Fair Isaac Corporation: Expensive Stock Is Not An Issue If You Have Pricing Power (FICO)

We believe that most investors are wrong in judging Fair Isaac Corporation (NYSE:FICO) stock as expensive based on current multiples. The pricing power and unique positioning in the market as a natural monopoly make the company still cheap relative to its prospects. We expect topline growth to continue supported by strong margin gains that will eventually drive EV/EBITDA significantly lower in the near future. Our target is $1420 with an upside potential of around 20%.

Don’t confuse expensive with high multiples

Everybody knows FICO and its famous scores. The company is used by 90% of lenders in the US to provide fundamental insights into the creditworthiness of their clients when they need credit. In the investment community, FICO is also known for its expensive stock and high valuation. Investors are debating on whether buying a company at 60 times earnings and 35 times EBITDA is a smart move, considering the risk of a valuation re-rate or misses on expectations.

But we think that simply looking at multiples and concluding this is an expensive stock is a good process. The thing with FICO is that it is a unique company. We wouldn’t be worried about comparing it to a Google or Meta given its market position – monopolistic – and extreme pricing power. Overall the debate on whether it is truly expensive or not comes down to their ability to grow topline figures and margins fast enough.

There are no true comparables to FICO, a company that controls 90% of the market in which it operates. What we can do is run a comparison with other companies that historically had a similarly strong market position. For example, Google is the perfect example of why the valuation multiples don’t really matter in the long run. Despite the EV/EBITDA being roughly the same (17.5x in 2020 vs 19x today), the stock is up 160%. How? Well, growing EBITDA and sustained expectations that they will continue to do so. This can happen because Google has strong pricing power given by its monopolistic position, and lack of alternatives for customers.

Another good example of the tradeoff between multiples, growth, and returns, is offered by Polen Capital and its Equity Heat Map.

The table shows the importance of both multiples expansion and earnings growth. If the multiples are expanding, it is sufficient to get a 10-15% growth rate to get superior returns. FICO grew its earnings by 26% (literally off this table) CAGR in the last 3 years. If we assume that the P/E is going to contract by 25-35% in the next few years, we can still get superior returns in the range of 11% to 22% per year, compounded.

Pricing power and MOAT are the key drivers of growth

The main thesis is that the company will continue to grow like it did in the past. Of course, many investors will point out the considerable amount of risk embedded in this expectation. But there is some good news too. Indeed, the success of FICO is not based on some pricing luck – which is what cyclical businesses experience. The sustained growth is the result of the intrinsic pricing power that the company has with respect to its products. As we mentioned in the beginning, FICO has around 90% market share for credit reports, as lenders rarely entrust other organizations when it comes down to the quality of the data. This assures that there is a wide MOAT around the business that safeguards its ability to raise prices while not impacting demand.

Then comes the second question: how far can it actually raise prices, without meaningfully impacting the overall demand for a credit score? Because we need to be aware that after a certain price ceiling, lenders will probably start developing their own internal metrics. In this case we find some useful insights from FICO blog itself:

It is important to note, though, that even after this current adjustment, at $3.50 per FICO Score, the royalty collected by FICO in the mortgage market constitutes only 15% of the cost of a $70 tri-merge credit report, the substantial value of which is derived from the FICO Score itself.

15% of the total cost of a report is currently collected by FICO. This means that any price increase enacted by FICO would only marginally impact the total price paid by lenders to download the report. Additionally:

With average closing costs of approximately $6,000 per mortgage[1], FICO’s royalties remain an exceedingly small percentage—approximately two tenths of one percent (or less)—of a consumer’s closing costs and are therefore not an impediment to home ownership.

This is also another powerful point: the impact of the FICO royalty on overall closing costs for a mortgage is less than 0.2%. There is clearly room for growth without even remotely impacting demand for this product.

Valuation: a standard DCF model reveals the upside potential

To stick a fair value on FICO we will use a standard DCF model, but with a strong input to forecast topline growth: pricing. We will look at historical pricing patterns for FICO royalties, and try to extract what may happen in the future, taking into consideration the aforementioned comments. We make the following assumptions:

• Topline growth between 25% and 20% for the next 5 years, primarily driven by price increases that similar to the one happening in 2024, will be substantial

• EBITDA margin expanding from 43% in 2023 to 45% before 2027 and 47% in 2032, driven by the highly scalable nature of the business model (i.e. software)

These two assumptions serve as the base for our forecasting, which yields this result:

Revenues are expected to grow to close to $10 billion 10 years from now, in 2034. The bulk of these gains will be directly translated into EBITDA and FCF, benefiting shareholders. Overall, after adjusting for around $1.6 billion of net debt, we derive a fair value of the equity at around $36 billion, or $1420 per share, representing an upside potential of 20% from the current levels.

Risks: As always, something could go wrong

As for the risks, FICO is clearly exposed to some. We assume that the price increases and the ongoing consolidation of its position as market leader won’t attract regulatory scrutiny and antitrust action. This is particularly important as recent reports of potential probes into FICO’s business have been increasing. Several parties, including senators, have been pressuring the DoJ to look into the business to assess potential breaches of antitrust law.

However, we believe that overall this risk is fairly limited. FICO spent decades and several hundreds of millions to build its proprietary database of customers’ datapoints used to evaluate their creditworthiness. The DoJ would basically be arguing that being successful against other competitors is a breach of antitrust law. Additionally, the recent in-court loss on the Microsoft-Activision deal is also supportive of our conclusion.

Conclusion

FICO has an extraordinary business model that has not already unleashed its full potential. Even though the company has been on an aggressive price-hiking phase, the overall cost of a FICO royalty compared to the total closing costs of a financing transaction suggests that there is still much room for expansion. Last but not least, the valuation does not appear expensive when plugging-in the aforementioned considerations, leaving room for upside of around 20% from the current price.