Fair Issac Corporation (NYSE: FICO) is a data analytics that has slightly beaten the market since its IPO in 1987.
A $10,000 investment in 1987 would've turned in $11,195,174, beating the SP500 by 29x.
When we evaluate a business, we often look for metrics such as pricing power, revenue growth, expanding margins, and a dedication to shareholder return. FICO scores (wink) well in all these metrics. In fact, one might even describe it as the perfect business.
In the past 5 years, revenue has grown at a 8% CAGR, EPS has grown at 23%, and EBIT margins have expanded an impressive 2,100 basis points. To say this is impressive is an understatement. Let's take a deeper dive into this business.
“Scores” accounts for 50% of FICO's revenues and is the consumer facing side of the business. FICO scores are ratings for consumers that range from 300 to 850. These ratings are given when a consumer applies for a credit, auto, or mortgage loan and are generated using FICO's proprietary algorithms. The lower the score, the less trustworthy and consequently higher default risk a consumer has. These scores will cost a business anywhere from a few cents to a dollar. FICO is so ubiquitous, it is used as a verb, demonstrating how ingrained it is in the lending industry.
90% of the largest lenders use FICO scores and 98.8% of the total dollars lent in the US use FICO scores. While financial institutions and lenders have their own in network algorithms and rating methods, they all use FICO scores to communicate with one another and understand each other. As such, FICO has a tremendous moat due to its network effect. It can also be seen as a complementary good, rather than an competitor for instituions.
While other methods such as VantageScore do exist, they pale in comparison to FICO's reliability in detecting default risk and lending health. When a loan is worth tens or hundreds of thousands of dollars, why save a few cents and go with a second rate score when you can get what's guaranteed to work?
Looking at margins, FICO's score margins are breathtaking. Their OPERATING MARGIN (not to be mixed with gross) for their scores segment is a whopping 88%, expanding from 77% in 2016.
FICO scores generates its revenue growth in two ways. One is through volume growth which they have less control over as that's sensitive to macroeconomic conditions. The second is through price increases. As aforementioned, FICO scores as used for Credit, Auto, and Mortgage applications. FICO systematically chooses to raise one category each year to control its revenue growth steadily. There is often no pushback as businesses can pass this price increase on to a consumer. When a credit application costs $75 but a FICO score costs less than a dollar, what does a few more cents matter?
FICO's other half of the business is their B2B software offering where they offer customer management, customer engagement, fraud detection, financial crime compliance, and marketing software. These software subscriptions are multi-year subscriptions and FICO consistently attempts to “land and expand”. To use a consumer relatable analogy, this is similar to us using Adobe or Microsoft and buying more products after trying just one after we realize their products are amazing and thus paying more annually.
Looking at their Dollar Based Net Retention Rate, FICO has been keeping their customers engaged and convincing them to spend more money. For those unaware, DBNRR is a measure of how much money an average customer is spending year over year. For example, FICO's most recent DBNRR is 112%. This would imply that a customer who is paying $100 this year will pay $112 next year either through choosing more features or price increases.
This segment of FICO is not nearly as mature as scores and has a much smaller operating margin. Operating margins are fairly low at 32%, but did improve 300 basis points from 29% of last year. FICO's B2B solutions is the market leader in fraud detection and customer management and protect 66% of card transactions globally. As enterprises move on to FICO's platform, operating income will quietly trickle up and margins will expand. In addition, the recurrent nature of subscription models will have a positive effect on the overall health of FICO's revenues.
Looking at capex, FICO has barely spent any money investing in the business. When we sum up the past 5 years, FICO has spent roughly 70 million dollars. This represents 1% of the past 5 years of revenues. So what has FICO been doing with their profits? The answer lies in their share repurchases.
In the past 5 years, FICO has spent $3.2 billion buying back their shares.
Their repurchases have retired 14% of shares outstanding, or a CAGR of -2.68% per year. However, if you were paying attention, you would have noticed FICO has only generated $1.6 billion in net income over this time period. How are they able to afford this then? The answer lies in their balance sheet:
As we can see, FICO has taken on substantial debt to fuel these repurchases. Management has consistently stated in their earnings call that they believe this is the best usage to deliver shareholder value and they continue to deploy this strategy. The most important question when evaluating this decision is what is the interest rate on this debt?
Looking at page 10 of their April 2024 10-Q, we can see that FICO's interest rates range between 4.00-5.25% for their senior notes which make up $1.3b of their debt. In addition, we have a revolving LOC at the SOFR rate + roughly 1.5%. The implied interest rate is currently 6.674% with $754m drawn down.
Solely looking at this one factor, it would be easy to question FICO's management as leverage can be scary. When you think of FICO as a whole however, FICO's high margin and constant cash generation reduces the risk of this debt being an issue. FICO does not distribute any dividends and has done almost no M&A. In addition, their repurchase timing has been exceptional as the bulk of their purchases were done when the stock price was around $400 in 2022 and the stock price currently sits at $1390.
Management is also aware of the precarious environment we stand in and has taken steps to deleverage the balance sheet though it is currently very comfortable with the amount of leverage it possesses.
All in all, FICO has everything you could ask for. They have low capital expenditures, expanding margins, consistent revenue growth, an impenetrable moat, and a management team dedicated to shareholder values. Unfortunately, their valuation is sky high.
The market has recognized the success of FICO and has placed an excessive premium to FICO. When investing in FICO, there's really no question about the exceptional business practices.
It ultimately boils down to one question: how much are you willing to pay for perfection?
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