Friends,
This week’s writing was prompted by a Business Breakdowns Podcast featuring Dev Kantesaria on Fair Isaac Corporation ($FICO). On several occasions I have thought that this is the best business I have ever invested in, if not the best business I have ever seen. I have never written about the company in great detail, mostly because I thought I had covered it already (albeit in a different forum). Now that all the alpha has been harvested (joking), I think that Dev’s talk covers some points that have been missed by the wider investing community.
For those of you who are unfamiliar with the company, and it’s incredible franchise, it broadly sells two different types of products:
Consumer Credit Scores,
Software
Credit Decisioning,
Fraud Detection,
Consumer Misc.
If you need help understanding the former, I can help you. If you need help understanding the latter, join the club.
FICO Scores are a common language used by industry participants to talk about the credit quality of a loan of a consumer.
Scores are one of the great all time businesses. If you have read my piece on Moody’s you’ll largely know why. Credit Ratings/Scores (be they individual consumer, or corporate) are naturally monopolistic businesses. The crux of why this is the case is because, overtime, investors seem to identify with the veracity of one or two Ratings/Scores when purchasing debt securities. This trust factor results in lower rates for securitised debt products.
Consumer Credit Scores differ from the Corporate Ratings Agencies in a few important ways. The likes of a Moody’s will have an analyst rate debt issues. FICO on the other hand provides the models that rates consumer credit data which is owned by the three large Credit Bureaus (Experian, Equifax, and TransUnion).
The Scores are used in over 90% of credit lending decisions, and are used in 99% of credit securitisations. 90 of the top 100 largest US lenders use FICO Scores, and it’s not just lenders who use the Scores. There’s over 700 insurers who use the FICO Score, 1/3 of all US retailers, 200 governments, and over 100 big pharma companies.
I am mostly interested in firms that display royalty-like characteristics. These tend to be the best businesses over the long-term. The reasons for this are multi-factorial. By their nature, royalties exist for as long as the underlying market they serve is functioning. They also do not face the key risk in business: they do not necessarily require heavy capital investments to continue to earn the same dollar. FICO is like a royalty to the second power - a tax on-top of a tax on the borrowing public.
The second reason why royalty-like businesses are preferable investment vehicles is that they often exhibit pricing power. The very best businesses, amongst which these ratings/scores businesses sit very comfortably, are able to layer both CPI and additional (special) pricing increases to effectively offset and benefit from adverse business conditions. This is investing nirvana.
A quick note on pricing power. The reason why this is such a key investing concept, especially if you plan is to hold securities for a long time, is that it is one of the few ways to receive more value than what you pay for. Pricing power offers flexibility and control over one’s financial statements. In times of growing underlying product volumes, pricing power can be implemented at your leisure; during times of volume decline pricing can be taken to normalise operating results. FICO, the credit ratings agencies (although to a lesser extent these days), the large tobacco firms, and even the likes of Amazon have showed this to be true. Ultimately, value is created for the marginal and continuing investor between the margins: layering on price increases, above the rate of inflation, is perhaps the only way to maintain outstanding returns on assets over many years.
For the longest time the Scores business did not flex pricing power. Most of the *very* impressive business performance of the company pre-2018 was fixed to volume growth. Over time, it is a virtual certainty that Scores volumes will grow. Two vectors are at play here. One is that various clients find more use cases for the Score over time. The second is that the body of “scorable” borrowers has grown as more data sources have been made accessible.
The reason why the Scores have pricing power is the result of a lollapalooza effect:
The universality of the Score:
The need for a universal standard for determining credit quality began in the 1980’s, with the passing of various pieces of legislation, but also through the consolidation of the credit bureaus. The modern FICO Score began in 1989.
This was reinforced by the decision of Fannie Mae and Freddie Mac in the mid 1990’s to mandate the use of the Score for conforming mortgages.
It is virtually impossible to securitise consumer loans without a FICO Score today. For mortgages, it is mandated by government edict.
Financial Institutions now actively encourage customers to check their FICO Score through complimentary readings. This creates a feedback loop of customer recognition and demand.
The need for the Score is based on investor demand, and are those securitised loans that don’t use it face the headwind of having a higher cost of capital. The core competitive advantage of the Score is not technological and thus even harder to replicate.
Ultimately the price of a Score is a fraction of the value that it brings to it’s ecosystem constituents. Not dissimilar from Moody’s or S&P this value gap continues to grow as debt issuance grows allowing for price hikes well in excess of inflation.
What separates FICO from some of the other businesses of its ilk - say the Credit Bureaus, Credit Ratings Agencies, Tax Compliance Software, Verisk Analytics, and Verisign - is it’s unconstrained, and actionable pricing power. For instance, some smaller financial institutions will see the prices of their Scores increase 400% this year. This jist here is that FICO can see Operating Income continue to rise in the mid teens to low 20s percentage range for as far as the eye can see. The double whammy of a levered buyback program coupled with the fact that the firm really doesn’t need to reinvest a whole lot of money to achieve this growth means that value of this business is hard to quantify in very precise terms. One could quite confidently say ‘a lot’ and be comfortable with a very high trailing multiple that is currently being applied to the shares of the company. This is the key attribute that has been missed by many market participants over the years. The market has quite often looked at it as though it were a flimsy, run of the mill software/data play. It’s been more like Coke c. 1980, or Moody’s c. early 2000’s.
The Software business, which is broken out into a number of different segments, has shown considerable promise in the last year. Operating margins have expanded from 10% pre-Covid to over 30% as of today. The platform, or cloud, offering continues to grow extremely quickly, and will likely show increased margins in the years to come. The draw back here is that this business does not enjoy insurmountable barriers to entry like Scores does. Largely speaking, it is facing intense competition from the other data-stalwarts - but in more positive news the investment dollars needed to fund it’s growth are diminishing.
I plan to write more on this company overtime. Mostly so I can prime my brain to identify more stocks with these characteristics.
Larry.