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5/3/2002
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Taking Stock: Fair, Isaac's Purchase Of HNC Makes Sense Where Credit Counts

Cross-selling opportunities between the companies abound.

Have you recently been turned down for a credit card? Or maybe you didn't get the home refinancing you recently applied for and wonder who disqualified you? Look no further. You can start throwing stones at the right party, and it's not your local bank branch. It's most likely Fair, Isaac and Co. (FIC-NYSE).

What made me notice Fair, Isaac again was the headline last week that the company is acquiring HNC Software Inc. (HNCS-Nasdaq). It's nice to see a company still making money, though that shouldn't have surprised me, given all the credit-card applications that fill my mailbox.

This deal makes sense on many levels. First, the businesses are complementary. Fair, Isaac's success stems from statistically modeling and predicting consumer behavior. Its analytics let companies turn data on individuals into measures of customer risk (for example, FICO scores, the standard measure of credit risk), sales optimization, and customer profitability. After having become the de facto standard for credit scoring for most financial institutions, Fair, Isaac has expanded into other services, including marketing and account management using proprietary decision engines and automated strategy-development systems.

HNC is one of the largest providers of analytic software based on neural network applications. By using large data sets, a neural network algorithm can train itself to recognize patterns of behavior that will likely predict similar outcomes.

In the area of spotting consumer fraud, HNC has few peers. This is an important area for many financial-services companies, telecom-service providers, and government and health-care organizations. It's especially effective in areas such as managing consumer credit-card fraud risk and processing health-care claims. The potential for cross-selling HNC services to Fair, Isaac's customers is obvious.

Everyone seems to love the deal but, as most investors know, large mergers carry high risk. This is the biggest acquisition in Fair, Isaac's history. Also, to get the benefit of cross-selling, Fair, Isaac will have to cross-train a combined sales force.

Under the terms of the deal, Fair, Isaac will pay HNC shareholders 0.346 shares of its stock for every share of HNC. At current valuations, Fair, Isaac investors will own about two-thirds of the combined entity, and its CEO will be Tom Grudnowski, Fair, Isaac's current CEO. The deal is expected to close in the third quarter.

Management expects combined 2003 revenue to be around $690 million. In the last fiscal year for Fair, Isaac (September) and HNC (December), revenue was $329 million and $227 million, respectively. Management estimates sales will rise from the combined $556 million to $690 million within two years--a low-teens compounded growth rate in a slowly recovering economy. Based on about $35 million in annualized cost savings, management projects 2002 earnings per share of about $2.85. Before the merger, Fair, Isaac was expected to earn about $2.39 per share, ending September 2002, up from $2 last year. HNC was expected to earn about 51 cents per share in 2002.

At the conversion ratio of the deal, the value for HNC shareholders would be $19.29, based on Fair, Isaac's price of $55.74. This is only a 1% premium to the current $19.12 price of HNC. Clearly, the market thinks there's little chance the Securities & Exchange Commission and Justice will block the deal.

Oh, yes, valuation. The Standard & Poor's 500 multiple is currently 21.4 times forward 12-month earnings-per-share estimates, so let's assume the new company gets at least that high a market multiple. Meanwhile, the S&P 500 is projected to grow at 7%, while the combined company is growing in the low-to-mid-teens. The valuation at a market multiple is $61 (21.4 times $2.85) by year's end. Not a huge upside (+11%), but it looks a lot better than a few of the other names that have been tossed around lately. Let's hope that all those neural networks will result in a steady level of appreciation.

William Schaff is chief investment officer at Bay Isle Financial LLC, which manages the InformationWeek 100 Stock Index. Reach him at bschaff@bayisle.com.


To discuss this column with other readers, please visit William Schaff's forum on the Listening Post.

To find out more about William Schaff, please visit his page on the Listening Post.

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