FICO: A New Reality (held)
Q2 24' - Scores kicking the lights out, valuation coming under pressure
As we hit earnings season you should expect more quick fire articles as the companies we follow report.
Fair Isaac Corporation FICO 0.00%↑ reported after the bell on Thursday. The results were quite strong despite the stock selling off over 6% today:
The company reported quarterly revenues of $433.8M up 14% YoY, quarterly operating income of $194.84M up 22% YoY, and quarterly net income of $129.90M up 28% YoY. Operating margins once again hit record highs, with gross margins not far off:
Cashflows did not reflect these otherwise strong results, as there were significant changes in the company’s accounts receivables.
Buybacks were executed pretty much in line with the company’s policy of returning virtually all free cash flow (if not a little more) to investors.
A hot topic during the earnings call was the rate of the growth of FICO’s decision management cloud. After many quarters of 40%+ annual growth in the platform, growth slowed to 32% this quarter.
So, things are pretty much chugging along as they have been for the past couple of years now….
There has been, however, significant colour added to the wider story of late.
Scores
Now that we are firmly on the other side of the FHFA’s decision with respect to the FICO score and conforming Fannie and Freddie mortgages, the playing field is much clearer going forward. As mentioned in previous notes (FICO Expectations Meet Reality and FICO Note) the question that is continually asked, but that is yet to be answered, is: when will the normalisation of the interest rate regime occur?
A little context will be helpful. Volumes for the FICO score are heavily cyclical. The reason for this is straightforward. Individuals need their score pulled when they are applying for loans with respect to certain large ticket items - cars, homes, and personal loans. Scores are also run for a number of more frequent credit decisions like credit card applications. The common feature amongst all these credit decisions is that they are far more likely to happen when credit conditions are easing than when they are getting tighter.
In my previous note I summarised how many of the underlying positive catalysts for FICO’s scores business have already played out. The secular growth story from here hinges on continued price taking and the direction of interest rates. While I want to state in the strongest possible terms that I am no macroeconomic forecaster, the likelihood of an easing rate environment seems as far off as it ever has. To quote CEO Will Lansing from last quarter’s call:
I mean rates have ticked up in mortgages recently, and so if anything, I guess, I feel like the rate -- the fall in rates might be slower than a lot of industry pundits had been forecasting.
The path of least resistance from here seems to be stasis, if not more rate hikes if inflation continues to pick up steam. The implications this will have for volumes is predictable. What FICO did to ameliorate this over the 2022-2023 period was take a significant amount of price in mortgage (well into the triple digits) which more than offset volume declines across the board (that includes reporting segments like credit card and automotive). Take another look at the sequential financial results above and it’s pretty damn hard to see when the volume collapse occurred.
A higher interest rate environment will keep volumes down, but it will also have to mean higher inflation. Higher headline inflation numbers get automatically added into the price of the score on an annual basis. The question going forward will be determining how much additional price FICO is able to take in such a scenario. Thankfully, Lansing gave us a hint already:
I quoted the above in a previous blog post to illustrate the pricing dynamic of the FICO score with respect to its most important reporting segment. The takeaway here is significant. Until now it was very unclear to investors (and even to many who work in the mortgage industry) what the actual cost of a score was. You could back into some numbers, but it was extremely difficult to come to an exact figure. Yours truly quoted a $10-$13 price per mortgage on more than one podcast!
This transparency speaks mountains - the cost of a score on a traditional tri-merged credit report can be as much as $8 on closing costs of $6,000. So the next logical question is to ask where the pricing umbrella is. My first point here would be that we are many, many years off finding where that actually is. My second point would be that the appropriate pricing umbrella is not the credit report cost, nor the elasticity of overall closing costs, but the utility of a 30 year fixed rate mortgage. Remember that a FICO score (and now VantageScore) is mandated for originating one of these. My best guess (and this is a number that inflates with the cost of housing) is several thousand dollars….
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