TIVP041: Fair Isaac Corporation (FICO): Scoring The World’s Biggest Credit Scorer w/ Shawn O’Malley & Daniel Mahncke

25:57So maybe you can give us a bit more insight and just tell us what exactly goes into a FICO score. Broadly speaking, it's just a reflection of your history of completing payments, how much you owe, how long you've had a credit history, as you mentioned, the types of credit you have, and whether you've added any new forms of borrowing recently. So if you take out a massive loan recently, it could either, in some cases, it could actually help, or in other cases, hurt your credit score. And what they're doing with that info is statistically weighing these various factors to determine the probability of someone defaulting on their loans.

26:33And crucially, FICO score is very effective at rank ordering credit risk across the US population. Otherwise, it would not have become the industry standard. And it's just like, it's great at reliably separating higher risk borrowers from lower risk ones. And we've seen that validated by decades and decades worth of lender data, really, and the losses that they've realized. And to your comments on how historical biases and discrimination can work their way into credit scores, FICO's competitor, Vantage Score, which is this joint venture formed in 2006 by the three credit bureaus in response to FICO.

27:10I mean, it has tried to be more inclusive. That has also pushed FICO to try to be more inclusive. And so, for example, Bandit Score 4.0 can score people with as little as one month of credit history or even just one account on file. And it can also leverage non-traditional data, you might say, like your rent payments, which as you mentioned, normally wouldn't be counted, even though, in my opinion, that does reflect a history of reliably paying a financial obligation, which should be relevant. And I would say on the one hand, it enables more people to get a score. Like Vantage Score says this new model can provide scores for 33 million Americans that traditional models wouldn't be able to.

27:55But at the same time, FICO argues that this data isn't as proven for actually assessing credit risk, which is ultimately what matters. And FICO CEO has really not been shy about saying that Vantage Scores optimize for inclusivity over actually assessing credit risk, while at the same time warning that a score based on less rigorous credit criteria could actually undermine loan safety and see more defaults because the predictive power is being lost. So, I mean, you can take that insight or leave it, but the reality is that they've been competing with Vantage score for over a decade, almost two decades.

28:34And they've seen no significant market share loss in that time. I mean, I would say the CEO of FICO definitely has an incentive to say that, right? But intuitively, more data points should lead to better results. So it probably has a point too. I mean, I guess the best predictor of quality is how many institutions actually use the scores. And as you told me, and as you mentioned now again, FICO has been, and it still is the number one. And beyond that, I guess it's just hard for us to get more insight. I mean, neither of us are professionals at modeling credit risk, right? For sure. And really, if you come away with nothing else from this episode, just know that the system for borrowing money, in my opinion, is way better than it was.

29:17And over the years, FICO has continued to try and refine its scoring system to be able to rate millions more Americans. But really, the most significant development came with the Equal Credit Opportunity Act that was passed in 1974, which accelerated the need for objective scoring as it made discrimination based on factors like gender or marital status illegal. And just to continue with the timeline of the FICO story here, through mergers and acquisitions in the 70s and 80s, the three major US credit bureaus, Equifax, TransUnion, and Experian emerged. And FICO's mathematical models were combined with the credit bureau's consumer data to release the first standardized credit bureau risk score known as pre-score in 1981.

30:07And the modern FICO score that many of us know that ranges from 300 to 850 was released in 1989. And it really became ingrained though, in 1995, when Fannie Mae and Freddie Mac institutionalized FICO scores by requiring their use for all mortgage originations they handled. So that was that stamp of approval we mentioned earlier. And that cemented FICO's industry standard status because there was essentially no option to not use FICO, at least as a bank. If you wanted Fannie or Freddie to be able to purchase a mortgage from you, you needed to have a FICO score from the underlying borrower, and you were going to have to pay for that.

30:50So FICO largely has Fannie Mae and Freddie Mac to thank for its hold on the securitization market, which is a fancy way of saying the mortgage-backed securities that investors are buying that are bundling together these mortgages. And once lenders were using FICO for mortgages, they really moved to using it for nearly everything else in consumer finance beyond just mortgages. I think what followed was a pretty interesting dynamic a couple of years later, I think it was in 1995. And at that time, FICO took this role of basically being a government sanctioned monopoly. And perhaps because they were worried about abusing their privilege, they went almost 25 years without raising the price for FICO scores at all.

31:35They relied entirely on volume growth. So basically more people applying for things like mortgages over time, requiring more FICO checks. And that basically was what drove the business success. But then in 2018, that changed. And as you told me, it changed pretty dramatically to an extent that they've now been very aggressive about taking price. So my question for you, Sean, is what happened? I mean, isn't it a bit weird to go so long without raising prices and then suddenly just do a 180? I mean, did volume growth come to a halt or did something change that made them just more comfortable in their monopoly positioning?

32:08I had the same questions when I first looked at this. And I mean, FICO began revamping its pricing strategy and instituting special price increases for various types of scores that it produced. Beginning with a 30 % increase in the price to access FICO's mortgage scores for banks. And then the cost of pulling FICO scores for auto loans and eventually credit card scores rose too. And from a shareholder's perspective, these price increases have added substantial annual revenue with very high incremental margins. And just to translate that into plain English, there's no extra cost for FICO when they raise prices.

32:48So all of that price increase really just becomes profit. And that is a special thing. With a manufacturing business, you can't really just raise prices in the same way. You actually have to sell more stuff, generally speaking, to grow the business. Otherwise, you're going to see an offsetting drop in sales volumes as people move to your competitors. but FICO really has no competitors and FICO can raise prices 10 % and without really a significant alternative, sales volumes won't fall off in any way. Meaning without any increase in the number of times their scores are used, they can correspondingly increase profits by 10 % or more with just a 10 % price increase.

33:29And that is a pretty tempting lever to pull. So it's amazing they went so long without doing it. And I'll just say, you know, to show the point, that's why I say 10 % or more, that's because if you raise prices 10 % and all of that incremental revenue falls to the bottom line, then with the same total sales volumes, you actually would increase your overall profits by more than 18%. So I did the math. So you don't have to, you can just take my word for it. But that is operating leverage in a nutshell. And it's something we talk about from time to time, but that's the math behind it. Being able to scale your business with no incremental costs, is a really, really good thing for profits.

34:10Yeah, we love to talk about it every time. And I mean, we want to go into these high quality companies, right? So whenever we can find operating leverage, we love to talk about it because it's just, it's a very powerful concept and why we like low capex and monopoly like businesses so much, right? To maybe take a quick step back and just explain why profits increase by more than 80%, whatever new actually only increases by 10. I know it's pretty easy to understand for every one of us who went to business school and learned it, but I think it's not trivial to just the average listener. So basically, when you don't have to spend any money on new employees or machinery to sell a new product, the extra dollars from price increases, they are layered on top of a fixed cost base.

34:49And what that means is that the margin on each new dollar generated is higher than the average margin. So profits increase more than revenue because you basically multiply the extra revenue by a much higher margin than before. And of course, as you said, this wouldn't work in a more competitive industry because you just can't raise prices like that. Higher prices would cut into sales volume, which cancels out the benefit. But that's what makes a company like FICO so attractive because with so little real competition, it's just an incredibly powerful concept. And just to circle back on the original question though, why do you think FICO chose to keep prices flat for so long and then decided to go ahead and start raising them?

35:28For decades, a FICO score is priced at pennies for credit cards and maybe only a few dollars for mortgages. And that low cost removed really any friction for lenders, securitizers, regulators, and the credit bureaus to adopt and distribute it. And so in other words, it was kind of a low cost strategy to help them reach the widest possible scale. And just to invoke Uber, I mean, it's similar to how they subsidize ride costs for years and driver compensation too, that allowed them to gain majority market share in different cities around the globe. And now that their position is more solidified, we've seen them start to raise prices to better align with the value they actually create.

36:10And so that's pricing power. And suppressing your pricing power for a period of time, meaning not make as much money as you possibly could, is a legitimate business strategy that can pay dividends down the road. And as such, that is how FICO can become a ubiquitous utility-like credit risk standard with powerful network effects once every investor, bank, and governmental organization benchmarks against the same number, is the switching pains just become very difficult to swallow for everyone. Finance is just, it's a complex sector in itself. And as you said, you don't want to be the one bank that basically chooses to only use VantageScore and then it goes wrong, right?

36:50It's just the safety in using the benchmark and FICO is that benchmark. And I think sometimes the simplest answer may very well just be the right one. I mean, it took them 20 plus years to entrench themselves enough to feel comfortable in their ability to raise prices without any consequences. And after successfully testing the waters, I think they feel emboldened to push even further. And that's currently what they're doing and what they have done in the past seven years. I think that's probably the right way to think about it. And on that point, if you were to try I imagine a transition that would take the most time to complete.

37:26I think getting banks, consumers, and the government to adjust to a new industry standard all at the same time. I mean, that would probably be the most bureaucratically painful process you could think of, which isn't to say that FICO's algorithm isn't also genuinely better than anything competitors have come up with. But they do have a wide moat where someone would have to come up with a dramatically superior credit scoring system. And even still, that might not be enough to overcome the red tape and inertia required to rewrite decades of institutionalized processes and best practices. And the way it works is that the big three credit bureaus collect a fee from lenders and remit a small royalty to FICO while keeping the bulk of the fees for themselves.

38:16So the credit bureaus are also very good businesses. And for FICO, choosing to leave their royalty split low for almost three decades, maximize the credit bureaus margins and probably reduce their incentive to push further on an in-house alternative before FICO could become too mainstream. And I mean, that's what happened. The bureaus did join together to launch VantageScore in 2006, but it just gained very little traction because FICO was so cheap. And had FICO raised prices earlier though, I mean, that competitive threat from VantageScore would have been taken much more seriously and could have led to much more disruption.

38:56And maybe just the last point I'll make here, and we kind of touched on it briefly, is that because FICO scoring is effectively required for conforming mortgages, aggressively pricing them could look like price gouging and taking advantage of the fact that Fannie Mae and Freddie Mac have designated FICO as this trusted intermediary. So instead, I think it's fair to say management chose to fly below the radar, especially once the FICO score became embedded in the mortgage process in the mid-1990s, basically not wanting to abuse this incredible advantage that had been gifted to them. And not coincidentally, the moment FICO began taking price in 2018, the Department of Justice opened an antitrust probe against them.

39:40And the FHFA rewrote the rules for Fannie and Freddie to allow them to use Vantage Core, while Congress also started pressing the company on cost. So there's been a huge benefit to shareholders as FICO has dramatically raised prices since 2018. But even if it hasn't come in the cost of sales volumes, it has come at the expense of regulatory scrutiny, essentially. Okay, so we talked about why they could raise prices and why it didn't really affect the business in any negative way, at least not materially. But why did FICO decide to start raising prices then? I mean, it sounds like a situation where if something isn't broken, you don't need to fix it, right?

40:18And maybe some small amount of price is okay, but to push the gas pedal pretty much all the way down seems like an obvious way to attract the wrong kind of attention, right? And I think they have done that. So considering that FICO is mostly a US thing and they are not an international company. I assume volume growth probably matured, right? I mean, the results since the price hacks have been fabulous, but you have to wonder if that comes kind of at the cost of their business long term. And if it pressures regulators to rewrite the status quo, there has to be a certain reason why they choose to go with these aggressive price hacks.

40:53I wouldn't disagree with you. To some extent, this is the reality of being a public company and the pressures that come with it. By 2018, I think it was fairly clear that adoption had plateaued. Volume growth alone could no longer move the needle. And obviously, after 25 years of not taking price, you could probably argue a sharp repricing was due just to account for inflation. And with FICO's role being firmly ingrained, I'm sure management felt like they could lift royalties without any kind of mass defections, especially by calling it a special pricing plan, suggesting that they weren't going to do this every year.

41:30And yet the early hikes were more than 25 % per year. And as such, their wholesale mortgage fee rose to$4.95 this year,$4.95, which is up roughly 700 % from 2018. And that number alone really is how FICO has gone from being a great business to own to an excellent one, the best of the best. And while revenues have compounded at just 10 % a year since 2018, which is good, but it's not eye-popping, net income has compounded at a 27 % CAGR. And I don't know about you, I've never seen anything like that, honestly. And when you account for share buybacks, earnings per share have actually further compounded at almost 31 % per year in that time, which is why the stock trades at such a large premium in price to earnings ratio terms to the broader S &P 500.

42:28It's twice as much as the median S &P 500 PE multiple. Those are just insane numbers. I think I now understand where the stock chart looks the way it does, because I think I told you before, the first time I looked at it, I just thought FICO might be one of those companies that just benefited from the bull run in the last decade because the stock just skyrocketed since 2018. But I guess it was just one of those moments where they changed a little tweak in the business and this time it was price increases. That just totally changed the trajectory of the business. But what concerns me a little bit though, and I don't want to linger too much on the bear case, but I think it's something we should talk about, is that if you look at how the business compounded before taking price, total earnings actually shrank from 2005 to 2018, so for 13 years.

43:14And revenues just grew at under 2 % a year. So you could say the top line was basically flat to up just slightly while earnings actually contracted over 13 to 14 years. And that's not very inspiring. And I just say that or mention that because if the bears are right in thinking that FICO has mostly exhausted its pricing power, at least without a lot of fuss from regulators, then you're getting a company at 50 times earnings that actually historically hasn't been a compound of earnings with most of that compounding coming just since 2018 as they've raised prices dramatically. And as the market has paid just a much higher multiple of earnings to own the stock.

43:52And that just sort of rings the alarm bells for me because the back of my head, just I'm thinking about owning the stock for the next five years out and buying it in 2018 would have obviously been brilliant and contrarian. But I'm not sure if the same is still true today, even after the sell-off that we've seen this year. And I don't know. I don't really know what to think about it. And so what I really want to understand better is the mode, right? We always want to understand the mode. And this time, I think it's even more important. And whether the mode is generally because of FICO's superior credit risk algorithm and if it's just due to the fact that the government basically gave them a monopoly.

44:28because what the government can give, it can also take. And that's kind of the concern I have here. Well, of course, FICO CEO Will Lansing believes the company's real moat is in the fact that it's the most predictive score of credit risk, plain and simple, in his opinion. As he puts it, the moat is not some government-conferred monopoly. That's not what makes us successful. That's how he worded it in one of the company's most recent earnings calls. And I would argue, though, that two things can be true. Of course, FICO's superior algorithm did help them earn their industry-wide recognition independently.

45:05And from the data I've seen, Vantage Score has narrowed the gap. But FICO's latest scoring models are still at least as good, if not better. and because of institutional inertia and the government mandating use of FICO in mortgages approved for Fannie and Freddie Mac, FICO's advantages were reinforced, allowing them to become really the standard language of credit risk in the U.S. And just to say that again, displacing an entrenched standard is extremely hard. And for decades, 90 % of U.S. lenders have used FICO scores when making consumer lending decisions. And over 95 % of US credit card and mortgage securitizations, these bundled loans sold to investors that we've talked about today, they reference FICO scores as the main measure of risk.

45:55And this universal adoption means everyone in the financial ecosystem speaks FICO. Lenders set interest rates or approval cutoffs based on different FICO ranges. Investors demand to know the average FICO score of loan pools and even consumers check what's my FICO score regularly. And I know I've certainly done it. And whenever I saw advantage score being used, like with credit karma, I would typically just be confused and wonder why it was slightly different from FICO. And ultimately, I just wanted to know my FICO score since I knew that's the one everyone else seemed to care about and go off of.

46:32And that is basically the definition of a network effect, which builds a self-reinforcing moat, the more institutions and people that rely on FICO, the more valuable and must-have it becomes. I get it. I mean, it just makes a lot of sense. And we talked a bit offline about it. As long as it's basically in place with all the institutions out there, it just makes no sense at all. Also for consumers to get any other credit score. I mean, when you've used an apples to apples comparison for decades, it's just hard to change that. And I know before the podcast, Sean, we also talked about SAT scores in the US and how they're kind of like the academic equivalent of a FICO score.

47:11And yet there's been some turmoil because the way the scores are calculated has basically changed a lot over the last years. And there's naturally a bit of variance in how difficult the tests are from year to year, which is totally normal without just using the same exact test. And so anyway, as I understand it, the whole scoring system has been changed multiple times, such that in one year, a score of 1 ,200 is a pretty good score. And in another year, it might be a poor score on the 2 ,400 point scale. And that just makes it difficult to compare the academic quality of students over time at a university, for example.

47:46And you're trying to adjust the scores across a sliding benchmark. And that's just messy. So there's real value in having a reasonably objective and consistently calculated scoring system that rate everyone against whether that be with college admission exams or in loan applications. And that's pretty much what FICO just delivers, right? Having a history of data that says, okay, people with a 680 FICO score have this percentage likelihood of default, while the percentage is this for a 750 FICO. And that history makes it easier and more comfortable to keep making decisions using FICO. And a new score might have a different scale or distribution, as you kind of pointed out with the SAT.

48:31And initially, there's also less of a real world track record to know how a given new type of score translates to risk and how predictive it is. And just because a new score says people are credit worthy doesn't make it so. It must be deeply evaluated and validated. before the market will actually trust it, which I think adds to the challenge of displacing FICO. And the lesson from today is that FICO has a first mover advantage. In an industry so reliant on network effects, that really matters more so than in other types of businesses, I would say. FICO basically invented modern credit scoring, and they had a huge head start in doing so.

49:10And by the time competitors like VantageScore appeared, FICO already had 15 plus years of industry integration, data and model refinement to give them a head start. And FICO hasn't stood still either. It rolls out updated versions roughly every five years to address new behaviors. And they've been able to, at least according to their own studies, predict credit risk more and more accurately with each new iteration of the FICO score. I guess the problem for competitors like Vantage Score, for example, is that credit scores are just way too important to make decisions based on factors like inclusivity.

49:43I mean, that might sound harsh, but when FICO scores are simply better, you have to use them. We talked about the financial crisis, and I would assume preventing a second one should be a little bit more important than trying to include as many people and credit scores as possible. And I mean, how much predictive power can be in a credit score that is based on one month's worth of data? And speaking of relevance, I've seen some articles which kind of give you the other side of the coin, because the Wall Street Journal, for example, has put out an article which argued that FICO is becoming less relevant itself, which at first might make some sense considering just how many more data points we have today.

50:22And that includes banks, merchants, and pretty much every player in the financial system. And I don't know, what do you think about it? Would you say those are serious concerns for FICOing in the long term, or is it more for like short-term noise? So there have been some reports that FICO is becoming a smaller factor in underwriting decisions at J.P. Morgan and Bank of America. And who knows? Maybe that is probably true, but who cares? You might be surprised to hear me say that. But what I mean is that it doesn't impact the number of scores being pulled, which is what drives FICO's business. And in fact, FICO scores are referenced dozens of times in the annual reports of companies like Bank of America and J.P.

51:04Morgan. I mean, I checked that myself. And banks have a lot more data they can use to make underwriting decisions and monitor credit accounts with. So it's only natural that FICO's so-called market share of the underwriting decision is lower than it was a decade ago. But I don't think that's the right way to think about it. I think that's the wrong framework. So at the same time, this doesn't mean that the FICO score isn't still used in each of those situations, which is what matters. It just means that banks are also using additional metrics to augment the FICO score now with. And the cost of a bad customer is far higher than the cost of a FICO score.

51:45And with banks paying up to$200 to acquire a lead for a credit card customer, paying a few pennies for their FICO score, which is a long proven metric, I mean, that is pretty negligible, ultimately. You know, underwriting is a highly differentiated and often proprietary process for a lender. And sometimes you see firms bragging about going beyond just using traditional credit scores. But again, that's a different thing than not using credit scores altogether. And even if loans are not underwritten using FICO scores, originators still use FICO scores as a way of communicating someone's credit quality.

52:23So there's a bank, One Main Holdings, which Citigroup sold off in 2015. In their 10K, I saw that they noted, quote, while management does not utilize FICO scores to manage credit quality, we group FICO scores into the following categories for comparability purposes across our industry. And so another example of this is with Toyota's auto financing unit. Even though it originates loans using Vantage Score, they've admitted in disclosures to still using FICO scores to describe their loan pool to investors. So then it sounds like the rare occasions where lenders do move away from using FICO, they still can't entirely escape FICO, right?

53:03I mean, and on that point, FICO has had a number of 20 % drawdowns nearly every single year over the past 15 years from investor panics, while still crushing the broader market overall. all. And in each of those cases, these sell-offs historically have been a great buying opportunity. And I wouldn't be surprised if that is once again proven true from today's prices. And to make this all more tangible though, how about we talk about FICO's business segment breakdown and profitability? Because I feel like we talked a lot about the entire business, its mode and why it's a great business, even its margins.

53:35But we did not yet talk about like deep into the business, what is it really that they do? What's the breakdown of profitability? So maybe you can give us some more color on that. So FICO's business is roughly split evenly in revenues between its score segment, which is a part of the business we've talked about so far. And it's what FICO is best known for, obviously. But it is also, they have a lesser known software segment that drives about half of sales too. But the credit score business is so much more profitable that that contributes to over 75 % of the company's overall operating income. So you've got two segments that contribute equally to the top line.

54:14Let's shape the bottom line very, very differently. And it's funny because software is usually the more profitable part of most businesses, even if it's not their core focus. But for FICO, their credit scoring business is so good that it dilutes the overall business quality to move into B2B SaaS. And basically, FICO software business sells a platform and a package of apps for lenders to use in making decisions like whether to approve a loan, how much credit to extend, reviewing whether a transaction is fraudulent. So it's distinct from the scores business, but I would say the software business certainly leans on FICO score data and kind of complements it.

54:55And this includes everything from fraud detection to facilitating mortgage originations, collection software for managing payment plans for lenders and customer communication systems like SMS and emails to communicate fraud alerts or payment collection reminders to borrowers. That is kind of everything that their software packages touch on. So it sounds like the way to understand this is these tools complement FICO's core algorithm and scores by creating kind of like ready-to-go tools for lenders to use in better underwriting loans or identifying fraud sooner without hard coding logic across dozens of systems.

55:35Right. But when we talk to people about investing in FICO, no one is really thinking about the software business. And granted, the bar is very high, but the software margins are just poor comparatively. It's hard to argue that this doesn't water down the business's quality and its golden goose. And when you have a business as good as FICO scores business, it's hard to go into any new area without there being a dilutive effect. But still, the software business has 30 % plus operating margins. So it's not a bad business at all. It's just that the Scores business has nearly 90 % operating profit margins, which honestly is maybe the most profitable business segment I've ever seen in any company.

56:1990 % is out of this world. And I think I now understand why the margins still seem comparatively low. I mean, don't get me wrong. FICO's margins are outstanding. But when we talked about the operating leverage of the business, I did wonder whether operating margins shouldn't be slightly higher than they actually are. And apparently they are significantly higher, but the software business basically dilutes them at least to a small extent. And it feels like a good moment to just summarize what I understand about FICO so far. So what I think is the big question from what I can tell is how the government will set regulations for which scores to use for conforming mortgage loans.

56:57But even though the government has concerns, FICO still is very much the industry standard across many different types of lending. So even with non-conforming mortgage with less oversight from the government, the private market has still largely preferred to go with FICO. And as such, FICO has been able to raise prices tremendously, as we discussed today, and to quite some extent. And making it Scores business, as you just said, pretty much one of the most profitable business units that we've ever looked at. because there are no incremental costs to do it. And they're just running data through an algorithm that was mostly developed decades ago and then marking up the price to license those scores to lenders or also to consumers like you who want to pay directly to see what their FICO score actually is.

57:42And in prep for our episode today, I tried to wrap my head around how cyclical FICO's business actually is. For example, does it map perfectly over the economic cycle or do they have some ability to be resilient in recessions. And it looks like, according to an interview I saw with FICO's CEO, that the business has done pretty well historically, whether mortgage rates are high or low. But he told CNBC that today we're roughly 40 % off-peak mortgage volumes. And in terms of the number of mortgage loans issued, and as such, the company could have a major tailwind behind it over the next year or two, if and when interest rates should come down.

58:23I think we've just seen first signs that might come down sooner than many people anticipated just a year ago. And all of that sounds very promising if you ask me. So I just wanted to basically run that by you and see your reaction. Is it kind of the whole picture or do I get anything wrong? Would you raise prices the way FICO has been able to without any decline in volumes? I mean, it does look like you can survive any economic cycle. But just logically, I'd have to say that, of course, this business closely tracks the economic cycle and financial system long term. More people taking out mortgages is good for business and fewer people taking out mortgages is bad for business.

59:03That is just a fact. And what we've seen is that with the ongoing price hike since 2018, that has more than papered over any weakness in mortgage origination. But again, there's a real question of how much longer they can sustain price hikes for. If they stopped hiking prices today, you'd see the business immediately become much more cyclical, closely tied to the amount of lending activity that occurs in the economy. So maybe there's a perfect formula here where they stop taking price at the same time mortgage volumes pick up. But we have to recognize that these are cyclical earnings that can just as easily swing down over time, buried under price hikes.

59:43And I think the way to think of it is that arguably as much as 90 % of FICO's revenue is exposed to financial services, making them, of course, very closely tied to credit market conditions. And during the great financial crisis, FICO's 2009 revenue was about 20 % below 2007 levels, with SCORE's revenues being down 27 % as people applied for fewer loans. And recurring revenues from their software segment, I think do help to balance this out. But that doesn't matter as much when, to say it once more, majority of the business's actual profits come from scores. It's hugely anchored to what happens with credit scores, which are very closely tied to the underlying economy.

1:00:24It's pretty incredible, though, that FICO has had a hot streak of something like seven consecutive quarters and maybe even more, where reported mortgage origination revenues in its score business grew at nearly a triple digit pace. I'm not sure anyone investing in FICO back in 2017, and even the most bullish of the boards could have expected that. And that sheer growth in mortgage scores revenues, driven by pricing actions, is bleeding over into scores revenue generally, with top-line growth for the scores business breaching the 20 % mark year over year. But scores for auto loans, credit cards, and personal loans have really added virtually nothing to incremental profits for years now.

1:01:05And last year, third quarter mortgage originations revenue were up 80 % versus the year prior, meaning that mortgage origination revenue accounted for 39 % of total scores revenue. But as early as 2022, it was probably closer to comprising no more than 25 % of overall scores revenue. That is startling growth and business mix changes for what is otherwise such a well-established company. company. And again, this is coming entirely from price hikes, particularly with FICO score checks for mortgage applications. It feels like we just can't stop talking about it, but for price taking to be such a driver of growth like that, I mean, that's just not supposed to happen.

1:01:45It almost feels like it violates the laws of economics that we'd learned in school, right? And for them to raise mortgage fees from 60 cents, and that's 60 cents in 2018 to$5 today. I mean, you said this earlier, but for anyone doing the math at home, that's more than a 700 % increase. That's just incredible. In less than seven years, right? Talking about all those numbers, I think it's time that we move on to discuss valuation, which is, of course, the most interesting and our favorite part of the show here, since we probably both agree that this is as high quality and profitable a company we've ever looked at, maybe alongside Visa, Universal Music Group, which we recently covered, and VeriSign, which you covered quite a long time ago on the show.

1:02:28And The pricing power, the stickiness, the industry adoption, the brand awareness, basically everything you could look for in a deep mode is here in FICO. So for even one of the best businesses in the world, you can overpay. And just this year, FICO shares have fallen from$1 ,900 per share to around$1 ,300 at the time of recording. Yet the stock still trades at around 52 times earnings, which is well more than twice the average valuation of the S &P 500. And, you know, those are the best companies in the US. And if you trade it twice, the valuation, it has to say something, right? I mean, I know that you know, Sean, that PEs don't tell much just on their own because there are differences and assumptions about future growth embedded into these multiples.

1:03:11But the point remains that you're basically paying for a company to grow earnings per share twice as fast as the market average. And you have a company that has already done that for several years now and attracting much more regulatory scrutiny on pricing. So not to beat you to the punchline, but I'm going to be a bit surprised if you tell me that the valuation is really attractive here. And I'm not sure how far we are away from, you know, seeing a very attractive valuation. But my gut tells me there's probably some more room for this thing to fall. Is that right? Your intuition there is pretty good, Daniel.

1:03:48But just to walk everyone through how I approach the valuation. And you basically have two distinct business segments. the scores business and a software business and within those the software business includes subscriptions to their new software packages as they migrate customers up the standalone software they used to sell and there's also this professional services consulting business where FICO would help customers customize specific tools for implementing FICO scores into their workflows but that has become less and less relevant because it's it's more labor intensive and just less profitable and even more dilutive, really.

1:04:24And then in the scores business, you've got the pricing and revenues for mortgages and then really everything else you can need to pull a credit score for all bundled under that same score segment. And listeners should should know by now that the scores business, generally speaking, is super high leverage, meaning that price increases directly ripple down to the bottom line, which is very compelling. Also, no one really knows how much further FICO can continue to raise pricing. I think that is really the crux of the bear argument, if you wanted to say it like that. There are a lot of financial analysts covering the company who are more optimistic than me, since a number of them expect the FICO score segment revenues to basically double over the next five years, just like it did from 2019 to 2024 after they first started raising prices.

1:05:10And I guess I just, I find that hard to believe with the regulatory scrutiny they've already gotten. I mean, scores doubled in those five years, even as mortgage originations have contracted because they raise prices so much. But now they have Congress and regulators breathing down their necks. So I just don't know if they can raise prices like that in the same way. So I'm skeptical. But I suppose the counter argument would be from the bulls is that we are in this period where mortgage borrowing is very depressed because interest rates have stayed high, while home prices really haven't budged much nationwide.

1:05:43wide. And so maybe you could be optimistic that if and when the Fed cuts rates over the next years, that could spur an uptick in lending and mortgage origination that propels the FICO scores business organically without the need to rely on price to the same degree. But still, no matter what, if you're going to project FICO scores revenues to more than double again, you're implicitly betting on a substantial degree of continued price eggs. And if that does prove to be true, paying a 50 xpe for a company like fico would not be as crazy as you'd think but that's a really rosy set of assumptions that i would say does not leave a ton of room for error in that valuation or margin of safety as we call it and you know especially as you have shifts in the competitive dynamics here where for the first time fico's moat is is maybe being picked away at with vantage core being used more in mortgages sold to fannie mae and freddie mac and i think the short answer We're just not sure yet how material that will be, but it is really the first sign of real competition in years for FICO due to these regulatory shifts for a company that is otherwise not used to having any meaningful competition.

1:06:53So I think you're right to be cautious about not just continuing to project that they can double their pricing every couple of years for FICO score checks, because you need a margin of safety larger than where the stock currently trades at, even after the already sharp decline this year. Listeners know that we always talk about how tricky and also dangerous it is to rely too much on multiples. And even just considering interest rates and everything like that into our investment thesis. It just doesn't help you much with the evaluation process, but it's certainly helpful to contrast the company's valuation with the overall market.

1:07:30And with companies you might deem to be peers due to being in the same industry or for having a similarly high quality tall world business, which is why we talked about Visa and why we in some cases even talked about Universal. And on that point, when I think of dominant financial service middleman with deep modes, I can't help but think of the credit rating agencies, right? We talked about Moody's and S &P before and they both have similarly high margins and they traded a significant premium to the market. But even for them, their PE ratios are in the 30 to 40 times range. And the same is true for Visa, which is another one of those quality compounders in financial services.

1:08:07And FICO has the potential from everything I've heard today to go faster than all three of those businesses over the next few years. So a premium to even those names might be justified. But a few years down the road. Once FICO has truly exhausted its ability to hike prices, and none of us know when that is, you would have to imagine that its variation multiple would contract to align better with these other ultra high quality businesses. And then of course, historically, you have the S &P, which trades at 15 to 20 times earnings, which is just a reminder to say that even when you're talking about a business like FICO, where growth is maturing and its multiple becoming more normalized, the implied valuation would still be twice that of the broader market.

1:08:50And the S &P 500 is not your average index. Those are the 500 best companies in the US. I mean, that's a really helpful context to provide listeners with. And in my model, I mean, that kind of lines up with the assumptions that you describe here. I think it's plausible that for a couple more years, they can dramatically boost revenues in margins just by raising prices in their score segment. But I don't think that can be sustained forever. And if by 2030, we have already seen limits to how much they can raise prices without triggering a revolt from customers or regulators, then the valuation should contract pretty substantially because we saw what this business looked like before price hikes.

1:09:29It was not nearly as good. And so a rich price of 50 times earnings to, I don't know, 30 times earnings or less, that seems very plausible to me. And that reflects that this is a company that still earns massive excess returns on capital, but it might be hitting a growth plateau with more vulnerability to regulatory pushback or recessions in the economy that it was otherwise immune to over the last seven years when it could just raise prices at no cost. So I don't want to bore everybody by getting super deep into the weeds of my model, but I think a reasonable fair value for this stock is maybe around$1 ,100 per share with it becoming attractive to us to actually add to the portfolio with a proper margin of safety closer to$930 per share.

1:10:14And I should say the last time I called for a really high quality company to need to contract 30 % or more was with the trade desk. And with that one, the stock promptly fell something like 40 % overnight within a couple of days of our episodes coming out. So I don't know, maybe we'll get lucky in that same way again and have a chance to snap up FICO below$1 ,000 a share. And I should say for anyone who wants to actually see our models, because it's hard to appreciate what goes into them just over a podcast, you can do that in our weekly newsletter where we share full recaps and everything we talk about the podcast and more with the valuation models and the details about them.

1:10:49So there is a signup link in the description below, or you can just visit theinvestorspodcast.com slash newsletters to see the archive of write-ups and valuations on every company we've covered. One of those companies is, as you mentioned, TradeDesk. And I think it's just a great example of why we are so cautious with investing in companies trading at high multiples, right? I mean, it's not that we disagree on the quality of the business, but we want to buy opportunities that feel at least a little bit asymmetric. And to find those, we need to have a relatively limited downside. And then the optionality of positive surprises on the upside, right?

1:11:24And whenever a stock trades at a high multiple, most of the time, the opportunity is already priced in. So the stock might keep performing well, but then you are left with all the decent returns it offers, but the business just can't keep up with the expectations and then you're left with all the downside. And for a company price at a multiple of 50 times, it doesn't take much to drop 20%. It's not like the business model needs to get disrupted or anything. It's basically just a headline about regulation or a single quarter in which price increases can't outweigh the stagnant volume to the extent that the market expects.

1:11:58And that alone would be enough to just send the stock tanking, right? And I know it sounds cliche, but investing is not a sprint. It's a marathon. And while we only had the chance to add, I think it was one company from our watch list. We still keep an eye out for them. And when they are more attractive, we can't pick them up. So building a watch list, in my opinion, is just as vital of a part of building your portfolio. And we are doing that each week. And I think it sounds like FICO will be one of those companies that will at first will be added to the waitlist. Yeah, definitely a waitlist candidate.

1:12:30Why? I don't know about you. I kind of feel like that's enough on FICO for one day. How about we move along just to get a little preview of your pitch for next week? Sure. I mean, just on FICO, I think this was as close to a finance company as you would get to without, you know, your bias or not liking them, as most of our listeners know. But, well, oftentimes you are the one bringing the high quality compounders that might still for prices a little too high for my taste. And I'm the one bringing companies that got beaten up a little too much for your taste. And I would say my next company, though, is in a similar ballpark to FICO.

1:13:07Not as much market power, but a phenomenal compounder operating in a duopoly. And it is cheaper than FICO, but it's still far from being a bargain. The stock is down. I think it's 25 % year to date. And one of the risks is something we have discussed in many other episodes as well, which is autonomous vehicles. And I think my last hint, because by now it's probably still a pretty difficult guess, would be that just like FICO, it recently made it into Francois Orchard's portfolio. So maybe that's a hint that helps people. Okay. All right. That should be a good one, as always. I think you tend to be better about bringing great ideas to the table where we don't have to wait for a huge contraction for the stock to become interesting.

1:13:47I bring a lot of great watch list names maybe. But on that note, let me leave you all with a quote for some inspiration. Peter Lynch, the legendary investor, tells us, quote, when you want to buy in the second or third inning and get out in the seventh or eighth. With FICO, I think it's hard to say that we're at the beginning of the story or where the company has a ton of runway and isn't broadly appreciated by investors. If you could have identified FICO's ability to raise prices back in 2018, that would have been a pretty early inning to jump into the investment thesis. And today, though, I have real questions about how long price hikes can be extrapolated further.

1:14:24See you all next week.