Fair Isaac Corp. (FICO, Financial) is one of the world’s largest decision support, analytics, software and solutions companies. Its main focus is helping businesses improve and automate their decision-making and risk management processes.
The company’s most well-known and most highly regarded product is its FICO score—an analytic single-figure estimate of a consumer’s creditworthiness used by lenders in the credit industry and clients in the employment, housing and insurance industries. The company’s clients consist of financial and service organizations, including banks, credit-reporting agencies, credit card processing agencies, insurers, telecommunications providers, retailers, marketers, property managers and health care organizations.
Fair Isaac operates in three principal segments: applications, scores and tools. The applications segment provides decision and risk management tools, market targeting and customer analytics tools and fraud detection tools and associated professional services. The scores segment includes the business-to-business scoring solutions, myFICO solutions, delivering FICO scores for consumers and associated professional services. The tools segment provides software products and consulting services to help organizations build their own analytic tools. Many of these analytics and scores are packaged to be available through the cloud as SaaS— software as a service— applications, providing a steady revenue stream tied to their use.
The company actively works with customers in a variety of settings to identify and apply their tools and applications, of which many applications reach far beyond traditional financial applications and stretch into marketing and operational system organization. One notable application includes the use of FICO analytical tools to optimize electrical power grid relay services. The company also supplies marketing and loyalty analytics and analytic services for some Fortune 500 e-commerce marketing companies. The company continues to integrate its vertical applications into the grocery, retail, pharmaceutical, life sciences and even consumer packaged goods industries.
2016 financial highlights
Fair Isaac continues to perform well year over year and is well past the 2008-09 recession which saw revenues tumble as consumer demand, loan activity and demand for analytic support and risk management services decline. Since the start of the recovery, the demand for traditional credit-scoring products has continued to grow. With an increase in housing prices, labor market churn, income growth and lending activity overall, the company’s sales have reached new highs. In particular, total revenues reached a record $881 million in 2016, surpassing the pre-recession high of $825 million.
Revenues advanced a healthy 5% in 2016. Revenues attributable to its scores services increased by 16% in fiscal 2016 compared to 2015. Fair Isaac’s applications and decision management software increased by 1% and 2% in 2016 respectively. The company continues to derive a significant portion of its revenues from international sales, with 36% of total consolidated revenues derived from clients outside the U.S.
Earnings rose at a faster clip than revenues in 2016 (27%) with a small portion of this growth driven by share buyback activities. Going forward into 2017, strength in the tools and applications markets, especially fraud protection and risk management, will keep earnings moving in the right direction. Management expects revenue growth of about 5%, while an increase in research and development expenses could offset some of the gains to earnings. Management projects per-share earnings will reach $3.39 for 2017, a level consistent with today’s levels. We should note the company’s diminished dividend payments will be offset by more aggressive share buybacks; the company has reduced share counts some 4% per year over the last 15 years and plans to continue to reduce this over the next few years. Few companies out there are so determined to reduce their share counts.
Purchase considerations
“Big data” and high-powered analytics remain a major point of focus among companies in the banking, retail, utilities, pharma, medical devices and health insurance industries as they are developing greater capacity to deploy tools in different aspects of their businesses. There are a number of companies, large and small, in the analytics business, but few have the market presence, brand reputation and customer loyalty enjoyed by FICO.
The company is a pure play and is considered to be the gold standard for credit scoring and risk analytics. Its tools are generally considered simpler and easier to use for clients who do not have advanced mathematicians working for them. The deep integration of FICO scores and products into companies' operations has raised switching costs, and with the brand recognition of the FICO score, we believe the company has established a strong and sustainable competitive advantage.
We also think earnings derived by the sales to the financial industry that has been subject to a series of new rules and greater risk-management standards will continue to rise. Financial and other decision-making products will also benefit from the trend toward greater data management and system sophistication. Long term, we can easily see FICO’s modeling tools being further integrated physical security platforms.
It is important to note, however, that while we really like this company and the prospects for its future, there are other credit scoring companies in the industry and Fair Isaac faces some stiff competition. The company regularly updates its scoring algorithms to include more factors and to improve probabilistic forecasting. We are not sure if these changes will affect the complexity of its systems and whether it will affect demand in the marketplace. That said, customer retention rates appear to be holding steady year over year.
It also important to note all technology-based companies are to some extent inherently risky. The company’s ability to broaden, sell and secure its services in a cloud environment and to maintain or increase margins in this space remains to be seen. We have some concern that FICO’s scoring system could one day either overcomplicate or oversimplify the scoring process relative to competitors, leading to a shift in client preferences away from the company. It is important moving forward, particularly for clients in the lending and insurance industries, that it achieves the right balance of product ease and simplification. FICO must ensure clients continue to use and rely on its products heavily as the network effect in this industry is very strong. Also, as has been seen in the past, the company is sensitive to economic downturns.
Estimating sales growth
When assessing the competitive strength and investment merit of any company, the first thing we like to do is to look at what is going on with sales — that is really the first level of inquiry any investor should undertake. Ideally, we are looking to invest in companies whose sales are strong, consistent and generally growing faster than Nominal GDP Growth (that is, Real GDP Growth and Inflation combined). The 10-year sales growth has been 0.7% a year. This compares to nominal GDP Growth of 3.3% per year over the same period. Back in 2008, Fair Isaac's sales dropped substantially due to the financial crisis and declining loan demand. After this decline, starting in 2011, sales have grown at a significant pace due primarily to the massive surge in demand for fraud detection and risk mitigation software. Overall, we think the company is on solid ground and retains substanital pricing power. We feel comfortable saying you can invest in this company if you are looking for solid growth. The company’s sales growth has been 7.3% per year over the last five years and 5.8% per year over the last three years. Its three-year revenue growth is actually ranked higher than 65% of the 1,454 companies in the Global Software Industry. We think sales will continue to grow at a steady pace of approximately 4% per year over the next few years and continue to expect good and predictable things from this company in the future.
Figure 1: Revenues ($ Millions) and Revenue Growth (%)
The second thing we like to do when assessing sales is to look at consensus market estimates. As reported in Yahoo Finance, the market is projecting 5.5% annual growth for this year and 6.3% for next year. These estimates are drawn from the projections of five analysts. The sales estimate is $930 million for 2017, which compares to the year-ago estimate of $881 million. The market is expecting 6.3% growth for next year, which would imply total sales of $989 million. Note the company is targeting 5% growth for next year, which would imply total sales of $925 million.
A third thing we like to do when assessing sales is to compute the company's sustainable growth rate. The sustainable growth rate reflects the rate of growth in sales that a company can support given its existing earnings power, capital resources and dividend payout policy. In any given year, a company's sustainable growth rate is calculated by multiplying its return on equity (ROE) by its retention rate. Rather than rely on data from only one year, however, we calculate sustainable growth by using the three-year average ROE and three-year average retention rate. FICO's ROE averaged 21.1% over the last three years while its retention rate averaged 97.2%, giving the company a sustainable growth rate of 20.6% per year.
Let's recap briefly what the sales data is showing us. From what we can tell, it is not unreasonable to estimate that sales over the next five years could grow at a rate of somewhere between 1% and 21%.
Table 1: Choices for Possible Growth Rates
We are going to select a rate of 3.7%. With $881 million in sales generated last year, this means we believe sales will continue to grow in the future and will reach about $1.1 billion in five years. This estimate reflects our understanding of the company's historical results, market demand, pricing trends, levels of competition and changing regulatory requirements.
Estimating earnings per share
Now that we have generated our sales estimates, we are going to estimate growth in earnings per share. This method applied below takes the sales growth projection — in this case, 3.7% a year — and subtracts the expenses and taxes. What we are left with are the earnings. Then we divide by the projected number of diluted shares outstanding to determine the earnings per share (see table below).
A projected growth rate of 3.7% will result in almost $1.1 billion in sales five years out. Now we need to take a look at the company's pretax profit margin (what is left over after expenses but before taxes are subtracted). In Figure 2 below, we can see FICO produces some pretty stable margins — 17.8% in 2013, 16.9% in 2014, 13% in 2015 and 16.4% in 2016. The average for the last five years has been 16.8% and the average for the last 10 years has been 16.4%. We believe the company's margins will normalize at about 16%. At this rate, projected pretax profits on $1.1 billion in sales would be just over $169 million. This means expenses would amount to $889 million.
Figure 2: Pretax Profit Margins (%)
The next step in our estimation process is to establish what tax rate will be paid on the company's profits. The most recent year’s rate was 24.3%. Normally we would not play with that number too significantly because, in general, it should not change very much from year to year. The only time we would make major changes to this number would be in instances where the current rate differed significantly from that of the past or if we had some knowledge about what rate was likely going to persist in the future, perhaps because the company is going to get some preferential tax treatment on operations abroad. For FICO over the last 10 years, the company's tax rate has been as low as 20.8% and as high as 32.9%. Tax rates for most U.S. companies will fluctuate between 35% and 40%. We are going to select a rate of 30%, representing the average rate of the last 10 years, excluding the influence of non-representative years. This would result in a tax expense of $51 million from pretax profits of $169 million in five years. This would leave us with $119 million in projected earnings five years from now.
Our next main consideration is a matter of determining the number diluted shares that will be outstanding in five years. Fair Isaac has decreased the number of shares outstanding over the last decade. There were 58 million shares outstanding in 2007, then the number of shares went down to 40 million in 2011 and then fell to 32 million in 2016. Currently there are 32 million shares outstanding. This data suggests the company has been redeeming about -3 million shares per year. We are going to rely on the company's historical share repurchase activities to guide our estimation process, but will be more conservative as we think capital will be required for continued tehnological advances and for potential acquisitions. As such, we project share repurchases of about 1 million per year over the next five years.
With shares estimated at 27 million in five years, EPS is expected to rise at a compound rate of 5.1% over the period. This is higher than our projected five-year revenue growth rate and reflects growing sales and a declining equity base. Note that it does not always work out this way. Based on this EPS growth forecast, we are expecting EPS of $4.35 five years out. Results of our forecasting procedure are summarized in the table below.
Table 2: Path from Projected Sales to Projected Earnings
Forecasting a target price-earnings multiple
Now we need to take a look at the price history of the company's stock. From Figure 3, we can see the spread between the high and low stock prices has increased significantly over the last 10 years. We have a current price of $133.96, with a high in the past 10 years of $132.87 and a low of about $20.26. We want to keep this variability in mind when establishing our upper and lower valuation range. Specifically, given the company's historical stock price behavior, we should expect the stock to fluctuate by at least $29.89 over the course of a year.
Figure 3: Stock Price History: Close, High, Low
Fair Isaac’s stock has traded at a moderately volatile price-earnings (P/E) multiple over the last decade, averaging 20.8 over the last 10 years, 25.7 over the last five years and 29.6 over the last three years. Currently the company is trading at 39 times trailing 12-month earnings per share and 39 times expected future earnings.
For determining an estimated target P/E multiple, the first thing we like to do is eliminate any outliers from the historical data series. This includes abnormal P/Es that are not reflective of the normal operations of the company. This could be the result of abnormal growth or significant one-time non-recurring charges or gains. In the case of FICO, we are going to leave the historical series intact. The next thing we like to do is to run an optimization procedure that reveals what P/E multiple yielded the best forecasting accuracy over the evaluation period. If in our judgement this multiple continues to accurately portray the earnings and cash-generating power of the company as well as the growth and risk characteristics, then we will use this multiple as our target multiple. If not, we will adjust the multiple upwards or downwards accordingly.
The figure below presents the historical P/E profile for FICO. We will utilize a target P/E multiple of 24.2 times, which we believe reasonably characterizes the risk-return attributes of the company's stock. This multiple represents a contraction of 37.9% relative to the current multiple. It also represents a contraction of 18.3%, a contraction of 5.9% and an expansion of 16.5% relative to the three-year, five-year and 10-year average P/E multiples respectively.
Figure 4: Historical P/E Multiple and Target Point of Reversion
Setting a target price and valuation range
We selected a target P/E multiple of 24.2 times. To determine a price target five years out, we then multiply this by our EPS estimate. EPS are estimated to reach $4.35 in five years, giving us a target price of $105.22. This price is lower than its current price and is more in line with where it traded in 2015. Nonetheless, to properly judge to what extent the stock may be under- or overvalued, we need to determine a fair value range within which we expect the stock to trade. To do this, we rely on the trend-adjusted average annual trading range for the stock, which from the analysis above we know is $29.89. This means, given our target price estimate, we expect the stock to trade naturally, and fairly, between $90.27 and $120.17. The result of this is that when the stock is trading below $90.27, it is in the buy zone. When the stock trades above $120.17, it is in the sell zone. Currently the stock is in the sell zone.
Conclusion
So what return can we expect for holding Fair Isaac's stock? Well, we now know we can expect stock price depreciation of 21.5% provided our earnings and multiplier estimates prove accurate. We can also expect to earn dividend income of about 40 cents over the evaluation period. Added to our price estimate, this means we could earn a compound annual rate of return of -4.6%.
All in all, we feel the company will continue to succeed operationally on the basis of its brand, reputation and market leadership. But we are concerned that, at the moment at least, almost all investors hold the same opinion and have bid the stock price up by over 200% over the last five years. That is a great return for investors that got in early enough, but we think this is too expensive given the midrange growth levels and even considering the aggressive buybacks. If you are going to buy this company, choose your entry points carefully.
Disclosure: We do hold any positions in FICO.
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