I’d argue they are the likes of MSCI, VRSK and VRSN – those are a collection of businesses that share similarities to FICO Scores business – they either own proprietary indices with high margins, possesses unreplicable risk analytics through data assets, or have regulated monopoly to operate .com registry with meaningfully above-inflation pricing power.  MSCI has traded at an average forward P/E of ~29x over the past 5 years, and that multiple is ~27x and ~28x for VRSK and VRSN, respectively. I will caveat that FICO Scores business has grown revenues and EBITDA at a faster clip than all those 3 peers over the past 3-4 years, but FICO does carry more cyclical risks

• Valuation: Using the average of ~28x, we get to $327 per share for FICO’s Scores business by FYE2021 – or by September next year, vs. current stock price of $310. This implies a triangulated EV/2022 EBITDA of ~21x, also reasonable compared to those comps

3) FICO’s Software business is undergoing a cloud transition, with weak current profitability due to high investment cadence, but growth could accelerate soon with a growing TAM

• This is a highly recognized asset. Gartners ranks FICO’s digital decisioning system in the leader category with strong current offering and strong strategy in its magic quadrant – best in class among a dozen peers

• Both Applications and DMS segments are undergoing cloud transitions as FICO has made more of its Software solutions available as hosted solutions through the FICO Analytic Cloud and/or AWS

• Cloud-based software revenues account for 37% of total Software revenues, while On-Premise account for 63% of the revenues (still the majority)

• The growth rates between the two are very different

• Cloud piece: grew +19% in 2018, +12% in 2019, estimated to grow at 20%+ going forward. Recent booking trends were very robust

• On-Prem piece: declined 9% in 2018, +11% in 2019, estimated to gradually decline in LSD to MSD % going forward

• 2019 Cloud bookings grew at ~double the pace of on-premise bookings

• FICO has been very excited about its DMS Product Map, but the segment is currently loss-making due to investments

• FICO believes DMS will open its TAM to more than financial companies – there is growing demand to augment and automate business decisions. In fact, management believes “every interaction for every B2C company on the planet could benefit from using our optimization of that interaction software”

• DMS is supposed to eventually host all of FICO’s software offerings – providing a single underlying cloud architecture

• Product roll-out progress is very good so far as most of the desired applications and core functionality will be available on the platform by year-end

• DMS bookings grow +90% YoY in 2019

• All these changes have dragged down profitability for the combined Software business, as EBITDA has been negatively impacted by higher investments in both the new Decision Management Software suite/platform have + Cloud transition

• Mgmt did confirm that peak of the investment phase is already here, so spending should begin to moderate

• As Cloud continues to scale, FICO will find efficiencies around development cost, standardization, etc

4) As Cloud transition continues to accelerate and we get past the investment phase, Software EBITDA can more than double between 2019 and 2022, justifying 1/3 of existing valuation

• I believe cloud delivery will be ~60% of Software revenue mix and DMS would make up 30% of revenue mix by 2022

• 2019 was the first year of Software EBITDA growth since investment cycle started, going forward the incremental margin will be higher on additional revenue growth, leading to sharp EBITDA margin expansion for the next few years for the combined segment (less 50% of FICO’s unallocated corporate costs)

• Valuation: putting 7x EV/Revenue on 2022 Cloud revenues (~23x look-through EBITDA at 30x normalized margin), 3.5x EV/Revenue on 2022 On-Premise revenues, and burdening its share of corporate costs at the blended implied EBITDA multiple (21x), we can get to an EV of $3.4bn for the Software business, or $112 per share

In conclusion, I believe FICO will reach an intrinsic value of $462 per share (+50%) over the next 18 months, consisting of $327 from Scores, $112 from Software, and $23 per share of interim FCF of $700mm (that is typically used to repurchase shares)

Catalyst

Continued earning beats