Earnings Call Transcript - FICO Q2 2021

Operator, Operator

Greetings and welcome to the Fair Isaac Quarterly Earnings Conference Call. During the presentation, all participants will be in a listen-only mode. Afterwards, we will conduct a question-and-answer session. As a reminder, this conference is being recorded today, Wednesday, May 5, 2021. I would now like to turn the conference over to Steve Weber, Vice President, Investor Relations and Treasurer. Please go ahead.

Steve Weber, Vice President, Investor Relations

Thank you. Good afternoon. And thank you for joining FICO’s second quarter earnings call. I am Steve Weber, Vice President of Investor Relations, and I am joined today by our CEO, Will Lansing; and our CFO, Mike McLaughlin. 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. These statements involve many uncertainties, including the impact of COVID-19 on macroeconomic conditions and the company’s business, operations and personnel 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 May 5, 2022. And now, I will turn the call over to Will Lansing.

Will Lansing, CEO

Thanks, Steve, and thank you, everyone, for joining us for our second quarter earnings call. I'd like to start by saying that I hope you are all safe and healthy. And I want to thank our dedicated FICO employees who have done an exceptional job meeting the challenges in the last year and never wavering in their commitment to FICO or their colleagues and our customers. We have a tremendous team, a great culture at FICO and I'm really honored to report that FICO was ranked number one on Forbes' annual list of America's best midsize employers. On the investor relations section of our website, we posted some slides that offer financial highlights of our second quarter. Today, I'll talk about this quarter's results and how we do our business at the midpoint of our fiscal year. I'll discuss how we continue to refine our strategy to optimize our Scores asset and sharpen our focus on our world-class decision management platform. We reported revenues of $331 million, an increase of 8% over the same period last year. We delivered $69 million of GAAP net income and GAAP earnings of $2.33 per share, up 18% and 20%, respectively. On a non-GAAP basis, net income was $90 million, up 40%, and earnings per share of $3.06 was up 42% from last year. We continue to deliver very strong free cash flow growth as well. Second quarter free cash flow was a record $152 million, up 178% from last year. I'm pleased to report that we continue to execute well against our strategic initiatives throughout the company. As we've said, for the last several quarters, we're continuing to migrate more of our business toward a subscription-based model, including SaaS software subscriptions and term license subscriptions for on-prem software. This strategic decision will provide a more representative view of the growth trajectory of our business. But it also gives us some difficult comparisons for last year, when we had significant upfront license revenues. In our application segment, we delivered $130 million of revenue, down 8% from last year due to a 29% decline in upfront license revenues and a 21% decline in professional services revenues. In our decision management segment, we delivered $33 million of revenue, up versus our Q1, but down 14% due to reduced upfront licenses and lower services revenue. Transactional revenues in DMS were up 34%, and as we continue to transition more of our software business to a recurring SaaS model. We continue to have a lot of interest in this technology and our pipeline contains more big deals as we continue to gain traction in the space. We remain committed to becoming the preeminent platform player in decisioning analytics and we're focusing our resources to make that vision a reality. On the Score side, the business continues to perform very well. Scores were up 31% in the quarter versus the prior year. On the B2B side, revenues were up 25%. There was continued strength in mortgage originations, which grew substantially year-over-year and also sequentially. We'll see more difficult comps in the back half of our year as it's now been a year since the refi boom began. Auto origination volumes were fairly flat, but revenues were up versus the previous year. We're continuing to see positive signs in cards and other unsecured loan activity. Volumes were still down from last year, but were higher than Q1. The price increases we instituted are starting to have an impact, giving us revenue increases in pockets where volumes are weaker. On the consumer side, we continue to drive impressive growth. Our B2C revenues were up 47% versus the same quarter last year. The growth of myfico.com is particularly remarkable, up 82% this quarter versus last year. The continued strong demand is a testament to the quality of our offering and an understanding by consumers that FICO provides the scores that lenders use. Finally, as you know today, we announced the divestiture of our collections and recovery product line. Michael will provide some financial details in a few minutes. But I'd like to explain the strategic rationale behind this move. We're extremely focused on our strategic vision to enhance, expand and distribute the FICO decision management platform. We believe we have an incredible opportunity to be a best-in-class leader in the next wave of business analytic technology. In order to fulfill our potential, we need to make choices to be able to allocate all the resources we can to the platform strategy. The FICO collections and recovery products help customers make important decisions throughout the lifecycle of collections and recovery. These products deliver excellent functionality and serve an important customer need. But the complexity of the underlying architecture makes it impractical to migrate to our platform; coupled with the need for high-touch professional services engagements and customization, it doesn't fit within our strategic framework. So as we did with our ESS divestiture, and as we do with our China joint venture, we've chosen to sharpen our focus and align our resources on our decision platform. I would like to thank the team that built and delivered an industry-leading set of products and solutions that have helped our clients enhance their collections and recovery efficiency, effectiveness and compliance. I want to assure the collections and recovery customers at FICO and Jonas Software are committed to serving our clients without disruption during this transition period. We're confident that Jonas Software will continue to invest in these solutions and support our clients and colleagues with the same commitment and partnership they've come to expect. I'll have some final comments in a few minutes. The first I'll turn the call over to Mike for further financial details.

Mike McLaughlin, CFO

Thanks, Will, and good afternoon, everyone. Today, I'll walk you through our second quarter results in more detail and provide some information on the impact of the divestiture of the collection and recovery products that we announced today. Revenue for the quarter was $331 million, an increase of 8% over the prior year. Our applications revenues were $130 million, down 8% versus the same period last year. The quarterly decrease in revenue was primarily driven by a decrease in upfront on-prem license revenue and professional services revenue. In our decision management software segment, Q2 revenues were $33 million, down 14% over the same period last year. We had an increase of 34% in SaaS subscription revenue in the DMS segment, but that was offset by decreases in upfront on-prem license and services revenue. Now, before turning to our Scores segment, I would like to remind you of the key moving parts that are impacting our application and our DMS segment revenues. First, our on-premise license revenues will continue to be negatively impacted as we move away from perpetual license sales to a ratable subscription revenue model. Second, we have changed our revenue recognition assumptions for on-premise license subscription sales. As a result, we now recognize less licensed revenue upfront, and we recognize more revenue ratably over the term of the deal. The net impact this quarter was lower license revenue on our applications and DMS segment of about $6 million versus what it would have been under our prior methodology. We anticipate the full year impact will be between $45 million to $50 million lower software license revenue this year, all of which will be recognized in future periods. We expect an especially difficult year-over-year license comparison in our fourth fiscal quarter, where last year we booked more than $60 million in upfront license revenue under the prior methodology. As we pointed out in the past, this change in timing will not have an impact on cash flows or the total revenue recognized from software license sales over the term of each subscription contract. Finally, as we explained last quarter, we are de-emphasizing low-margin non-strategic professional services engagement, which is resulting in lower PS bookings and revenues. This is driven by our core strategic goal of selling more high-value recurring revenue software. Professional services are a very important component of our business model, providing installation and configuration services for our software, and advisory and consulting expertise that enables our customers to leverage the power of cutting-edge analytics in their business. These parts of our professional services business are here to stay. The reductions you are seeing in our services business are the result of our strategic decision to focus our energies on these value-added services. Now turning to our Scores segment. Revenues were $169 million, up 31% from the same period last year. B2B was up 25% over the same period last year, driven by continued high volumes and mortgage originations, as well as some unit price increases across our different Score categories. In the B2B business, we also had a royalty true-up and an annual license deal this quarter that had a small positive impact on overall revenues. B2C score revenues were up 47% from the same period last year, with both myfico.com and B2C partner revenues growing significantly. This quarter, 79% of total revenues were derived from our Americas region, while the EMEA region generated 15% and the remaining 6% was from Asia Pacific. Recurring revenues derived from transactional and maintenance sources for the quarter represented 85% of total revenues. Consulting and implementation services revenues were 11% of total revenues, and license revenues were 4% of total revenue. SaaS software revenues, not including related PS revenues, were $62 million for the quarter, up 8.8% from the prior year. Q2 bookings totaled $84 million, flat with the previous year, generating $9 million of current period revenues, a 10% increase. SaaS bookings, including the associated professional services, were $25 million for the quarter, down 19% from the previous year. Professional services bookings of $22 million were down 35% from last year. However, overall software bookings excluding professional services were up 5% year-over-year. We continue to see a strong pipeline for our software products and we feel good about the bookings outlook for the full fiscal year. But again, we do expect bookings to trend lower overall compared to historical numbers as a result of our de-emphasis of professional services sales and somewhat shorter-term lack of typical SaaS and on-prem term license contracts. As a side note, we remain committed to providing our shareholders with more of the common metrics that subscription software companies typically provide in order to give investors a better understanding of our software business. We continue to work to extract and validate the necessary data and we hope to provide it sometime this fiscal year. Our operating expenses totaled $230 million this quarter, compared to $218 million in the prior quarter, which included a $7 million gain on the sale of product line assets. Excluding that one-time gain, expenses were up $5 million, primarily due to increased incentives expense. Compared to Q2, 2020, operating expenses were down $2 million. We do expect expenses to step up somewhat in the back half of the year as we gradually redeploy the restructuring savings we incurred last year to add strategic headcount primarily related to the development of our decision management platform software. We also expect our travel and entertainment expense to increase once we are able to resume in-person meetings with our customers and colleagues. Our non-GAAP operating margin, as shown in our Reg G schedule, was 39% for the quarter, a margin expansion of 700 basis points from the same period last year. GAAP net income this quarter was $69 million, up 18% from the prior year quarter. Our non-GAAP net income was $90 million for the quarter, up 40% from the same quarter last year. The effective tax rate for the quarter was 25%. We expect our FY 2021 recurring tax rate to be approximately 26% to 27%. And we expect the net effective tax rate for the year to be about 19%. That's prior to the impact of the divestiture of our collection and recovery business. We do expect to book a taxable gain on the sale, and we will provide more details on that next quarter. Free cash flow for the quarter was $152 million compared to $55 million in the same period last year, an increase of 178%. For the trailing four quarters, free cash flow was $461 million. At the end of the quarter, we had $198 million in cash, up $53 million from last quarter. Our total debt now stands at $975 million with a weighted average interest rate of 3.9%. Turning to return to capital. We bought back 441,000 shares in the second quarter at an average price of $466 per share. During the quarter, the prior board repurchase authorization was exhausted, and a new $500 million authorization was approved. At the end of March, we had about $470 million remaining on that authorization and continue to view share repurchases as an attractive use of cash. Finally, I'll walk through the expected impact of the divestiture of our collection and recovery products. As Will said, we made the decision to divest these assets to increase our focus on our decision management platform. The collection and recovery products we sold accounted for less than 10% of total company revenues. Because they often involve significant professional service engagements, as much as half of total revenues, they had a much lower margin profile than our platform products. There will be some noise in the next few quarters as we work through the transition. But we expect that this divestiture will not have a significant impact on our pre-tax income. We expect to close the deal sometime in our third fiscal quarter, and the sales proceeds will contribute to funding a $200 million accelerated share repurchase program that we plan to execute once the transaction closes. With that, I'll turn it back over to Will for his closing thoughts.

Will Lansing, CEO

Thank you, Mike. As I said in my opening remarks, we remain focused on our strategy and committed to taking our decision management platform to a growing number of interested customers. At the same time, we are innovating and providing cornerstone value in Scores in both B2B and B2C. Finally, as you know, we haven't provided guidance for this fiscal year; we still see a lot of volatility as we see the global economy begin to open back up. We have tremendous confidence in our business model that is far more focused on providing long-term value than hitting specific numbers for the next few quarters. It's those values that drive us to favor ratable subscription revenue over upfront license revenue. So for now, we're not providing any formal guidance until we see how the credit markets stabilize and we understand the full-year impact of our recognition of license revenues. Now, I'll turn the call back to Steve so that we can do some Q&A.

Steve Weber, Vice President, Investor Relations

Thanks, Will. This concludes our prepared remarks and we are now ready to take your questions. Operator, please open the lines.

Operator, Operator

Thank you. The first question comes from Manav Patnaik with Barclays. Please proceed with your question.

Unidentified Analyst, Analyst

Hey. This is actually Greg on for Manav. I think the divestitures you've made so far make a lot of sense when you explain them. Just wondering if there's any smaller products left out there that could be candidates for similar treatment? Or from here, it's more about being selective in the contract going forward?

Will Lansing, CEO

I would say that this is pretty much the end of the reprioritization of our resources. So we don't see any significant divestitures in our immediate future.

Unidentified Analyst, Analyst

Okay. And historically, M&A hasn't been a big part of the story. As you go through this process of reprioritization and thinking about capital allocation, is there potential for M&A to be a bigger part of the story going forward?

Will Lansing, CEO

I'd say that the potential in the future is about the same as the potential in the past; it's always been there. And we've always had trouble finding anything that we find as attractive as investing in ourselves. Our current plan is to deploy all of the proceeds from this transaction in stock repurchase.

Unidentified Analyst, Analyst

Okay. And maybe last one for me. Just on the sales pipeline for the software business, I think you said you're pretty bullish about what you're seeing. Any color by geography as we see different fits and starts and reopening by geography? If there's any areas that you're seeing more traction, any color, that would be helpful? Thanks.

Will Lansing, CEO

I'd say that South America is strong. But we're seeing signs of the economy waking up across the board. Mike, I don't know if you want to add anything to that.

Mike McLaughlin, CFO

I guess what I would add is the nature of our sales on the software side are lumpy and long sales cycles for the most part. And so month-to-month, even quarter-to-quarter changes in the ability of our customers to have people in the office, to meet face-to-face due to the pandemic and other things, it doesn't necessarily show up with the same frequency as might for a company that has a shorter sales cycle and more high-frequency, lower ticket sales. So, the pipeline that we see in the major regions we serve looks healthy, all things considered in all regions. And I wouldn't be able to identify anything specific that would make one region or another stand out.

Operator, Operator

And the next question comes from the line of Kyle Peterson with Needham. Please proceed with your question.

Kyle Peterson, Analyst

Hey. Good afternoon, guys. Thanks for taking the question. Just want to talk a little bit about the expense trajectory. I know you guys said that you expect those to go up a little bit next quarter, given some investments pick in the DMS side? Does that outlook include the transition of some of the costs associated with the debt collection business? Or how should we think about kind of the expense trajectory and what transition costs and stuff you guys expect to occur?

Mike McLaughlin, CFO

We'll be able to provide more. Can you hear me?

Kyle Peterson, Analyst

Yes.

Mike McLaughlin, CFO

Sure. So we'll be able to provide a little bit more detail on that when we get to the closing. So stay tuned next quarter for any more specifics we're able to share. In general, as we said in our remarks, we don't expect it to have a material impact on profitability, which means that the expenses that we expect to remove are in the ballpark of the revenues that we are selling. And furthermore, we do continue to believe that our expenses for the year relative to last year will be about the same if not down a little bit. So all the trends that we saw in our expenses, not including the impact of collection and recovery divestiture, continue to play out, and we still feel good about the full year.

Kyle Peterson, Analyst

Okay. That's helpful. And then, I guess just on the scores business. Quarter came in very strong. Is there any additional color you guys could give us on what drove some of that strength between some of the recent pricing initiatives that you guys have taken versus just volume with some of the healthy credit markets and the strong B2C business?

Will Lansing, CEO

I'd say, it's more on the volume than on the pricing, although the pricing is trying to feather in as card and some of the places where we put price increases in last year start to pick up in volume. So it's both. But I tip to volume. And then, I think the real strength, mortgage continues to be strong and the real strength I think is B2C is just remarkable.

Operator, Operator

And the next question comes from the line of Surinder Thind with Jefferies. Please proceed with your question.

Surinder Thind, Analyst

Good afternoon. Question on the B2C. Can you provide a little bit of additional color? Obviously you provided some metrics, but the revenue growth sequentially was really strong after there was a temporary pause. Any color in kind of what drove that? Was there additional marketing with your partners that we should be thinking about, maybe some seasonality? Any outlook you can provide would be helpful?

Will Lansing, CEO

No. I would put it in two categories, because the strongest part of it was myFICO. And I'd say it's attributable to very strong execution. There's some seasonality, of course, but I attribute some of the strength to very strong execution and to consumers' increasing interest.

Surinder Thind, Analyst

Got it. And what is the current mix between myfico.com and your partner at this point in terms of the B2C revenues?

Will Lansing, CEO

Here, I'm not sure we break that out. Mike, I don't know that we disclose that. Do we?

Mike McLaughlin, CFO

Yes. We don't disclose that. Sorry.

Surinder Thind, Analyst

Got it. Regarding the special price increases that were implemented, if I understood correctly, you mentioned they are gradually being integrated at this stage. How should we interpret that? Are they fully impacting this quarter, or did only a portion, perhaps half or two-thirds, take effect in the previous quarter? How should we view that distribution?

Will Lansing, CEO

Well, I think you shouldn't think in terms of fully in except that the volumes that they were applied to had lower volumes. And so as those volumes returned, you'll see a little more impact. But at this point, volume is going forward.

Surinder Thind, Analyst

Got it. And if I understand correctly, it was mostly on the card and auto side for the impact?

Will Lansing, CEO

It was spread around; there were card increases.

Surinder Thind, Analyst

Got it. And how far below normalized levels are card volumes at this point? Obviously, auto volumes have fully recovered. We can pretty much track mortgage volumes on a daily basis, but there's less insight into card volume. Any additional color you can provide there?

Will Lansing, CEO

I really can't. I will say that we have seen sequential increases in cards, which you can also see from the results this quarter of the card issuers and the bureaus. So we're seeing the same trends they see, and overall across our categories. So whether it's cards, autos, or mortgage volume trends that we've seen are not inconsistent with what you can see from some others in those businesses.

Operator, Operator

And the next question comes from the line of Caroline Conway with AllianceBernstein. Please proceed with your question.

Caroline Conway, Analyst

Great. Thank you for taking my question. I'm curious about the implications of the divestiture on customer retention and the strategy for expansion into new service areas with existing customers. What seem to me to be beneficial to keep a relatively full suite of financial services products available, especially as we look to drive DMS adoption, but that may be overestimating the role of this product line. So it would be great to get your thoughts on that strategically?

Will Lansing, CEO

No, you're absolutely right that we have many customers who utilize both our collections and recovery product line, as well as other solutions we offer. We've always believed that a broader range of capabilities provides high value to our customers. Our customers won’t be negatively impacted by this. They will continue to receive excellent support, innovation, and investment in this product line from Jonas. We have a strong relationship with Jonas and will collaborate closely. Therefore, I’m not concerned about our customers being well taken care of, as I am confident they will be. This change allows us to allocate resources and investment towards enhancing the platform side of our solutions for customers. There's no doubt that this is the right area for us to focus on.

Caroline Conway, Analyst

Great. And just as a follow up to that, are there any other components of the relationship with Jonas that you're expecting to emerge? Are there any products that you're expecting to leverage from their side?

Will Lansing, CEO

No. It's really around collections and recovery. But then we have some parts of our FICO that will continue to operate in and near and around the collection space. For example, FICO advisors will continue to provide consulting, advice around collections. But generally speaking, the business is turned over to Jonas, and we'll make sure that the transition is seamless.

Operator, Operator

The next question is from Jeff Mueler with Baird. Please proceed with your question.

Jeff Mueler, Analyst

Thank you. Good afternoon, on myFICO, so recognize your brand strength, recognize that part of the market is doing well in terms of the branded paid channel. I guess the indirect and some lead gen players pulled back. I'm not talking about your partners; I'm talking about alternatives in the market pulled back at points over the last year, which I think benefits the myFICO channel. Anything further you can say about execution? If it's changes in how you're going about marketing or changes in product? What I'm trying to get comfort with is some sustainability of myFICO strength if some of those lead gen partners start to lean back into the market?

Will Lansing, CEO

It's a good question. It's challenging for us to determine whether the impact is due to their pullback or our strong execution. It appears that there is significant interest in monitoring credit, especially during these times. myFICO.com is a natural choice for this. While our marketing efforts are relatively modest, our brand strength is evident, as we have over 90% aided awareness of the FICO brand in the U.S. It's not surprising that we are receiving considerable attention. We will always aim to position ourselves as an innovation leader with comprehensive products. We strive to be the premium product in the market while also experimenting with new offerings that we encourage our partners to adopt.

Jeff Mueler, Analyst

Okay. And then just maybe any update on the uptake or usage of the resilience score index?

Will Lansing, CEO

It continues to be used, and it's in test with essentially. We actually have quite a number of lenders using it now. And so far, the feedback is very positive. We're not charging for it, so it doesn't have any revenue impact.

Jeff Mueler, Analyst

I understand we will receive the new financial metrics later this year, but could you clarify what you consider on-strategy revenue? It seems like there are multiple components such as DMS, DMP, and the SaaS versions of various products. You provided a metric that excludes professional services. Can you clarify what you see as core on-strategy revenue and its current status?

Will Lansing, CEO

Let me turn this over to Mike in just a minute to answer that question more fully. But what I would say is everything that we have left in our portfolio is what we want to have in our portfolio. It's a combination of legacy products and our platform products. We've been in a process of migrating the capabilities from legacy products to the platform. As a result, increasingly, the new sales happen on the platform, and we consider that to be truly strategic. So platform sales are where we want to be because they allow our customers to leverage a platform for small incremental investments to get a lot of incremental benefit. I mean, there are benefits for FICO and for our customers on the platform. That said, we have a really large business of FICO Solutions that are in place, on-prem, some in the cloud, but mostly on-prem. And we anticipate that those will be in use by our customers for many years to come. We continue to invest in those. We will continue to maintain those, and we will continue to make sure that our customers are getting the full benefit of the investment that they made over past years. As they're ready to migrate to the platform, we'll be ready to take them there. But the business really has both sides. What you'll see is that the, call it, legacy solutions, the off-platform solutions, we're not selling nearly as much of that going forward. The energy is going into selling the platform. But we'll be supporting both. Mike, if you want to add anything.

Mike McLaughlin, CFO

Sure. Hey, Jeff. Look, as we think about how to recast our reporting to be more helpful to you and our shareholders, the principles are the focus on recurring software revenue, hence are beginning to shine more of a spotlight on the services revenue because those are declining. We're trying to make them decline, but we're just trying to focus on the services that really add value and let them reach their natural level in terms of revenue. The margin profile is not such that we generate a whole lot of value out of the services directly that adds value to our customers and increases the stickiness, and all that. But PS revenue for PS revenue's sake is not something we're seeking. So our focus is on recurring software. Our metrics will help you see that more clearly. Second, the apps versus DMS distinction is less and less relevant. It's been in place for a long time in our disclosure, but it's outlived its usefulness. So we're likely to simplify and talk more about software versus scores as opposed to applications scores and DMS. Finally, the key – the prime directive in our software business is the platform. So we'll help you get better insight into what our platform revenues are doing and what's happening in our revenues that are to-be platforms, not yet, but on the roadmap. So those are the things we're trying to achieve as we think about how best to expose it to you.

Jeff Mueler, Analyst

I think we all look forward to that. So thanks, guys.

Operator, Operator

And there are no further questions at this time. I will now turn the presentation back to Mr. Weber.

Steve Weber, Vice President, Investor Relations

Thank you. Thank you, everyone for joining today's call. Have a good day. We look forward to speaking to you again soon. Thank you.

Operator, Operator

And that does conclude today's conference. We thank you for your participation and ask that you please disconnect your line.