FICO stock | Economic Moat

 

Economic Moat

With about 80% of Fair Isaac's profits based on the scores segment, the scores segment is the primary determinant of the firm’s overall moat rating. We believe Fair Isaac Corporation merits a wide moat rating in its scoring segment with a network effect as a moat source. Once a credit benchmark such as a FICO score gets adopted by many stakeholders (banks, investors, regulators, and consumers), it becomes difficult to displace.

In general, we believe there are two main use cases for FICO scores. The first is to make an underwriting decision for an individual loan. The second is as a benchmark for credit quality among various stakeholders such as originations, investors, analysts, and regulators.

We do not believe the underwriting use case is particularly moaty. Many lenders do not use or do not heavily weigh FICO scores for consumer lending decisions. Underwriting is a highly differentiated and often proprietary process for a lender. Capital One, for instance, differentiated itself with an “information-based strategy” that used information technology and sophisticated analytics. More recently, buy now pay later fintech Affirm in its annual report noted that, “we consider data beyond traditional credit scores, such as transaction history and credit usage, to predict repayment ability, and leverage this with real-time response data.” Upstart Holdings boasts that some of its lender partners have eliminated FICO score requirements. Furthermore, banks using their own scores can more quickly adapt when issues arise. Over time, we could see Equifax Workforce Solutions—which currently has income and employment records on over 60% of US payrolls—as becoming more important in the underwriting process. However, for lenders that do use FICO scores as part of the underwriting process, we acknowledge some switching costs exist such as having to test a new scores’ efficacy, training employees on a new scoring methodology, and integrating the new score and reason codes (Fair Isaac provides “reason codes” that explain the reasons why a consumer does not have a high credit score) into the bank’s internal system.

It is the benchmark use case that we believe gives Fair Isaac its wide moat. Even if loans are not underwritten using FICO scores, originators still use FICO scores as a way of communicating their credit quality. OneMain Holdings, which Citigroup sold in 2015, notes in its 10-K that, “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.” Another example of this is Toyota Motor’s auto financing unit, known as Toyota Motor Credit Corporation or TMCC. Even though TMCC originates loans using a VantageScore, in its auto finance receivables disclosures, TMCC uses FICO scores to describe its loans to investors. To this end, FICO notes that 98.8% of US securitization solely cite FICO scores as a credit measure risk.

Finally, about of one third of the scores segment revenue is from its business-to-consumer offerings. About half of the firm’s B2C revenue consists of the firm’s direct-to-consumer myFICO.com offering, whereby the firm sells FICO scores and credit monitoring directly to consumers on a website. A use case would be a consumer tracking their credit scores before applying for a mortgage. We believe FICO has strong brand awareness among consumers and that Fair Isaac has developed a brand-related intangible asset. The remaining part of the firm’s B2C revenue is with partnerships, such as its partnership with Experian. Experian switched from VantageScore to FICO in 2014 in its consumer offerings, which were struggling at the time. For example, Experian operates Experian Boost, which offers consumers a way to increase their FICO score. In the consumer channel, we believe the distribution partner can be more important than the score. For example, Credit Karma uses VantageScore for its service; we don’t view this is as being indicative that VantageScore has great brand awareness among consumers. Rather, we believe that Credit Karma’s brand and marketing overshadow the brand of any particular credit score.

The greatest competitor, in our view, of Fair Isaac is VantageScore, a joint venture among the Big Three credit bureaus (Equifax, TransUnion, and Experian) founded in 2006. As the underlying data inputs for FICO scores are from the credit bureaus, FICO scores are typically sold by the three credit bureaus. The relationship between the credit bureaus and FICO could be described as “frenemies.” Shortly after VantageScore was launched in 2006, FICO sued VantageScore on grounds that its scoring system was confusingly similar to FICO’s “300-850” range, but the courts ruled against FICO. Other times, the relationship between the credit bureaus has been more cooperative. We note that in 2014, Experian switched from VantageScore to FICO for some of its consumer offerings, which we view as a sign that FICO has greater credibility among consumers. In addition, Fair Isaac’s recent pricing increases appear to be benefiting the bureaus as they are using higher FICO score pricing to justify their own price increases.

Since its inception in 2006, VantageScore has made limited progress. Synchrony Financial made headlines with its switch from FICO to VantageScore, and we believe the rationale for the switch may have been a royalty dispute between TransUnion and Fair Isaac. We view the Synchrony win as more of a one-off than a trend. VantageScore only has 31 employees (according to PitchBook as of May 2023) and US joint-venture income reported by EFX, EXPN, and TRU is immaterial.

From an environment, social, and governance perspective, access to credit including homeownership, particularly among different demographics, is an important issue to policy makers. To this end, the Federal Housing Finance Agency, which oversees lending requirements for government conforming loans (that is Fannie Mae and Freddie Mac) has announced a transition from a “tri-merge” requirement (three credit bureau report of Equifax, Experian, and TransUnion) to a “bi-merge” requirement. In addition, the credit scores will move from FICO to both a FICO 10T and VantageScore 4.0. The credit scores will consider alternative data and trended data. Implementation, if it will occur, has been delayed and this does not seem to be a priority for the Trump administration. It is not clear whether a FICO score and a VantageScore will be required from each bureau (that is four scores in total versus two). We view the inclusion of VantageScore as a win for VantageScore. However, with FICO scores still being required, we view the moat as still being intact even if the firm takes a revenue hit from fewer scores being provided. We believe mortgage revenue is about 40% of scores revenue and about 25% of firmwide revenue. Furthermore, the timing and implementation of the bi-merge requirement has been delayed.

We note that Fair Isaac possesses aspects that are common in network effect businesses such as a winner take all dynamic (FICO generates the vast majority of credit score revenue and in the securitization market boasts a 98%-plus market share), a highly scalable business model (scores has adjusted segment operating margins of over 80%), and meaningful pricing power. We also note that credit bureau and credit score costs are relatively immaterial for lenders. For example, a mortgage credit report may cost $50-$100 with Fair Isaac receiving $15 of this. In comparison with a $300,000 mortgage loan with a closing cost of 0.5%-1.5% of the mortgage (or $1,500-$4,500), the credit report/score is a small part of the fees paid. Fair Isaac generated $706 million in scores revenue in fiscal 2022 and with over 13 billion scores produced suggests an average of about $0.05 a score. In the context of over $1 trillion in credit card debt and over $500 billion of auto loan originations per year, Fair Isaac’s fees are a small cost of the underwriting process.

Fair Isaac’s software unit generates about half of its revenue but only about one quarter of its profits. In this segment, Fair Isaac provides workflow tools for account origination, customer management, customer engagement, fraud detection, financial crimes compliance, and marketing primarily to financial institutions. Competitors include Experian, Equifax, Moody’s Meridian Link, CGI Group, Pegasystems, SAS, Adobe, Salesforce, and ACI Worldwide, IBM, Feedzai, Featurespace, and BAE Systems depending on the application. We view this segment as having a narrow moat based on switching costs. Once a software platform is installed for a certain use case, we believe that a client will face the switching costs of investing time and expense into implementing a new software platform. Additionally, firms that switch face operational risk such as operational disruption and loss of data when switching software products. We note that the firm’s dollar-based net retention rates have hovered around 105%-115% in recent years, a strong result, in our view.