Fair Isaac Corporation

Moat: 3/5

Understandability: 3/5

Balance Sheet Health: 4/5

Fair Isaac Corporation (FICO) is a leading analytics company, best known for its FICO credit scores that are used by lenders, but the company also offers a broader range of software and data solutions.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

FICO operates in a fairly niche, but highly competitive, market. It’s not a tech darling, nor it’s something everyone easily understand, but what we can definitely know is that they earn high margins and that they have a very sticky customer base.

Business Overview:

  • Revenues Distribution: FICO’s revenue is primarily divided into two segments:
    • Scores: This segment generates revenue from the sale of FICO credit scores, used extensively by lenders to assess credit risk.
    • Software: This segment includes a wide array of software solutions for decision management, fraud detection, and customer communication, along with analytics and consulting services related to these software solutions.
      • Within software, the two main offerings are: Platform Software and Application Software.
    • FICO’s revenues are primarily in the U.S, but also have international revenue streams from the Americas, EMEA and Asia Pacific.
  • Industry Trends: The financial services industry, the primary customer base for FICO, is rapidly changing.
    • Lenders face increasing regulatory scrutiny, which is forcing them to be more efficient in their decision-making, increasing the reliance on technology and data analysis.
    • Consumer expectations are also changing, with customers expecting greater speed and convenience from lenders. FICO’s cloud-based solutions position the company well to capture this trend.
    • The demand for fraud detection and cybersecurity software is also rising rapidly, as both consumers and companies are becoming more vulnerable to fraud. In general, automation, data analytics, AI and security are important trends that are affecting this industry.
  • Margins: FICO boasts high operating margins in the 50-60% range (before amortization of intangibles), a clear indicator of pricing power and efficiency.
  • Competitive Landscape:
    • The market for credit scoring is very concentrated, with the FICO score being the de facto standard, they are the leader in this segment.
    • The software market is more competitive, with multiple firms offering different solutions, but FICO has a leading position in this market too.
    • FICO must be constantly innovative to stay ahead of the competition.
  • What Makes FICO Different?:
    • Their “moat” is its wide acceptance for their FICO score, they are well-known across the lending industry as the leader, making them a primary option for lending firms. This wide moat is reinforced with switching costs, as their customers have integrated their products deeply into their workflows.
    • FICO focuses on building and maintaining a well-balanced ecosystem of products, instead of focusing on a particular product, which is helping them to diversify and remain strong.
    • The company is also investing heavily on R&D and AI to remain competitive and innovative.
    • Their software and analytics capabilities combined with their leading score, allows a broad spectrum of customers to use their services in an all-in-one platform.

FICO is moving from on-premises software toward its FICO Platform, which offers customers more capabilities such as better analytics and decision intelligence.

Financial Analysis:

  • Revenues: FICO has been growing revenues consistently, albeit at a slow pace, with their subscription revenue now becoming more important to the company than their transactional revenue. For fiscal year 2022, their total revenue was $1,428 million, and for 2023 their total revenues came at $1,413.6 million.
  • Profitability: Gross profits were 71.6%, for 2022, and for 2023, 71.6% too. This is very impressive, indicating that FICO has solid control over their expenses, while also having good pricing power. For 2022 net income came at $372.5 million and for 2023 net income came at $354.9 million.

  • Balance Sheet: FICO has a very good balance sheet, although there are quite a lot of intangible assets due to previous acquisitions. In September 2023, they had $1.8 billion in total assets, with cash & cash equivalents of $119.7 million. They have $1,362.8 million in total liabilities, mostly from debt and deferred revenue (meaning customers pay FICO before utilizing the software, which indicates that their products are valued). FICO has a equity of $467 million with an accumulated deficit of $1,302 million. All this said, their balance sheet is still healthy for the company of its kind, but the deficit should be monitored.

  • Free Cash Flow: For 2023 their operating cash flow was $404.3 million, capital expenditures were $30.9 million and thus the resulting free cash flow came at around $373.4 million. This free cash flow is excellent, indicating that FICO has enough profits to fuel future acquisitions and maintain a healthy level of growth.

  • Valuation: FICO has a price to earnings ratio (P/E) of 40, a very expensive figure, meaning that investors are paying a high premium for FICO’s current earnings, that is to be seen if they could maintain this valuation. P/B is at 27.30 and with this ratio, we can see that book value is far under their market value. The price to sales of the company is at 10.5.

Moat Assessment:

FICO’s moat is rated a 3 out of 5. Here’s why:

  • Strong Customer Relationships and High Switching Costs:
    • FICO’s solutions are deeply embedded within financial institutions’ workflows, leading to high customer retention and significant switching costs.
    • The transition from old systems to new systems would be complex and expensive, thus many companies prefer to stick with what they already use, which is usually the industry-leading provider FICO.
  • Brand Recognition and Network Effects:
    • The FICO score is synonymous with creditworthiness, which builds brand recognition and creates a network effect: Lenders demand the score so they can determine risk, and customers want the score because it leads to credit.
    • This creates a self-reinforcing cycle that limits the possibility of new entrants in the credit scoring space, allowing FICO to remain dominant in the market.
  • Regulatory Moat:
    • FICO has some level of regulatory moat, as their score is widely used and accepted by regulatory authorities.
  • Limited Technological Innovation and Potential for Disruption:
    • Their innovation, primarily in the AI field, is a great positive for long-term growth, but it is also a risk for the company because if other companies create better AI based products, FICO can be easily surpassed. There is a risk of disruption that should be monitored.

The most important thing to take away from the moat analysis of FICO, is that their score product is quite difficult to replicate due to the vast acceptance, making a wide moat, but their software operations are very susceptible to technological disruption. Therefore, their overall competitive advantage could be rated as a narrow-moat.

Legitimate Risks to the Moat and Business Resilience:

  • Technological Disruption: Emerging AI and ML technologies could give rise to new credit scoring systems, potentially disrupting FICO’s core business. Also new software companies can easily disrupt them, as they are reliant on an old technological ecosystem.
  • Industry Consolidation: Consolidation in the lending industry can create fewer but larger customers, who have more bargaining power.
  • Economic Downturn: A significant economic downturn could reduce lending activity, decreasing the demand for FICO’s services. Furthermore, if inflation rises, then their income from investments may be hurt.
  • Increased Regulatory Scrutiny: Changes to regulations that change how credit is used or how financial software is developed can disrupt FICO’s established markets.
  • Reputational Risk: FICO’s reputation is closely tied to the accuracy and reliability of its credit scores. Negative publicity, due to credit or fraud scandals, can have a big impact on investors.

Management’s Perspective & Recent Concerns:

  • On the latest earnings calls, management emphasized their ongoing transition to FICO Platform and their investment into the growth of cloud-based offerings. They acknowledge that their software business is more complicated and may vary. They have repeatedly stated that their recurring revenues are a priority for them. Also management have emphasized a renewed focus on building more partnerships and expanding into new markets, especially the underrepresented Asia Pacific Market.
  • In recent earnings calls, there were no particular indications of any current controversies, or large problems, just the normal challenges of maintaining growth and margins. They are focusing on expanding to new markets in their software division, which also serves to diversify their revenue streams.

Understandability Rating:

FICO receives a 3 out of 5 for understandability.

  • Their core business (credit scoring) is relatively straightforward to understand. However, the complexity of their software division and the subtle interplay with different financial services makes it less easy to fully understand.
  • FICO operates a specialized ecosystem with interconnected parts. If an investor wants to fully comprehend the business, they should understand how their data, software and scoring system interact with each other.
  • Their financial statements can be opaque without knowing the specific sector they are involved in and their business models.

Balance Sheet Health Rating:

FICO receives a 4 out of 5 for balance sheet health.

  • They maintain a good balance sheet, with enough cash for operating activities and some minor acquisitions.
  • The fact that they have a lot of intangible assets can be concerning, and that’s why their rating is less than perfect, as intangible assets can have variable values.
  • Their high negative equity, due to share buyback programs, isn’t a great point for their stability.

In Conclusion:

FICO is a well-established leader in the financial analytics sector, with a strong core business in FICO scores. However, their growth prospects depend on the continued growth and innovation of its software offerings. Even though they have a relatively strong moat, it should be monitored constantly. Their main risks for the future involve technological disruption and regulation changes. They are reasonably easy to understand, and for now they can maintain their status as a profitable and stable business.