FICO: A High Score Business - [Business Breakdowns, EP.111]

[MUSIC PLAYING] This is Business Breakdowns. Business Breakdowns is a series of conversations with investors and operators diving deep into a single business. For each business, we explore its history, its business model, its competitive advantages, and what makes it tick. We believe every business has lessons and secrets that investors and operators can learn from. And we are here to bring them to you. To find more episodes of Breakdowns, check out joinkalosses.com. All opinions expressed by hosts and podcast guests are solely their own opinions. Hosts, podcast guests, their employers, or affiliates may maintain positions in the securities discussed in this podcast. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. This is Zach Bus, an investor at Eronic Capital. And today, we're breaking down fair Isaac Corporation, or commonly known as FICO. FICO is best known for its consumer credit scores product, which has become a common language across the world of consumer loans and banking. Less well known, but a major piece of the business, is FICO's software offering that helps financial businesses with fraud detection, customer relationship management, and loan origination. Between these two offerings, scores and software, FICO earned 1.3 billion last year. To break down the business, I'm joined by Dev Cantissaria, managing partner at Valley Forge Capital Management. In going through the business's history and business units, Dev explains why it would be tough to design a better business than FICO on paper. Please enjoy this breakdown of FICO. [MUSIC PLAYING] All right, Dev, looking forward to this conversation to break down fair Isaac or FICO. I thought a good place to just set this stage would be start with a basic overview of the business, what initially attracted you to the story, and then we'll have the opportunity to dive a bit deeper into the value chain and some of the nuanced aspects of the business, which you find particularly unique and underappreciated. So maybe just an overview to kick things off. We try to look for the best business models in the world, and we have been following fair Isaac for many years. The story with her Isaac was a dominant franchise and Scores business is one of the highest quality business models on the planet, but there wasn't a lot of organic growth during the early years of the company. Its growth was completely related to volume, and there was really no change to pricing of its Scores product. But that changed in 2018, which got us interested in a company. If I look at what their basic business model is today, I know they have both the Scores component and a software component. So I want to better understand what those key products are and the value they provide to their customers. So today, the revenues of the company are evenly split between Scores and software, but Scores provides over 75% of the operating income of the company because that side of the business has much higher margins. But as background, the company, as you mentioned, has two main business lines. The first is its consumer credit scores, which help with assessing credit risk for consumer loans, such as mortgagees, autos, credit cards. The second line of business is software. This portion of the business delivers data analytics for things like loan originations, fraud detection, customer management, customer communications. The company is evenly split in terms of revenue between these two pieces. If we talk about Scores first, like of Scores are a common language used by the various industry participants to talk about the credit quality of a loan or a consumer. Today, it's the best way that we have to assess and monitor consumer credit risk. The company delivers over 15 billion scores every year. And as I mentioned before, these scores are used to originate loans of various types. Also used to monitor loans. They are also used to market loans to certain target populations. And the score is also played an important role when you want to package loans and sell them to Wall Street in securitizations. So scores, I would describe them as an important common language that all of the industry participants speak. Today, over 250 million Americans can be scored using a FICO score. And scores are very inexpensive, generally less than a dollar each. And some scores are even a penny or a fraction of a penny, depending on the use case. To give you an idea of the far reach of FICO scores, they're used in over 90% of the credit lending decisions. They're used in over 99% of credit securitizations. 90 of the top 100 largest US lenders use FICO scores. And it's not just lenders. There is over 700 insurers that use FICO scores in a third of all retailers, more than 200 governments, more than 150 farm and health care companies. So FICO scores have found many uses over time. I think it's important to not differentiate, but perhaps explain they're the credit bureaus, which are in and of themselves, great businesses, and then there's the FICO score business. How do the two businesses work together and differentiate and perhaps compete in ways as well? I think some of the history of the industry is important to go through here. Before the 1960s, there was a significant character component to lending decisions. You could imagine a farmer in a small town who walks into a community bank looking for a loan. He didn't have audited financials of his farm. He didn't have a credit card history. There was no easy way to know what all of his outstanding loans or liabilities were. And so the loan decisions back then were largely based on trust and familiarity and the value of the collateral that you were loaning against. There were very few objective factors to work with. And so most of these loan decisions were highly subjective. There's also no concept of a variable interest rate, depending on your credit risk. So you would walk into a bank and they would have a single rate displayed for what a home loan would be, and the bank would have to make a decision of simply yes or no. So Bill Fair, who is an engineer and Earl Isaac was a mathematician, and they worked together at Stanford Research Institute. And they saw an opportunity to bring some standardization and objectivity to the lending process. In 1956, they started a consulting firm together called Fair Isaac & Co. Each of them contributed $400, and it began in a studio apartment in San Rafael, California. And the story is that they sent letters out to the 50 largest lenders in the US, explaining their ideas, but only one responded. And that was the American investment company, AIC. So this company hired them to analyze their credit files. And in the beginning, the factors used to assess credit risk were quite primitive like age, occupation, income. What they really needed to refine their models were large data sets. So combining the mathematical models with large data sets, consumer characteristics, deep alt history, and this was important for them to refine and improve their models. So Fair Isaac sold its first credit scoring system in 1958. And if you look into the 1960s, AIC and other similar companies began using root of entry, computer derived credit scoring. Companies had to send surveys to prospective borrowers, but consumers didn't have the patience to provide 50 plus variables. The scoring models needed to focus on 10 to 15 factors that were most important. The scoring systems also back then were not universal. GD credit work, which was a large lender at the time, might have had 15 to 20 different scoring systems, depending on the underlying populations and the types of loans that they were looking at. The scoring systems were extremely helpful to lenders, because they could tighten their loosen standards based on changing the cutoff score level. This is something that they didn't have before. The lenders could also compare loans across locations. They could trap them over time to get an accurate sense of overall company risk. Prior to credit scoring, there was no easy way to assess the changing credit risk across thousands of on loans, for example. They also know how the ability to charge variable interest rates based on a credit risk. So this was the initiation of the subcrime lending market. In 1974, the Equal Credit Opportunity Act was passed. And this accelerated the need for some type of objective scoring in a loan process. At that point in time, it became illegal to discriminate on factors, such as gender or marital status. Lenders needed to show regulators and consumers some objectivity in the process. So if there were series of mergers and acquisitions of the '70s and '80s, emerged the remained credit bureaus that we have today, Equifax, Prins, Unit, and Experian. And the first standardized credit bureaus risk score, pre-score was released in 1981. Pre-score incorporated the credit bureau information for the first time. So if I go have the mathematical models, the credit bureaus had consumer data. These companies were combining that to form pre-score. Previously, it was the banks and retailers that had this fine data that were fed into the vital models. And so the scores for a long time were custom built for certain banks. And these models were not shared amongst the various lenders. They were very specific to each bank or each financial institution. Pre-score was the first generic model that was not custom built. The scores were generalizable across lenders and a wide variety of loan decisions. And the scalability also lowered the cost of scoring, which could now be standardized across the entire industry. The score that we know today, the modern FICO score, was released in 1989. That's a sport that ranges from-- 300 to 850. It is said that the 1 to 300 range was left for another scoring product, which I don't think we've ever seen. And that 0 to 99 was meant for special post to identify incomplete data. People often wonder why score has this odd range of 300 to 850. And then I think the other critical industry development to mention is that in 1995, Fannie Mae and Freddie Act institutionalized like those scores by making it required for all mortgage originations that they would handle. So a business with a very interesting history that's settled into this monopoly-like structure. To me, lending seems prosickical, mortgages, auto loans. I would assume volumes tend to rise when the economy is booming and rates are declining or volumes decline as the economy slows in a rising rate environment. People may be skeptical of the continued trajectory of that growth. What is it about this business that allows them to grow at a steady pace despite what would be natural cyclicality in my uninformed view? Now, you are correct in pointing out that the scores business, the business to business side is cyclical. And when there's a recession, there's less mortgages, less auto loans, less credit cards being issued. And so the best data point we have is going back to the financial crisis in the 2007 to 2009 timeframe. Scores revenue declined about a third. That is one of the reasons that people have a negative view of the company at times. But overall, scores volumes will increase over time due to the many additional use cases we have for scores. And due to the recent change to how the price scores, and we'll talk about that maybe a little bit later, they're able to add special price increases across different categories of scores. And that's allowed the company to maintain revenue or even grow scores revenue despite volumes being flatter down. Perhaps a related question or maybe Jason, how does the software offering co-exist or partner with the scores side of the business or are they somewhat independent of each other? The software business can be a standalone business. Many investors have thought that there was a benefit to separating the two business lines. There is some processing. Many of the software solutions are sold to banks and financial institutions. But those are likely different departments. I believe that they can largely be standalone businesses. But scores generates a lot of free cash flow. And at the moment the software side requires heavy investment. Now most of that heavy investment occurred over the last five years and that investment is declining. But there is at the moment a nice financial compliment of the two businesses and that you have a scores business that has very high operating margins, north of 85%, with its special price increases growing steadily in the mid to high teens. And then you have a much younger platform software business that has been created where very fast growth, but it's young and it requires investment. The cash flow from the scores side helps support this awkward side. But not a lot of direct complementary selling or cross selling between those two businesses. To focus the conversation on the scores business, just given how robust that offering is and the opportunity set ahead of them, we haven't mentioned much in the way of competition in that business. My understanding is they have a pretty dominant market share. But who are the competitors and how are they organized? So let me start off with some background on the scores business. The scores business revenue is about two thirds business to business or B2B. And one third of the business is business to consumer or B2C. The latter is far less cyclical. The B2B scores business, there's mortgage scores, there's auto scores, and then there's credit card in personal lending scores. Those three categories are all roughly the same size. The cost of the score depends on the type of score. Whether it's mortgage, auto, credit, and how that score is going to be used. Whether it's going to be used for originations, monitoring, or marketing. Mortgage origination scores carry the highest pricing. And marketing scores can be less than a penny each of those carry the lowest pricing. Scores today is a very US-centric business. So over 95% of scores revenue today comes from North America. There's a small contribution from areas like the UK, Brazil, and China. And if you look at what a Flaco score is, it's composed of five major factors. So for a consumer that would include payment history, the amounts that you owe relative to the limits that you have, the length of credit history, the frequency of new credit, and the types of credit used. And so those are all weighted to form your Flaco score. But it's very interesting how Flaco scores are sold. Flaco scores actually have three layers of customers. It's important to mention again that Flaco only produces the mathematical models. And these are then combined with the credit bureau data to create the scores. So fair Isaac does not gather or retain any consumer data of its own. So the direct revenue for scores comes from the credit bureaus, which represent about 75% of scores revenues. But the end customer is in fact the banks and financial institutions, which are making the credit decisions. The credit bureaus sell consumer credit reports to these banks and financial institutions. The Flaco score generally represents less than 5% of what is called a tri-merge report that is generally about $50. So a tri-merge report is simply all three credit bureau reports combined together in one consolidated report. So the three credit bureaus are simply passing along any price increases that Flaco makes. And they often layer on their own markup at essentially 100% margins. So the credit bureaus interestingly, although under the customer of Flaco, they're agnostic to Flaco's price increases. The financial institutions will usually take the costs of the credit reports and include those in a closing costs that consumers pay. So if you go for a mortgage, you know there's a large list of closing costs, where the credit reports are often part of the consumer pay. So although Flaco is increasing prices at a higher level, you have to go many layers deep before you get to gradually pay for those price increases. The fourth mentioning that scores are extremely cheap relative to the loan sizes. So you can imagine on a $400,000 mortgage decision, a Flaco score is less than a dollar. And if you look forward, you could say, well listen, even if a Flaco score costs 10 times more, let's say $5, it still offers tremendous value to the ecosystem or the loan originator. Prior to 2016, Flaco had not increased the prices of its scores for 25 years. As I mentioned before, the growth was entirely based on changes in volumes of scores. The company began instituting special price increases for its various scores in 2018. They first started with mortgage scores and raised prices there 30%. And then the following year it was autos via roughly that same amount and the year after that, it was the credit card scores. And they continued to rotate these annual price increases across the different categories. These special price increases add about $60 million of annual revenue to Flaco and they come along with incremental margins of 95% plus. Now, I wanted to talk a little bit about the different types of scoring models. As I mentioned before, there's about 230 million Americans that can be scored using the standard Flaco score. But the eligible population has been increasing, especially with the introduction of their new Flaco 10 suite. The company launched the Flaco 10 suite in January 2020 and they say it's about 10% more predictive than the previous score of Flaco 9 which launched in 2014. All of this is relevant to get to your question about competition. Let me mention a few more things about Flaco's course today. They come in a lot of different flavors. So, Flaco 10 comes as also Flaco 10 T, which uses more recent trend data. Like, what has been happening to this consumer over the last 60 or 90 days? Flaco XD uses cable cell phone and utility bills to assess credit risk in people that have limited credit history. This particular variety of score adds another 12% of the potential population that is scoreable using Flaco scores. Ultra Flaco links to bank accounts to assess activity and balance sheet strength. And that score can add 20 points to your regular Flaco score. There's also a Flaco resilience index which identifies customers who are more resilient to economic stress relative to other consumers that have the same Flaco score. And there's also industry specific score. So, there's the Flaco autos for and the Flaco bank part score. The reason I'm telling you all of this is when we talk about competition, the main competitor for Flaco scores is Vantage score. In Vantage score launched in 2006 by the three credit bureaus. And it has tried to differentiate itself by saying that it can score 40 million more individuals than the standard Flaco 9 score. These are mostly individuals within to no credit history. With the launch of the Flaco 10 suite in January, 2020, Flaco 10 Ultra Flaco Flaco xD. The difference in the number of scoreable people between Flaco and Vantage score drops to about 10 million people. But what matters is the credit eligible individuals. Those are the people that can actually receive loans. And that difference falls to 0 to 2 million people. So although Vantage score launched and has tried to differentiate itself based on this purported advantage of being able to score more individuals, that has been largely nullified by the recent rollout of the FICO 10s suite. FICO is dominant in admission critical applications such as originations and monitoring of consumer levels. Vantage score has significant share in areas like marketing and lead generation where you have the cheapest scores where it's not as critical that the decision is right. Importantly, in 2021, a major company in the industry's synchrony, which is the largest provider private label credit cards in the US, switched to Vantage score from FICO after a three-year transition period. And at the time this cost quite a stir. But after the implementation process, analysts estimate that synchrony will only save 2 to 3 million dollars a year on a revenue base of 18 billion. What they lost by switching away from FICO scores was the ability to, for example, securitize their debt at attractive interest rates. So given the limited risk for word of switching, I see very few companies following synchrony's path. I would love to peel back the onion a bit on their inability to securitize their originations by removing the FICO score. How exactly did that play out? And were they aware of that when they made the decision to switch? They did ultimately have a debt offering that used Vantage score. It's very analogous to the rating agency business of Moody's and S&P Global. 90% of all the debt in the world is rated with Moody's and S&P. If an offering uses another provider, usually the issuer ends up paying about 50 bases points more in their interest rate. So there's really no way to undercut S&P and Moody's. We took our own credit rating agency to compete with Moody's and S&P and offer us services for free and it still wouldn't make sense to use them. So the similar concept within securitization is that FICO's are the accepted standard for risk assessment. And if you go to Vantage score or other methodologies, although there isn't a definite scientific number of what you will be paying the additional interest, it will be viewed as a lower quality offering and there will be additional interest to pay. I can't quantify it, but probably in the range of zero to 50 bases points. It's eminently rare to find a business that benefits from scale economics, network effects, very high switching costs. It appears all at the same time and it's quite remarkable how they established themselves. I guess Vantage scores is one competitive threat. I should probably ask the obligatory question around artificial intelligence, just given how incredibly topical it's become and how that could impact the competitive advantages the business have. How are they thinking about potential competitive risks in that way? Score predictability is measured using the Ginny coefficient. The Ginny coefficient is a ratio that represents how close the model is to being a perfect model and how far it is from being a random model. The perfect model would have a coefficient of one and a random model would have a coefficient of zero. So if you look at this coefficient for some of the recent scores. Vantage score of 3.0, 4.0, 5.0, 8, 5.9, the coefficient for all those scores is around 0.70. And that coefficient has not improved in essentially 15 years. So we haven't reached what is close to peak predictability for consumer credit loan decisions. Now, fair Isaac claims that FICO 10 made me about 10% better than the previous scoring models. FICO 8 was introduced in 2009. FICO 9 was introduced in 2014. Interestingly, the older scores are still heavily used by banks and financial institutions. As recently as 2021, the majority of FICO scores were still based on an old model FICO 8. There has been a concern that some new companies upstart is a good example. These companies are applying their own algorithms in addition to using FICO scores. So what's interesting is that upstart is not replacing FICO scores. They actually use FICO scores in their methodologies, but they're layering on top their own algorithms or own data. Although it's been fun as something new and exciting banks have been doing this for decades. Banks have always had their own proprietary data, their own client files, their own algorithms. They've always been adding to the FICO scores, never relying on FICO scores alone. But it's an interesting question on whether AI can improve predictability in the future, but to do it without potential discrimination. That's quite important. And that's one of the advantages of something like FICO score is on race, gender, marital status, where you live, the type of job you have, FICO scores can be objective, whereas an AI program may not. So it does come with risks. You mentioned the example of synchrony potentially looking to switch in their trials and tribulations. My understanding is that there's a transition at Freddie and Fanny as well that potentially impacts the business. I'd love to unpack that a bit with you as well. There was an overhang on Fair Isaac stock for a couple of years as we were awaiting the decision from the FHFA, the Federal Home Finance Agency. And they looked at the situation, felt that Fair Isaac had a monopoly on scoring a mortgage originations that went through Fanny and Freddie. They decided that they were going to have a review process. And investors were quite worried that this could affect Fair Isaac's dominance and mortgages. What ultimately came out as a decision was a bit of a surprise to most people. The FHFA decided that they were going to require the use of both FICO 10T and Vantic score 4.0. So it doesn't affect the use of FICO scoring. It now requires the use of an additional score that is owned by the three credit bureaus. But the credit bureaus that were pushing for Vantic score here may now be regretting that fight because what happened was that FHFA reduced the requirement of credit bureau reports needed for mortgages that go to Fanny and Freddie. So it used to be the case that you would need re-credit bureau reports for these mortgages. And what the recent decision has decided is that they only need two slots or two reports. So what it has effectively done is reduce the revenue pie of mortgages by a third. And now the three credit bureaus have to compete with each other on every mortgage for the two slots. And so the miniscule incremental revenue that they gain by getting Vantic score inserted into the mortgage process, that small benefit I think is heavily outweighed by the lost revenue from going from the three bureau reports to the two credit reports for the mortgages. One part of the business we haven't spent a ton of time on yet is the BDC side of the business. And it's rare that you have such high brand awareness for something that's financially derivative and complex and kind of behind the scenes. But I presume that the non-aided brand awareness of a FICO score is actually incredibly high for a financial product. And they've been able to leverage that brand to create a very healthy consumer business. Can you just explain how that business works relative to the scores business and what's different and exciting about it? The BDC part of the scores business is about a third of the revenue of the scores business. And the BDC scores part of the business is composed of two major pieces, my FICO and partnership licenses. The former my FICO we estimate represents about 40 to 45 percent of the total BDC business. The company launched my FICO in the early 2000s and it allows consumers to see attract their FICO scores from the three credit bureaus and it provides additional benefits such as identity theft monitoring. This was a way for consumers to feel like they're in more control over their credit and that's been a very successful business line for the company. FICO also distributes its scores through partnerships and the best example of this is a partnership they have with Xperian they just for new recently for five years with Xperian. Customers can use a product called Xperian Boosts again to monitor their FICO scores and see how it changes relative to their use of credit or repayment of credit. This part of the business is the BDC part of the business is not very cyclical and it's highly profitable. FICO receives realties based on these partnerships as you can imagine these partnership royalties come in very high margins and these partnerships are growing at a very fast rate. The company has a program called the FICO score open access program and this allows financial institutions to give the FICO score a way to consumer so most of us may have seen our credit card company offering us free FICO scores or our bank allows Fargo will offer you free access to your FICO score and all of this I think is brilliant. It helps create this networking effect throughout all the industry participants to focus on the FICO score. The FICO score is the real score to focus on not vanted score. There are companies like credit karma which is owned by Intuit today that uses the vanted score and so to fight competitors FICO is widely distributing its score throughout the ecosystem so that it maintains its place as the default standard. We touched on it a bit earlier but the software business makes up today 50 percent of the revenue and is growing at a very healthy pace. We'll get into the nuts and bolts of the financials later but it's interesting. This is a business that has across all segments, almost 80% margins, which in of itself seems very much like a software business. What exactly is their software offering and what are they investing behind there? The software business represents about a half of the company's revenue, but only a quarter of upgrading income. That's because the software business has margins far lower than the scores business. Software is sold as multi-year subscriptions with payments based on usage, such as the number of accounts or transactions, and are subject to minimum payments. Software products and services for Verizon can be bucketed into six major categories. There's fraud detection, customer management, originations, financial crimes, compliance, customer engagement in marketing, and there's a bit of overlap between each of those areas. Banko software is the market leader in a few of these categories, such as fraud detection and customer management. Falcon fraud manager is arguably the most successful commercial use of AI ever. It protects about 2/3 of the credit card transactions worldwide, probably having the customer management system overseas about 2/3 of the world's credit card accounts. So those are the two areas where fair Isaac is a clear market leader. About five years ago, the company began heavily investing in moving its software applications to a new platform called the Flygo Platform, previously called the decision management system, which offers a modern architecture with more flexibility and configurability. Flygo Platform is the foundation upon which all of Flygo's applications will ultimately resign. The investment in the new platform reduced software margins from the mid-20s to the low double digits in fiscal year 2021. Flygo Platform is available on premises or through the cloud. Today, about 40% of software revenue comes from cloud-based offerings. The many years of investment in Flygo Platform appears to finally be paying off. The platform is growing in the 40 to 60% range annually, and today represents about 20% of annual recurring software revenue. Interestingly, the platform is not cannibalizing the non-platform offerings, which are still showing low single digit growth. So the platform is growing the overall revenue pie, and this can be seen in the company's net revenue retention rates. The company is not only getting new users for the platform, but those users are expanding the items the order from Flygo's menu of offerings. The power of the new platform is at a scaleable. The subscription-based pricing provides for more individual revenue and gives the company more pricing power. So this will ultimately result in higher margins. We can begin to see the positive impact on companies' financials already. Software operating in-comb margin has increased from about 10% in the last couple of years to 30% per year. So platform growth is currently strong, and investments in the software business should decline in the coming years. But it is worth noting that it is a highly competitive area, if your Isaac is the market leader in some areas like we discuss, but AI will significantly alter the landscape in the next few years. And it's hard to predict who the winners will be. There is no single overall software competitor for Flygo. Each product line has a different set of competitors. Some of the major competitors include the three competitors, but there's Pegasystems, SIS, IBM, Moody, Varisk, and many others. You mentioned a couple of their software offerings, like Falcon and Triad. Perhaps you can bring them to life. What exactly are customers using Falcon and Triad for? What's the value proposition? How do these products help their customers? Yeah, it's worth diving deep into a few of their product offerings so we can see how many help companies automate critical decisions. As we discuss, two areas are far as Isaac is a clear leader is broad detection and customer management. Together, these two sets of solutions represent almost 50% of total software revenue. So if we talk about Flygo Falcon fraud manager in Flygo Intelligence Network, which is their enterprise solution, this represents an aggregate of about 30% of software revenue for the company. Flygo Falcon fraud manager is generally considered most accurate and comprehensive solution for detecting transaction fraud and can reduce fraud losses up to 50%. So this offering is part of the Flygo Falcon platform and these solutions allow financial institutions to identify and react quickly to fraud and minimize the impact to both the company and customers. Their tools can detect fraudulent credit card and debit transactions, problematic bank transfers, e-commerce fraud, check fraud, retail card fraud, identity theft, and merchant fraud. Falcon analyzes any transaction and assigns it a score just like the Verizon scores business. If that risk score exceeds a threshold, then action is taken such as blocking a credit card transaction. Falcon looks at manufacturers to determine the probability of a transaction being brought. For example, for a credit card payment, it incorporates data such as where do you normally shop? What do you usually buy? How much do you typically spend? What time of day do you shop? The merchant's history of fraud, the geography of the transaction. The Flygo Falcon intelligence network is the core of Flygo's enterprise fraud solution. More than 9,000 global institutions contribute transaction to non-monetary data needed for Flygo to create the machine learning predictive features that aimed at differentiating non-fraud versus fraud activity. So like Flygo scores, this is an example of the analytic models being continually strengthened to an access to broad data sets. And this networking effect is very difficult to replicate for a new comment. If you look at the other area where they're dominant customer management, they have been offering called Triad. And so Triad customer manager, which is supplemented by strategy director, the latter is the company's next generation set of customer management tools that's being built on the Flygo platform. This represents the world's leading credit account management system. These tools together account for about 15% of software revenue. Triad is used to increase credit loan portfolio size, reduce loan loss provisions, reduce fat debt, and increase average account balances. The offering allows companies to balance customer needs, risk, revenue, and cost. So customers of this product are generally financial services and telecommunications companies and retailers. And as I mentioned earlier, 65% of the world's credit card accounts are managed with the Triad set of solutions. Credit and debit deposit risk managers and other users can measure customer risks with the predictive analytics that are provided by these offerings. They can set up targeted risk-based strategies. They can automate a host of decisions using these strategies. They can test new strategies against current offerings to continually improve results. So a bank, for example, can use Triad to manage the deposit accounts and help with decisions related to things like overdraft pay, no pay decisions, account polls, fee waivers. Companies can use Triad to increase their target client base for product offers, which can lead to an increasing customer deposits and help reduce attrition. They can instant to risk-based pricing on individual accounts. So the solution allows flexibility in balancing risk in market equals. And I think the third offering that I just wanted to quickly mention is like the origination manager. The origination manager uses, again, predictive analytics to decision modeling technology. And this allows financial institutions to adjust lending strategies. These solutions allow financial institutions to handle more credit applications due to the automated nature of the offering, reduce approval times, increase customer acquisition, while controlling the level of risk at the portfolio level, which can be turned up or turned down. In essence, it gives companies the power to decide the parameters of the new credit relationships they're establishing. So the risk, the potential profitability, and retention rates across multi-scenario analysis. We have, I think, a great understanding of the competitive differentiation and positioning of the business and why you find this to be such an attractive place to be invested. If you're extremely helpful, if you can take us through the financials of the business at a more granular level, thinking through the margin structure of the growth prospects and then this business produces prodigious amounts of cash, what are they going to do with it? Today, quite ago, it has about $1.5 billion of annual revenue. It's compounded. It's recached flow by 15% annually over the last 10 years. It should be able to grow in the mid-teens for the foreseeable future, if not the high 15s. As I mentioned, revenues split 50-50 between scores in software, score margins are north of 85% today, software margins are roughly 30% and should expand going forward. Overall, for the company, you have EBIT margins that are about 40%, but this is a company whose margins could be a lot higher. And that's an important part of businesses that we like at our firm is having businesses that still have a tremendous amount of operating leverage. It's surprising to see margins increase at these rates for businesses at this size. Not many other businesses or sectors or industries have such margin growth. Importantly, the business model is extremely capital-like. They've gone through the capital-intensive years of the software business that expenditures on the screen. stock price should decline going forward. But if you look at the last two fiscal years, the company has had less than $10 million in CAPX to support a company whose market cap is approaching $20 billion. That is absolutely credible. The capital-like model, along with the operating leverage, really does make this a special business. If you look at the capital allocation of the company, what you'd like to see as a business that does not have to make defensive acquisitions, does not have to reinvest heavily in the business to keep it going. So in the case of FICO or Fair Isaac, over the last five years, they've been able to use all of their free cash flow, essentially, to buy back a tremendous amount of stock. The company has required 20% of its outstanding shares over the last five years and 25% over the last 10 years. It's really an amazing use of capital. And it really just, again, points to the power of the scores business. And that you don't have to invest a lot to maintain its dominance and you don't need to buy businesses to protect your franchise. So it really is a very rare and special story as it relates to capital allocation. - Just considering this business, giving your opportunity to study it for multiple years and participate in other places in the value chain, like the credit peers themselves, what do you think it is the most underappreciated aspects of this business amongst people who have the opportunity to invest or work with the business? - There's always a bear case for any company. So many investors worried about the synchrony, transition advantage score as possibly being the start of maybe other market share shifts in scores. There was concerns about what the FHFA decision would be. There's always worries of antitrust, regulatory investigations regarding FICO's dominance in scores. We talked about AI being highly disruptive to the predictability of assessing credit risk as well as on the software side. I think ultimately, what is important to understand is our firm, we don't invest in businesses where you have to twist somebody's arm to use the product or service. We believe in what we call natural monopolies or oligopolies. And this is a case where the end users of FICO scores derive a lot of benefit from the scores, whether that's securitizations, whether it's monitoring the credit quality of loans between different loan departments. If one bank is buying another bank, assessing the credit quality of the bank that you're acquiring, having a standard score to be used across the entire consumer credit industry just provides natural value. And because the score is so cheap, relative to the loan decisions being made, there is just a tremendous runway for pricing power that still delivers exceeding value to the end users of these scores. What I like about this business is you're not forcing anybody to use the score. Everyone can go out tomorrow and use Vanche score. I've always said that two kids in a dorm, MIT, could come up with an equivalent mathematical model for credit scoring, but that's not what matters. What matters is the networking effect that these scores have. - Bit of a random question, but curious, given the free cash flow profile and the capital-lite nature of the business, I'm somewhat surprised that private equities never attempted or perhaps they have to take it private and grow it even quicker and hire margins behind the scenes and perhaps hide from any regulatory related risk. Was there any ever attempt by private equity to get involved? - We know of no potential M&A activity, but the company would be a very exciting asset for many financial institutions as well as private equity. And there's been many opportunities to buy the company at depressed levels over the last five years because of some of the items like the FHA decision or what was happening with synchrony. Arguably today, based on its profile, we don't really believe in some of the parts at our firm, but you could imagine splitting the two businesses at what multiple each piece scores and software deserves. I mean, you can really get to some ridiculous valuations for this company, so I think even today, it's an asset that I think a private equity firm would be lucky to own. - We always conclude this conversation with a very similar question. And so I'm curious, you identified this as an incredible opportunity in 2018 and still see multiple years of compounding ahead of you. What lessons do you borrow from this business and apply to others that you potentially evaluate to invest in? And on the flip side, what lessons would you like other managers, executives, operators, or businesses to take from the fair Isaac story and apply to their own business to kind of drive total shareholder return and create value for their stakeholders? - Let me take the second part of the question first. If you had to design an ideal business from scratch, FICO has most of the elements that you would be looking for. It's an a dominant market position, tremendous pricing power, provides great value for the price of its product, long runaway for pricing power, operating leverage, not a lot in the way of reinvestment, a natural networking effect, which keeps its scores relevant. You really can't sit down on a piece of paper and design a better business than what FICO is. And I don't think FICO can be readily engineered. If I look at the crop of IPOs and specs, there's almost 1,000 of them that came to market over the last few years, we have not been able to identify single one whose business model is as compelling as Fio Isaacs. So there is no easy way to create another Fio Isaac. It is just an accident of history. Obviously there were smart decisions made along the way to get to where they are today. Why didn't we identify Fio Isaac? Why was 2018 the right time for us to get involved? We'd like to be great historians of companies. We were following this company for a long time, new of its dominant position. We were worried about its organic growth profile. And then we realized that there was a change happening that many others in the marketplace may not have realized. The investment business is about looking forward in assessing future risks and future growth. Near-term share price volatility doesn't bother us at all. But actually gives us the opportunity to buy into great businesses like Fio Isaacs. So the more volatility that these companies have, the better for launch of investors like us. - Well, this is a fantastic story and it's a very under-appreciated, nearly $20 billion market cap company, which there aren't many of the financial profiles, fantastic debars to entry extremely high. We really enjoyed this. And we thank you for donating some of your time. - No, thank you for having me. I enjoyed talking about one of my favorite companies in the world. - To find more episodes of breakdowns, ranging from Costco to Visa to Moderna, or to sign up for our weekly summary, check out joinkolasis.com. That's J-O-I-N, C-O-L-O-S-S-S-U-S.com. (upbeat music)