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Fair Isaac: A monopoly with plenty of growth ahead.

Opdateret: 23. jan.

Fair Isaac is known for the FICO scores, which are an industry standard that give Fair Isaac a significant competitive advantage, resulting in a 90% market share. Furthermore, their software business is growing significantly, and the addressable market is still large. Thus, there are many things to like about Fair Isaac, but is now the time to purchase shares? This is what I will investigate in this analysis.

This is not a financial advice. I am not a financial advisor and I only do these posts in order to do my own analysis and elaborate about my decisions, especially for my copiers and followers. If you consider investing in any of the ideas I present, you should do your own research or contact a professional financial advisor, as all investing comes with a risk of losing money. You are also more than welcome to copy me.

Since I have attended the workshop with Phil Town, I have decided to change the layout of my analyses a bit. I will do some more calculations and briefly go through why the company has meaning to me. I have changed the format of the analysis a bit to try to make it shorter and with less numbers. If you want to read more about how I evaluate a company, please go to "MY STRATEGY" on my website.

For full disclosure, I should mention that at the time of writing this analysis, I do not own any shares in Fair Isaac. If you would like to copy my portfolio or view the stocks in my portfolio, you can find instructions on how to do so here. I don't own shares in any of their direct competitors either. You can purchase Fair Isaac shares or fractional shares on eToro. eToro is a highly user-friendly platform that allows you to get started with as little as $50.

Fair Isaac was founded in 1956 in Montana, United States. Fair Isaac is particularly known for the FICO score, which was introduced in 1989 and is currently the standard measure of consumer credit risk in the United States. Fair Isaac has two operating segments: Scores and Software. Each segment contributes approximately 50% of the revenue. Scores include the FICO scores, which are used by nearly all major banks, credit card issuers, mortgage lenders, and auto loan originators in the United States. The way it works is that their analytical algorithms are applied to credit data collected and maintained by the three U.S. national consumer reporting agencies in order to generate a credit score. Thus, Fair Isaac does not collect or store data themselves, which makes it a capital-light business. Fair Isaac charges a fee per score based on the volume of clients. The Software segment includes solutions that address customer engagement, such as acquisition and pricing, onboarding, servicing and management, and fraud protection, in over 100 countries worldwide. They typically sell their software as multi-year subscriptions, with payments based on usage metrics such as the number of accounts, transactions, or deployed decisioning use cases. These subscriptions often include contracted minimum payments. Their software has a high return on investment (ROI). Most bank customers achieve over 100% ROI within the first year, which makes it highly valuable and difficult to replace. Fair Isaac has a moat in the form of FICO scores, which are required for conforming mortgages delivered to Freddie Mac and Fannie Mae. Additionally, their high return on investment for customers in software suggests that they have also established a moat in the software segment.

Their CEO is Will Lansing. He became the CEO in 2012 but had been serving on the Board of Directors at Fair Isaac since 2006. Prior to joining Fair Isaac, he served as the CEO and president of InfoSpace. He has also held CEO positions at ValueVision Media, NBC Internet, and Fingerhut, and has held leadership roles at General Electric, Prodigy, and McKinsey & Company. It means that he has vast leadership experience from many different sectors. He holds a B.A. from Wesleyan University and a J.D. from Georgetown University. Will Lansing has done a tremendous job as CEO at Fair Isaac, as he has created significant value for shareholders. This is exemplified by the fact that the stock has increased by more than 20 times since he assumed the role of CEO. He currently holds 1,7% of the shares in Fair Isaac, which is approximately four times more than what is required by his contract. According to Comparably, his employee rating is 73/100, which puts him in the top 25% of companies of similar size. I believe that Will Lansing's results speak for themselves, as he has generated great value for shareholders. Therefore, I am very comfortable with Will Lansing leading Fair Isaac moving forward.

I believe that Fair Isaac has a strong moat. I also have great confidence in the management. Now, let us investigate the numbers to determine if Fair Isaac meets our criteria for having a strong moat. In case you want an explanation of what the numbers represent, you can refer to "MY STRATEGY" on the website.

The first number I will investigate is the return on invested capital, also known as ROIC. Ideally, you would like to see a return on invested capital (ROIC) above 10% in all years. Fair Isaac has consistently delivered a high return on invested capital (ROIC) and has only had one year with a ROIC lower than 10%. ROIC has reached new levels since 2019. This is because management made the decision to implement yearly price increases on their scores segment and transitioned their software from a license model to a cloud-based subscription model. Thus, I believe we can expect to see these high ROIC numbers continue in the future, which makes Fair Isaac very intriguing.

The following numbers represent the book value + dividend. In my previous format, this was referred to as the equity growth rate. It was the most important of the four growth rates I used in my analyses, which is why I will continue to use it in the future. As you are accustomed to seeing numbers in percentage form, I have decided to provide both the actual numbers and the year-over-year percentage growth. At first glance, the numbers don't look particularly good, as we have seen a decrease and even negative numbers in the past three years. The reason is that management has taken advantage of the low interest rates on loans and has used debt to finance share buybacks. Hence, I wouldn't give too much importance to these numbers.

Finally, we will investigate the free cash flow. Free cash flow, in short, refers to the cash that a company generates after covering its operating expenses and capital expenditures. Levered free cash flow is the amount of money a company has remaining after paying all of its financial obligations. I use margins to enhance clarity and improve understanding. Free cash flow yield refers to the amount of free cash flow per share that a company is projected to generate in relation to its market value per share. It is not surprising to see that Fair Isaac has had positive free cash flow in all years. As with ROIC, we have observed an uptick in free cash flow and levered free cash flow margin since 2019. During this time, management made the strategic decision to implement annual price hikes in scores and shift from a license model to a cloud-based subscription model in software. The free cash flow yield in 2023 is the lowest it has been in ten years. This suggests that the shares are expensive, but we will discuss this further in the analysis.

Another important aspect to consider is the level of debt. It is crucial to determine whether a business has a manageable debt that can be repaid within a three-year period. This can be assessed by calculating the ratio of long-term debt to earnings. After performing the calculation on Fair Isaac, I have determined that the company has a debt-to-earnings ratio of 4,61 years, which exceeds the limit of 3 years. It is higher than I would like because management has utilized inexpensive debt to fund share repurchases. Management doesn't seem too worried about debt and has stated that they don't have any significant plans to reduce it. They intend to maintain the debt at its current levels. Thus, while I don't like debt, I will give management the benefit of the doubt. It is reassuring to know that they are comfortable with this level of debt.

Like any other investment, there are risks associated with investing in Fair Isaac. One risk is macroeconomics. The current macroeconomic conditions could lead to a significant decline in credit activities in the United States, particularly in the real estate market. The low interest rate environment has boosted credit activities, and as interest rates continue to increase, we will likely see a decrease in transaction volume. If we experience a prolonged recession, the period of low transaction volume could be extended, especially in the real estate sector. It would hurt Fair Isaac, as their credit scoring business charges a fee per transaction. Competition. Despite Fair Isaac having a 90% market share, there may be a risk of competition moving forward. In their annual report, Fair Isaac mentions that the market for their solutions is highly competitive and constantly evolving. They also mention that many of their competitors are larger than Fair Isaac, have more development, sales, and marketing resources than them. Furthermore, we may see AI disrupting the business landscape, and companies like Upstart have business models that consider requirements beyond just the FICO score. This should result in higher approval rates, lower interest rates, and faster payouts, while reducing fraud and loss rates. Relying on a few customers. Fair Isaac generates a large part of its revenue from three major consumer reporting agencies in the U.S. Experian, TransUnion, and Equifax. Collectively, these agencies accounted for 41% of the revenue in the scoring segment in 2023. The loss of or a significant change in a relationship with any of the three consumer reporting agencies could have a negative impact on their revenues and operational outcomes. These three agencies are not only the largest customers of Fair Isaac, but they are also competitors. The three agencies have introduced VantageScore as a joint venture to compete with Fair Isaac.

There are also plenty of reasons to invest in Fair Isaac. The Scores segment. Fair Isaac's score segment continues to grow as management adopted a new pricing strategy in 2018. Prior to 2018, Fair Isaac had not raised prices for 25 years. Management has stated that they price their services from basis points to single-digit dollars. Typically, these services are used in decisions that are worth hundreds, thousands, tens of thousands, or even hundreds of thousands of dollars. Thus, the company believes it will be able to continue increasing prices for years to come, thereby boosting revenues in the scores segment. The Software segment. As mentioned previously, Fair Isaac has transitioned from a licensing model to a cloud-based subscription model, which has accelerated their revenue growth and margins. One example is that the operating margin has increased from 21,9% in fiscal year 2019 to 42,3% in fiscal year 2023, and it continues to rise each year. Furthermore, the total addressable market is significantly larger than the current market share of Fair Isaac. They are targeting the largest 200-300 financial institutions globally, of which they have only penetrated 15%. This means there is a potential upside of 5X. CEO Will Lansing has stated, "The software business could be much bigger than the scores business in the fullness of time. The TAM is enormous. Share buybacks. The company has continued to buy back shares over the course of ten years, rewarding shareholders. Shares outstanding have decreased from 32,15 million in 2013 to 24,77 million in fiscal year 2023. It means a decrease of approximately 23% in shares outstanding. And nothing suggests that management will stop. In fiscal 2023, Fair Isaac bought back 615.000 shares at an average price of $659 per share, totaling $406 million. They still have $121 million remaining on their current share repurchase program. Management has also mentioned that they continue to view share repurchases as an attractive use of cash.

Now it is time to calculate the price of shares in Fair Isaac. I perform three different calculations that I learned at a Phil Town seminar. The first is called the Margin of Safety price, which is calculated based on earnings per share (EPS), estimated future EPS growth, and estimated future price-to-earnings ratio (P/E). The minimum acceptable rate of return is 15%. I chose to use an EPS of 16,93, which is from fiscal year 2023. I have selected a projected future EPS growth rate of 15%. (Management expects a 15% growth). Additionally, I have chosen a projected future P/E ratio of 30, which is twice the growth rate. This decision is based on the fact that Fair Isaac has historically had a higher P/E ratio. Lastly, our minimum acceptable rate of return is already set at 15%. Doing the calculations, we come up with the sticker price (some call it fair value or intrinsic value) of $507,90. We want to have a margin of safety of 50%, so we will divide it by 2. This means that we want to buy Fair Isaac at a price of $253,95 (or lower, obviously) if we use the Margin of Safety price.

The second calculation is called the Ten Cap price. The rate of return that an owner of a company (or stock) receives on the purchase price of the company is essentially its return on investment. The return should be at least 10% annually, and I calculate it as follows: The operating cash flow last year was 469 and capital expenditures were 4. I attempted to review their annual report to determine the percentage of capital expenditures allocated to maintenance. I couldn't find it, but as a rule of thumb, you can expect that 70% of the capital expenditures will be allocated for maintenance purposes. This means that we will use 3 in our calculations. The tax provision was 108. We have 24,77 outstanding shares. Hence, the calculation will be as follows: (469 – 3 + 108) / 24,77 x 10 = $231,73 in Ten Cap price.

The final calculation is called the Payback Time price. It is a calculation based on the free cash flow per share. With Fair Isaac's Free Cash Flow Per Share at $18,45 and a growth rate of 15%, if you want to recoup your investment in 8 years, the Payback Time price is $291,25.

I believe that Fair Isaac is a fantastic company with great management. They essentially have a monopoly because their credit score is an industry standard and is even required when delivering conforming mortgages to Freddie Mac and Fannie Mae. This means that they have a significant moat around their business. Management has also done a great job in rewarding shareholders and making strategic decisions. Transitioning the software from a license model to a cloud-based subscription model and implementing price increases on scores were excellent choices that have benefited the company. The macroeconomic environment could pose a short-term risk for Fair Isaac, but it should not have a long-term impact on the business. Competition could be something to monitor, as we don't know how AI will disrupt the business. However, so far, it doesn't seem to be impacting the business of Fair Isaac. Customer concentration will always be a risk, but there is currently no indication that Fair Isaac's relationship with its largest customers will change. Additionally, since VantageScore was founded in 2006, it is unlikely that it would suddenly have an impact on Fair Isaac. Fair Isaac has plenty of room to grow, as they can continue to increase prices in their scores business. The costs for customers are very low compared to the potential loss. Their software business also has plenty of room to grow as it serves a large addressable market, and margins are increasing year over year, which is great to see. I would love to add Fair Isaac to my portfolio if I could buy it at what I believe is its intrinsic value. The intrinsic value is twice the highest calculation, meaning it is double the Payback Time price. Thus, I will buy shares in Fair Isaac if it drops to $582,50.

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