Fair Isaac Corporation (FICO) Q2 2011 Earnings Report, Transcript and Summary

Good afternoon. My name is Mike, and I will be your conference operator today. At this time, I would like to welcome everyone to the FICO Second Quarter 2011 Conference Call. [Operator Instructions] Mr. Weber, you may begin your conference call.

Thank you, Mike. Good afternoon, and thank you for joining FICO's second quarter earnings call. I'm Steven Weber, Head of Investor Relations, and I'm joined today by CEO, Mark Greene; and CFO, Mike Pung. You will find on the Investor Relations portion of the FICO website a copy of today's press release, our Regulation G Disclosure schedule and our financial highlights. While our press release describes financial results compared to the prior year, today management will also discuss results in comparison to the prior quarter in order to facilitate understanding of the run rate of our business. Certain statements made in this presentation may be characterized as forward looking under the Private Securities Litigation Reform Act of 1995. Those statements involve many uncertainties that could cause actual results to differ materially. Information concerning these uncertainties is contained in the company's filings with the SEC, in particular, in the Risk Factors and Forward-looking Statements portions of such filings. Copies are available from the SEC, from the FICO website or from our Investor Relations team. In order to provide additional information to investors, we will use certain non-GAAP financial measures on this call. A reconciliation of these non-GAAP financial measures to the most directly comparable GAAP financial measures, entitled Regulation G Disclosure, is available on the Investors page of our website under the Presentations tab. A replay of this webcast will be available through June 4, 2011. Now I will turn the call over to Mark Greene.

Thanks, Steve, and good afternoon. We'll proceed as usual today in 3 parts. First, I'll summarize the quarterly results and assess our business in light of current market conditions. Then Mike Pung will provide further financial details. And finally, I'll discuss our business outlook for the balance of fiscal 2011 before we take your questions. For the second quarter fiscal 2011, revenue was $153 million, down $3 million over the prior quarter, but up $9 million or 6% year-over-year. Non-GAAP earnings per share in the quarter were $0.39, down $0.05 from last quarter but up 39% year-over-year. Bookings were $58 million compared to $84 million last quarter and $54 million in the second quarter of 2010. Year-to-date, revenue and bookings have grown 5% and 24%, respectively, from the prior year. Our Applications and Tools revenues were up 7% to 8% while Scores are down 3%. Let me break out our quarterly performance for the 3 segments of our Decision Management portfolio. First, the Applications segment consists of business software used by clients to help make smarter decisions over a customer life cycle. Revenues from such applications was $96 million in the quarter, down 2% sequentially and up 10% from the same period last year. We saw improved performance from our Fraud and Originations [Fraud Management and Originations] solutions, mainly as a result of several very large license deals signed during the quarter. We had another solid quarter in the Fraud Management business, which consists of Insurance Fraud Manager and Falcon Fraud Manager for banking. Fraud Management bookings exceeded $40 million for the quarter and revenue grew 3% from Q1, which is our largest quarter since the third quarter of 2008. We remained very pleased with the performance of these strong franchises. We signed another large Originations Manager deal during this quarter with the North American Bank, which is our third deal since we released this offer last December. Originations revenue grew 11%, sequentially, and 27% from the prior year, and bookings exceeded $10 million during the quarter. Next, we'll look at our Scores segment, which consists of predictive analytics used to assess risk. Overall, Scores revenue was $41 million, flat from the prior quarter. We tracked 2 subsegments here. B2B [business-to-business] scores which are scores sold to financial institutions and B2C [business-to-consumer] scores which are scores sold directly to consumers at our myFICO website. And on a direct basis -- I'm sorry, and indirectly to consumers through bureau partners. The B2B scores subsegment continues to track with the slow improvement in the economy, and B2B scores revenue was down slightly from the previous quarter. As we move forward, we are focused on maintaining our market leadership in this area, in anticipation of a return to meaningful growth as the economy recovers. Quarter highlights include, first, as we saw a continued increase in marketing acquisition activities across the U.S. Scores business, with a 90% quarterly increase over the prior year, led by both direct sales to customers, as well as through our distribution partners. This is one of the leading indicator that originations, which is up 1% in the U.S. over the prior year. We view this as an encouraging indicator of future growth. In the quarter, we also saw an increase in the market adoption of the latest version of the classic FICO Score which we call FICO 8, with approximately 4,000 lenders now using FICO 8 within their risk management practices. That represents a 14% increase quarter-over-quarter, and a further sign of FICO strong market position and continued success in meeting the needs of our customers. In March, we announced that the automobile finance industry is migrating to the FICO 8 auto score, with most lenders completing the adoption process by May. FICO Scores are the established credit scoring standard in the auto industry, and are used by lenders and dealers as part of auto loan and lease originations, and for servicing and loss management activities. The industry-wide migration to the new FICO 8 auto score will allow vendors and dealers to share more consistent information, as they finance vehicle sales and because of the scores superior ability to assess risks, extend credit to their customers with greater confidence. Finally on Scores. As part of our continued investment in analytic innovation, in April, we announced a new research into the capability to predict strategic defaults in the mortgage industry. This is an important breakthrough regarding one of the most troubling trends emerging from the recent trouble in the housing market. People who choose to walk away from mortgage obligations that they can actually afford. Our FICO lab team demonstrated the ability to predict with unprecedented accuracy that the individuals at greatest risk of strategic defaults. Among the research findings is that people who commit strategic defaults have different profiles from the high risk individuals who default on mortgage based on inability to pay. Industry interest in this strategic default solution is very strong, and we're currently working with the largest North American mortgage lenders to validate our research on their mortgage portfolios. Turning now to the consumer segment of the Scores business. Revenue increased substantially for direct sales to consumers in myFICO.com, driving 9% overall growth sequentially. The increase was partially offset by decline in revenue generated from our bureau channel partner, selling FICO Scores to consumers. Our third and final business segment is Tools, which consist of rules management, modeling and optimization products, embedded within our applications and also sold standalone to clients building their own applications. Revenue in this Tools segment was $16 million during the quarter, down 9% from last quarter but up 11% from the prior year and up 7% year-to-date. While this business has fluctuated due to economic uncertainties, we remain confident in our product offering and pipeline. So to summarize the quarter, we streamlined our cost structure and we allocated our resources towards growth opportunities, product innovation and client service. We achieved solid results across all 3 segments, with continued signs of stabilization in scores and growth in our Applications and Tools segment. Bookings were $58 million, a 6% increase over the comparable quarter last year. Now let me pass the call to Mike Pung for further financial details.

Thanks, Mark. I want to emphasize 3 points in my prepared comments today. First, our year-to-date revenue was up 5% from last year. We grew our Applications and Tools business and continued to see stability in our Scores business. Second, in February, we restructured our costs to enhance our operating leverage which we began to see reflected in this quarter's results. Adjusted operating margins expanded slightly and are expected to grow in the second half of the year, and free cash flow was $53 million during the first half of the year. Finally, we will be reiterating our annual revenue guidance. Mark has already discussed our revenue results by segment, so I'll provide some additional comments as they relate to specific aspects of our business. Revenue for the quarter was $153 million. By region, this quarter, 73% of total revenue was derived from the Americas region versus 77% in the prior quarter. Our EMEA region generated 20% of our revenue compared to 17% in the prior quarter, and the remaining 7% was from Asia-Pacific, compared to 6% in the prior quarter. By type of revenue. Recurring revenue, which is derived from transactional and maintenance sources, for the quarter, represented 73% of total revenues versus 74% in the prior quarter. Consulting and implementation revenues were 18% of total revenues, this quarter and last quarter. And license revenues were 9% of total revenue versus 8% last quarter. We continue to expect license revenues as a percent of total revenue to increase for the remainder of the fiscal year. Turning to bookings. We've generated $17 million of current period revenue on bookings of $58 million, a 29% yield. This compares with $17 million of revenue on bookings of $84 million, which was a 20% yield in the prior quarter. The weighted average term of our bookings for the quarter was 19 months compared to 42 months in the prior quarter. During this quarter, our mix of bookings was more heavily weighted towards license and services, while revenue was realized in a shorter duration when compared to our transactional bookings. Of the $58 million in bookings, 25% related to Fraud Management products, 18% related to Originations products, 17% to Decision Management Tools and 13% to customer management products. We had 12 booking deals in excess of $1 million, one of which exceeded $3 million. Transactional and maintenance bookings were 29% of total this quarter versus 60% last quarter. Professional service bookings were 48% this quarter versus 25% in the prior quarter. And finally, license bookings were 23% in the quarter versus 15% last quarter. On to operating expenses. Our operating expenses excluding the restructuring charge totaled $122 million this quarter, down $3 million from the prior quarter. This decline was primarily related to the savings from the cost restructuring we announced in the middle of the quarter. We expect a further decline in operating expenses in the third quarter and the rest of the year, as we see the full impact from these announced reductions. Finally, our restructuring charge was $11.5 million, larger than what we announced in February, due to some additional actions taken before the end of March. As you can see on our Reg G schedule, non-GAAP operating margin before amortization, stock-based compensation and the restructuring, was 24% for the second quarter compared to 23% in the prior quarter. GAAP net income was $8 million but excluding the restructuring charge, it was $16 million, consistent with the prior quarter. The effective tax rate was about 30%, consistent with our guidance. Free cash flow. As you know, we define free cash flow as cash flow from operations less capital expenditures and dividends paid. Free cash flow for the quarter was $22 million or 15% of revenue, compared to $31 million or 20% of revenue in the prior quarter. Year-to-date, free cash flow is $53 million, due in part to a $7 million decline in our accounts receivable and a $6 million increase in deferred revenue. Now moving on to the balance sheet. We have $263 million in cash and marketable securities on our balance sheet. This increased from last quarter due to our operating cash flow minus the shares that we repurchased during the quarter. Our total debt remains at $520 million with a weighted average interest rate of 6.1% and our cost of debt remains at about $8 million per quarter. The ratio of our total net debt to adjusted EBITDA is at 1.9x below the covenant level of 3x. Our total fixed charge coverage ratio is at 3.6x, well above the covenant level of 2.5x. We had no borrowings under our line of credit facility, and anticipate that we will refinance it before it matures in October. This quarter, we repurchased 629,000 shares of stock at a total cost of $17.1 million or about $27.25 per share, and have $157 million remaining under our current board authorization. We continue to evaluate the best way to deploy excess cash to maximize shareholder value and consider our share repurchase plan a very attractive use of our cash flow. We also regularly evaluate and consider opportunities to acquire relevant technologies and products that advance our strategy or strengthen our portfolio and competitive position. With that, I'll now turn the call back to Mark.

In this concluding section, I'll discuss our prospects and outlook for the remainder of fiscal 2011. Concerning our Applications and Tools business, we are seeing gradual signs of improved spending on technology, with budgets beginning to ease and investments being made across the markets we serve, with a predictably strong quarter in both Europe and Asia Pacific, and we see a healthy pipeline of opportunities both there and in the Americas in the second half of the fiscal year. Concerning prospects for our Scores business. Although marketing solicitations have grown, we continue to be concerned about the outlook for the mortgage activity during the remainder of the year. Recent reports on existing home sales, housing starts, foreclosure activity and employment confirm the we're still in a slow recovery. The net of these offsetting trends is that we continue to expect our total B2B scores revenue to grow over time at roughly the rate of GDP. For our B2C business, revenue growth will be largely tied to the success of our marketing efforts through myFICO.com. From an operational perspective, we've now streamlined our organization and realigned our investment in support of areas with the greatest potential for growth. We also made a management change in our Scores unit, and remain confident that we are properly focused on delivering superior analytics into the marketplace. Taken together, these actions enable us to compete more aggressively and win more deals. Now the guidance for the remainder of fiscal year. We're updating our previous guidance for FY '11 to account for the impact of the final restructuring charge during last quarter. The updated guidance is as follows: Revenue of $620 million to $625 million, unchanged from our previously stated guidance, but with growing confidence in delivering the high end of this range; net income of $68 million to $72 million on a GAAP basis, with its previous GAAP guidance of $70 million to $73 million; excluding restructuring charges, non-GAAP net income of $77 million to $81 million versus the previously stated $76 million to $80 million. GAAP earnings per share of $1.71 to $1.81 versus $1.75 to $1.83. And excluding the restructuring charges, non-GAAP earnings per share of $1.93 to $2.03 versus $1.90 to $2. In closing, I'd like to reiterate my confidence in the direction we're headed. The markets we serve are coming back to life. Our revenues and pipeline are increasingly healthy. And our clients tell me consistently that FICO solutions get right to the heart of their most pressing challenges. We remain focused on bringing the greatest possible value to our clients and shareholders, and to ensuring the company's long-term financial health and success. With that, I'll turn the call back to Steve for a question and answer. Steve?

Thanks, Mark. This concludes our prepared remarks, and we're ready now to take your questions. Mike, please open the line.

[Operator Instructions] Your first question comes from the line of Manav Patnaik from Barclays Capital.

First question is just around, I guess, could you give us an updated headcount number, what it looks like at the end of the quarter and may be what it is today. And just around that, I just wanted to get your take in terms of your comfort level around with all the significant cost-cutting initiatives that you guys are undertaking, how comfortably do you feel whether or not that cutting into the muscle of the company, and I guess if not was there just too much excess that time around?

The headcount at the end of the quarter was about 2,030.

2,033 to be exact.

I guess I wouldn't characterize that level in either the way that you post. I think we learned during the downturn as to many of our customers become ever more productive and efficient and we saw an opportunity to do that one more time, largely by flattening some of the organizational structure that we had. We're pretty lean and efficient these days. I don't think we've cut too deeply. But I also would say that there's probably not an additional restructuring that we can contemplate doing. I think we've gotten down to the level of efficiency that feels right for this time, and we know how to run the business at this level.

Great. And just one more sort of, I guess, big picture question around. Maybe a little more color you talked about a little -- I guess the slow recovery but you also threw in a few data points in that way, the leading indicator seemed to be showing nicely for you guys, looking ahead. So I guess related to that, the revenue guidance that you maintained, does that -- I guess does that not take into account what the leading indicators could mean for you guys? Or does that basically means that maybe you see a little more lag before those leading indicator actually start throwing in that extra benefit for you guys?

Good question. First, I would point out the language used in reiterating our revenue guidance that, there's increasing comfort about achieving the high end of that range, right. So that's -- which rose this quarter. In terms of the leading indicators, there's two subs to them. We do, in fact, like what we see in terms of the pipeline for Applications and Tools. Those numbers are growing, and they look quite healthy in the back of the year. With respect to Scores, we are happy with the amount of marketing and originations activity taking place at the front end of that life cycle, but there is some concern in the marketplace about the rate on which those marketing solicitations get converted into new business. I don't think that's a phenomenon unique to us. But as we check with a number of players in the industry, not all of the market solicitations are converting to new business at the rate that they used to prior to the recession.

Your next question comes from the line of Michael Nemeroff from Wedbush Securities.

Just following up on Manav's question and Mark's answer about the conversion rates. Looking at the score in revenue from last year, Mark, it was actually up, I think, there was a true up in Q3, based on your commentary with the conversion it's not really coming in as high as maybe they were in the past. Would you expect that Scoring revenue to be down year-over-year again, especially on the transactional and maintenance line?

Yes, Mike. This is Mike Pung here. We expect that scores to be relatively flat or up slightly. If you exclude the true up that we had last year in the third quarter.

And just remind us again how much that true up represented?

We said last year were several million dollars, so between $3 million to $4 million.

Okay, between $3 million to $4 million. And then, Mike, if you wouldn't mind just maybe talk about the cash flow targets. You obviously had a couple of quarters in the cash flow side. Do you think that you've maybe pull forward some stuff and collections have been a little bit stronger than you thought, and then maybe give us an update on what you're expecting for the year for operating and as well as free cash?

Yes. We're maintaining the same guidance that I gave you last quarter. For the annual free cash flow to be somewhere between $90 million and $95 million. As you know, it can fluctuate a little higher, a little lower depending on the timing of payments, primarily on the receivables side. But we feel pretty good about the $90 million to $95 million level.

And then one last one, if I may, to Mark. Mark, I think you guys mentioned in your remarks you talked about maybe putting some capital to use for acquisitions. I don't think I've heard that commentary in several quarters and I was just wondering if there are any specific areas that maybe you think that you could share with us where you'd like to target.

I can't be overly specific. It is true that we are looking these days and I'll remind you of previous, say, the philosophy, which is we look for niche capabilities to supplement our existing portfolio. So we're not looking to buy new customers or new revenue sources. We're looking to buy technologies that would be more cheaply acquired and built, and we can see places in our product portfolio where such investments might strengthen our Applications portfolio. So we're looking, and we're sending a message that says we're active in the space but nothing further to announce.

Okay. And then just one last one if I may. For Mike, so the restructurings were down, I mean, we're not going to see anymore restructurings going forward related to the most recent announcements.

No, we could be $11.5 million this quarter and to the degree there any adjustments going forward, I would expect them to be simply true ups of minor items related to our facilities.

So Mike, I think you understood we really only saw about a half quarters worth the benefit of those restructurings in last quarter. And the reason why Mike comments said that we expect OpEx to climb down this quarter is that we got the full quarter's worth of benefit.

Your next question comes from the line of Nat Otis from KBW. Nathaniel Otis - Keefe, Bruyette, & Woods, Inc.: When you talk about FICO 8 and auto industry, any thoughts on the financial impact to the switching any way?

No. The upgrades from prior generations to new generations this quarter is coming at no incremental revenue to us. What they do, do is secure that base, if you will, for many years to come. So Scores are typically used for 5, 7, 10 years time, getting an entire industry sectors such as auto on to our newest version. So it locks in and secures that revenue stream. But it's not an incremental lift beyond the revenue stream that was there before. Nathaniel Otis - Keefe, Bruyette, & Woods, Inc.: How long do you we think something like that will take ultimately?

Well, the conversion of that particular industry is the recurring in a small number of months, and that has a 3 or 4 months in part because they're such interconnecting that's across the auto players that they sort of move as a group, and we've been working very actively with them to support them in that sort of bulk transition. But as indicated, auto players and many other industry sectors once they settle on a score that works with them typically used it for a minimum of 5 years. It's uncommon to see swap out of scores generations within less than 5 years. Nathaniel Otis - Keefe, Bruyette, & Woods, Inc.: Then just quickly on the balance sheet. Looks like you shifted a good amount from marketable securities to just cash. Anything there to read or anything important there?

No, all we were doing is changes in some banking relationships and some banking structures but nothing more than that.

[Operator Instructions] Your next question comes from the line of Michael Nemeroff from Wedbush Securities.

Just a question, if I may, on the competition, specifically around the Tools division. Is there anything that's happening, obviously, it was a good quarter. So I was just trying to see if there's any change in the competition and who you're seeing? And then also in scoring, do you still, are you seeing or hearing any of the banks that you're working with talking about VantageScore using it in production because it's something that a lot of investors asked us, I believe.

With respect to the Tools business, the primary competitor there remains when we talked about in the past, IBM, with their high-reward product. I guess, I have growing confidence in what I stated before that the market supports two players in that race and there's ample evidence to believe that we and they can both succeed and we like where we're going with the Blaze product and we tend to compete with slightly different opportunities and IBM does. We walk through things that are tend to be more industry dense and they tend to have more sort of generic solutions but there's room for both of us. You should also note that in the quarter we did have one large optimization deal that helped the numbers and that is our so-called express optimization product that plays nicely with Blaze. With respect to Scores and VantageScore, we continue to believe that our product and technology is superior to theirs. We do know that there's a lot of marketing activity underway on their part. We continue to be of the view that before that, while customers are benchmarking and evaluating lots of alternatives, and we see some pricing pressure, et cetera, I'm not aware that we've lost customers to VantageScore.

Thanks, Mark. And then just in the Scoring business itself, you'd just give us the Scoring revenue but we've got that breakdown of the transaction and maintenance, professional services and license. What is the license and that actually had step function up in terms of that revenue, it's small obviously. But I just want to understand are you selling it as an all-you-can-eat license or if you could just maybe go into detail about that.

There's no difference, there's no change, Michael, in the model for selling scores. The small incidental license, transactions are transactions that we've done outside the U.S. but in a very minor way.

So the comparison to last year show that you didn't have any, so that would mean that you just didn't sell any outside the U.S. of that time?

That's right.

There are no further questions at this time.

Thank you, Mike. This concludes our call. Thank you all for joining.