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Tuesday, June 29, 1999

An Investment Opinion
by Warren Gump

Scoring Fair Isaac & Co.

A profitable way to invest in many industries is through the "support" business -- those that help facilitate the main business at hand. The best example of this situation is probably air travel, where it seems like people have made more money from firms like Sabre Group Holdings (NYSE: TSG), the operator of a major computer reservation system, and OAG, the Official Airline Guide, than airlines themselves. While the banking business has been quite profitable on its own, businesses that support it can also find lucrative niches. Fair Isaac & Co. (NYSE: FIC), the developer of credit scoring and other products for the financial services industry, has found just that kind of sweet spot.

Fair Isaac was a pioneer in the creation of credit scoring technologies, which are now commonplace in the granting and maintenance of consumer credit like credit cards and lines of credit. You may not know it, but every time you apply for a credit card, you are most likely "graded" by a computer scoring system. This system combines data you provide on the application as well as information gleaned from your credit report. A higher score will be awarded to those who pay obligations on time, hold steady jobs, and maintain balances below their credit limits. Developing the exact scoring methodology (i.e., how many points to deduct for a late payment) and software to implement it is a major part of Fair Isaac's business.

You don't need to apply for a credit for Fair Isaac to earn revenue, since the company also sells screening and monitoring products. You think it's a mystery as to why you get one of those "preapproved" offers of credit in the mail? Your receipt of that mailing is not a haphazard risk being taken by the mailing financial institution. You were selected because you met the criteria the bank was searching for when it scanned its own or publicly available credit databases. Fair Isaac sells algorithms and software that help these institutions mine through that data to find the best candidates for these offers. The company also sells products to monitor accounts and avoid overexposure to various credit risks.

In addition to credit products, the company has a rapidly growing business called DynaMark, which provides database management and data processing service to direct marketers. So far this fiscal year, revenues for the division are up 42%, on top of the 65% increase in 1998. While most of its sales come from the financial services sector, it also targets catalog merchandisers and fundraisers. The division's external sales represented 20% of Fair Isaac's revenues in 1998.

Given the deluge of credit offers you have likely received, you could imagine that Fair Isaac has been fairly successful over the past few years. Between 1993 and 1998, the company saw its revenue increase at a compound annual rate of 30% and earnings per share grow at an annualized 35%. With such strong performance, you can imagine that the stock was an excellent performance. From 1993 to 1996, that was the case. The company was awarded an increasing valuation based on the prospects for excellent returns. Since that time, however, the stock has been sluggish. In fact, the current stock price of $35 � is off about 30% from its mid-1996 high.

Part of the problem affecting Fair Isaac's stock was a slowdown in earnings growth because of ambitious company forecasts. While the company's revenue was growing faster than 20% in late 1997, it had budgeted expenses based on even more dramatic growth, resulting in a slight earnings decline for that quarter. One of the primary culprits of the higher expenses was a dramatic boost in research and development (R&D) spending as the company focused on bringing more new products to market. While disruptive to short term results, the company was trying to develop a product portfolio for the future.

As 1998 progressed, Fair Isaac regained some favor on Wall Street as earnings growth rebounded strongly later in the year. The stock, in fact, rebounded as high as $54 9/16 this past January, despite warnings from management that 1999 would be tough because of Y2K fears, continuing bank consolidation, and sales growth being dependent on the introduction of new products. Earnings for the quarter ending in December 1998 increased a whopping 75% from the prior year's slightly depressed number, but management still cautioned about the outlook for 1999. Some investors started shying away from the stock.

The stock went through a massive correction in early March after the company announced a reorganization in order to expand its presence beyond financial services into healthcare, telecommunications, and eBusiness. Although the company had already started to target the healthcare and telecommunications, this new structure is expected to help increase penetration in those markets. The primary products to be offered in these areas are related to receivables management and direct marketing.

The new eBusiness division is more amorphous, with a mission to "provide unique decision control solutions for new players in the Web world." The stock market reaction to this announcement, a 25% drop over two days, was most likely not caused by these new initiatives themselves. Instead, it was a reaction to the warning that although 1999 results wouldn't be impacted by these moves, the company might see some downward pressure on margins in 2000, depending on the pace of investment -- particularly in eBusiness.

One of the reasons I have been interested historically in Fair Isaac is its "light" business model. The company had gross margins last year of 65% and net operating margins of 16%. Increased R&D spending accounted for the three percentage point drop in operating margin from the prior year. Despite this drop in margins, the company is still generating lots of cash. Over the past three years, cash from operations has exceeded net income by 25%-70% and has also exceeded capital expenditures. Given those statistics, it probably isn't too surprising that the company has cash and marketable securities of about $4.50 per share and no debt.

Where will Fair Isaac stock go from here? The earnings outlook over the next 18 months is not as clearly defined as those for many other companies. Results could be hampered by sales slowdowns related to Y2K and increased research and development expenditures on new products. The company will also likely see sales and marketing expenses increase as new markets are aggressively pursued. While near-term prospects aren't crystal clear, you are able to pick up shares for the company for only 17x earnings estimates for the year ending in September.

It's unusual to be able to find a company with such an entrenched position in our information economy, a solid history of earnings growth, and a clean balance sheet at such a low valuation. Granting subjective bonus points for my belief that management has a fairly high likelihood of being successful in some of its new ventures over the next couple of years, I score Fair Isaac quite highly as an investment vehicle worth following closely.

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