Fair Isaac Corporation is a company primarily focused on two areas – risk management software and credit scoring solutions. They also have a duo of supporting areas which brings in about a quarter of the total business – professional services and analytic software tools. Below is a summary of their offerings:
- Credit Scoring Solutions: These solutions include a number of scoring products and associated services. The scoring products include FICO® score, FICO® mortgage score, FICO® expansion score (uses alternative data to generate a score – used for customers with limited credit data), FICO® credit capacity index ™ (score that rates the ability to take on more debt), FICO® bankruptcy scores (rates the chance that an account will result in bankruptcy losses), FICO® revenue scores (rates revenue potential of revolving credit accounts), and FICO® insurance risk scores.
- Strategy Machine Solutions: Preconfigured decision management applications are provided as part of these solutions. The products fall under a number of industry areas with risk management being the common theme: Marketing - FICO® Precision Marketing Manager, Originations - FICO® LiquidCredit® service, FICO® Capstone Decision Manager, FICO® Capturestone® Decision Accelerator, Customer Management - FICO® TRIAD® Customer Managemer, FICO® Transaction Scores, Fraud - FICO™ Falcon® Fraud Manager, FICO™ Fraud Predictor with Merchant Profiles, FICO™ Falcon® ID solution, and FICO™ Card Alert Service, Collections and Recovery - FICO™ Debt Management solution, FICO™ Recovery Management System™ solution, FICO™ Network, and FICO™ PlacementsPlus® service, Insurance and Healthcare - FICO™ Insurance Fraud Manager, FICO™ MIRA™ Claims Advisor for Reserving, Analytics - Predictive Analytics, FICO™ Custom Decision Optimization, Portfolio Analytics, Consumer - myFICO® service, Score Watch® subscription.
- Analytic Software Tools: The tools offered are FICO™ Blaze Advisor® business rules management system, FICO™ Model Builder, FICO™ Decision Optimizer, and FICO™ Xpress Optimization Suite.
- Professional Services: Rounding this group up are business and solution consulting, marketing services, and analytic services.
Strategy Machine Solutions are industry-tailored decision management systems which primarily apply analytics to specific business challenges and processes. Fraud Solutions and Customer Management solutions together account for close to 30% of revenue from this business unit. This suite of products came from HNC Software which was acquired in 2002. HNC Software acquisition was a great complementary fit as it added analytic software based on neural networks. The technology is used in the FICO™ Falcon® product line and it strengthened the offerings in the insurance and telecommunications markets. The unit accounts for about 52% of revenue and 38% of net operating income. Competition for this business is mostly traditional software companies including heavy weights like IBM. As such, the profit margin is under 20%.
Analytic Software Tools are products for businesses to build their own custom-tailored decision management applications. These tools are also used as common software components in their strategy machine solutions. The products cover Rules Management, Model Development, and Optimization. Though this is a small unit accounting for only 7% of revenue and operates with about 15% profit margin, these products along with the associated professional services drive additional business in the strategy machine solutions area and hence are vital to their operations.
Professional Services help deploy products successfully in client environments. It brings in close to 20% of revenue but operates at near break-even margin. Even so, given the complexity of the software and expertise required to deploy products successfully, it is a critical area.
An organization restructuring in October 2009 consolidated the business units into three operational units: Scores (scoring solutions as above, myFICO® consumer and associated services), Applications (Strategy Machine Solutions above excluding myFICO® consumer and associated services), and Tools (Analytic Software Tools and associated professional services). With this, the professional services were integrated with the associated business area.
Fair Isaac’s credit scoring solutions is a great business with high profit margin. FICO® scores are de facto standard used by credit issuers (consumer loans, credit cards, home loans, revolving credit, etc.). Fair Isaac however does not keep or maintain customer profiles, the requisite in generating scores. Instead they depend on the major credit reporting agencies (Equifax, Experian, and TransUnion) for this data. This arrangement worked well for a number of years but in 2006 the major credit reporting agencies developed an indigenous product called VantageScore to compete directly with Fair Isaac. VantageScore is a huge competitive threat that can eventually erase half of Fair Isaac’s operating profit as it can potentially impact all of Fair Isaac’s scoring products. Fair Isaac’s main defense is that their scoring products use data drawn from disparate sources. Be that as it may, if the data providers are able to provide scoring solutions amongst themselves and effectively bypass Fair Isaac’s product, then the writing is on the wall that this business stands to lose.
Fair Isaac committed a strategic blunder by failing to recognize its scoring range as a proprietary asset that mandated protection. FICO® scores are reported as numbers in the range 300-850. Fair Isaac trademarked this scoring range in 2004 but by then, competition was already using the scoring range in their proprietary scoring models (VantageScore). This is the issue in a lawsuit filed by Fair Isaac against the major credit reporting agencies.
Fair Isaac’s software business operates in a highly competitive business environment and is capital intensive. Add to this the weight of their professional services and the recipe is right for a business model with relatively low profit margin. Its competitive strength is the proprietary technology used in their products – as pioneers in analytics and neural network technology; they are well ahead of the curve when it comes to the raw technology. In spite of this, it hard to pull forward in profit margins due to:
- They compete with much larger software vendors with deep pockets that can provide a more integrated enterprise story, and
- For the software to remain state-of-the-art, sizeable R&D spending is required.
- Being able to sell multiple integrated products to clients,
- Enable the development of custom client solutions, and
- Leverage professional services and analytic tools to develop solutions in new industry areas.
Below is a table that summarizes Fair Isaac’s financial position:
|Earnings per Share||1.82||1.70||1.33|
|YOY PE Growth||15%||(7%)||(22%)|
|YOY Revenue Growth||0%||5%||15%|
Fair Isaac’s financials over the last three years undoubtedly show a deteriorating trend. The ongoing US economic environment and weakness in financial credit market hit Fair Isaac’s consumer and customer management business and that business should recover as credit environment improves. The saving grace is the modest amount of growth in the fraud and marketing solutions businesses. The decline in net margins was slight over the last three years only because of aggressive cost-control measure – the headcount has reduced by about 25% to roughly 2000.
Fair Isaac (FICO) has an enterprise value of about 1.2B and a forward PE around 18. Historically Fair Isaac grew at a healthy pace but the last three years has shown negative growth as a result of the credit environment prevailing in the US. Assuming credit conditions are normalized, the valuation is reasonable from a strictly financial perspective.
Fair Isaac’s high-margin scoring business is under threat by the big-3 credit reporting agencies. Fair Isaac responded to this threat by legally challenging the VantageScore scoring product introduced by the credit reporting agencies as anti-competitive and unfair. This strategy is risky as this could jeopardize partnering with those agencies. On the bright side, Fair Isaac does have a complementary set of scoring products that together should act as a differentiating factor in fending off the challenge from VantageScore.
Fair Isaac’s software business is a steady but lower-margin business. This is disturbing as the software industry in general is rapidly consolidating. The present day trend for big customers is to buy solutions from an exclusive list of large vendors that can cater to all of their business needs as opposed to point products from a large set of vendors. This trend does not bode well with Fair Isaac’s business model unless they are able to build exclusive partnerships with the big vendors.
Although the valuation is reasonable, there are a number of serious risks with its business. Overall, we rate Fair Isaac’s stock (FICO) a Hold.