Headwaters Capital Management, an investment management firm that was recently founded last September 2020, published its first quarterly letter, the HCM Q4 2020 Investor Letter – a copy of which can be downloaded here. The portfolio is composed of 25 stocks that went live in 2020, that’s why no investment performance was discussed in the initial letter hence, only the reasons behind the fund’s latest stock picks were presented.
Headwaters Capital Management, in their Q4 2020 Investor Letter said that they see an outstanding value in Fair Isaac Corporation (NYSE: FICO) that was caused by their profitable ‘SaaS’ business model. Fair Isaac Corporation is a data analytics company that currently has a $14.4 billion market cap. For the past 3 months, FICO delivered a 13.90% return and settled at $496.16 per share at the closing of January 22nd.
Here is what Headwaters Capital Management has to say about Fair Isaac Corporation in their Investor Letter:
“What do the financials look like for a monopoly business with a royalty business model? Unsurprisingly, FICO’s scores business operates with an incredibly high operating margin of 86%! The cost to calculate the FICO score is a fixed cost so every additional score calculation carries an incremental profit margin of 100%. As a result, profitability for the company continues to improve as revenue grows. Prior to 2016, FICO had not increased the price for its score in over 25 years. In 2016, it tested annual pricing increases that were in-line with inflation and saw little pushback from customers. In 2018, FICO realized that the continued investments it had made over the past 25 years to improve the predictability of its scoring model had created enormous value for both lenders and consumers. As a result, FICO implemented a special pricing increase for mortgage customers, that I estimate was an ~75% pricing increase from $0.06/score to $0.10/score. As you can imagine, the mortgage channel did not blink an eye at the pricing increase, which gave FICO confidence to roll out special pricing increases to its auto and some credit card customers over the following two years. The company has stated that intends to continue pushing through special pricing increases on an annual basis and the credit card market remains the largest remaining opportunity. In terms of revenue/profit growth, the Scores segment should post consistent +15% revenue growth on the back of low to mid-single digit volume growth combined with a 10% pricing tailwind.
While the monopoly status, pricing power and profitability all support an investment in FICO on its own, its capital allocation priorities provide more support to the investment case. FICO made the decision a number of years ago to effectively return 100% of its free cash flow to shareholders in the form of share repurchases. Additionally, the company has utilized debt to accelerate share repurchases. The
company is performing a multi-decade leveraged buyout of itself and we as shareholders can participate in the LBO for free. Over the past 10 years, the company’s share count has decreased by ~30%. Going forward, our ownership percentage in the company will continue to increase as the company steadily reduces the number of shares outstanding.
FICO has a government blessed monopoly in consumer credit scores and the company continues to provide innovative new scores that continue to enhance the value of the score for both consumers and lenders. The company’s monopoly status, recent pricing optimization actions taken in its Scores business and the steady use of cash flow to reduce share count make the company an ideal long-term holding for Headwaters Capital. I estimate that FICO can grow its free cash flow by 15-20% annually primarily on the back of continued Scores revenue growth, but also improved profitability from the software businesses. Combined with an ~3% annual reduction in share count, FICO should grow FCF/share by 20% going forward. What is the right multiple for monopoly business that is growing FCF/share by 20% annually? Once again, I believe at least a 30x FCF multiple is appropriate. Using a 30x FCF multiple on my 2025 FCF estimate yields a price target of $925, or 17% annual returns to shareholders.”
Last December 2020, we published an article telling that Fair Isaac Corporation (NYSE: FICO) was in 43 hedge fund portfolios. Its all time high statistics is 45. FICO delivered a decent 21.22% return in the past 12 months.
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Video: Top 5 Stocks Among Hedge Funds
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