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Executives

John D. Emerick - Jr., Vice President, Corporate Development and Treasurer

Dr. Mark N. Greene - Chief Executive Officer

Charles M. Osborne - Executive Vice President and Chief Financial Officer

Analysts

Michael Nemeroff - Wedbush

Kyle Evans - Stephens

Fair Isaac Corp. (FIC) Q4 2008 Earnings Call November 5, 2008 5:00 PM ET

Operator

Good afternoon. My name is Christie and I will be your conference operator today. At this time, I would like to welcome everyone to the Fair Isaac Corporation Fourth Quarter Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. [Operator Instructions].

Thank you. Mr. John Emerick, you may begin your call.

John D. Emerick - Jr., Vice President, Corporate Development and Treasurer

Thank you very much Christie. Good afternoon everyone. I’m John Emerick of Fair Isaac and I thank you for joining us for our fourth quarter and fiscal 2008 earnings conference call. A replay of this call will be available on our website through December 3rd, 2008.

The forward-looking statements made on this call and in the news release distributed today should be viewed with caution. These statements represent our guidance and outlook as of today and are subject to risk and uncertainties, which could cause actual results to differ materially from those expressed and/or implied by these statements. These statements may include statements concerning our business strategies and reengineering plan and the actual expense, revenue and net income impact associated there with. We assume no obligation to update the forward-looking statements included on this call whether as a result of new developments or otherwise.

Fair Isaac’s product roadmaps and similar marketing materials should also be considered forward-looking and subject to future change at Fair Isaac’s discretion. Any future functionality, features or enhancements discussed today are Fair Isaac’s current projections on the product direction, but not specific commitments or obligations. You may obtain additional information concerning a variety of factors and risks that could cause actual results to differ materially from today’s forward-looking statements by referring to our annual report on Form 10-K for the year ended September 30, 2007, as subsequently amended, which is filed with the Securities and Exchange Commission and in other reports we file from time to time with the commission.

Specifically, please refer to those sections in our Form 10-K and Form 10-Q reports entitled forward-looking statements and risk factors. These reports that we file from time to time with the commission are publicly available on the SEC website sec.gov and on our website fairisaac.com. A reconciliation of certain supplemental pro forma information that we provide to the most comparable GAAP information is posted on the Presentations page found within the Investor Relations portion of the Fair Isaac website.

On the call with me today are Mark Greene, our Chief Executive Officer, and Chuck Osborne, our Chief Financial Officer.

Now, I’ll turn the call over to Mark.

Dr. Mark N. Greene - Chief Executive Officer

Thanks, John. Good afternoon. We’ll proceed today in three parts. I’ll first discuss Fair Isaac strategy and our recent performance against that strategy. Then Chuck will provide further financial details. Finally, I’ll discuss our outlook before we together take your questions.

Let me begin by reprising our strategy. Fair Isaac is the leader in decision management, transforming businesses by making every decision count. We provide analytics and scores, rules management tools, and applications to help firms manage their relationships with consumers over their financial life cycle. This ranges from marketing, to acquiring new customers, originating new accounts to them, managing those accounts for profitability, collecting receivables, and preventing fraud. Our strategy has been to see growth by driving these offerings and four industry verticals with strong spending opportunities, financial services, insurance, retail and healthcare. And to expand beyond our traditional US and Western European footprint into growth markets such as China and Latin America.

Over the course of the past fiscal year, this has meant shifting resources to building new products and cultivating new clients. To fund these growth initiatives and to ensure proper returns to shareholders, we instituted this past March an ongoing reengineering for growth discipline, in which we continually look for ways to work more efficiently to improve product profitability and to remix towards high margin, high growth businesses.

Under this reengineering program, we significantly retooled our sales, marketing, development and service delivery functions. We attacked our operating expense base of $657 million, reducing it by $100 million and to various efficiency measures including the sale or exit of several unprofitable business lines with an associated 350 person in headcount. We also reallocated $30 million towards growth initiatives.

As we completed this work over the past summer, we felt well positioned to achieve modest revenue growth in our fiscal ’09, which began on October 1st. The global financial crisis, which erupted in late summer, altered this picture. We saw in the closing weeks of September two negative effects. First, software purchasing activity slowed as some banks stopped procurements to conserve cash. Second, the crisis depressed transactional revenues such as PreScores used for financial account marketing purposes.

For details, let me turn now to our fourth quarter results. Revenue for the quarter was a $178 million. We saw strength in two areas. Geographically, Asia Pacific grew 18% and Latin America grew 34% compared with the prior year quarter. Product wise, full year collections and customer management applications grew 11% and 7% respectively, validating the relevance of these offerings in a current financial crisis.

In the quarter, we also enjoyed a significant win for our customer management transactional analytics platform at a large North American bank. We saw revenue weakness in three areas. First, new software licenses were $4 million below our expectations, as several banks froze spending in late September to conserve cash. This phenomenon occurred on both sides of the Atlantic, with three procurements frozen in North America, two in Latin America and one in Europe. Second, scoring revenues were $3 million below our expectations, as we observed a substantial fall-off in mid September of PreScores used for marketing. And third, professional services were $2 million below our expectations as clients’ access to slowdown previously contracted implementation engagements to lighten their operating expenses.

Turning now to bookings, bookings were $71 million in the quarter against $64 million in the prior quarter. For the entire fiscal year, bookings totaled $327 million compared with $302 million in the prior year. I credit our sales force for achieving such bookings growth in the face of difficult market conditions.

And earnings per share for the quarter were $0.49 versus guidance of $0.36. $0.03 of this over achievement came from operations, where our revenue decline was more than offset by improved expense disciplines resulting from reengineering. An additional $0.10 per share came from a one-time favorable tax adjustment.

We remain highly focused on driving shareholder returns through a stringent expense controls in the face of a difficult and unpredictable revenue environment. I’ll have more to say on this when we talk about the road ahead. But, first let me turn the call over to Chuck for further financial details.

Charles M. Osborne - Executive Vice President and Chief Financial Officer

Thank you, Mark. Let me address a few of the details surrounding our financials. Revenue from continuing operations in the quarter was $178 million, a 3% decrease from the prior quarter and a 10% decrease from the same period last year. Revenue for fiscal year ’08 was $745 million, a decrease of 5% from last year’s continuing operations of $784 million.

Fully diluted GAAP earnings per share from continuing operations for the quarter were $0.49, a 27% increase from the prior quarter and an 18% decrease from the same period last year. These share results are higher than the second half guidance of $0.74 that we offered in April. Our GAAP EPS for fiscal 2008 was $1.64, a 15% decrease from fiscal 2007 GAAP EPS of $1.94 per fully diluted share and higher than our guidance of $1.52 for the year.

Bookings from continuing operations for the fourth quarter were $71 million, from which we generated roughly $15 million of current period revenue, a 24% decrease as compared to bookings of $93 million, yielding $25 million in the same period last year.

Overall, during the quarter we experienced reduced levels of bookings as financial institutions slowed their investments in new projects. Some of our largest deals represented renewals of business already in place and therefore are not reflected in the new bookings.

Our transactional or recurring revenue for the quarter represented 76% of total revenues, against 73% for the same period of the prior year. Consulting and implementation revenues increased to 19% of total revenues this quarter from 18% in the same period last year. Finally, one-time or license revenues were 5% of total revenue, against 9% in the same period last year. This quarter, 34% of total revenue came from outside the United States, compared with the 30% international share reported last year during the same period. Our international business is growing both in absolute size and relative importance, reflecting our emphasis on geographic diversification.

Our operating expenses presented as a percentage of revenue break down as follows; cost of revenues was 37% for the quarter and fiscal year as compared to 34% in the same quarter last year and 33% for fiscal 2007. This is primarily the result of higher personnel costs relating to both increased salary rates and the shift in our revenue mix towards labor-intensive professional services activities.

Research and development costs were 11% for fourth quarter and 10% for fiscal 2008 compared to 9% in the same quarter last year and full fiscal year. This reflects increased investments in our scoring initiatives and development of our decision management applications.

Finally, selling, general and administrative costs were 32% for fourth quarter and 33% for fiscal 2008 compared to 35% for the same quarter and prior fiscal year. This decline is the result of lower commissions, fewer general and administrative personnel, reduced share based compensation, and decreased travel expenses.

Net income from continuing operations in the quarter was $24 million, a $5 million or 26% increase over last quarter, and a $9 million or 27% decrease from the same period last year. The fourth quarter net income from continuing operations was helped by lower personnel expenses, lower commissions, and lower direct materials costs. It was hurt by a $1.5 million after-tax charge for severance costs and charges relating to facilities closures.

Net income for fiscal 2008 was $81 million, a 27% decrease from fiscal 2007 income of a $112 million. This decrease resulted from lower revenue, continued investments in China, reengineering charges, and lower net interest income, all of which were partially offset by lower operating costs and a tax benefit this quarter from the reversal of valuation allowances previously established from foreign losses.

Turning to our cash flow, we define free cash flow as cash flow from operations less capital expenditures and dividends paid. Free cash flow for the trailing 12 months is currently $132 million. This decline from previous periods can be attributed to lower revenue, reengineering costs, and new investments in growth initiatives. However, with free cash flow of roughly 18% of our revenues, the Fair Isaac business model is inherently strong and positions us well for future growth.

Looking at our capital structure, on August 15th we paid off the $266 million in bonds that were put to the company. After the put, $323,000 of bonds were outstanding, so we called these bonds and retired the entire contingent convertible effective September 16th.

In May, we had utilized funds from our private placement to repay the majority of the outstanding balance on our revolving line of credit. In August, we drew down on the revolving line of credit and used a small amount of cash for the repayment of the convertible bonds. The current amount outstanding on our revolver is $295 million.

This quarter we did not repurchase any shares in the open market as our strategy in this tumultuous time is to conserve cash. Our fully diluted share count is essentially unchanged at 48.6 million shares. As of September 30th, we had $148 million remaining under our existing share repurchase authorization.

Now, let me turn the call back to Mark for concluding remarks. Mark?

Dr. Mark N. Greene - Chief Executive Officer

Given the recent unprecedented volatility in financial markets and our limited visibility into customer spending intentions, we are not providing guidance on this call. We remain in close dialog with our clients especially those in banking to better understand their business strategies and likely spending plans. Simultaneously, we are reviewing our own strategy to ensure that we are focused on delivering solutions of greatest value to the marketplace. We expect these efforts will yield greater clarity and permit us to provide fiscal ’09 guidance by the time of our first quarter earnings call in January.

Let me now provide an update on the current health of our business and on the opportunities as well as pressures that we see in front of us. Concerning the fundamentals of our business, we continue to strengthen the company’s core business processes and operations.

Starting with development, our development teams are performing well, having fully embraced the IBM technology partnership and adopted a unified development methodology and architecture across all of our product lines.

In the last quarter, we shipped new versions of our Blaze and TRIAD account management product with advanced rule visualization capability. Our new decision management applications are on track for delivery as previously committed. Starting in December of this year, with our Debt Manager 7 product for collections and recovery, which adds new capabilities for mortgages and home equity loan workouts; and continuing in April 2009, with Falcon 6 for Fraud Management, which will add some new adaptive analytic capabilities to that product. Our development team has also delivered the latest version of our FICO score, FICO 08 to two of our credit bureau partners.

Moving on to sales, our sales teams have fully standardized on a professional pipeline management discipline, which includes strategic account planning and detailed deal close plans. This level of account intimacy is important in the current era of turbulence among our clients. We’ve also continue to build out our indirect sales channel. We are well engaged with our bureau partner, Equifax, on the scoring partnership announced in June and now have a variety of joint go-to-market campaigns underway. We are also building out our system integrator channel and we will be announcing tomorrow a new partnership with Infosys, adding to our existing strategic alliances with IBM and Accenture. Fair Isaac is now actively partnered with Infosys on opportunities in our marketing services business and on Blaze rules management opportunities in several industries and geographies.

Next, our research group is focused on bringing our best talent and products to bear underneath to the financial services industry. We recently formed a new mortgage research partnership with most of the Top Seven US mortgage originators, to develop timely solutions to the global credit crisis. This includes, for instance, the use of credit risk management tools and scores on consumer financial health in the context of mortgage and home equity loan workouts.

Outside of banking, our research team is using the innovation management process established earlier this year to bring three new predictive analytic products to market: one to help insurers’ fight fraud, one to help retailers cross sell merchandise, and one to help healthcare providers to manage their receivables.

Let me now turn to the future, the challenges and opportunities that we see in the months ahead. The credit crisis has two main implications for our business. The first is consolidation in the banking industry, which has a mixed impact. For sales of our new software licenses, we expect a slightly larger slice of a smaller IT pie, since Fair Isaac tends to benefit from a flight to quality when banks merge in challenging times. For our transactional businesses, consolidation has less impact since our revenues are tied to the number of consumer accounts rather than the number of banks. Overall, consolidation in the banking industry will likely cause a moderate reduction in our financial services revenue stream.

The second phenomenon is budget restraints in this economic down cycle, which also has two consequences. IT spending in our markets had been growing at about 7% a year, but it’s now projected to shrink between 1 and 5% in 2009. At the same time, our decision management offerings are increasingly relevant with strong value propositions that our clients find very attractive. The net impact of this new budget conservatism is yet to be seen.

Let’s consider how these factors impact our scoring, tools and application businesses. Scoring is perhaps the most volatile business and needs to be understood in two parts. The smaller portion is our consumer business, which we expect will continue to grow as consumers increasingly monitor their own personal financial health. The larger portion is scores sold to financial institutions through our bureau partners. The volume in such business fell roughly 15 to 20% in September as banks throttled back on new account acquisition. Volumes now appear to have stabilized at this lower level and we currently expect them to remain stable in the near-term. This means that we will see year-over-year declines for the next few quarters, followed by improvement as origination activity picks up coincident with an expected economic recovery.

Next, our tools. Tools such as Blaze Rules Engine and Model Builder are very relevant in the consolidation wave, now in the banking industry since they can be used to enforce consistent decisioning processes, such as credit risk management across merged banks. As some banks move to a build-it-yourself model, we expect to see modest growth in our tools revenue.

And thirdly, our applications business, applications for decision management resonate well with banks in the current environment as they seek to know their customers and maximize the lifetime value of each consumer relationship. However, some banks profess limited ability to spend on these applications under current conditions, and we do know that these applications have long sales cycles even under normal circumstances. We, therefore, expect our applications revenue will remain under pressure throughout fiscal ’09 with improved prospects in fiscal ‘10.

The overall result of these factors is unclear; although likely we see some erosion in revenues for the next several quarters followed by return to growth as the financial services industry recovers. We are working with our clients to better understand this financial trajectory and we expect to deliver fiscal ’09 guidance by the time of our first quarter earnings call.

That said, be sure that no matter what revenue guidance we provide, we fully expect to remain solidly profitable to this downward economic cycle. Our confidence in this is derived from our aggressive expense management program and our strong base of recurring revenue, which provides great stability to earnings. Fair Isaac remains a company in very good financial health. We are solidly profitable, having generated free tax profits of $113 million last fiscal year. We produced substantial free cash flow, which totaled $132 million in fiscal ’08 and we have a strong balance sheet with ample liquidity consisting of $259 million in cash and a conservative net debt outstanding of $311 million.

We continue to aggressively manage or expenses to maximize earnings. Under our reengineering program, we have frozen new hires and salary increases. We are further trimming non-revenue producing headcount and are clamping down on discretionary expenditures such as non-revenue producing travel and marketing programs.

While the near term challenges are significant, we have the appropriate controls in place to both generate solid earnings and to keep investing in our decision management strategy, a strategy that is particularly relevant in these trouble times.

Now, Chuck and I will be happy to take your questions. Operator, please open the line for Q&A.

Question-and-Answer Session

Operator

[Operator Instructions]. Our first question comes from the line of Ariel Schochet. Your line is open.

Michael Nemeroff - Wedbush

Hi. It’s actually Michael Nemeroff. Thanks guys for taking my questions. Just one for Mark. Obviously it’s a tough environment and I can appreciate the no guidance right now. But can you just give us a sense of how much worse do you think the environment could get and is it possible that you will not be able to grow revenues from continuing operations in 2009?

Mark Greene

Well, anything is possible at this point. I guess I would admit to limited visibility. I do have two answers for you. With respect to the scoring business, I’ll point you back to my comments that said, the recent evidence suggest that that is stabilizing at the rate that we saw exiting the quarter, which will mean of course when you do the year-on-year math that there’ll still be some decline, but we don’t see the going forward rate of scoring continuing to fall as it had in late September. So we see signs of stability there. That’s encouraging. We keep monitoring that on a daily basis.

With respect to software license sales, I guess what I would say is the pipeline continues to look good as it did last quarter, but the lesson we took away from last quarter was a fair number of deals that looked good to go, which we had authority and approval, got pulled by the customer as they moved to cash conservation. And we are still talking to clients to understand whether those disciplines remain in effect or whether they have been relaxed. So I’d say there is latent demand for our products. What we have to do is satisfy ourselves that we can convert that into actual business.

Michael Nemeroff - Wedbush

Okay. And then also, so far you’ve identified approximately $100 million in cost. Just wondering how much more you could potentially cut if, for example, the environment doesn’t improve as you are expecting it to in the back half of ’09?

Mark Greene

In my remarks at the end where I talked about some additional trimming of staff, salary freeze, hiring freeze, et cetera, we are targeting in the range of 5% of our operating expense. That’s on top of the previously worked out 15% or so of our cost base. So you should take the 15% that we did earlier in this year and tack on roughly 5% that we are doing as we speak.

Michael Nemeroff - Wedbush

And then just one more, one for Chuck, if I may. You’d mentioned that the cash flow has been strong and stable. I was just wondering why you wouldn’t be repurchasing shares in this market if you don’t think that the cash flow is at risk?

Charles Osborne

Well, even thought the cash flow is not at risk, we still have net debt on the books. We are frankly still looking to invest in our products. The decision management suite still is consuming development cost. We have the usual amount of CapEx that goes with the refresh of our servers. And then lastly, in the geographic expansion, we are still making some investments overseas, particularly China. So we are conserving cash for those reasons. You might also take a look at our balance sheet with our receivables. We fully expect in sometime, we might see some of the banks stretching some of our receivables out. We are just guarding against balance sheet flux like that.

Michael Nemeroff - Wedbush

Great. Thank you very much.

Charles Osborne

Thank you.

Operator

[Operator Instructions]. Our next question comes from the line of Kyle Evans. Your line is open.

Kyle Evans - Stephens

Hi, thanks for taking my questions guys.

Mark Greene

Hi, Kyle.

Kyle Evans - Stephens

Like to start off with, last quarter you were kind enough to split the scoring revenue decline into three components; PreScore pricing, volume and a one-time true-up. Looking at the decline this quarter, could you do some thing similar for us?

Mark Greene

Sure. There was no one-time true-up this quarter, so no anomalous events. Pricing, while we continued to see competition out there, I wouldn’t tell you that we had pricing declines. In fact, one thing to know about our business is that many of our clients paid on a pricing grid where the price is a function of the volume driving and as their volumes have fallen off, some of our clients are paying a higher unit prices for their scores. So, if anything scoring prices are holding up to rising over time. So, the phenomenon that we are talking about, what we observed in the quarter is essentially all volume reduction and roughly half of that was in the front half of the scoring life cycle, these are the PreScores and the other half was sprinkled around various parts of the spectrum. Although off late, there is encouraging signs on the back part of that life cycle as for instance many banks are now moving towards monthly polls of what we call Account Management Scores to stay in touch with the financial health of their borrowers, where as in past they only used to do so quarterly. So, we are actually seeing signs of late that scores will be in greater demand in the mid and late stages of the life cycle, even though we still see weakness at the front part of the life cycle in the PreScore area.

Kyle Evans - Stephens

Great. I know we are not going to get detailed segment operating income and margins until you guys file the 10-K, but could you give us some rough sense or directional sense for what scoring margins are going to look like when we get that document?

Charles Osborne

Yeah, I think those will still be very profitable right now without full allocations against it. We are probably in the 70 to 80% margin on scoring.

Mark Greene

The scoring margins are generally holding up. The problem that we have is the volume problem, not either a price or margin problem.

Kyle Evans - Stephens

Okay, great. Could you describe any competitive shifts that you’ve seen in the software side. I know it sounds like the pipeline is healthy, you just can’t get it to come through, but have you seen any change in the landscape there since IBM acquired ILOG?

Mark Greene

No, actually to my knowledge and you may know better that deal is not closed, so the acquisition is pending and the answer is no, at least with respect to customer purchases. And in fact we’ve seen something of the reverse with respect to some of ILOG’s distributors and partners, many of whom are interested in doing business with Fair Isaac instead. So, this is fairly typical in the industry, you tend to get that kind of near term positive pop and we are seeing some of that in the channel and not seeing much behavior change at all with respect to end customers.

Kyle Evans - Stephens

Okay, one last question I’ll get back in the queue. How material was the drag that went in North America end of period and was that something that you guys expected when you issued guidance last quarter? Thanks.

Mark Greene

Well, it’s certainly within the pipeline and right now in front of me I don’t have the data on the actual size of the deal, but it would be over a period of time, it was about a $10 million booking. I can’t tell you exactly which period. It falls into the future as well; water falls out into our revenue stream.

Kyle Evans - Stephens

Okay, thank you.

Mark Greene

Thank you.

Operator

We have no further questions at this time.

Dr. Mark N. Greene

Thank you very much, operator. We appreciate it.

Charles M. Osborne

Thank you all.

Dr. Mark N. Greene

Have a good day.

Operator

Thank you so much for your participation today. Our call is over. You may now disconnect.

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Source: Fair Isaac Corp. F4Q08 (Qtr End 09/30/08) Earnings Call Transcript
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