First American Financial Corporation (FAF) Q3 2015 Earnings Report, Transcript and Summary

Greetings, and welcome to the First American Financial Corporation's third quarter 2015 earnings conference call. [Operator Instructions] A copy of today's press release is available on First American's website at www.firstam.com/investor. Please note that the call is being recorded and will be available for replay from the company's Investor website for a short time by dialing 877-660-6853 or 201-612-7415 and enter the conference ID 13621641. We will now turn the call over to Craig Barberio, Director of Investor Relations, to make an introductory statement. Please go ahead, sir.

Good morning, everyone, and thank you for joining us for our third quarter 2015 earnings conference call. Joining us on today's call will be our Chief Executive Officer, Dennis Gilmore; and Mark Seaton, Executive Vice President and Chief Financial Officer. At this time, we'd like to remind listeners that management's commentary and responses to your questions may contain forward-looking statements, such as those described on Pages 4 and 5 of today's news release, and other statements that do not relate strictly to historical or current fact. The forward-looking statements speak only as of the date they are made, and the company does not undertake to update forward-looking statements to reflect circumstances or events that occur after the date the forward-looking statements are made. Risks and uncertainties exist that may cause results to differ materially from those set forth in these forward-looking statements. Factors that could cause the anticipated results to differ from those described in the forward-looking statements are also described on pages four and five of today's news release. Management's commentary contains and responses to your questions may also contain certain financial measures that are not presented in accordance with Generally Accepted Accounting Principles, including adjusted earnings per share, adjusted pre-tax margin, personnel and other operating expense ratios and success ratios. The company is presenting these non-GAAP financial measures, because they provide the company's management and investors with additional insight into the operational efficiency and performance of the company relative to earlier periods and relative to the company's competitors. The company does not intend for these non-GAAP financial measures to be a substitute for any GAAP financial information. In the news release that we filed today, which is available on our website, www.firstam.com, the non-GAAP financial measures disclosed in management's commentary are presented with and reconciled to the most directly comparable GAAP financial measures. Investors should use these non-GAAP financial measures. With that, I'll now turn the call over to Dennis Gilmore.

Thanks, Craig. Thanks for joining our call. Today I'll review our third quarter financial and operating results, provide an update on the impact of the new integrated mortgage disclosure rule and conclude with a few comments regarding our outlook. Overall, our financial results this quarter were strong, as our title segment continue to generate solid operating leverage and revenue growth. Revenues in the third quarter were $1.4 billion, up 10% from the same quarter last year. The increase was primarily driven by strength in our purchase and commercial businesses. After adjusting for net realized gains and losses, earnings per share this quarter were $0.71 compared to $0.65 for the same quarter last year. We benefited from strong purchase closings throughout the quarter, driven by a healthy spring selling season. In the third quarter, revenues in our purchase business were up 14%, driven by increases in both closed orders and the average fee per order. While our open purchase orders are following the typical seasonal decline through September, they are up 5% compared to last year. And through mid-October, they continue to be up 5%, demonstrating the ongoing strength of the housing recovery. Open orders in our refinance business were down 7% on a sequential basis. During the quarter, a modest decline in interest rates caused refinance orders to increase to 1,700 orders per day by September, and they have remained at that level through mid-October. Our commercial business continues its strong performance in the third quarter, with revenues up 15% compared to the same quarter last year. Average revenue per commercial order was up 10%, driven by an increase in the average transaction size and the number of large transactions closed. After adjusting for net realized gains and losses, our title segment's pre-tax margin was 10.9% compared to 9.4% last year. During the third quarter, we continue to benefit from improved market conditions and our ongoing focus on expense management. Our success ratio was 49% during the third quarter and year-to-date we are at 51%, significantly better than the 60% we set for an increasing revenue environment. Revenue in Specialty Insurance segment was $101 million, up 7%. However, pre-tax income declined due to higher claims. Our home warranty business was impacted by higher seasonally related claims. And our property and casualty business incurred higher losses, primarily as a result of the recent large wildfires in northern California. As we discussed on our last call, we continue our focus on implementation of new integrated mortgage disclosure rule, which became effective October 3. At this stage, it's too early to evaluate the rule's ultimate impact. We still anticipate temporary delays in closings throughout the remainder of this year, and potentially the early '16 as industry participants adapted required changes. As more of these transactions close throughout the fourth quarter, we'll have a better assessment on the overall impact of the new disclosure rule. As I previously stated, I believe this new environment presents an opportunity for First American as a settlement service provider that's prepared to deliver the highest quality work. Looking forward, we remain optimistic. The improving economy increases our confidence and the outlook for sustained growth in the purchase market as we enter 2016. Our commercial business continues to show strength, as we enter the seasonally strong fourth quarter. As the housing market continues to improve, I believe the company is well-positioned to deliver strong financial results, creating long-term value for our shareholders. Now, I'd like to turn the call over to Mark.

Thank you, Dennis. Total revenue in the third quarter was $1.4 billion, up 10% compared with the third quarter of 2014. Net income was $76 million or $0.69 per diluted share compared with net income of $81 million or $0.74 per diluted share in the same quarter of last year. After adjusting for realized gains and losses, earnings per diluted share was $0.71 compared with $0.65 in the prior year. In addition, the third quarter of 2014 benefited from certain non-recurring tax benefits, which contributed to a 30% effective tax rate. In the Title Insurance and Services segment, direct premium and escrow fees were up 11% compared with last year. This growth was driven by a 3% increase in the number of direct title orders closed and a 10% increase in the average revenue per order. The average revenue per order increased to $2,119, driven by higher average fees for both commercial and purchase orders. The average revenue per order increased 10% for commercial transactions and 7% for purchase transactions. We continue to see a large number of commercial deals closed, as well as higher residential housing prices, which has had positive effects on our average revenue per order. Agent premiums were up 16%, reflecting the normal reporting lag in agent revenues of approximately one quarter. The agent split was 80.2% of agent premiums. Information and other revenues totaled $162 million, up 1% compared with last year. Higher demand for certain other companies' non-insured services and products was partially offset by lower demand for the company's default information products. Personnel cost was $380 million, up 10% from the prior year. This increase was primarily due to higher incentive-based compensation driven by the improvement in revenues and profitability. Other operating expenses were $202 million, essentially flat versus last year, despite a 4% increase in open orders. Higher temporary labor costs were offset by lower production-related expenses. The ratio of personnel and other operating expenses to net operating revenue was 72.3%, an improvement from the 74.5% we posted in the third quarter of last year. The provision for title policy losses and other claims was $72 million or 6.5% of title premiums and escrow fees compared with a loss provision rate of 6.7% in the same quarter of 2014. Pre-tax income for the Title Insurance and Services segment was $137 million in the third quarter compared with $121 million in the third quarter of 2014. Pre-tax margin excluding realized gains and losses was 10.9% compared with 9.4% last year. Turning to the Specialty Insurance segment, total revenues were $101 million, up 7% compared with last year driven by higher premiums earned in both the property and casualty and home warranty business lines. The loss ratio for this segment was 69%, an increase from the 60% we experienced last year. Both, our property, casualty insurance and home warranty businesses had higher claims we experienced this quarter. Our property and casualty business incurred $3.5 million of home owner insurance claims related to wildfires in northern California during September. The fire has caused nine policy limit losses and we don't expect to incur any additional losses as a result of this event. In our home warranty business, the loss ratio increased from 65% from 59% in the third quarter of 2014, due to higher claim frequency as well as higher contract servicing cost. We experienced unusually low-claims activities in the third quarter of 2014 and the loss ratio in home warranty this quarter reflects our typical third quarter claims experience. Pre-tax margin for the segment was 2% versus 11% in the prior year. Net expenses in the corporate segment were $23 million, up $8 million relative to the prior year. Most of this increase is related to lower investment income and higher interest expense from our senior notes offering that closed in November 2014. The effective tax rate for the quarter was 34.3%, higher than the 30.2% tax rate in the third quarter of last year. This quarter's tax rate was in line with our expectations, while the tax rate last year benefitted from certain non-recurring tax items related to our foreign operations. In terms of cash flow, cash provided by operations was $185 million versus $121 million in the third quarter of last year. The increase was primarily due to a reduction in working capital and higher cash and earnings. Capital expenditures were $32 million, up from $26 million in the third quarter of last year. Increases in fixed assets, title plants and capitalized data were partially offset by decline in capitalized software. Debt on our balance sheet totaled $585 million as of September 30. Our debt consists of $549 million of senior notes, $31 million of trustee notes, and $5 million of other notes and obligations. Our debt-to-capital ratio as of September 30 was 18%. I would now like to turn the call back over to the operator to take your questions.

[Operator Instructions] Our first question today is coming from Jeremy Campbell from Barclays.

So you guys mentioned potential delayed closings due to TRID, given that you start booking expenses when the orders opened and booked the revenue when orders closed, if TRID along HC closing timeline, should we expect pressure on your margins heading to the fourth quarter?

If that happens, yes, we would expect margin pressure, just as you mentioned. Typically, it takes about 60 days to close a purchase transaction and roughly 45 days to refinance transaction. And so obviously, if those timeframe gets extended, our revenue will be delayed and we won't have a corresponding delay in expenses, so if there is a significant impact in TRID or you'd think our margins would settle in the fourth quarter.

And you said, do you think maybe the delays where we're back to normal some time early 2016, is that you guys mentioned on the call earlier?

Again, I think the rule went into effect on October 3, so first couple of weeks no impact to us at all, actually have been very smooth for us, we're ready to go. We'll start to see the majority of our closings happening mid-November, late-November and that's when we get the real full impact of the rule. So I do think that there will be some temporarily delays in closings in fourth quarter, potentially into the first quarter. And that is simply just because of industry participants getting used to the new processes. And basically, like I mentioned on my script too though, I actually view this as a great opportunity for us. We're ready to go, our people are ready to go, and our systems are ready to go. So I think it's actually an opportunity for us as we get through these changes.

And then we can see very large commercial transactions. Blackstone recently just bought that big Stuyvesant Town apartment complex here in New York for a little over $5 billion. Do they have to get a title policy on that? And if so, how would they think to split it up between the different title insurance companies?

Well, the answer specifically on that transaction will be, yes, and we'll actively try to get our piece of that. How they will typically split it up is depending on the size, they will look for potentially a number of insurers to participate.

And does that usually close in one big chunk or like a series of different closing over time?

That would depend specifically on a transaction, the details of that transaction.

Our next question today is coming from Bose George from KBW.

On the Specialty Insurance segment, what can we think about for a good normalized loss ratio going forward? And then can you also just talk about the seasonality of that?

The quarter was a difficult quarter for us simply because we had two events happening. We had the unique wildfire in northern California. They cost us about $3.5 million in our property and casualty business more than our normal loss rate. On home warranty, we had two issues happened. The performance the year before was seasonally a strong force. We had a mild summer. This year, we've had more of a normal summer. And always our third quarters are most difficult or are most stressed quarter for that home warranty business. So I think we probably dropped back in the normal loss rates for home warranty for the third quarter and we'll spring high back in the fourth and first.

And in terms of the normalized loss rate for the specialty segment, Bose, on annual basis it's typically between 56% to 58% annually. But obviously, there is a lot of seasonality in that rate.

Actually, just in the corporate segment, the pre-tax income there this quarter, is that a good run rate going forward?

Yes, that is a good run rate. We had a $23 million loss in corporate. That was basically what we had in Q2, little bit less, but that is a good run rate going forward.

And then just one on the fee per file, this and that category was up a fair amount year-over-year. I'm just curious what drove that and just what's in there other than the default category?

Most of it is default related -- over half of its default. We do have some other ancillary products, but we sort of think about it as a default. There's some timeshare business we have and some other products, but it's mainly default and timeshare.

So that 670, I mean could that sort of go back to where it was the last couple of quarters?

It could. I mean, we saw a little bit of unusual number there this quarter. And I don't think that's sustainable going forward.

Our next question today is coming from Eric Beardsley from Goldman Sachs.

Just wondered, if you could talk a little bit about potential growth in the information and other segments, that you've launched several new products there? And if there's anyway for us to think about year-over-year growth rates moving forward?

Right now it's going to be fairly minor. What we're really doing right now is building out our databases to support our core title business. We actually think we have achieved a very unique public record database now and so we're helping. It displays our external vendors for title right now. And then the second thing is we're going to continue to build out some products and services for our lender basis, but it will be more of a moderate growth over the next year or so.

Are there any trends you can share for October? Sorry, if I miss them.

Well, orders were up 5% on a year-over-year basis right now, so it's continuing to perform strong on order basis.

And is there any mix in terms of purchase refi trends?

Not really. On an annual basis, our purchase orders are up 5% and our refinance orders are up 8%. So there hasn't been a whole a lot of movement in terms of the mix, just in October.

In terms of commercial, have you seen any knock-on effects from any slowdown in transactions, as we came later into the quarter?

No. We're continuing to run strong, business was up 15% from the year ago, continuing to perform well across our space and across our product type. So I think that that will continue to have a strong fourth quarter going into '16 also be a good year for us.

Our next question today is coming from John Campbell from Stephens.

Hey guys, its Hayden Blair sitting in for John Campbell. I had just a couple of questions, maybe longer-term as far as TILA-RESPA Integrated Disclosure. Do you guys see any opportunities there to potentially improve agency retention rates? And is there maybe also some M&A opportunities available post this regulation?

It's probably premature to make those calls right now. Again, the rule is brand new. We really won't see the full impact of it until, again, we typically get well into the fourth quarter. But at just at the highest level, I just think it's an opportunity for First American. I do think it may present some acquisition targets, but only if it makes sense to us and if it's in the right locations. Again, I must say the same thing, I think it's an opportunity for a company like First American, as we operate in this new compliance oriented environment.

And then, the MBA recently put up their numbers for both '17 and '18, seems like a pretty steady $1.3 trillion market. Is that kind of a normalized market that would still allow you guys to do a 10% to 12% title pre-tax margin or because that's lower than this year's originations, would you expect that to be on maybe the lower end of that range?

We're still sticking with our current guidance of 10% to 12%, and we think that market will support that.

So our next question is coming from Kevin Kaczmarek from Zelman & Associates.

I guess going to back to the information segment, I know that business can be affected by refi and default activity. But assuming those normalize at some point, what's sort of a core growth rate excluding fluctuations in those two items for the information and other?

It's difficult to say, Kevin. On the one hand we have products that we sell, they're doing information and other, like property reports and other types of things that are tied to mortgage originations. So there's a big component just tied to mortgage originations in the U.S. As you know, there is the default-related business, which has its own cycle. We also have a lot of our international businesses in information and other item, which has its own cycle. And then, finally, we have our data and a title plan business fits in there, and we select that business as sort of on the early stages of the long-term growth trajectories. So when you mix all those together, it's difficult to pinpoint what a growth rate is for the overall line item, because there is just so many different drivers.

And then, in terms of TRID, I heard your comments before about it being related to -- although it took a little long-term impact. But I guess, is there a minimum size, an agent needs to be, to operate in the new environment? I mean, I would expect some consolidation on the agent side. But can you give us a sense of how big an agent needs to be now?

I don't think it's driven by a size component. It's actually driven by the necessary compliance to be TRID readiness. That it's the readiness at all, until then have the comfort with the lenders. So I don't think it's driven by size, I just think it's driven by the actual performance of the individual agent.

And lastly on the provision, how long do you think you're going to keep that at 6.5%?

Our expectation now is through the end of the year. And it was consistent with what we've been saying really at the beginning of the year is we booked 6.5% this quarter, we booked 6.5% in Q1 and Q2. Based on everything we're seeing right now, we expect to book 6.5% in Q4, assuming claims come-in in line with our expectation, and then we'll reevaluate in Q1 of next year. And I think as we sit here today, we would expect it to start drifting down back to more normalized rate beginning of next year.

Our next question today is coming from Mark Hughes from SunTrust.

Any one-timers in the operating expenses that were flat on an absolute basis year-over-year? Anything that's non-recurring or unusual in that?

This quarter, I would say, there is really nothing material in the other OpEx line. In personnel cost, we did true-up our 401(k) it was roughly about $5 million, and that had our personnel line item. But we will just consider that sort of normal operating noise. So there wasn't really anything extraordinary that we would point out.

Right, so that reduced your profits by about $5 million, is that right?

Yes.

And then, the cash flow impact, could you give us an update on what you would anticipate for 2016 reduced cash payments for losses, what does that mean for your free cash flow?

Well, we're seeing our pay claims fall, and that's happening in Q3. Our pay claims were about $50 million in title. Q3 of last year they were $57 million. So we're seeing them fall. If you're looking at kind of a year-to-date basis, our pay claims are flat in title, mainly because we paid two of the largest claims we've ever paid in our history, happened in the first half of the year. And that those two totaled $35 million. When you back that out, our year-over-year pay claims on a year-to-date basis have fall significantly. So we feel like they're going to continue to fall as we go into next year. As we talked about in Investor Day earlier this year, we feel like there is about a $50 million cash flow pick up on annualized basis, just because of the fact that our pay claims that are going to continue to fall and probably get to that normalized rate.

Our next question is coming from Ryan Byrnes from Janney.

Again, if I look at the corporate segment, this is maybe more of a mechanical question, but it shows the net investment income was negative $5 million. So I'm just trying to wrap my head around as to what that would be a pension expense, I guess the 401(k). Is that what it's coming in at?

Well, you characterized it as mechanical question, so I'll give you a mechanical answer here. So we have a deferred comp plan for certain of our employees, that's on our balance sheet. And when the assets in that deferred comp plan rise, our investment income is going to rise. And when they fall, our investment income is going to fall. But there is a corresponding increase or decrease that basically mirrors within our personnel cost. So if you look at Q2 versus Q3, our investment income was down $5 million, but our personnel cost were down $5 million. And there was virtually no change in pre-tax income. So it's really just a pass-through. If you're looking at year-over-year, our investment income was down $5 million. Our personnel cost was flat, and that's because there was another thing that was happening were in Q3 of last year, at corporate we had a roughly of $5 million pension benefit that we took. And we've had a pension plan that's been frozen for some time. There was a benefit that we took, that we didn't get that benefit of this quarter and so that sort of explains the driver there.

And then, if I may, information and other revenues were kind of down modestly sequentially, and you noted that obviously lack of the delinquent business was part of that. But I was just trying to figure out, trying to size that that type of book annually, what that would be? And then obviously, we would think that that would continue to be a pressure going forward? Just if you guys could help us size what that book currently is?

Annually in the information and other line item, it's roughly about $80 million a year of revenue on an annual basis.

Our next question today is coming from Jeremy Campbell from Barclays.

Just one quick follow-up here. As we sort of think about the commercial market, and still try to kind of size that up as far as transactions go, when a company like Blackstone buys like a REIT or hotel company, does title need to be done on an underlying properties or not, because they're just basically buying the corporate equity?

Typically, there is title insurance involved in those types of transactions, typically.

Our next question today is coming from Jason Deleeuw from Piper Jaffray.

You've got Eric Robinson on for Jason. My first question relates to the higher personnel costs in the quarter, due to the incentive compensation. Should we view this is kind of a new expense run rate going forward or is that more one-time?

Well, I would say, we definitely increased our incentive comp and our balance expense this quarter, just because of the higher profits in revenues that we experienced this quarter, but it's typically more seasonal. So I don't think you'll see that same level heading into fourth quarter.

And then just one follow-up here, have you guys started to notice any weakness in energy related states like Texas?

It's starting to happen right now in Houston and North Dakota. We think that that will continue to show weakness going into '16, but I should point out that is not a significant part of our commercial business.

There are no additional questions at this time. End of Q&A