Fair Isaac Corporation (FICO) Earnings Call Transcript & Summary

We'll go ahead and get started. Thanks, everybody, for joining us this morning. I'm Patrick O'Shaughnessy, the Capital Markets technology analyst here at Raymond James. And up next, we have Fair Isaac, better known as FICO. On their behalf, we have CFO, Steve Weber. It's his and FICO's first visit to our conference. So welcome.

Great. Thank you, Patrick. Thank you for having us. We have never been here before, and it's great to be here.

Terrific. So to kick things off, for the benefit of folks in the room who are maybe a little bit newer to the story, can you please just provide a discussion or an overview of what Fair Isaac does and maybe how that compares today versus 5 years ago?

Sure. First of all, there's 2 different pieces to our business. There's the Score business, which people are most familiar with. We provide FICO Scores to a wide range of users. Almost all decisions on credit in the U.S. and most of Canada are made with the FICO Score. So there are people who use them to originate new loans. They'll use them to market to people. If you've got an offer in the mail for a credit card, typically, there's a score [ poll ] ahead of that to determine who to mail to. And they're also used for account management purposes to understand the underlying risk in the portfolio and then decide who maybe to offer cross-sell or upsell opportunities, too. That -- and we also have a consumer business as well. That's -- the B2B piece is the scores are used by banks. That's 2/3 of the business. The other 1/3 is a B2C business that there's 2 components to that. One is our myFICO.com business where we sell financial monitoring products to consumers -- directly to consumers through a website. And then we also have a partner program. We have a number of partners, the biggest of which is Experian, and we partner with them on all their consumer offerings like Boost, things like that. So that's that side of the business. That's about roughly half of the revenues. It's most of the profits. It's a very profitable business. The other half of the business is Software. We've had software products for 30 or 40 years now. Historically, they were point solutions sold into banks to help with different pieces of the customer life cycle, originations or account management or fraud detection. In the last several years -- this gets to the second piece of your question. In the last several years, we've actually changed the architecture underneath it. So it all operates in the same common architecture, and we're now able to offer pieces of this -- piece of the IP as microservices on a platform. So you don't have to buy out of the box, off-the-shelf solutions anymore. You can actually put together your own use cases on top of this platform. It will ingest all the data and you can make -- you can use our analytics on top of that data to apply to do whatever kind of decisioning you want to do. So more and more banks are -- they're trying to build their own proprietary decisioning, and we can provide the analytics for them to do that and to put that into their workflows. So that's that piece has changed. In terms of the Software -- or Score side, the changes have been -- again, it's very widely used, and we've started this to price increases over the last several years. For a long time, we never changed the prices. In the last 6 or 7 years, we started to change prices, and we -- there's a big gap between what we charge and what the values that's derived. So we're just trying to close that gap a little bit by increasing prices in some areas. We're also increasing some of the technology we provide with the Scores. We have different things like the FICO Resilience Index, which shows it's kind of almost like the score version of a risk -- potential underlying stress testing, almost. It shows what -- how different consumers could potentially respond with a downturn. So there are things like that we're doing for innovation on the Score side, and we're also doing a lot on the Software side, obviously with innovation.

Perfect. I'm going to probably circle back to a few of those topics a little bit later on. But for now, what do you think investors that are new to the story don't appreciate about FICO in the way that some of your best informed shareholders do?

Yes. I think a lot of people don't really understand the Software business. They don't even know we have a Software business. It's a big part of our business, and it's a big part of our ongoing growth story. Historically, a lot of these products were fairly legacy businesses. They were very deeply penetrated, but they weren't really growing much because they were so widely used. But the platform, our new FICO Platform really is something that's spurred a lot of growth for us. So we're seeing ARR growth better than 40% on that side. So that piece, it started out small, but now it's becoming a more significant piece of the overall Software business. So that growth is going to -- and we think that's going to continue for a long time, and that's going to drive a lot of our future growth and profitability that we never have seen in the past. So I think that's something that people don't really realize yet. They're starting to recognize that with the performance we're putting up there, but it kind of gets dwarfed by the Scores business a lot of times. I think on the Score side, people don't realize how deeply embedded it is and how difficult it is to come up with something else. That's really become a standard that everybody uses. Regulators use it to understand risk. They can look across the industry and determine risk in bank A versus B versus C via the FICO Score. So it really is a tool that the regulators use, investors use, the securitization markets use to really understand a portfolio.

And maybe building off of that last point, so I think a big topic of conversation at the conference this year is GenAI. And people use GenAI to all sorts of different use cases, including risk models. So why do you think FICO has been so resilient to competitive disruption and including people using AI to maybe create more accurate risk models or whatever they would do with it?

Well, yes, a big part of this is that there are a lot of really great uses for generative AI, but there are limits, particularly when you're running -- in financial services, where most of our business is, it's so highly regulated. And it's really difficult if you -- the granting of credit is something that's probably more regulated than almost anything in the world. You have to be able to -- if you turn someone down, you have to explain why, and you have to have specific examples of why. And that's part of our process, we can provide that. We have reason codes that say, "You were turned out for this loan because you had late payments," things like that. If you have an AI model that's constantly renewing, you kind of lose that and you lose the ability to explain to a consumer. You lose the ability to explain to regulators what risk you're taking on and why you're making the decisions you're making. So you have to be able to prove that you're not -- whatever metric you're using doesn't show [ dispute ] impact to specific groups. And the FICO Score, along with the underlying bureau data, has proven to be objective and nondiscriminatory over time. So that's the biggest thing. We use a lot of AI actually on our Software side. So for things like risk, some types of risk management for fraud detection, we use a lot of AI there because that's an area where you need to constantly update your models. And things like our Falcon Fraud Manager used -- has been using machine learning back to neural nets back to the '90s. So I mean, we've been one of the early adopters of a lot of this, and we have built it into our software.

So getting back to something that you touched on in your introductory comments, how do you think about the value FICO is providing to lenders and the customers? And how does that inform your view on pricing in the Scores business?

Yes. I mean, a lot of times, the FICO Score is the primary decision, at least the gate, in terms of whether someone moves forward to the process or not. In some cases, with credit cards, that's the sole metric used to determine whether somebody gets a credit card and what the rate is going to be and what their credit line might be. So it's a very important metric. And the price on it is very small compared to the value that it's provided. So we look at that and we look at are we charging the right amount for the amount of value that's being derived. So it's -- there's no real magic to that, but it's something we spend a lot of time thinking about.

And then within the Scores business, we touched on pricing power, but it's basically price times volume. And loan origination volume is something that's out of your control. It's something due to the macro. What's your philosophy in terms of managing the uncertainty of origination volumes as you're thinking about growing Scores over time?

Yes. It's difficult. It's difficult to know because I don't think anybody can tell you with any degree of accuracy what's going to happen with mortgage originations next year. We certainly don't know. It's -- mortgage probably has been the most volatile in recent years because of -- when the rates were really low and people were working from home, there's a lot of refi activity happening. And then when the rates went up so quickly -- so much so quickly, the market kind of froze. So the volumes are down at historic lows today. We don't know when that's going to change. I mean, it's probably a combination of people getting used to the rates and maybe some rates coming down. So over time, that will revert to the norm, but we don't know when that will be. So it's difficult for us to really project that. We tend to think longer term. We can't really manage quarter-to-quarter or even for a year. We tend to think about where do we want this to go over time. And then those volumes, we have it on a long time horizon. So we try to get to where we think we need to be and let the volumes kind of be what they are because, again, we have really no control over the volumes at all.

In terms of just you guys think about revenue and the revenue generation that you want to have for a particular year, to the extent that origination volumes are coming in weak, do you have the flexibility to maybe flex pricing a little bit more in that environment?

We do, we do, although, again, we don't really know what's going to happen. So we'll probably flex pricing no matter what. We don't think, "Well, this year's volume is going to be lower, so let's raise it more. This year, volumes are going to be higher, so let's raise it less." We kind of raise of what we think it's the right amount. And hopefully, that's enough to cover what if today our volume decreases. But again, we don't really -- it's difficult to really project with any kind of precision what volumes are going to be. So we -- when we guide, we kind of guide at the lower end of what expectations are on revenue because the last thing we want is to miss because the volumes weren't as high as we thought. So we tend to be very conservative with the way we guide. We don't assume things are going to get better any time quickly because, again, we have no control over that. So if things do get better faster, then we'll get the upside from that. But we don't want to be in a position where we're basically crossing our fingers and hoping that things get better.

Makes sense. So you've kind of touched on earlier, FICO is best known for its Scores franchise, but Software is almost half the company's total revenue, and it's growing at a very healthy pace. Can you describe the interconnectivity between the Scores business and the Software business, how it all fits together?

Yes. They have common customers. That's probably the biggest thing. Our domain expertise really is primarily in financial services. We -- that's our history going back into the company. We started in the '50s. So with the premise -- it was 2 Stanford grads. Their premise was that you could use data and make better decisions. If you look back, the way credit was granted in the '60s and '70s, it was kind of who you knew. You'd go into the office and you'd talk to somebody. And if they knew your uncle, you probably would get the loan. If they didn't know who you were, you probably wouldn't. So was that fair? By any means, but they had really no way to judge creditworthiness. So what we did is we built scorecards originally, and then we built a score on top of bureau data, which is being collected. And we found a way to kind of objectively look at how creditworthy is someone. And then we realized that we could actually kind of build some of this into software and make it repeatable. And we were one of the -- probably one of the first analytics companies -- true analytics companies. And we built these analytics into software. So we looked for ways to take all that you knew about somebody and figure out -- use that to figure out how to price it, right? So that's what our TRIAD account management was. Who should we give credit line increases to? Someone calls and wants a credit line increase, how do you make that decision? And TRIAD helps with that. And then there's other parts of the same life cycle. What information -- and we have originations management. What information do you need to gather to determine whether to get someone a loan or not? That score is pulled in, but you want to automate the process, right? You would -- you don't want to have to tell somebody look for the score. You have the software that pulls it all in, pulls all the information you need and can generate the new account. So we had point solutions like that, that really helps -- help banks use the score in an automated fashion. That was really the genesis of the Software business. And that's kind of why the 2 kind of makes sense together because there are some synergies just in terms of pulling it all together and people understand FICO and they know the FICO Score, and they're more -- they look and trust us on the software side as well.

So the competitive dynamics of your Software business faces are pretty different than what the Scores business faces. How much of your Software growth is coming from market share gains versus just taking advantage of a growing end market?

Yes. That's a good question that's hard to define. A lot of our growth right now is on the platform. The platform use is for a lot of things that we don't have products for and a lot of things that products don't exist for. A lot of it is really customer-specific. It's proprietary decisioning they're trying to build. All the banks have -- they've gathered a lot of data. They're looking for ways to use that data. They have a lot of data scientists. But we -- they need the tools to actually automate the process. And banks are all talking about digital transformation. And especially, this has been spurred by the pandemic. They realize that people don't come into offices anymore. So more and more of their decisioning is through a map or through a website. So they have to have a way to automate that. They have to have a way in real time to make decisions. If a customer applies for something, you can't just say, "We'll get back to you next week," because that's a lot of what you used to do where you used to come in to the office, and they would sit for -- somebody for 2 hours and then they say, "We'll get back to you 2 days." It doesn't really work anymore. So you have to -- it has to be more instantaneous. So you have to have a full view of the consumer when you have the interaction, and you have to know what you're going to do before the consumer calls. So in some cases, they're running batch processing overnight. In case someone calls tomorrow and asks for this, what are we going to offer them? Or in some cases, it's real time. In some cases, you're taking all the data and realizing based on what we know about summary and based on the fact that we have their DDA account, they got to raise 3 weeks ago, and they don't have car loan, maybe they're going to want a new car. So let's offer it to them before they go shopping because they might not come to us. So they're trying to get more and more of a 360 view of the consumer and understand what the consumer wants and provide that to them before they ask because if you just flood them with e-mails, I think all of us know that you get flooded with e-mails, at some point, you just tune them out. But if you can -- if somebody knows you really well and targets you with the right information, you're probably more likely to develop a longer-term relationship. And they're all -- all the banks are trying to get a bigger share of the customers' wallet, and they're all trying to improve the loyalty and improve the relationship with the consumer.

Why does FICO win in that space with your Software customers? There are a number of other credible alternatives, whether it's some stuff that Moody's might do or SES or some other platforms. Why are you guys winning?

Yes. I think it's because we can provide an end-to-end solution. I mean, we really -- we provide the whole decisioning behind this. We have lots of different pieces, components of this. So we have a rules engine, we have optimization. We have modeling capabilities that can pull all this together on an end-to-end basis and then deliver the decision to whatever the actual workflow is. And there's a lot of people that have pieces of this, but there really isn't anybody right now in the financial services space that offers this kind of technology end to end. And again, that's important because all the components together is a much more powerful solution than just trying to cobble pieces together.

So changing gears a little bit. When you are meeting with investors, in particular, your biggest, longest-term shareholders who really understand the company well, what are they asking of the management team at FICO? And what are they saying, "Hey, don't do this?"

Yes. I think it's probably more of the same that we've done. Keep the strategy progressing that we're on today. I think 5 years ago, the Software business wasn't very interesting. We had a mature business that was growing mid-single digit and didn't show any signs of accelerating off of that. Now we're seeing a lot of growth there. So I think a lot of our longer-term, bigger investors are interested in seeing what that can become. And they now think there's a lot of value on the platform side. So I think there's a lot of interest in continuing to invest in that and make sure that we make the most out of that opportunity. So we get a lot of questions about our -- what kind of investments do you still need to make in that? What are -- how do you make those decisions? And what are the trade-offs? And are you investing in now, frankly, to make the most of this? We get that a lot on the Score side. It's about what is the trajectory of the Scores business and how do you maintain your market share and how do you -- what's your pricing strategy going forward. We don't really talk a lot about that. It doesn't really serve anybody's interest to talk a lot about all the details of that. But we're -- we spend a lot of time and money reinvesting in the Scores business to make sure that we have the best possible score available. And we do a lot of things around the classic FICO Score in terms of new innovation to drive more value. We have something called FICO Resilience Index, which we released a few years ago, which shows the -- again, the potential risk in a downturn, things like that, that we're not just sitting back and taking the money, and we're actually investing a lot in that. In terms of what they don't want us to do, they don't want us to completely change course and go off and do something crazy. So just a lot of times, there's questions about M&A. Are you going to buy -- spend $1 billion and something that doesn't really fit? And we don't do a lot of M&A. There's not a lot that would fit with us. We look at a lot of things. But on the Software side, our strategy is to really build on top of this platform and maintain a significant amount of similar code base. If we were to buy a large product line from somebody, it really wouldn't fit. The integration would be difficult. We'd probably overpay. And we'd spend a lot of time just trying to get it to fit into the rest of it. So typically, we build rather than buy. And we use our cash flow primarily for buybacks. We drive a lot of cash flow. We have a really strong cash flow generation. We don't have a lot of capital expenses. Our capital -- CapEx is tiny. We're a capital-light company. So we typically use our buybacks for -- our free cash for buybacks, and that's worked really well for us. At a high level, we think we can drive strong top line revenue growth. We think that through efficiencies, we can drive better than that in terms of net income. Then with buybacks, we can drive better than that with the EPS growth. So we're giving our long-term shareholders a bigger piece of a growing pie.

You kind of touched on capital intensity, and that's something I've been thinking about the last few weeks as it pertains to my information services coverage. You guys are relatively unique and very little CapEx as you mentioned. And that's different from some of the other companies that I cover. Is that an accounting decision from you guys or you just have everything as operating expense? Or are you not making big software investments in the same way that some of your competitors might be?

Well, our CapEx is -- typically has been data centers, which, right now, we don't have many of. We're trying to get out of the data center business. We're putting more and more on AWS and other public clouds, primarily AWS. But we're not in the data center business. We -- in some cases, we had to have our own private data centers for some of our clients because AWS took a while to become PCI compliant. So security wasn't there early on, but now they are. So -- and they can scale data centers much better than we can. They can have them all over the world. So early on, again, most countries have a limit on what kind of data can leave the country. So you had to have -- they had -- every bank had to have a data centers in country. And AWS wasn't available everywhere, but now they are. So we're getting out of the data center business. So that was typically a big use of CapEx for us. We don't capitalize our R&D. That goes way back. A lot of our R&D is on-prem or historically has been on-prem. So we don't -- we capitalize very, very little of that. We tend to expense it as we go, and we're happy with that because we don't have an overhang from expenses kind of still out there. So we pretty much pay as we go. We tend to be very conservative overall in terms of accounting practices, and we're happy with that. So what you see is kind of what you get. You're not going to have a whole lot of capitalized expense out there that we're kind of hoping to pay for. We have very little of that. So yes, our CapEx is very small. You see also our depreciation is a tiny number. Our amortization is a tiny number just because of all these decisions we've made.

And then relative to the other information services companies that I cover, FICO does tend to be on the higher end of using stock-based compensation. Can you talk about that philosophy of why that's a pretty material part of total compensation?

Yes. We're probably more like a lot of tech companies in terms of the stock-based comp. So just from a cultural point of view, that's an important part of our compensation. I mean, you look at -- throughout the company, the salaries are fairly low. They're pretty much below market typically. And a big piece of the compensation for a lot of the people in the company is the stock-based comp. Part of that comes from our kind of legacy in Silicon Valley. The -- we were competing with a lot of tech companies there. But we have a big number of our -- a large number of our employees that are participating in stock-based compensation. So I think it's a little over 40% of the company that has a part of their compensation as stock-based comp. And it really comes to our -- it's one of our core values. We've got core values like anybody else, and one of them is act like an owner. And we really want people to think of this as they are an owner of this company and they're making decisions like an owner would and like a shareholder would in terms of really optimizing for long-term shareholder value. So an important part of that is if you have shares, you feel like an owner. And it's been -- it's good for us because most [ places ] tend to get an RSU that vests over 4 years. So by the time you've been there a few years, you have a significant amount of money that's vesting every year, and it makes it attractive to stay. And when we -- everybody is interested in how the company is performing, and they're really invested in that. So it's something we've kind of feel strongly about and that we're -- if we are different than some, I think it's been a good thing for us. But we do think of it as a cost, right? I mean, internally, we think of stock-based comp and salaries together. We don't really -- we think about compensating people in a total basis. So the -- even the grants every year are value-based. They're not share-based.

Speaking to compensation. So management at FICO is not compensated on returns on invested capital, but it kind of seems as if you're optimizing for that metric anyway. How does management and the Board think about ROIC? And how has that informed your capital allocation decisions?

Yes. I mean, we do think that way, right? We do think -- and some of these are all kind of played together. So I mean, we -- that's not the way the compensation model is set up. That's not to say that it'll never will be, but it -- that really is kind of the way we think. Every investment we make is with an eye toward what's the return on this. We spend a lot of time -- especially on the Software side, there's a lot of potential investments we can make, and a lot of it is about what is the return on this specific investment and what is our total company's return on invested capital. I mean, it's something we do think a lot about. And really, we try to be as efficient as possible in terms of the balance sheet. In terms of all the investments we make, efficiency and the -- and how that will impact the long-term value of the company is something we spend a lot of time thinking about, and the Board certainly does as well.

And then as your Software business has grown in recent years, it does seem to require at least some incremental working capital. How do you think about the free cash flow implications of continued growth in Software?

Yes. And the working capital piece is on both sides, frankly. I mean, I think the way -- when we have increases in revenue, typically what happens -- on the Scores side, we have -- once a year, the price increase goes up. And that -- you get a pop in receivables and just think about this as a flush through. So that kind of happens to us every year. On the Software side, we do have a lot of banks around the world, and some of them just tend to be slower payers. We don't really any issues with the real delinquencies or with charge-offs, bad debt. But some of the larger banks, particularly in South America, are slower paced. So banks, they'll negotiate longer payment cycles, especially if there's FX issues. So we do have to deal with that occasionally, but it's something we look at. It's something we try to manage and try to manage the DSO down certainly.

Well, I'm going to pause there and see if there's any questions out in the room.

I'm wondering about the regulation interfering with predictability. In other words, it's not the government. You cite medical debt should be [indiscernible]. Is there concern given the predictability of the product?

Yes, yes. So the question is around regulation and if that impacts predictability like medical does as an example. So actually, medical debt is an interesting thing because it didn't use to be that when we looked at a consumer's credit file or when anybody looked at it, you couldn't tell what was medical debt and what wasn't. And actually, it's better to be able to look at medical debt separately because medical debt is less predictive than other types of debt because a lot of times, it's not sure who should pay it, right? You get a bill. You don't know if you should pay it to the insurance company. So sometimes, that will go longer. Now with the latest scores that we score medical debt a little bit differently. It doesn't have that much of an impact on everyone, but there's -- it can certainly have an impact to some. In terms of government regulation, I mean, we try to do the right thing and try to make the score the most predictable we can. Regulators, for the most part, I think they want the best outcome. To the degree that they don't like the outcome, in some cases, we try to look at this objectively and say, "This is what it looks like." If there are other factors you want to take into this, if you want to put your finger on the scale somewhere else, then you do this outside of the score. We try to maintain complete objectivity in the score.

All right. Well, nothing else in the room, so I will keep going. We've spent a lot of time talking about the B2B component of Scores. But the B2C component, how do you guys think about the long-term growth opportunities in that part of your business?

Yes. It's an interesting piece that we didn't have -- I mean, if you go back 15 years ago, it was almost a nonexistent business. So there's 2 different pieces of the B2C business. One is our own myFICO.com business, where we sell financial monitoring products to consumers. And it's a product that has dark web monitoring. You have access to your bureau reports and your score, and it has simulators that show what might happen if your behavior was different, what that might impact your score and how the different score would give you different rates. It also has ID theft protection and insurance around that. So it's kind of a full-on product. We're also doing some things -- we have a really great team running that product line, and we're doing some things in terms of a freemium product, where we're offering some free services that people can add on to. So there's a lot of things we're doing in that space. It's become a really good business for us for something that was really small. During the pandemic, a lot of people really got engaged with that kind of a service, and we had really massive growth there. And even as people kind of got back to normal, it kind of waned a little bit, but it still held up really well. So it's a really good business for us. It's a really good extension of our brand. The other side of the B2C business is partners, and our biggest partner in that space is Experian. So if you see Experian running Experian Boost commercial, things like that, we partner with them on that. And we provide scores and simulators and things into that package as well.

All right. Maybe one last question then. How do you think about the trajectory of margins for each of the segments going forward?

Yes. The Scores business, the margins really can't get a lot better. It's like an asymptotic line. You just -- you can only get so close to 100%. It will fluctuate a little bit as the mix between B2C and B2B fluctuates. B2B is a little bit higher margin than B2C because our myFICO business has some cost of goods sold. So you get a little bit of noise in there, but it's not going to move much. I mean, we'll get more dollars, but the percentage can't go up a whole lot more. On the Software side, we're investing heavily into it right now. So the margins we're running, probably, we're at the bottom in terms of margins on the Software side. And as we get more scale and as we kind of build some of the efficiencies into the platform, there's a lot of room for those margins to expand. So we're totally subscale, and we're happy running the business as it is because we're really focused on growth. But we're going to see a lot more margin growth in the future on the Software side, more like normalized Software margins. But it's early stage yet.

All right. Terrific. I think that's a good spot to end. But thank you, everybody, for attending, and thank you very much to Steve.

Great. Thanks.