Fair Isaac Corporation (FICO) Q3 2014 Earnings Report, Transcript and Summary

Good afternoon. My name is Suzanne, and I will be your conference operator today. At this time, I would like to welcome everyone to the Fair Isaac Corporation Quarterly Earnings Conference Call. [Operator Instructions] Thank you. Mr. Steve Weber, you may begin your conference.

Thank you, Suzanne. Good afternoon, everyone, and thank you for joining FICO's third quarter earnings call. I'm Steve Weber, Vice President of Investor Relations, and I'm joined today by our CEO, Will Lansing; and our CFO, Mike Pung. Today, we issued a press release that describes financial results compared to the prior year. On this call, 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. This call will also include statements regarding certain non-GAAP financial measures. Please refer to the company's earnings release and Regulation G schedule issued today for a reconciliation of each of these non-GAAP financial measures to the most comparable GAAP measure. The earnings release and Regulation G schedule are available on the Investor Relations page of the company's website at fico.com or on the SEC's website at sec.gov. A replay of this webcast will be available through July 24, 2015. Now I will turn the call over to Will Lansing

Thanks, Steve. Today, we announced the results for our third quarter of fiscal 2014. I'll briefly recap those results, update you on the status of our strategic initiatives and talk about how we see our business position as we enter the last quarter of our fiscal 2014. In our third quarter, we reported revenues of $198 million, an increase of 8% over the same period last year. We delivered $21 million of GAAP net income and GAAP earnings of $0.58 per share, up 5% and 8% respectively from the prior year. We delivered $29 million of non-GAAP net income, flat with last year, and non-GAAP EPS of $0.83 per share, an increase of 3% from the same period last year. We had another good bookings quarter, delivering $84 million of new deals, up 20% from the prior year. I'm pleased with these results and encouraged that much of our revenue growth this quarter was driven by our Applications segment, an area where we had seen limited growth over the last several quarters. In fact, the Application segment was up 13% over the same period last year, and the growth was throughout the entire Applications portfolio, with double-digit growth in Marketing, Mobility, Originations, Banking Fraud and Collections and Recovery. Our Q2 bookings and Q3 revenues and Applications show the progress we've made in pursuing our growth strategy in this segment. We've added functionality to many of our products, and in most cases, they are now available on a SaaS basis. We believe this opens up new markets to us for these best-in-class products and will create new growth opportunities for us going forward. In fact, this quarter, we sold our first large Decision Management platform deal to a large telecommunications company. In our Scores business, we continue to make progress on our consumer initiatives. This past quarter, we announced that Hyundai Motor Finance, Kia Motors Finance and Sallie Mae will all be providing FICO Scores to their customers. We now have 14 customers participating in our Open Access program. We're also in final stages of discussions with several large card issuers to deliver Open Access or our credit education program or both. Consumers know the FICO brand. As they come to understand how the FICO Score is used by lenders, we believe they will have a better handle on their own financial situations, and there will be less confusion in the marketplace. In our third quarter, we also made significant investments in our business. Mike will go into further detail when he discusses the numbers. But I'd like to give you the rationale behind these strategic investments. First, we significantly increased our R&D spending to address a tremendous opportunity, which is to extend the distribution of our IP through new platforms, both through our Decision Management platform and also through platforms being built with third-party distributors. We view these as excellent opportunities to meet evidence demand and provide more robust and competitive products to our existing and prospective customers. We have also made some important investments in our sales and marketing function. This includes geographic expansion to emerging markets that have demand for our products and also improve coverage in our existing geographies. As we plan for continued growth, we're committed to having the proper sales resources and distribution channels in place to bring our products to market. We view these investments as critical to fueling the long-term growth and competitive strength that we believe we can drive from our assets. This quarter, we also returned substantial value to shareholders through our share repurchase program. As I've said in the past, we're committed to repurchases, not just to offset dilution, but also to give loyal shareholders a bigger piece of an expanding pie. In the third quarter, we repurchased nearly 1.6 million shares, more than 4% of the shares outstanding. We continue to view share repurchases as an attractive use of cash, and our strong cash flow provides us opportunities both to repurchase shares and to make strategic acquisitions that will strengthen our portfolio and competitive position. As we move through the final quarter of our fiscal 2014 and look toward the year ahead, I'm more convinced than ever that FICO is well positioned to excel in each of the segments of our business. We remain extremely focused on execution to deliver superior products for our customers and sustainable value growth to our investors. I'll now turn the call over to Mike for further financial details.

Thanks, Will. Good afternoon, everyone. Today, I'll emphasize 3 points in my prepared comments. First, our revenues this quarter were $198 million, an 8% increase from last year. Our Applications business grew 13% to $130 million, with increased revenues across the entire portfolio. Second, we delivered $21 million of GAAP net income, and $29 million of non-GAAP net income. Free cash flow was $25 million for the quarter, and we returned $94 million to our shareholders through our share buybacks. Finally, we are refining our guidance for the full year to reflect the current business momentum. I'll break revenues down into our 3 reporting segments, starting with Applications, where revenue was up 13% to $130 million versus the same period last year and up 12% versus last quarter. This is the highest revenue we've ever recorded in our Applications segment, delivering growth across all of the products in the portfolio compared with the same period last year. The biggest gains came in Marketing, up 26% from the same period last year; Mobility and Originations, both up 17%; and Bank Fraud, which is up 13% from the same period last year. We also had a good bookings quarter in Applications, signing $54 million of new deals, up 24% from the same period last year. In the Tools segments revenues were $22 million, up 4% versus the prior year. The growth this quarter was driven by sales in our Blaze Rules product. We also had a good bookings quarter in Tools, up from 31% from the same quarter last year. Finally, in our Scores segments, revenues were $45 million, down 4% from the same period last year. On the B2C side, we're up 6%, versus last year on the B2B revenues, we were down 7% from the same quarter last year due to a mix shift towards volumes with lower price points. Looking at our revenue by regions. This quarter 69% of total revenues were derived from our Americas region, our EMEA region generated 23% and the remaining 8% was from Asia Pacific. Recurring revenues derived from transactional and maintenance sources for the quarter represented 67% of total revenues. Consulting and implementation revenues were 19% of total revenue, and license revenue were 14% of total. Turning now to bookings. We generated $15 million of current period revenues on bookings of $84 million or an 18% yield. The weighted average term of our bookings was 28 months this quarter. Of the $84 million in bookings, 19% relates to Rules; 16% each to banking fraud and Collections and Recovery; and 10% to Marketing Solutions. We had 14 booking deals in excess of $1 million, 5 of which exceeded $3 million. Transactional and maintenance bookings were 24% of the total this quarter. Professional services bookings were 47% this quarter. And finally, license bookings were 29% in the quarter. Our operating expenses totaled $161 million this quarter, when compared to $147 million in the prior quarter or up $14 million. As Will mentioned, we increased our investments to support important strategic initiatives. We added 19 additional heads to our sales and marketing functions, as we built out our teams to meet demand, increased our lead-generation spend and invested in other customer-related activities. We also increased R&D expense by $4 million, as we're in a heavy investment period for our Decision Management platform. Finally, our cost of revenues was higher, primarily driven by third-party contractors, utilized this quarter to deliver increased services revenues. While these additional investments created some headwind in the near term, they were made towards advancing our strategic objectives. As you can see from our Reg G schedule, our non-GAAP operating margin remained at 25% in the third quarter, unchanged from the same period last year. GAAP net income was $21 million, flat with the prior quarter. Non-GAAP net income was $29 million, also the same as the prior quarter. The effective tax rate was 32% this quarter. We expect the effective tax rate to be about 33% to 34% for the full year, unless the R&D credit is reinstated before the end of our year. Free cash flow for the quarter was $25 million or 13% of revenue compared to $27 million or 15% of revenue in the prior year. Fiscal year-to-date, we've delivered $95 million of free cash flow compared to $78 million in the first 3 quarters of last year. Moving on to the balance sheet. We have $93 million in cash on the balance sheet. This is down $15 million from last quarter, driven by share repurchases and partially offset by the cash we generated from our operations, and draws off our revolving line of credit. Our total debt is $530 million, with a weighted average interest rate of 5.3%, with [indiscernible] of $83 million balance under our $200 million revolving credit facility. The ratio of our total net debt to adjusted EBITDA is 2.2x, below the covenant level of 3x. Our fixed charge coverage ratio is at 4.9x, well above the covenant level of 2.5x. During the quarter, we returned $94 million in excess cash to our investors, repurchasing about 1.6 million shares at an average price of $59.36, putting us at the end of the quarter with remaining $56 million on the current $150 million board authorization. And we continued to view share repurchases as an attractive use of cash. We also evaluate opportunities to acquire relevant technologies and products that advance our strategy or strengthen our portfolio and competitive position. Finally, I'd like to discuss our full year guidance as we enter our final quarter. Three quarters in, we are now refining our guidance to the following: we believe revenues will be between $773 million to $776 million; GAAP net income will be between $88 million to $90 million; GAAP earnings per share will be between $2.53 and $2.60 per share; non-GAAP net income, between $122 million to $124 million; and finally, non-GAAP earnings per share of $3.51 to $3.56. These changes reflect the revenue momentum we have built from our bookings growth and view of our current sales pipeline and also the impact of the additional investments and share repurchases we made in quarter 3. Next quarter, we'll be providing guidance for fiscal 2015. So with that, I'll turn the call back to Steve for Q&A.

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

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

This is Greg calling on for Manav. I'm going to ask about the B2B business and the mix shift towards volumes with lower price points. I'm just wondering if that's a strategic decision or if that's a fluctuation that we could see reversed going forward.

Yes, no, that's not a strategic decision. It's simply a function of banks and those that buy credit scores from us buying more prescreened Scores, marketing Scores, which are at lower price points than Originations compared to last year. Those will ebb and flow depending upon marketing programs, and health and consumer lending.

Okay. And then, I guess, on the buybacks, highest in recent memory. Wondering if there's any reason to expect a slowdown there, or is that kind of a pace we can expect going forward?

Greg, the way we think about buybacks, we've talked about this in the past, is that we balance buybacks against M&A activity. And we continue to feel like investing in ourselves is a really great opportunity. We're very happy with our prospects. That said, there's imperative about time to market. And so when it's appropriate, when we can find the right deal at the right price, we do from time to time, go out and buy other companies. In the last year, they've been very small, and they really haven't affected us in any kind of dilutive way. Where we sit today is we have a very active M&A group, corporate development group that scours the planet for interesting tuck-in acquisitions and bigger acquisitions, frankly. But at the same time, our sense is that valuations are high. And so as we think about the trade-off between buying businesses and buying assets versus building things ourselves organically, we have been -- in the last year for sure, we have been favoring organic build. And you see that reflected in our expenses. Our P&L reflects the investments that we've been making in, especially in product development. And some of those are very specifically opportunities where we considered buying companies and thought, you know what, we can build the same or better for less money and it'll take a little bit longer, but we're patient, and we know we'll do a high-quality job doing it ourselves and controlling it. And so kind of given valuations in the marketplace and given our own skills in building the stuff ourselves, lately, we've been favoring organic build with the P&L expense impact that, that brings. The benefit is that it has freed up plenty of cash for stock buyback, and so we've been taking advantage of that. So the long answer to your question is, we continue to be interested in buyback. We'll continue to do it cash permitting. And it does compete with M&A and it all depends on the opportunities in front of us, and they vary from quarter-to-quarter. But right now, valuations feel pretty full out there.

Okay. That makes sense. And maybe just talking big picture on the macro backdrop before the consumer. What are you seeing there? Are you seeing banks starting to move down the credit quality chain? And are there specific asset classes that you see elements of credit loosening?

What we are seeing is banks moving. They continue to be very focused on compliance and the new regulations, making sure that they are really buttoned up from a risk and compliance standpoint. But we've recently seen more appetite for focusing on the business itself and improving revenue. And so you see a little more originations activity, you see a little more prescreen, which I think is a function of their belief that, that consumer is ready to engage in a little more business. So that's what we're seeing.

Your next question comes from the line of Matthew Galinko, Sidoti. Matthew Galinko - Sidoti & Company, LLC: First one is just how many of the additional sales headcount is quota carrying? And can you provide a number of how many sort of total quota-carrying reps you have at this point?

We don't break that out. That's -- we just haven't shared that, and we don't do that.

It's pretty safe to say, though, that as we're adding new heads, they're field people rather than marketing people, and they're quota-carrying folks, Matt.

That's correct. Matthew Galinko - Sidoti & Company, LLC: Got you. Fair enough. And should we think of this sort of as a trend where maybe we'll be adding more through the balance of the year? Or are you pretty comfortable with numbers where you're at?

Actually, it's a great question, and it's a question that we debate internally all the time. What's very clear is that our IP and our product portfolio far exceeds our distribution capability. And we go to market directly, we go to market through partners, we go to market every way we can. But the direct side of that equation, we are growing it, and we're growing it as much as we can afford to invest in it, and it's still not enough. And so we spend a lot of time looking at channel partners and trying to develop channel partners. We are investing in -- I mentioned earlier, we're investing in platforms that partners of ours can use to take our IP to their customers. So that's a long way of saying we feel like our distribution is not as big as it should be. And we want to improve it on every dimension, both directly and through channels and partners. Matthew Galinko - Sidoti & Company, LLC: Got you. And then one last one. On the R&D side, should we see the increase this quarter kind of as a -- and maybe over the next couple of quarters, as kind of a burst? Or is that a level we can kind of expect to sustain over a couple of years as you build out new functionality?

Probably safer to think of it in terms of years because we -- the opportunity is enormous. We will -- we're going to wind up with fleshing out the product portfolio and our technology either organically or through M&A. To the extent that it happens organically, which we're doing now and which we anticipate doing for the foreseeable future, you will see, I wouldn't call a burst, I'd call it a sustained burst of R&D, especially D, kind of expense. So yes, I think, it's something to plan on. Yes, I think that's a fair thing to plan on.

Your next question comes from the line of Bill Warmington from Wells Fargo.

So a question for you on the Open Access program. Just wanted to ask if -- what type of benefits you've been seeing and whether you're seeing that flow through to actual revenue yet, or what it would take to see that.

Well, so probably everyone on the call has seen some of our partners leveraging our Open Access program to put FICO Scores in the hands of their consumers. And most notably, Discover and Barclays have been really promoting the FICO Score as part of their offering. But we're in talks with a lot of other banks to do this. I think that we've shared that the Open Access program is not designed to be a revenue driver in itself. The idea is that it is a score that can be freely reused, so if a bank uses the score in making a credit decision, they are free to share that score with a consumer for free. We don't get money from that. It's part of -- the good citizen part of that is there's a lot of transparency, and the consumers can learn -- can understand how the credit system works better, when they can see their FICO Score and how the decisions are made. The longer-term benefit from that for us is, obviously, our consumer scores franchise is that much stronger, our brand identity is that much stronger. And we have programs built around it like an education, an Credit Education Program, which we're in conversation with banks about, where there are additional paid services that kind of build off of Open Access, although they're not tied to Open Access. And so we think that there's a revenue opportunity there. And so that's really where it's going. I would say it's very early innings. We're not seeing -- so the short answer is there's no revenue from Open Access today. It wasn't designed to be a revenue producer. But it is proceeding exactly according to plan in terms of strengthening the franchise and giving us opportunities for other revenue-producing things like our credit education programs, which we're now sharing with other banks.

Okay. In terms of your cloud offering. Last quarter, I believe, you sold about $10 million of the new backlog that came from the SaaS versions of Debt Manager and Originations Manager. The -- how did that trend this quarter? I can't remember if you gave that number or not.

Yes, we didn't, Bill. This quarter, cumulative from the beginning of the year, we're at about $14 million or so of backlog. So we signed up about another $4 million. So we're moving along.

Yes, definitely. And then I wanted to ask about specifically on -- I couldn't remember if you mentioned specifically credit card-related volumes. They were up very strongly last quarter. And I just wanted to ask about those this quarter.

Yes, so credit card marketing was up a tick from where it was compared to last year, down actually slightly from last quarter. I don't think there's any apparent trend there, but those were how the volume numbers came out. Auto volumes for Origination were strong. Much of the rest was not on the Originations side. So it was a solid quarter on the Score side, but I wouldn't call it extraordinary or the signs of any trends on the B2B side this quarter.

Got you. And then I just wanted to ask if you were seeing -- to describe what -- if you're seeing any change in terms of the volume and the quality of the deals that you're seeing out there in the market for M&A.

The volume and quality of deals? There's plenty of volume. I mean, there's a lot of opportunity. And we have a lot of stuff go through our Corp Dep department. And quality -- price aside, the quality [indiscernible] there's a lot of good assets out there. There's a lot of innovation going on. And particularly in our space, in the analytic space, you have tons of startups. You have established companies, more established companies that have now built franchises over a period of years. And so there's a lot of attractive opportunities. But everything is relative, and so it may be an attractive asset. But if the price isn't so attractive, or if it's not attractive relative to investing in ourselves, you see us sitting on the sidelines, and that's what you've seen.

[Operator Instructions] Your next question comes from the line of Brett Huff with Stephens Inc.

On 4Q, just based on what you guys have said, it sounds like we should expect an absolutely, sort of maybe roughly flat level on R&D from 3Q to 4Q. My question is what's going to sort of get us to that higher or the higher sort of margin that's implied for 4Q? Is it better gross margins? Is it lower SG&A? Kind of how does that trend for 4Q? And then maybe can I ask that question again for as we look into next year also.

Yes, so for the fourth quarter, what we believe from the modeling we've done and the guidance we gave is that we ought to have a heavier mix in license revenue than we have throughout the year. It doesn't necessarily mean services revenue are going to go down dramatically. We have a lot of services backlog that we've been burning, and that, of course, has been driving some of the growth. But as we mentioned last quarter, we have some renewals coming through on the license side. And we had a step-up in expenses, and as we hold the line on expenses this quarter, depending upon how the mix comes out in the license and the Scores revenues, so will the guidance.

And so the SG&A, that's where the sales folks reside, so it's not only R&D, it's in SG&A as well.

Yes, yes. In the SG&A -- the only real variability, if you will, in the SG&A is the incentives that are tied to performance. And so if we outperform, that line item will go up, and if we perform as we expected, it'll be at or around where finished here in quarter 3.

Okay. And then sort of outlook for next year. I don't know if it's sort of a run rate coming out of this year for R&D that makes sense. Maybe also SG&A makes sense. That would imply a -- how do you guys view margins? I mean, that might imply sort of flattish margins. Or is it something we should expect that you guys are earnest enough about spending that you're going to get after that investment and maybe compress margins as we head into next year?

Yes, so we're, like many, in the budgeting cycle right now, and so we're not in a position to talk about next year yet. We will in November. But one of the things I think that's been hallmark of the company here is that we manage the expenses wisely. And we wring a lot of cash out of the company, and we try to put that cash to good use. And so if you believe those things, then you'll hear from us in the fourth quarter in terms of how we plan to invest and manage the business going forward with the opportunities ahead of us.

Got you. And then just a couple on capital. You said the repo, you've got $56 million left. Is that -- did I hear that right?

Yes.

On the authorization. On the authorization, yes, I'm sorry.

Yes, we've $6 million left on that. And will you, I presume, that you all would tend to re-up that if you keep burning away at it pretty good?

That has always been what we do, and we would anticipate doing that, although we obviously can't speak for the board. But we -- for years now, we have reauthorized every time we exhaust the existing.

And then on the free cash flow, I think you said $25 million this quarter, $95 million or so year-to-date. Am I -- did I hear that right?

That's right.

And then can you -- is there -- should we -- are there going to be seasonality for that? If there's a lot of license in next quarter, should that come up a little bit?

Well, so, usually, the license revenues typically come in the last month of the quarter. So to the degree the license revenues signed in the month of September, that probably will be sitting in AR. In this quarter, with the $25 million that we did in cash flow, our DSO went up by 3, 4 days, which is about $7 million, $8 million. And that represents the -- some of the license revenue we signed towards the end of the quarter. So my point is, it's strictly a timing issue. We actually had a fair amount of collections the first week of January that missed the cutoff, or that $25 million would've been higher. And so we kind of look at it as a trailing full quarter to kind of smooth out those sorts of items.

And then as we look to next year, I know you're not going to give us guidance. I'm not asking for that. But is there anything that would change the cash flow growth as it -- should it mimic roughly sort of your pro forma EPS? Is there a reason that working capital might get eaten up? Or anything like that, that would cause a difference in how your just pro forma EPS might trend versus cash flow?

No, none that we expect, just based upon what's happened to us over the year. So that's probably a good marker for you.

Okay. And then this is my last question on the business. I know that you had mentioned in your prepared comments about really working on figuring out new distribution channels, particularly the -- as you SaaS-ify or make more SaaS-like some of your businesses, some more modern distribution channels. Any update on that? Any milestones that we've hit in terms of number of products we've gotten into that new mode, or interesting new conversations you're having with developers that might be using some of that functionality?

We're having -- we're in a lot of conversations right now, and I think we'll have things to announce in the near future, but we're not prepared to announce anything today.

There are no further questions at this time. I turn the call back over to the presenters.

Thank you, Suzanne. This concludes today's call. Thank you, all, for joining.