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Executives

John Emerick – VP Investor Relations

Mark Green – Chief Executive Officer

Tom Bradley – Chief Financial Officer

Michael Campbell – Chief Operating Officer

Analysts

Carter Malloy – Stephens Inc.

[Mike Latimore – Northland]

Michael Nemeroff – Wedbush Morgan

Fair Isaac Corporation (FIC) F3Q09 Earnings Call July 22, 2009 5:00 PM ET

Operator

I would like to welcome everyone to the FICO third quarter '09 earnings conference call. (Operator Instructions) Mr. Emerick, you may begin your conference.

John Emerick

Good afternoon everyone. Thank you for joining FICO's third quarter earnings call. I'm John Emerick, VP of Investor Relations and I'm joined today by CEO Mark Greene, CFO Tom Bradley and COO Mike Campbell.

You will find on the investor relations portion of the FICO website a copy of today's press release, our Rate G disclosure schedule and a new financial highlights presentation. A replay of this webcast will be available through August 22, 2009.

Certain statements made in this presentation may be characterized as forward-looking under the Private Securities Litigation Reform Act of 1995. Such 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 portion of such filings.

Copies are available from the SEC, from the FICO web site, 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 including free cash flow, adjusted EBITDA and operating expenses excluding restructuring charges.

A reconciliation of these non-GAAP financial measures to the most directly comparable GAAP financial measures entitled Reg G disclosure is available on the investor page of our website under the presentations tab.

Now I will turn the call over to Mark Greene.

Mark Greene

We'll proceed today in three parts. First, I'll summarize the quarterly results and assess our business in light of current market conditions. Then Tom Bradley will provide further financial details. Finally, I'll discuss our strategy and business outlook for the quarter ahead before we take your questions.

Revenue in the third quarter of fiscal 2009 was $156 million, down 15% from the prior year, but only 2% from the prior quarter. GAAP earnings per share from continuing operations in the quarter were $0.37 flat with the prior quarter and down 3% from the prior year.

After adjusting for an $0.08 per share loss from the sale of product line assets and restructuring charges, this equates to non-GAAP earnings per share from continuing operations of $0.45 which compares favorably with the $0.42 reported a year ago.

That $0.08 charge booked in the quarter resulted from the June sale of two applications specific to the telecom industry as part of our previously announced strategic refocusing. Those two sales complete the divestitures of all non strategic products and now allow us to focus full attention on our four core industries; banking, insurance, health care and retail.

For the past year, we've emphasized stringent cost containment to protect earnings in the face of a challenging revenue environment and this quarter was no exception. These efforts have paid off in improved non-GAAP operating margins which increased from 23% a year ago to 25% last quarter to 28% this quarter.

Thus, we've nearly hit the 30% non-GAAP operating margin target set forth in our business model. Importantly, this improvement in profitability is taking place even as we maintain significant investments in sales, delivery and in research and development which reached almost 12% of revenue this quarter.

Let me discuss the quarter's results according the segments of our decision management portfolio; namely scoring, which are the analytics used to asses the risk of various transactions and entities, applications which use these scores to help businesses make smarter decisions over customer life cycles, and software tools such as Blaze rules and optimization engines on which these applications are based.

Starting with scoring, scoring revenue increased 11% over the prior quarter. This increase is consistent with normal [inaudible] and does not necessarily indicate a turning point in our market. Scoring revenues grew principally from credit bureau risk scores which were up 12% partially benefiting from a surge in the refinance volumes as mortgage interest rates fell below 5% early in the quarter.

We had three positive developments in our scoring business this quarter. First, the latest version of the classic FICO score, known as FICO 08 is available this month at all three U.S. credit bureaus. Over 400 lenders are using or testing FICO 08 which provides up to twice the improvement in predictive power compared to previous FICO editions.

Second, to enhance consumers' access to their personal FICO scores, we launched a score view service which makes FICO scores available online at internet banking sites. During the quarter, we were pleased to sign a major U.S. credit card issuer to this service meaning that millions of their consumers will soon have free access to their individual FICO scores when they bank online.

These consumers will also be provided free educational offerings on credit literacy and the opportunity to purchase credit monitoring services from our Myfico website.

And third, continuing our emphasis on innovation, we announced with our partner Equifax, the availability of a new credit capacity index which is the first forward-looking risk management tool that rank orders consumers based on their ability to take on future debt. We've already seen considerable interest in this credit capacity index which will help lenders to strengthen their account acquisition and account management strategies while minimizing exposure to potential losses by not burdening consumers with too much debt.

The credit capacity index, coupled with the classic FICO score now provides a multi dimensional view of consumer risk.

Turning to our next segment; applications. Applications revenue fell by $5 million or 6% from the prior quarter. $3 million of this drop occurred in our consumer scoring business which has historically been reported as part of applications although that will likely change as we move through our next fiscal year. This decline was mostly due to experienced withdrawal from the Myfico website.

$2 million of the drop in applications occurred in our traditional decision management portfolio with varied results across different phases of the life cycle. At the front end of the life cycle, we saw growth in precision marketing solutions. This was offset by weakness in account management where revenues declined slightly due to consolidation and account closing activity among banks.

We were encouraged by the strong pipeline developing for many of our applications including our new fraud products for credit, debit and EDA, known as [stock and six] and a product for insurance known as insurance fraud manager.

We expect these pipelines to convert into bookings and revenue in the quarters ahead recognizing that it often takes at least six months of deployment before such applications start to generate new transactional revenues.

Our third category is tools. Tools revenue increased by 15% over the prior quarter and 4% over last year. This segment consists of our world management, modeling and optimization tools. This quarter, we secured several wins for our express optimization and Blaze rules management tools including an enterprise agreement with a large credit card organization which has adopted Blaze as its global platform for rules based applications.

While we support these foreign applications and tools offerings and services, chiefly consisting of consulting and assistance in integration work. After accounting for a one time deferred revenue adjustment last quarter, our services revenue has remained essentially flat over the last three quarters.

We're maintaining a healthy roster of service professionals in the belief that their skills will be in demand as we sign and in deploying the engines that we now see in our applications pipeline.

To summarize the quarter, I'm proud of these results overall. The modest revenue decline suggests that we're beginning to stabilize the business. More importantly, we've made dramatic changes to the cost structure of the business, reducing expenses by over $80 million year to date while achieving strong bottom line results and positioning us for even strong profitability when the economy recovers.

Let me now pass the call over to Tom Bradley for further financial details.

Tom Bradley

I'll start with revenue and as Mark mentioned, revenue for the quarter was $156 million, a modest 2% decline from the prior quarter. Recurring revenue for the quarter represented 77% of total revenue, an increase from the 74% for the same quarter last year, and a 1% increase from last quarter.

This high percentage of recurring revenue is a testament to the strength of both our Falcon and Kayak brands as well as the retention rate on our maintenance revenue. Consulting and implementation revenues were 18% of total this quarter versus 21% in the same period last year. One time license revenues were 5% of total and mainly consistent with last quarter and the prior year quarter.

Finally, our international business this quarter was 30% of total for $47 million compared to 32% or $51 million last quarter and 31% and $58 million from a year ago period. At constant exchange rates, roughly $5 million of the $11 million year over year decrease was caused by a stronger U.S. dollar.

Regarding bookings, we had total bookings of $49 million this quarter which created $11 million of current period revenue, a 22% yield. We believe our pipeline is strong for the Falcon IFM products as well as from stabilizing market conditions. This should tend us towards larger and longer term contract bookings in future quarters.

Moving to expenses, third quarter continued to benefit from our expense management effort with operating expenses before restructuring and asset sale charges equal to $120 million, a 6% decline over last quarter and 21% lower than last year.

As we've noted in past calls, these savings cut across most categories, but we are intentionally maintaining investments in sales, delivery and R&D.

Regarding the asset sales that were mentioned, we previously announced that we divested two product lines this quarter; liquid credit for Telecom and Romax. These product generated $5 million of revenue during the third quarter.

We recorded a $2.9 million non cash pre cash charge on these divestitures due to the reduction of good will associated with the products. Because the good will is not deductible for tax purposes, our after tax loss was $3.9 million or $0.08 per share.

Looking to the bottom line, income from continuing operations this quarter was $18 million, essentially flat with last quarter and a 4% decrease from the same period last year. These amounts reflect the after tax impact of the previously discussed restructuring charges and asset sales.

This results in earnings per share from continuing operations of $0.37 this quarter which compares to $0.37 last quarter and $0.39 the same quarter last year. The effective tax rate was about 36.5% for the quarter, an increase from the prior quarter as the level of income from the United States increased relative to the other geographies.

Additionally, the provision for income tax includes a discrete tax expense associated with the sale of the Telecom product lines. This increased our tax rate by 3% for the quarter. Our year to date effective rate is 30.5%.

I think the fact that our revenue declined by only 2% and the operating expenses declined by more than 6% is good evidence of the efforts we've undertaken to deliver the highest possible profitability in this environment.

In fact, as Mark mentioned and as you can see in our Reg G schedule, non-GAAP operating margin before restructuring and sale related charges, amortization and stock based comp increased 28% this quarter, continuing the improving trend.

I'll finish with cash flow and the balance sheet. We define free cash flow as cash flow from operations less capital expenditures and dividends paid. The free cash flow for the quarter was $34 million or 22% of revenue compared to $38 million or 21% of revenue in the same period last year.

Our year to date free cash flow is $110 million or 23% of revenue compared with $93 million or 16% of revenue from the prior year period. This improvement is driven by our previously discussed expense reductions and from effectively managing our accounts receivable.

This ongoing cash flow further strengthens our liquidity position. We now have $372 million in cash and marketable securities on the balance sheet plus $260 million available against our revolving credit facility which means we have a total of $632 million in immediately available liquidity.

Our debt remains unchanged from last quarter, consisting of a $295 million balance outstanding on our revolver which carries an all in interest rate of 1.74% and $275 million in outstanding notes. The ratio of our total net debt to adjusted EBITDA is now down to 4.4 times, well below the covenant level of 3 times.

We did not repurchase any shares in the open market this quarter and our fully diluted share count remains essentially unchanged at 48.9 million shares. We have $148 million remaining under our existing share repurchase authorization. In light of the increasing cash position and our ongoing ability to generate free cash flow, we are now evaluating how to best deploy accumulated cash to maximize share holder value.

I'll turn the call back to Mark.

Mark Greene

In this concluding section, I'd like to update you on the health of our business and prospects going forward to the end of the fiscal year. Let me begin with scoring.

Scoring revenues continues to be hard to predict. Our bureau partners report a slowing rate of decline in scoring volumes but not yet a recovery. We are beginning to see the effects of deterioration in the credit card space which cuts both ways for us. Banks are consolidating or closing part of their accounts which hurts our transactional revenue, but their also looking for help in places share of law growth, credit line management and pre delinquency management.

We continue to view the scoring segment as a decent proxy for the health of the U.S. economy and our scoring revenue as an indicator of this [inaudible] and believe that our scoring volumes, revenues and margins will recover as the general economy does, while we are pursuing additional tactics now to increase scoring usage even in this environment.

In applications, we're pleased with markets favorable reception to our latest fraud offerings and to our new retail action manager product which significantly advances the use of marketing analytics in retailing.

We're already making good progress in converting a pipeline of over $200 million for these products into new signed business. Application sales cycles remain long and new deployments take several months before they generate new transaction revenue, so our revenue ramp from these applications will be gradual.

In tools, we're optimistic about our prospects because of the strength of our product lineup and a growing set of distribution channels. The latest versions of our rules engine and express optimization tools lead the industry in terms of performance and functionality and we're building solid distribution relationships with OEM and system integration partners for these tools.

In summary, the overall market and our own business both appear to be moving sideways.

Now the guidance going forward. Although we're encouraged by clients' reaction to our new products, our visibility into their spending intentions remains limited so we are not yet able to provide revenue guidance.

Given our focus on managing costs to earnings, we are able to continue providing guidance on expenses. We previously guided fiscal '09 operating expenses would total $525 million excluding restructuring charges. In light of the sale of our Telecom product lines, and our ongoing engineering initiatives, we're revising that operating expense guidance to $505 million, an improvement of $20 million. This implies operating expenses of $122 million in the current fourth quarter.

Let me conclude with a perspective on FICO standings at this pivotal time in the financial services industry. I believe that FICO is uniquely positioned at the corner Main Street and Wall Street if you will. Our consumer offerings play well on Main Street in these challenging times.

As one example, our mortgagereliefonline.com website has drawn 130,000 visits from homeowners seeking assistance with loan modification with 4,000 modifications completed so far and an epic 10,000 in process.

At the same time, our decision management scores applications and tools are more relevant than ever to Wall Street. That is to the banks trying to manage risks and improve profitability. This is demonstrated by the strong pipeline we referred to earlier.

So we see plenty of evidence that the decision management offerings are relevant to both consumers and businesses. We also value the trust that we've earned through decades of providing objective, analytical insight into credit and risk management issues.

The FICO brand is the gold standard in this environment and we work hard to be good stewards of that brand. Part of that stewardship was rebranding the entire company earlier this year from Fair Isaac Corporation to FICO, a name by which we are best known in the market.

We'll be extending that concept next month as we change our New York Stock Exchange ticker at the close of trading on August 17 from our three character ticker FIC to a new four character, FICO. As of August 18, we will continue to trade on the NYSE with this new four character FICO ticker.

[inaudible] for our long terms prospects, I remain confident that FICO has the products, talent and market opportunity to be a strong growth company. We do need to see an end to this recession and resumption in IT spending in order to fully realize this growth potential.

Since such a recovery is not yet apparent, in the interim, we're managing expenses to protect earnings while still investing in our scoring application and tools businesses. We'll provide further updates on those investments and on our growth prospects on our next call in November which occurs shortly after the start of our fiscal 2010 period.

John, back to you now for a Q&A period.

John Emerick

This concludes our prepared remarks. We are now ready to take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Carter Malloy – Stephens Inc.

Carter Malloy – Stephens Inc.

On your scoring revenues, I'm trying to get a sense for exactly what it was in the quarter that, I know you talked a little around it, but more specifically what it was in the quarter that pushed it sequentially. I'm not really, with the weakness in the credit card industry and some of your competitors not doing that well, I just wanted to get more color around that.

Mark Greene

Two primary drivers. One, a lot of that is normal seasonality. The quarter just ended is typically stronger than the quarter before and second, within that we saw more than usual improvement in the mortgage space due to refi activity as interest rates fell below 5%. You know there was a big spike in refi activity at that time.

Carter Malloy – Stephens Inc.

Your expectations are that you'll at least hold the line there, assuming the economy.

Mark Greene

The last part on the mortgage refi, is your guess. We see strong indications that 5% is the magic threshold. When rates are above that, refi could fade away as it did for the last couple weeks of the quarter, so your guess as to where rates are going and that will tell you where the mortgage part of our business is going, although it's not a huge lever. Mortgage is between 10% and 15% of our scoring business. We're much more based in the credit card segment where there are ongoing challenges.

Carter Malloy – Stephens Inc.

So with card issuance down where it is now, there is a lag effect there. I would kind of expect it to have an effect on that segment going forward, right?

Mark Greene

I think that's right although there are puts and takes there. Clearly the diminished level of credit activity is negative. What's a modest positive in the card space is the movement by many banks to more frequently FICO scores to reflect closer to real time to help their consumers, so that's helping the scores as the [inaudible].

Carter Malloy – Stephens Inc.

And have you identified how big an opportunity you think it is, the direct consumer piece within the banking side?

Mark Greene

We have big hopes but I'd rather not comment on those hopes until we see some traction as the product rolls out. So a significant market opportunity, we need to get a couple of months of experience under our belt to see what kind of penetration we get in that opportunity.

Carter Malloy – Stephens Inc.

It's strange what you said with the credit card companies checking more. It's strange that the collections and recovery was down and yet your precision marketing was up. It seems kind of the opposite of what everyone else has been experiencing.

Michael Campbell

I think some of the main driver was a very large deal that was comparable in the same period last year. Our collections and recovery business and pipeline continues to be strong for obvious reason.

Mark Greene

It was a difficult compare.

Carter Malloy – Stephens Inc.

On the flip side of that, precision marketing being up, what was the driver of that?

Michael Campbell

We're staring to have customers come online from a transaction perspective on some of these new products, so that's driving revenue up.

Operator

Your next question comes from [Mike Latimore – Northland]

[Mike Latimore – Northland]

On the myfico.com, do you feel like that's at a kind of normalized or stabilized rate now after the quarter post Experian exchange?

Mark Greene

I think that's right. On the Experian matter, of course we would love to see them return to that business. We continue to believe that consumers are best served if they have the ability to assess all three forms of their FICO score in one site which is what myfico was designed to do.

So we're hopeful that we can get that back, but until that time I think we're operating at about the right level of business.

[Mike Latimore – Northland]

In terms of the change in cost outlook for the year, $20 million difference from last quarter, how much of that relates to the telecom sale?

Mark Greene

That's a small part actually. It's more just having more visibility on where our expense efforts are coming and based on our actual third quarter experience. There's some impact there and that's rolled in, but it's not a huge number.

[Mike Latimore – Northland]

The quarter ago when you were at $525 million for the year, you gave some color, but what is the major change over the last few months here that would cause you to want to lower expense outlook a little bit more?

Mark Greene

We just kept real good traction on all the expense efforts, and we've had less people around. There's less travel. [Inaudible] both airfares and hotels. We've been able to renegotiate our communications and some of our infrastructure contracts which not only provide ongoing benefit but impact our accruals going forward.

Less outside consulting fees, is just almost good news every time we turned around when it came to expenses this quarter. So I don't think all of that play directly through in the run rate, but a big part of it plus a couple of million dollars on the Telco assets leads us to the new guidance.

[Mike Latimore – Northland]

You mentioned from optimism around the fraud management product and the insurance management product, does that give you, should we kind of expect the bookings to be stable or even grow a little bit based on that?

Mark Greene

I think we feel very good about the bookings future. There is a question of timing on that. When you're sitting as we are with $200 million of opportunity and very quality stuff there and significant transaction sizes, quite a few number of sizes and $50 million transactions, we're optimistic that as listing comes good, the booking will take off and so will revenue.

But I am cautious still on timing. In this environment it's very difficult how quickly these opportunities, our clients are all going through additional budget reviews and approval cycles so it's difficult to say how quickly that pipeline will convert into true bookings and revenue.

[Mike Latimore – Northland]

And the tax rate for the fourth quarter should be closer to that 30% to 31% range, is that right?

Thomas Bradley

It should be close to the year to date range, correct.

Operator

Your next question comes from Michael Nemeroff – Wedbush Morgan.

Michael Nemeroff – Wedbush Morgan

Did you mention headcount? I think I missed that if you did.

Mark Greene

We did not mention it but it's 2,150 I believe, right about that number.

Michael Nemeroff – Wedbush Morgan

And that compares to what last quarter and the previous Q3. Do you still have a buy back program in place and what's still left on that if there is one?

Mark Greene

There is a buy back program still in place with $148 is our authorization. We haven't repurchased any shares in over a year but we were active prior to that, but that authorization remains intact.

Michael Nemeroff – Wedbush Morgan

You're selling off a bunch of the different assets and I see that and it makes sense. You're getting back down to the core. Could you give us a sense of what the organic growth rate was of the businesses that remained when things were good? So what kind of a normalized growth rate should be expect out of the units and the business lines that remain currently versus what they were a couple of years ago.

Mark Greene

There is a question about whether the history that I'm about to cite is reflective of the reality we're in now, so to answer the question whether we have a new reality or whether we have a temporary detour of the old reality, but we used to believe that the organic growth rate of our four core industries was on the order of 7% to 10%.

That still feels right to me at some point in the future, but clearly not today. So I guess I'd have you model the [inaudible] version of our business that we're meant to go in that range. But I wouldn't want to give you a date quite yet.

The question on head count, I can read three numbers for you on headcount. Fourth quarter '08 number was 2,480. Second quarter of '09 was 2,183 and third quarter of '09 was 2,142.

Michael Nemeroff – Wedbush Morgan

Of the $49 million of the new bookings, how much of that was brand new bookings and how much of that was renewal of existing contracts?

Thomas Bradley

$49 million is the net new bookings number.

Michael Nemeroff – Wedbush Morgan

I know it's net new, but I assume that renewals count as a new booking when you resign it, no?

Thomas Bradley

Those do not count as new bookings.

Michael Nemeroff – Wedbush Morgan

The revenue and expense breakdown of the liquid credit in Romax business, you said $5 million a quarter for both of them. Is it about evenly split on the revenue and what was it doing in expenses? Was it a profitable business?

Thomas Bradley

The revenue was roughly split. It generated profit. At one point on a direct basis, expenses in the $2 million to $3 million per quarter.

Operator

Your next question comes from Carter Malloy – Stephens Inc.

Carter Malloy – Stephens Inc.

Last quarter, the lumpiness of that business [inaudible] $13 million run rate on revenues. Do you feel comfortable with the pipeline on express authorization that you will be able to maintain that $12 million to $13 million type range?

Thomas Bradley

We are confident in our pipeline at this stage. We're also making some very strong moves in the channels as well so we're working to sign up additional people around the globe to help push those products. So we're confident in those numbers.

Operator

This concludes the questions. If you have additional questions, you may do so or I'm turning the call back over to Mr. Emerick.

John Emerick

Thanks very much and we'll look forward to our call in November.

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