Fair Isaac Corporation (FICO) Q3 2011 Earnings Report, Transcript and Summary

Good afternoon. My name is Wesley, and I will be your conference operator today. At this time, I would like to welcome everyone to the FICO Third Quarter Earnings Call. [Operator Instructions] I'd now like to turn the conference over to Steve Weber to begin. Please go ahead, sir.

Thank you, Wesley. Good afternoon, and thank you for joining FICO's Third Quarter Earnings Call. I'm Steve Weber, Head of Investor Relations, and I'm joined today by CEO, Mark Greene; and CFO, Mike Pung. You'll find on the Investor Relations portion of the FICO website a copy of today's news 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 Investor page of our website under the Presentations tab. A replay of this webcast will be available through September 3, 2011. Now I'll turn the call over to Mark Greene.

Thanks, Steve, and good afternoon. We'll proceed today as usual in 3 parts. First, I'll summarize the quarter results and assess our business in light of current market conditions. Mike Pung will then provide further financial details. Finally, I'll discuss our business outlook for the balance of fiscal 2011 before we take your questions. For the third quarter of fiscal 2011, we had mixed results, with revenue down when compared to the prior year and prior quarter, but net income up significantly compared to the same periods. Third quarter revenue was $151 million, down $2 million over the prior quarter and down $5 million year-over-year. Non-GAAP earnings per share in the quarter were $0.58, up 49% from last quarter and up 41% year-over-year. Bookings were $50 million compared to $58 million last quarter and $64 million in the third quarter of 2010. Year-to-date, revenue and bookings have grown 2% and 8%, respectively, from the prior year. Our transactional and service revenues remained strong during the quarter. However, our license revenue declined by about $5 million versus the prior quarter. This is always disappointing as we had several large deals in the pipeline that we expected to sign by the end of the quarter that did not. I've noted in prior calls that we expect some variation in framing around revenues associated with large license deals. And we believe the lower license revenue this quarter is an example of that. The deals that failed to close in time were not losses, but pushed into the current quarter, and we still expect them to come good. On the expense side, this quarter, we realized the full benefit of the restructuring that we did last quarter. Our operating expenses are down $9 million from last quarter and down $11 million from the prior year. Despite the decline in license revenue, our adjusted operating margin grew to 28% this quarter compared to 24% last year. Let me now break down the performance into the 3 segments of our Decision Management portfolio. Beginning first with the Decision Management Applications segment, which consists of business software used by clients to better understand and predict consumer behavior to help them make smarter decisions over customer life cycles. Revenue from these applications was $92 million, down 4% sequentially due to a drop in license sales and up 1% versus the same period last year. Within this Applications segment, we had another solid quarter in our Fraud Management business, which consists of Insurance Fraud Manager and Falcon Fraud Manager for banking. Fraud Management bookings were nearly $18 million for the quarter, up 24% from the previous quarter and up 52% from the previous year, while revenues grew 2% and 9% on a sequential and year-over-year basis. We remain very pleased with the performance of our strong Fraud Management franchise. Turning next to our Scores segment, which consists of predictive analytics to use risk -- to assess risk. Overall Scores revenue was $42 million, up 2% from the prior quarter. We track 2 subsegments here: B2B, which are scores sold to financial institutions; and B2C, which are scores sold directly to consumers at myFICO.com, as well as scores sold indirectly to consumers through bureau partners. The first of these, the B2B Scores segment, continues to track with the economy, as B2B Scores revenue were up slightly from last quarter, although down 10% from the same period last year due primarily to a true-up in royalty fees last year. We continue to focus on maintaining our market leadership in this area, and we look for opportunities to provide new revenue streams. Highlights from the quarter include that the marketed option of our latest score, which is FICO 8, continues to grow with approximately 6,000 lenders now using FICO 8 in their risk management practices. That's up from about 4,000 reported last quarter. Secondly, we launched a new strategic default analytic solution for the mortgage industry with validations underway with top clients and a strong and growing pipeline. Third, we saw large client marketing acquisition activities continue to grow with a 17% quarterly increase year-over-year. And fourth, we launched a new FICO Medication Adherence Score, which uses predictive analytics to forecast an individual's likelihood of taking his or her prescription medication as directed. This FICO Medication Adherence Score is HIPAA-compliant and it will help improve prescription adherence, boosting therapy effectiveness and reducing healthcare costs. We're now in active discussions about this offering with the 40 top health care companies and 10 top pharmaceutical companies that are already our clients. And we're confident that this innovative product will make a big impact in the healthcare marketplace. Now concerning the regulatory front, new regulations took effect last month as part of the Dodd-Frank Act, including establishment of the Consumer Financial Protection Bureau. We support the CFPB in its efforts to promote transparency and simplicity in consumer lending. The regulations that went into effect in July changed the risk-based pricing notices and adverse action notices that creditors must send to consumers. We anticipate that in more than 90% of cases, these notices will now include a FICO score, hoping to strengthen awareness of FICO scores among consumers. I previously mentioned that in anticipation of these new regulations, we launched scoreinfo.org, which is an educational website to provide consumers with comprehensive credit education and information about these new risk-based pricing rules and other federally mandated credit disclosure notices. This free, noncommercial website helps consumers understand how FICO scores are calculated and used and what can be done to improve credit standing. It's also consistent with our long-standing belief that better consumers understand credit score and credit health, the more likely they'll be to prefer the FICO score, or as we refer to it, the score that matters. These new regulations are not expected to have a material effect on FICO's revenues. The scores being disclosed already will have been purchased by lenders through Equifax, Experian or TransUnion. So we expect neither a gain nor a loss in revenue as a result of these score disclosures. We do, however, anticipate that increased awareness of FICO scores will motivate more consumers to visit myfico.com for products and information. In this B2C or consumer segment of our Scores business, we saw another revenue increase in the third quarter for direct sales to consumers through myfico.com. In the quarter, revenues grew 6% sequentially. That increase was partially offset by a decline in revenue generated from our bureau channel partners selling scores to consumers indirectly. The third and final segment of our Decision Management portfolio is Tools, which consists of rules management, modeling and optimization products embedded within our applications and also sold standalone to clients who build their own applications. Revenue in this Tools segment was $17 million during the quarter, down 3% from the prior year but up 6% from last quarter and up 3% year-to-date. Because these tool offerings are generally sold with licenses, there tends to be more volatility in their revenue trends. So to summarize our third quarter results, license revenue was disappointing due to the timing of completing several large deals, but we saw improved earnings performance as a result of the restructuring we announced last quarter. With our new leveraged model, we achieved significant expansion in margins this quarter. And as we sign the larger deals we have in our pipeline, we're confident that we can deliver both top and bottom line growth. Let me now pass the call to Mike Pung for further financial details.

Thanks, Mark. I want to emphasize 3 points in my prepared comments today. First, revenue growth remains a high priority for the organization. And despite this quarter's soft license revenue results, we are confident that we're investing in the right areas to drive growth over the long term. Second, we delivered significant improvement in operating leverage and free cash flow during the quarter and will continue to manage our expenses wisely. Finally, we'll be reaffirming our guidance for the current fiscal year. Mark has discussed our revenue results by segment, so I'll provide some additional comments as it relates to specific aspects of our business. Revenue for the quarter was $151 million. By region, this quarter, 75% of total revenue was derived from the Americas region versus 73% in the prior quarter. Our EMEA region generated 18% of our revenue compared to 20% in the prior quarter and the remaining 7% was from Asia-Pacific, both this quarter and prior. Recurring revenue, derived from transactional and maintenance sources for the quarter, represented 74% of total revenues versus 73% in the prior quarter. Consulting and implementation revenues were 20% of total versus 18% in the prior quarter, and license revenues were 6% of total revenue versus 9% in the prior quarter. We expect license revenues as a percent of total revenue to increase in the fourth quarter. Turning to bookings, we generated $12 million of current period revenue on bookings of $50 million or a 24% yield. This compares with $17 million of revenue on bookings of $58 million, a 29% yield in the prior quarter. The weighted average term for our bookings was 19 months, both this quarter and last. Of the $50 million in bookings, 36% related to our Fraud Management products, 20% related to Tools, 11% to collections and recovery products. We had 10 bookings in excess of $1 million, one of which exceeded $3 million. Transactional and maintenance bookings were 34% of total bookings this quarter versus 29% in the prior quarter. Professional services bookings were 46% this quarter versus 48% in the prior quarter. And finally, license bookings were 19% this quarter versus 23% in the prior quarter. Turning to operating expenses. Excluding the restructuring charge from last quarter, this quarter life [ph] the operating expenses were $113 million, down about $9 million from the prior quarter. The decline was primarily related to the savings from the cost restructuring we announced and the timing of certain expenses tied to lower revenue. We expect that the current quarter represents the full benefit of the restructuring and that expenses will likely trend up slightly as revenue grows. As you can see on our Reg G schedule, non-GAAP operating margin before amortization, stock-based comp and restructuring was 28% for the third quarter compared to 24% in the prior quarter. GAAP net income was $23 million and the effective tax rate was about 27% for the quarter, which included a favorable tax settlement. We expect effective tax rate to be about 30% in quarter 4. On to free cash flow. We define free cash flow as cash from operations less CapEx and dividends paid. The free cash flow for the quarter was $41 million or 27% of revenue compared to $22 million or 14% of revenue in the prior quarter. Year-to-date, our free cash flow is $94 million compared to $69 million over the same period last year. Moving on to the balance sheet. We still have $259 million in cash and marketable securities on the balance sheet, basically flat from last quarter as our operating cash flow offset the share repurchases. Our total debt stands at $504 million, with a weighted average interest rate of 6.1%, and our total cost of debt is about $8 million per quarter. The ratio of our total net debt to adjusted EBITDA is 1.8x, well below the covenant level of 3x, and our total fixed charge coverage ratio is 3.6x, well above the covenant level of 2.5x. We have no borrowings under our line of credit facility and still anticipate that we will refinance it before it matures in late October. During the quarter, we repurchased 1.2 million shares at a total cost of $35.2 million or about $28.84 per share and still have $122 million remaining under our current board authorization. We continually 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 or products that advance our strategy and strengthen our portfolio and competitive position. With that, I'll turn it now back to Mark.

Thanks, Mike. In this concluding section, I'll discuss our prospects and outlook for the remainder of fiscal 2011. In our Application and Tool businesses, we continue to see gradual signs of improved spending on technology, with the budget easing and investments being made across the industries we serve. Last quarter, was saw strength in both EMEA and Asia-Pacific. And going forward, we see a healthy pipeline of opportunities across all of our geographies. Concerning prospects for our Scores business, we believe that the beginnings of a credit turnaround are underway, with consumers spending a bit more and banks generally more willing to extend additional credit, which should be good for economic growth. That's tempered, however, by uncertainty in Washington, sluggishness in the housing market and still high unemployment numbers. The net of these offsetting trends is, as we've consistently said, that we expect our total B2B Scores revenues to grow over time at roughly the rate of GDP growth. For our B2C business, revenue growth will be largely tied to our success in marketing efforts through myFICO.com. Now to guidance for the remainder of FY '11. As Mike indicated, we're reaffirming our previous guidance for the fiscal year as we move towards year end. That guidance is as follows: Revenue of between $620 million and $625 million. We continue to believe that we have the pipeline to deliver total revenue in this range, and we have plans in place to close the deals needed to achieve these numbers; net income of between $68 million and $72 million on a GAAP basis, with increased confidence in hitting the top end of net income as our expense management efforts bear fruit; non-GAAP net income of between $77 million and $81 million excluding restructuring charges; GAAP earnings per share between $1.71 and $1.81 and non-GAAP earnings per share between $1.93 and $2.03 excluding restructuring charges. In our call next quarter, we will be issuing guidance for fiscal 2012, which starts in October. In closing, while we had mixed results this quarter, particularly on the top line, we're now realizing the benefits of our restructuring efforts in the form of earnings growth. And thanks to our exceptionally strong operating leverage, we expect to continue generating healthy earnings for our shareholders as our top line growth picks up. Our confidence in the top line is due in part to the fact that we're consistently releasing new versions of our market-leading products, and in part to the fact that we've built a robust pipeline of large deals, which we are well positioned to win. As always, we remain focused on bringing the greatest possible value to our clients and shareholders and on ensuring the company's long-term financial health and success. With that, I'll turn the call back to Steve for a Q&A period. Steve?

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

[Operator Instructions] Our first question comes from Carter Malloy with Stephens Inc.

So first thing is the obvious on the revenue front. Can you talk about what types of deals are coming through? It sounds like there's some big license deals potentially there. And in the pipeline, your confidence of closing those, because it looks like you've got to get to $10 million sequential type of bump in revenues to get just to the low end of that guidance range. I just want to get content there. And as you talk about the revenue guidance, is that -- are we looking at the low end of that range or midpoint or actually even above that going into Q4?

Carter, this is Mike Pung. So couple of major deals that we were expecting to get closed in the third quarter but didn't. And they really range from term license deals in our Tools business and in the Applications business and in particular, deals related to our Falcon product and our Debt Manager products. They're deals that we've been working on for some time. They were well into the selling process and each one had a little bit of a different story behind why we didn't bring them to closure at the end of the month. We've seen some good luck, actually, since July 1 in getting a number of them signed and it gives us some increased confidence in being able to hit the guidance numbers that we've described.

Okay. And so if those deals do push it up in $160 million, $165 million rate on that quarter, can we assume what some of that is sort of -- not necessarily one time, but that's a boost to the model and maybe we should temper that back some, or throttle that revenue rate back some as a run rate going forward.

Yes, that's exactly right. I mean, what we fell short on, roughly the $5 million that Mark referred to in his comments this quarter, we'd see picking that up in our fourth quarter, but that would not be kind of the traditional sequential quarter run rate of revenue growth. It's simply a timing of license deals.

Got it, okay. And are there any true-ups in that with the bureaus?

Not in this quarter, no.

No.

Okay. And then on the expense side, first off, hats off, Mike, to you and your team there. Great job on the OpEx front. You commented on the run rate going forward stepping up with the revenue. Is that on the COGS side or on the OpEx side as well?

You'll probably see it on the COGS side and then a little bit in SG&A, maybe a $1 million or $2 million increase in our fourth quarter and going forward. Some of it was a matter of timing on period expenses that did not occur in third quarter that we expect to see in the fourth quarter. Other parts of it are the timing where we spend money with respect to our myFICO direct marketing dollars. We had a light quarter in digital marketing spend this quarter. And that's part of what drove the expenses down and that will probably normalize itself out over next quarter and beyond. But we're talking a couple million dollars, not a lot more.

Okay and R&D likely to stay here?

R&D likely to stay in the 9% to 11% range.

Okay. And then the other income line where you have interest income of $8 million or so a quarter, was there something in there that helped it, maybe I missed it on the call earlier. But was there an additional component to that, that brought that maybe down this quarter?

Yes, there was. We actually -- I mentioned earlier we had a favorable tax settlement with one of the state jurisdictions here in the U.S. And it went back to some pretty old periods. They sent us a check and it included a couple million dollars of interest. And we don't book interest income on tax settlements until received. So there's about a $1.8 million to $2 million credit in the interest line item that's nonrecurring.

[Operator Instructions] The next question comes from Thomas Ernst with Deutsche Bank.

This is Nandan on behalf of Tom. You talked about, Mike, at the beginning of your section that you're going to continue focusing on revenue growth. Obviously, revenue growth has been a bit challenging. Are you continuing to enhance your product? I mean, what gives you confidence that you might -- should be able to grow revenues going into next year, particularly if the economy remains somewhat tenuous?

It's Mark. The product updates in innovation, that's not a new phenomena. It's an ongoing one. What's newer is, as you recall, about a year ago, just over a year ago, we brought in a new leader of the sales team. He's brought in quite a bit of leadership underneath him. And I'm quite impressed by the progress that team has made in sort of perfecting their sales process and methodology. We were not happy with the result last quarter; the slips, the deals that pushed was not what we wanted to see. But in general, we have a very professional, very high energy sales team these days. And they're pursuing some very large transactions, much more sort of the solutions sale as opposed to small foreign product sales. So I like the pipeline. The pipeline is healthy, it's well qualified to large interesting [ph] deals and we're making good progress against it.

And related to that, you said there was one $3 million deal. I believe I heard that. Was that a suite sale? Or was that a more traditional product sale?

Let me take a look. That was a suite -- well, that was a traditional product sale. And give me a second, I'll tell you exactly where it was at. It was in our Tools business.

[Operator Instructions] Mr. Weber, there are no further questions at this time.

Thank you, Wesley. As a reminder, we'll be holding an Analyst Day on November 3 in New York in conjunction with our FICO World Conference, so we hope to see you at that. This concludes our call today. Thank you all for joining.

Thank you.

That does conclude today's FICO Third Quarter Earnings Call. You may now disconnect.