Fair Isaac Corporation (FICO, Financial) is the most dominant player in the U.S. credit scoring industry. The company holds a near-monopoly market share in the U.S B2B credit scoring market , largely due to the universal adoption and trust in the FICO Score as the leading credit assessment standard among financial institutions. This dominance translates into exceptionally high profit margins and growth rate for FICO, as reflected by its perfect GF score of 10 out of 10 for both growth and profitability. FICO has been an exceptional compounding machine with an astounding annualized compound annual growth rate (CAGR) of 41% over the last ten years. While I think FICO is worth following in the long term, currently FICO's stock is extremely expensive as the stock has a P/E ratio of more than 110 times, indicating significant overvaluation.
Company Overview
Founded in 1956, FICO has a rich history spanning across almost six decades. Initially, the company gained prominence for its pioneering work in credit scoring. Later it invented the FICO Score, which remains the industry gold standard. The launch of FICO Score was an instrumental event in the history of the U.S lending market. Over the past few decades, FICO has evolved from being a credit scoring company to a provider of comprehensive decision management solutions. Today FICO operates in two primary segments: Scores and Software.The Scores segment is primarily focused on credit scoring and analytics, while the Software segment offers a suite of enterprise software solutions aimed at automating and optimizing decision-making processes. This platform-based strategy has enabled FICO to address a broader range of use cases and customer needs.
Over the last three years, the revenue split between the two sectors has been fairly balanced, with each contributing around 50% to the company's overall revenue.
While the revenue split between the Scores segment and the Software is even, the Scores segment has a significantly higher operating margin and contributes disproportionately more to FICO's overall operating income.
As demonstrated by the table above, FICO's Scores segment enjoys an impressive operating margin of 88%, while the operating margin of the Software segment is only 33%. Notably, the operating margin of the Software segment has been increasing every year, due to operating leverage.
FICO's Competitive Advantages
A business operating with an 88% operating margin undoubtedly holds significant competitive advantages. In the case of FICO, I believe the competitive advantages are manifold.
First of all, the FICO Score enjoys an unparalleled level of trust and recognition among consumers and financial institutions. Although most big banks, including JP Morgan (JPM), have attempted to develop their proprietary credit scoring systems, FICO remains irreplaceable. All three major consumer reporting agencies, TransUnion(TRU), Equifax(EFX) and Experian still need to use FICO for their credit reporting system. Approximately 40% of FICO's revenue were derived from the three consumer reporting agencies. This brand strength extends to FICO's software solutions, making it easier for the company to win new deals and expand its market share.
Secondly, FICO has the most comprehensive and capable platform offering in the industry. FICO's corporate webiste states that FICO “has a deep expertise in analytics, particularly in the areas of credit scoring, fraud detection, and customer management”. The company's ability to leverage these capabilities to develop advanced decision models gives it a competitive edge over other software providers. As stated in FICO's most recent annual report, “an important part of FICO's platform software strategy is to increase customers's usage of platform capabilities across their business”. This comprehensive offering allows FICO to cross-sell additional capabilities to existing customers, driving growth and increasing customer stickiness, as evidenced by FICO's “145% dollar-based net retention rate for platform solutions” for FY 2023.
Thirdly, with the increasing regulation of financial services, FICO's solutions, which are designed to deal with the increasing complexity of regulatory and compliance requirements, are well-positioned to meet the client's compliance need.
Valuation and risk discussion
From the above analysis, it is obvious that FICO is a great business. However, the market has more than reflected FICO's greatness as it is trading at a P/E ratio of 114 times. Gurufocus's proprietary GF Value Rank assigns FICO a score of 1 out of 10, the lowest possible ranking. Over the past decade, FICO's P/E ratio has ranged from a minimum of 23 times and maximum of 114 times.
While FICO is priced for perfection by Mr. Market, the company does face some risks both in the short-term and in the long-term.
The biggest long-term risk for FICO is regulatory risk. Although FICO appears to be invincible at present, as a de-facto monopoly, it will very likely to face regulatory changes in the future, which could impact the demand for FICO's software solutions. For example, in October of 2022, the Federal Housing Finance Agency (FHFA) validated the use of both VantageScore and FICO Score 10T in mortgage lending.
The second risk to FICO's business is the risk of economic downturn. While FICO's scores business has demonstrated resilience during past economic downturns, the software segment could be more vulnerable to reductions in IT spending by financial institutions if the U.S is hit with another financial crisis.
Last but not least, the rapid pace of technological innovation, particularly in the areas of artificial intelligence (AI), poses a risk to FICO's existing offerings. The company needs to continue investing in R&D to stay ahead of the curve and maintain its competitive edge.
Conclusion
To sum up, FICO is a well-established player in the financial services industry, with a strong brand, comprehensive platform offering, and deep analytical capabilities. While the company faces some risks, its competitive advantages position it well for continued growth and success in the long-term. However, it appears that presently, investors are too enthusiastic for FICO's future prospect. Despite the stock's excessively high valuation, I would not recommend shorting it. Instead, I encourage readers to continue monitoring the progress of FICO's business fundamentals and to wait patiently for a much better price point.
