In a recently published Q1 2019 Portfolio Update, Newbrook Capital Advisors posted a thorough analysis of Fair Isaac Corporation (NYSE:FICO). If you are interested you can download a copy of the letter here. Among other things, the fund said that it believes the company is a good investment opportunity for a long position for several reasons, those being – Scores Pricing Cycle, Software Business Cloud Transition, Strong Management Team with Aligned Incentives, China Opportunity – each of which the fund further discussed in detail. We bring you that part of the letter:
Fair Isaac Corporation (FICO)
FICO is a leading information services company primarily serving the financial services industry. Its primary business provides the well-known FICO credit score that is used for the majority of U.S. credit decisions. The credit score business is a high margin licensing business (85% EBITDA margins) in which FICO licenses its methodology, proprietary models, and name to the U.S. credit bureaus (Equifax, Experian, and TransUnion) who then run their data through FICO’s models to produce credit scores. FICO’s secondary software business is a collection of decision management applications that businesses use to optimize operations and customer engagements. FICO has traditionally offered its software in a traditional on-premise deployment model (upfront licenses and maintenance), but over the past five years has transitioned to a ratable cloud subscription model. We believe FICO is a compelling long idea for the following reasons:
- Scores Pricing Cycle – The credit score business accounts for 34% of consolidated revenue but essentially 100% of consolidated operating income. The business is in the early stages of a re-pricing cycle that we believe will lead to significant bottom line upside over the next several years. FICO scores have been deeply embedded in the U.S. financial system for over three decades and are a key input in credit underwriting and monitoring for financial institutions. In 2018, 13 billion FICO scores were pulled. Pricing was static at $0.01/score for the 25 years prior to 2016. Management renegotiated their contracts with the credit bureaus and was granted the ability to raise pricing annually. The company then implemented moderate price increases in 2016 and 2017, and a special price increase in 2018. According to our research, the company increased prices on a small portion of their score volume by a factor of 4x, which enabled total consolidated pricing to grow 27% and segment revenue growth accelerated from 11% in FY 2017 to 28% in FY 2018. FICO received little pushback from customers as the amount financial institutions spend on FICO scores is a small fraction of money spent on credit data, which itself is not material to overall P&L. The company instituted another special price increase in early 2019 and we believe that this new trend will drive growth for the next several years. We expect FICO’s credit score business to grow revenue and EBITDA by 15% to 20% annually for the next three years.
- Software Business Cloud Transition – FICO’s software businesses account for 64% of consolidated revenue and operate slightly better than breakeven. Over the past five years the company has been transitioning its legacy licensing model (with large upfront license payments) to a ratable subscription based business model (i.e. a SAAS transition like Adobe, Autodesk, and PTC have successfully undergone), which pressured segment revenue growth and operating margins. Segment revenue growth slowed during this transition period from over 10% to 3% in 2018, and EBIT margins contracted from 16% to 1%. We believe the transition is reaching its inflection point, which should result in revenues reaccelerating. Management’s FY 2019 guidance supports this notion as they guided segment revenues to increase 9%, which will be the fastest rate of growth since 2013. Cloud is one third of its software business today and the company has publicly stated that they expect this to grow 20% annually for the next five years. In addition to the acceleration in revenue from the business model transition, FICO’s software segment has several other tailwinds that should sustain revenue growth over the coming years. The move to cloud makes its products easier to sell, quicker to install, and easier to consume, which has enabled FICO to sell to smaller financial institutions and expand outside of financial services. The company also has new cloud versions of its two largest software products coming to market in 2019 which should benefit segment revenue growth in 2020 and 2021. We believe that the software business will grow over 10% annually for the next three years and can ultimately earn 30% EBIT margins. Applying a conservative 5x to 6x EV/Revenue multiple values the software business at $4.4 billion ($3.6 billion net of debt).
- Strong Management Team with Aligned Incentives – CEO William Lansing owns $73 million of FICO stock. In December 2018, Lansing converted a significant amount of restricted stock units into options with a much higher strike price to give himself more upside to stock appreciation. In addition, the majority of the entire management team’s total compensation is based upon financial performance and stock price appreciation. Approximately 75% of management’s total compensation is long-term, with 33% tied to the performance of FICO’s stock relative to the Russell 3000. For every 1% of outperformance relative to the benchmark, management earns an additional 3% of stock units, but for every 1% of underperformance they lose 4% of their stock units. Management seems to believe its stock is undervalued as they have reduced share count 10% over the past five years and continue to buy back stock. We would not be surprised if the company were either sold or broken up in the next few years.
- China Opportunity – Over the past six years, in partnership with the People’s Bank of China, the company has developed a FICO score specifically designed for the Chinese market that has proven to be highly predictive and effective. FICO and the PBOC have already produced scores on most of China’s growing middle class (400 million people and expected to expand to 800 million by 2025). Chinese banks see FICO’s automated score as a means to defend themselves against Ant Financial and Tencent (who are able to offer consumer credit in a quick and efficient manner) and as a result FICO is seeing fast adoption within the Chinese banking sector. China only accounts for 1% of credit score revenue today but is growing rapidly and we see this as an underappreciated opportunity for significant long-term growth.
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Fair Isaac Corporation is a San Jose, California-based data analytics company that was founded back in 1956. It has a market cap of $8.06 billion, and it is trading at a price-to-earnings ratio of 57.19. Since the beginning of the year, Fair Isaac Corporation’s stock gained an amazing 50.47%, having a closing price on April 12th of $279.11.
At the end of the fourth quarter, a total of 24 of the hedge funds tracked by Insider Monkey were bullish on this stock, a change of 14% from the second quarter of 2018. Below, you can check out the change in hedge fund sentiment towards FICO over the last 14 quarters. With the smart money’s capital changing hands, there exists an “upper tier” of noteworthy hedge fund managers who were adding to their stakes significantly (or already accumulated large positions).
According to publicly available hedge fund and institutional investor holdings data compiled by Insider Monkey, Cliff Asness’s AQR Capital Management has the most valuable position in Fair Isaac Corporation (NYSE:FICO), worth close to $57.6 million, corresponding to 0.1% of its total 13F portfolio. The second most bullish fund manager is Royce & Associates, managed by Chuck Royce, which holds a $52.3 million position; the fund has 0.5% of its 13F portfolio invested in the stock. Some other peers with similar optimism contain John W. Rogers’s Ariel Investments, Israel Englander’s Millennium Management and Richard Scott Greeder’s Broad Bay Capital.
Disclosure: None.
This article is originally published at Insider Monkey.
