Description

Buy Fair, Isaac (FIC, NYSE $58), the company whose name is practically synonymous with credit scores. Fair Isaac is merging with HNC Software, a great strategic fit, in an accretive transaction for FIC. We believe the acquisition offers $50 million + of cost savings (not fully factored into street models), significant revenue synergies (not at all factored into anyone’s projections) and will reposition Fair Isaac as a software company addressing large, fast-growing markets. Consequently, Fair Isaac shares will likely be awarded a richer valuation.

Fair Isaac is cheap today for what we view as a software company with great products, a great brand, a proven management team and great free cash flow dynamics. Pro forma for the acquisition, the company has a balance sheet with $9 of net (of debt) cash and an enterprise value of about $1.86 billion or 8.5X our F03 EBITDA estimate of $218 million. Since it is obviously not a capital intensive business, EBITDA less capital expenditures / Enterprise value is a very attractive 10X (not bad for a 20% EPS grower). The combined company should generate cash EPS (which adds back goodwill amortization) of $3.18 (conservatively) in F03 (September) and $3.80 in F04 so the stock trades at 18X F03 and 15X F04 CEPS. However, given the substantial excess balance sheet cash, EV/EBITDA or EV/EBITDA less cap X are the most significant valuation matrics.

We like the FIC management team. CEO Tom Grudnowski, who joined FIC from Andersen Consulting in December 1999, has driven the EBIT margin from 16.9% in F2000 to 23.3% last quarter. We believe he has a similar but ultimately much bigger opportunity with soon to be acquired HNC as duplicative R&D spending is eliminated, low ROI R&D projects are killed and big G&A synergies are reaped. Importantly, we believe management is very open to a major share repurchase plan (current plan is $100 million) with the $500 million of cash on its balance sheet, which would obviously be highly accretive. We believe the company has repurchased about 1 million shares in the past month and expect that the current $100 million buy back will be complete by the time FIC files its proxy in a few weeks.

We very much like the business itself, which we view as rather unique and has a high percentage of recurring revenue – about 73%. Both Fair Isaac and HNC provide an array of statistically derived predictive analytic products, custom software and equations. The products are used to screen prospective customers, evaluate applicants’ credit, identify fraud, and manage existing credit accounts. Both companies’ key products (Fair Isaac in scoring and HNC in fraud detection) own their respective markets. The credit bureaus and credit card processors are the biggest customers and financial institutions are the biggest vertical. Each company has been branching into new verticals such as retail, and online credit decisioning, telecom and insurance. The combined company should better penetrate these verticals as well as create more of a presence in the UK, Europe and Japan.

In short, we think there are several ways to get paid in this name and we believe most are quite likely. First, we believe the cost savings from the HNC acquisition may prove conservative. Second, we believe the revenue synergies are not at all factored into the models. Third, the company is likely to do a major share buy back which puts a floor beneath the stock and should be highly accretive. Fourth, Fair Isaac is likely to be re-valued as a fast growing software company (indeed, its growth over the past 2 years has been better than a lot of high flying software companies still valued on a price to revenue multiple due to their lack of earnings) And ultimately, we believe the company will become a valuable strategic acquisition for one of the large card processors or data companies.

Note: market cap is pro forma for HNC

Catalyst

the stock is down about 8% since announcing the deal even though it's 10% accretive on a CEPS basis. So the first 18% should be easy. We also think the company is positioned to beat numbers due to higher than modeled cost saves, revenue synergies and accretive share buyback.