Fair Isaac Stock: Great Company, Bad Valuation (NYSE:FICO)

Every so often, I come across a great company that I kick myself for not finding sooner. I believe Fair Isaac Corporation (NYSE:FICO) is such a company. FICO’s main business is providing credit scoring reports to help lenders assess the creditworthiness of borrowers. It is used in almost all major purchase transactions, from mortgages to auto loans.

FICO’s near ubiquity in the modern financial economy has helped propel the stock to an 87x return since it listed on the NYSE in 1996.

However, I believe there are limits to what investors should pay, even for great companies. I would definitely not recommend investors buy FICO at 19x Fwd EV/Sales. Instead, I believe current shareholders should consider taking profits.

Company Overview

Fair Isaac Corporation (“FICO”) is a leading data analytics company founded in 1956 by engineer Bill Fair and mathematician Earl Isaac (hence the name Fair Isaac). Since its founding, FICO has been focused on developing mathematical models to aid in credit risk assessment.

FICO is perhaps most well-known for its namesake FICO Score, a credit score that nearly all major banks, credit card issuers, mortgage lenders and auto loan originators use to assess an applicant’s credit risk. However, it is important to recognize that FICO is more than just a score business, as FICO also provides data analytics software to help business customers make key decisions.

In fact, FICO’s revenues are nearly evenly split between its Scores business and its Software business (Figure 1).

History Of Credit Scoring

FICO was one of the first companies to introduce credit risk scores in the late 1950s, revolutionizing the way lenders evaluate the creditworthiness of borrowers. Initially, FICO worked with business clients to develop credit scoring models that were specific to that company. These were typically mass merchants selling large ticket items on installment plans that needed a way to track and assess the creditworthiness of their customers to ensure they will be paid back.

Merchants would collect information on their customers and send it to a local credit bureau for storage. In fact, in the 1960s, the market for credit bureaus was very fragmented, with more than 2,000 local credit bureaus across the United States.

However, over the next few decades, coincident with the introduction of computers to store and analyze data, large national credit bureaus started emerge and buy out their smaller local peers, computerizing the information they had on consumers. Today, there are only 3 national credit bureaus remaining: Equifax, Experian and TransUnion.

In 1989, FICO worked with the national credit bureaus to create a generalized credit scoring model that could be used to evaluate all consumers. The idea of a generic credit scoring model appealed to the national credit bureaus because it meant that lots of different companies can use the same credit score to make their lending decisions, thus standardizing the whole credit decisioning process.

FICO Scores were further cemented as a crucial part of the financial decision-making process when Fannie Mae (OTCQB:FNMA) and Freddie Mac started to ask mortgage applicants to submit their FICO scores in the 1990s. Today, FICO Scores are said to be used by over 90% of the country’s top lenders.

Credit Scoring Is A License To Print Money…

FICO Scores range from 300 to 850, with higher scores indicating higher creditworthiness. To calculate an individual’s FICO Score, the company takes into consideration the individual’s payment history, amounts owed, length of credit history, how often the individual apply for and open new accounts, and the mix of credit products the individual has.

Once created, a FICO Score is like an individual’s “credit passport”, following the individual as he/she progress through his/her adult lives, from applying for credit cards, to obtaining an auto loan and purchasing a home.

FICO Scores is a classic example of the business school concept, network effects, in action. The more it is used by lenders to assess the creditworthiness of borrowers, the more likely future lenders and borrowers will have to obtain a credit score in order to take out a loan. Once obtained, consumers spend an inordinate amount of time trying to ‘improve’ their FICO Scores so they can quality for lower rates on their loans.

Being the de-facto gold standard of credit decisioning has been like a license to print money for FICO. Looking at FICO’s cash flow statements, we can see that the company has consistently generated hundreds of millions in free cash flow every year (Figure 2). In the past decade alone (2014 to 2023), FICO has generated $2.7 billion in unlevered free cash flow.

FICO’s business is also very capital light, with total capital expenditures of only $181 million in the past 10 years (Figure 3). Coupled with modest leverage, this has allowed the company to buy back $4.4 billion in stock from shareholders.

…Leading To Monster Stock Performance

FICO’s license to print money has led to its monster stock performance. Since its IPO on the NYSE in 1996, FICO’s stock has delivered over 8700% in total returns, almost 8 times that of the S&P 500 (Figure 4).

But Valuations Are Getting Extreme

However, even great companies can become sells when valuations get extreme. Currently, FICO is trading at an extremely elevated 59x Fwd P/E and 19x Fwd EV/Sales (Figure 5). Seeking Alpha gives FICO a valuation grade of F.

To see why 19x Fwd EV/Sales is a problem, readers are reminded of this quote from the former CEO of Sun Microsystems (“SUNW”), one of the darlings of the dot-com bubble:

“…2 years ago we were selling at 10 times revenues when we were at $64. At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?”

For FICO, even though it is practically a money-printing machine, I would not want to be buying shares when it is trading at 19x Fwd EV/Sales. Even if every dollar of sales has 100% margin, as per the SUNW anecdote, investors will need 19 years to be paid back their capital!

What About Growth?

One reason why some investors may be willing to pay up for FICO shares is because of its growth rate (Figure 6). In the past year, FICO has been able to grow its topline at a rapid 10.8% YoY rate, leading to EPS growth of almost 20%.

However, investors need to realize that FICO is not Nvidia, a semiconductor company seeing exponential growth due to the hype surrounding artificial intelligence adoption.

Instead, FICO’s core business is tied to the real economy – when the economy does well, more consumers apply for loans, and FICO sees more volume in FICO Score reports.

In fact, we may be seeing the limits to FICO’s growth rates in real time, as the company recently disappointed in its Q1/24 earnings report, reporting $382 million in revenues vs. consensus looking for $391 million.

After surging in mid-2023 as consumers shrugged off gloomy economic reports and spent with a vengeance, FICO’s Scores revenues have declined for 2 quarters in a row to $192 million in Q1 (Figure 7)

While Scores revenue still grew 8% YoY, it was mostly driven by price increases in the business-to-business (“B2B”) subsegment, as business-to-consumer (“B2C”) revenues declined 3% YoY on lower volumes.

Insiders Have Not Bought A Single Share

Another way to gauge whether a company is a good investment is to look at what insiders are doing, as they typically have the best information on a company’s prospects. For FICO, we can see that insiders have not bought a single share in the past 2 years. Instead, they have collectively sold $106 million in shares through 158 transactions (Figure 8).

When insiders are selling hand over fist, investors should question whether they should follow suit.

Risks To FICO

On the downside, as we mentioned above, FICO is tied to the real economy as its Scores business is directly driven by the volume of credit transactions. If the economy slows, the growth rate in transactions also slows and may even decline, as we saw recently in B2C volumes.

There is also a risk of FICO Scores being replaced by credit scores from other companies. For example, in October 2022, the FHFA announced it was replacing the traditional FICO Score with the FICO 10T and the VantageScore 4.0 scores.

While FICO remains one of the key score providers to the FHFA with its FICO 10T model, VantageScore is a direct competitor to FICO and is a joint venture between the three national credit bureaus. Over time, the credit bureaus may nudge mortgage borrowers to obtain a VantageScore 4.0 instead of a FICO 10T score, thus weakening FICO’s moat.

Finally, on the upside, with the Federal Reserve set to lower interest rates in 2024, perhaps the economy will reaccelerate and consumers will rush out to buy new homes and cars. This could drive a boost to FICO Score volumes and a reacceleration of revenue growth for FICO.

Conclusion

Fair Isaac has been an incredible stock, returning 87x since its 1996 IPO. Built upon its namesake FICO scores, FICO is a money printing machine as its business enjoys the network effects of being used by 90% of lenders as the gold standard in credit decisions.

However, at some point, even the best companies should be sold, as its valuation becomes unsustainably high. Trading at 19x Fwd EV/Sales, I believe the risks are to the downside for FICO’s shares and would recommend investors who currently own shares to consider taking profits.