Investment Thesis

Fair Isaac (NYSE:FICO) has been one of the best-performing stocks in the past decade, with shares up over 1,300% during the period. Unlike most companies that struggled in the past year, it continued to outperform and is currently trading near its 52-week high. The company has a strong moat as it benefits from a near monopoly in the credit scores space. It also has solid growth opportunities with its analytics and decisioning software solution, which is often overlooked by investors. The company continued to deliver impressive results in its latest earnings, with the bottom line growing by double digits despite facing tough macro headwinds. However, the company’s valuation looks quite stretched after the recent rally and further upside should be limited. Therefore, I rate Fair Isaac as a hold and will wait for a better entry point.

Why Fair Isaac?

Fair Isaac is a California-based financial technology company that specializes in analytics and data decision software solutions. It is the company behind the popular FICO Score, the standard metric for consumer credit risk in the US. Besides credit scores, the company also provides decision-management solutions to businesses for fraud protection, compliance, analytics, customer engagement, and other use cases.

Fair Isaac has a strong moat thanks to standardization and data advantage. Since the FICO Score was introduced in 1989, it has been gaining a strong reputation and popularity thanks to its precision and consistency. Over the years, it has slowly become the standard measure of consumer credit risks for lenders. The standardization of credit scores made it very hard for new entrants to compete as most lenders simply do not bother to use other metrics now. Adopting multiple credit scoring systems is complex as they all use different algorithms and preferences, making it hard for lenders to process applications efficiently. For instance, 98.8% of securitization in the US solely cite FICO Score as their credit risk measure.

It also has a strong data advantage that makes it even tougher for other companies to disrupt its business. FICO Score currently processes over 10 billion credit decisions each year, and the data generated from these decisions are then able to be used to further improve its decision-making capabilities through advanced AI and ML (machine learning). Its accuracy and consistency should continue to improve over time and strengthen its leading position.

The company’s analytics and decision-management solutions also have huge growth opportunities, especially in areas like anti-financial crime. According to Nasdaq (NDAQ), the TAM (total addressable market) of anti-financial crime is estimated to be $18 billion in 2022. The market has been expanding as the cases of financial crimes continue to rise. In the past year, the attempted wire fraud by value grew 119% YoY (year over year). The increasing need for anti-financial crime solutions should be a solid growth driver moving forward.

Financials and Valuation

Fair Isaac’s latest earnings were solid as most of its revenue is generated from subscriptions that are very sticky. The company reported revenue of $344.9 million, up 7% YoY compared to $322.4 million. The growth was mostly driven by software revenue, which increased 9% from $152.9 million to $166.9 million. Software ARR (annual recurring revenue) was up 11% from $582.9 million to $524.3 million. Customers continue to increase spending and the net retention rate was 110% for the quarter.

The credit scores segment was softer, which grew 5% YoY from $169.5 million to $178 million. The B2B (business to business) segment was up 11% due to higher pricing and volume in originations. Auto originations revenues were up 24% while card and personal loan originations revenues were up 19%. However, this was offset by the decline in the consumer segment, which dipped by 6% as rates continued to rise and mortgage origination dropped.

The bottom line was strong as the company demonstrated significant operating leverage. Despite revenue being up 7%, operating expenses were down 1.1% YoY from $206.8 million to $204.5 million. Most of the decline is attributed to SG&A (selling, general and administrative) expenses, which decreased 5% from $98 million to $93 million. R&D (research and development) expenses also dropped 6.2% from $39 million to $36.6 million. This resulted in the net income growing 14.8% YoY from $85 million to $97.6 million, or 28.3% of total revenue. The non-GAAP diluted EPS was $4.26 compared to $3.70.

After the massive rally since last May, the company’s valuation looks pretty stretched at the moment. It is currently trading at a PE ratio of 43.8x, which is pretty expensive considering its high single digits revenue growth and mid-teens EPS growth. The multiple is also elevated compared to rating peers, as shown in the chart below. The three company has been trading at a similar range historically but the trend has diverged recently. S&P Global (SPGI) and Moody’s (MCO) are currently trading at a PE ratio of 31.9x and 39.6x, which represent a meaningful discount of 37.3% and 10.6% respectively.

Investors Takeaway

Fair Isaac is a wonderful company that should continue to perform well in the long term. The formidable moat in credit scores provides strong pricing power while its decision-management solutions should be another solid growth driver as use cases increase. The strength of its business generates strong operating leverage that should enable long-term double digits EPS growth, as shown in the latest earnings. Fundamentals are important but the price you pay also matters a lot. The company looks fully valued at the moment with multiple meaningfully above peers. I believe the current price level offers limited upside and I rate the company as a hold.